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0.
Introduction
Microeconomics assumes that market equilibrium, that is when
supply equals demand, is the optimum economic outcome. Under these
conditions, the willingness of consumers to pay equals the willingness of
producers to supply. Everyone is happy.
As we will see later if market equilibrium
conditions do not exist, there is market failure and, from an economics
perspective, a legitimate
reason for government to intervene. There
are times, however, when even though market equilibrium exists a
government may decide it is, rightly or wrongly, in the public interest to
intervene. Five interventions are considered:
1. Housing Market
a)
Natural Disaster
Consider the case of a natural disaster that
significantly reduces the housing supply (P&B 4th Ed. Fig. 7.1;
5th Ed. Fig. 6.1; 7th Ed not displayed). Assuming the population remains constant, that
is the disaster causes only a loss of property not of life, then the
short-run supply of housing shifts up to the left reflecting a decrease in
supply and an increase in price. Overtime, however, higher prices
encourage new construction that eventually shifts the supply curve back to its
original equilibrium position.
Assuming that the cost of construction remains constant there
is also a long-run supply curve of housing - a mix of private homes and
apartments or condos. Movement along this long-run supply curve reflects
growth in demand caused by increased population. All things being equal,
the initial short-run equilibrium before the disaster reflects the point on the
long-run supply curve corresponding to the existing population. As
population grows the short-run demand curve will tend to shift out to the right
with price remaining constant, again assuming construction costs are constant.
b)
Rent Control
Part of the short-run adjustment process involves price, that is, if demand
exceeds supply, prices will tend to rise. In the case of rental property,
which tends to be the type of housing available to the poorer members of a
community, a price rise takes the form of rent increases. If
government decides for reasons of vertical equity (unlike treatment of persons
in unlike situations) that the poor need to be protected from rent increases (or
for political reasons, there are more poor voters than landowners) then it may
impose rent controls in the form of a rent ceiling (P&B 4th Ed. Fig. 7.2;
5th Ed. Fig. 6.2; 7th Ed
Fig. 6.1 & Fig. 6.2).
In effect, rent control imposes a price which is less than that determined by
the market. This means that demand (the willingness of consumers to pay)
exceeds the supply (the willingness of producer to supply). This
results in a housing shortage. Because demand exceeds supply yet price can
not increase other forms of behaviour take the place of a price increase.
For example, given a shortage:
i
- consumers must search harder and harder to find supply when it does
become available. Search activity is costly; and/or,
ii - consumers will 'bribe' supplier, for example, by paying more 'on the side';
by accepting little or no maintenance or support services; by accepting 'run
down conditions'.
The effect of rent control is to reduce the return to suppliers. If they
cannot cut back production directly they may do so indirectly. First, new
rental accommodation will not be built which, if population continues to grow,
accentuates the shortage. Second, existing rental property will be allowed
to 'run down', eventually into 'slum condition'. With excess demand and a
fixed price, the supplier can recoup his or her opportunity cost by running the
building down until it is uninhabitable, then tear it down and build private
homes or condos for sale on an open and competitive market without price
controls. This again accentuates the housing shortage.
2. Labour Market
a) Labour Saving
Technological Change
Assume that the labour market for low-skilled workers is in equilibrium (P&B 4th Ed. Fig. 7.4;
5th Ed. Fig. 6.; 7th Ed not displayed). The demand for labour (what producers are willing to pay)
equals the supply of labour (what workers are willing to accept). A new
labour saving technique is innovated causing the demand curve to shift down to
the right. The wage rate falls. As the wage rate falls the
number of workers willing to accept the wage declines eventually shifting the
supply curve up to the left until market equilibrium is restored. The
process of adjustment can take a great deal of time, however.
b)
Minimum Wage
Low wages for unskilled labour may create a question of vertical equity (or
political reasons). Government may decide that with such low wages
unskilled workers cannot support themselves, their children and/or other
dependents above the 'poverty line'. Accordingly government may intervene
by establishing a 'minimum wage rate'.
If this rate is below market equilibrium rate such a minimum has no real
effect. If, however, it is above the market equilibrium price (P&B 4th Ed. Fig. 7.5;
5th Ed. Fig. 6.5; 7th Ed
Fig. 6.3 &
Fig. 6.4) the supply of willing workers exceeds the demand of producers. As
in the case of rent controls, if the price cannot adjust, other forms of behaviour will evolve. For example, some workers will offer to work some
hours 'off the books'.
3. Taxation
To
finance public spending (a pleasure), government must raise revenue through
taxes (a pain). This pleasure/pain of public finance is described in the
Introduction: The Pleasure & Pain of Public Finance to my paper "A
Radical Analysis of 'Personal' Taxation." An increasingly important
source of tax revenue is sales tax, for example, the GST and provincial sales
tax. The question arises: who pays the tax? Is it the consumer or
the producer or both?
Consumer demand does not change if a sales tax is imposed. The demand
curve reflects the quantity of a good or service consumers are willing to buy at
a given price. If the price goes up, one slides up the demand curve; if
the price goes down, one slides down the demand curve - all things being
equal. Accordingly, to the consumer the real price of a good is its retail
price plus any associated taxes.
A sales tax does, however, shift the supply curve up to the left.
Producers are willing to supply a certain quantity of goods or services if the
receive a given price. With sales tax, such goods and services are offered
for sale at a higher price (P&B 4th Ed. Fig. 7.6;
5th Ed. Fig. 6.6;
7th Ed Fig. 6.5). The supply curve shifts and a new
equilibrium is established at a higher price and a lower quantity than before
the tax.
As to who pays the tax, the answer depends on the elasticity of supply and
demand. If there is perfectly inelastic demand, for example for a
'necessity', the demand curve is vertical (P&B 4th Ed.
Fig. 7.7a; 5th Ed. Fig. 6.7;
7th Ed Fig. 6.7) In this
case the consumer pays the full tax. If, on the other hand, demand is
perfectly elastic ((P&B 4th Ed. Fig. 7.7b;
5th Ed. Fig. 6.7;
7th Ed Fig. 6.8), then the producer pays the whole tax.
In the case of supply elasticity, the situation is reversed (P&B 4th Ed. Fig. 7.8;
5th Ed. Fig. 6.8;
7th Ed Fig. 6.9). If supply is totally inelastic, that is the supply curve is
vertical, then the supplier bares the full tax. If supply is perfectly
elastic, however, the consumer will pay the tax
4. Prohibited Goods
While some goods like recreational drugs are illegal and hence prohibited, the
remains that a market exist, that is there are buyers and sellers. To
understand the effect of prohibition, we begin with market equilibrium assuming
no prohibition (P&B 4th Ed. Fig. 7.10;
5th Ed. Fig. 6.10;
7th Ed Fig. 6.13). A prohibition affect both demand and
supply. It imposes penalties, that is costs, on both. The effect is
to shift the supply curve up to the left and shift the demand curve down to the
left.
5.
Agriculture
a)
Unregulated Market
Agriculture is subject to significant fluctuations in supply yet a relatively
inelastic demand, people have to eat. We begin by assuming only domestic
production is involved. In any given year, the supply is fixed and
perfectly inelastic, a harvest is the harvest is the harvest. In an
unregulated market (P&B 4th Ed. Fig. 7.11;
5th Ed. Fig. 6.11; 7th Ed not displayed), a bad harvest shifts supply to the
left. This raises prices and will actually increase revenue to the
farmer. A bumper crop, on the other hand, will shift supply to the right,
lower prices and reduce farm income.
b)
Inventories
Many agricultural commodities can be stored, that is placed in inventory.
Inventories serve to stabilize prices between growing seasons. Without
inventories the above situation applies, that is a good harvest lowers prices, a
bad harvest raises prices. Inventories reduce these price fluctuations
(P&B 4th
Ed. Fig. 7.12;
5th Ed. Fig. 6.12; 7th Ed not displayed). A good harvest can be used to increase inventories,
that is, not all output goes to market and price decreases are moderated.
In the case of a bad harvest, inventories are sold, thereby increasing supply
and reducing price increases.
c)
Price Floors
A price floor acts like a minimum wage. If the floor is
less than market equilibrium, it has no effect. If it is greater than
equilibrium price it will create a demand gap between the larger amount
suppliers are willing to provide at the floor price, and the quantity consumers
are willing to buy (P&B 4th Ed. Fig. 7.13;
5th Ed. Fig. 6.13; 7th Ed not displayed).
d) Quotas
Quotas (on eggs, grain, beef, etc.) act like a perfectly inelastic supply curve
(P&B 4th Ed. Fig
7.14; 5th Ed. Fig. 6.14;
7th Ed Fig. 6.11). If the quota output is less than equilibrium output
the price will be higher and the supply lower. This creates a supply gap
where producers have an incentive to exceed their quota. This can lead to
increased supply that forces the system back to equilibrium.
e)
Subsidies
Subsidies act like a reverse tax
(P&B 4th Ed. Fig. 7.15;
5th Ed. Fig. 6.15;
7th Ed Fig. 6.12).
The tend to shift the supply curve to the right. Output increases and
prices fall. Such
'supply-side' subsidies financially reward increased production by offering
subsidies per bushel of output or per acre planted.
This approach has led to a frightening subsidy spiral.
In effect, production subsidies reduce the final price of farm output
below the cost of production. This,
in turn, means that even efficient farmers cannot earn enough to maintain
operations. This, in turn, leads to
more subsidies that lower prices further. And,
so on and so on and so on...
For a different approach please see my "Putting
Culture Back into Agriculture"
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