PUBLIC POLICY: GOVERNMENT PROGRAMS ON SUPPLY AND DEMAND

Here we take our first comprehensive look at some policy making. Using the framework of supply and demand analysis, the role of policy in the determination of prices and quantities in a market is explored. In the case of taxes or subsidies the price the consumer pays will differ from the price the seller receives (although there is a single equilibrium quantity), and with price floors or ceilings, a single price does not result in quantity demanded equaling quantity supplied. Yet another policy - quotas - artificially imposes a quantity supplied that would result in a single quantity and price in the market. As you can see, the world of policy making in economic markets quickly becomes complex and confusing.

A General Look at Market Policy Making

When starting an analysis of government policies on markets it is important to focus on the goals of the policy makers, for tools that affect markets can be used for many purposes. In 1990, with the Federal government budget deficit spiraling even more out of control than before, the President (Bush) and congressional leaders held a budget "summit." While the focus of this meeting was to devise ways to bring down the deficit, secondary interests also played a role.

One interest group suggested that sin taxes be used. That is, any new taxes or increases should be on things like tobacco and liquor. Besides raising more revenue for the government, sin taxes would discourage the use of these products, providing secondary health benefits. Another group suggested imposing an oil import fee. While an $8 per barrel fee would raise $30 billion (Newsweek, May 28, 1990, page 52) it would also lower our dependence on imported oil. Besides, with gasoline more expensive as a result, environmentalists argued that this tax would help curb pollution.

Still further suggestions included axing bad or ineffective programs which subsidized individuals, for example cutting postal subsidies for charities (which contribute to the vast amounts of junk mail and solicitations many of us endure), railroad subsidies, and artists. Cutting subsidies for the Small Business Administration, and ranchers who graze cattle on federal lands (the user fees do not cover the full cost, so in essence it is a subsidy) has also been suggested.

All of these proposals would increase government revenues or lower government spending, and all would discourage some activity. There would be less driving and pollution with the oil import tax, fewer ranchers and small businesses and less junk mail if those subsidies were removed or diminished. What is most interesting here is that instead of focusing on how to raise revenue or close the gap, the focus is on who would be affected, and how much. Thus, we get a clear picture of multiple goals of policy making, and the complications it entails. While the focus is on closing the deficit, there is also interest on what is encouraged or discouraged.

So the first issue a policy maker must face is the purpose of the policy. If the purpose is to raise revenue, most likely a tax (under one name or another) will be imposed. The focus will be on the amount of money that the tax will generate. Alternatively, to cut costs (by reducing subsidies), again the focus will be on dollars. And a major focus is who pays those dollars, the seller or the buyer.

But often, there is the behavioral goal; to encourage or discourage some consumption. A general rule is taxes discourage consumption or actions, subsidies encourage consumption or actions. Usually, some consumption is discouraged if it has potential or real harm or undesirable characteristics. Taxes on foreign sources of oil, by making it more expensive and thus lowering the quantity demanded, remove our liability to future embargoes, where oil used as a weapon can hurt our economic well-being. Or if some activity is polluting (like burning wood in a wood stove or fireplace) making it more expensive lowers individuals propensity to burn. But some activities are considered beneficial. One reason charitable contributions are tax deductible is to encourage such contributions. Farmers are subsidized to ensure and support domestic sources of food. Local communities and states will make tax concessions or provide subsidies to new businesses to bring jobs to a community. Thus, interestingly, tax payers in one area of the country lower the cost of consumption in other areas of the country through local subsidies to bring in businesses and provide jobs. The subsidies lower the costs to the producers, which is then passed on to consumers elsewhere.

An alternative approach to encouraging or discouraging activities is direct limits. This approach is most often applied to discourage activity. For example, limits might be placed on the amount of pollution that can be produced, or on access to wilderness areas for recreational purposes through a permit system. During the late 1970s, rationing of gasoline limited its consumption. If a minimal consumption level is to be mandated (encouraging consumption) often the government must step in as a provider. Direct minimum limits are not very common.

Another possible focus of policy is to influence the price of a good. Rather than to encourage or discourage an activity, direct policies on prices usually directly benefit buyers or sellers. Price ceilings, such as rent control, are designed to directly make housing more affordable. And price floors, often on agricultural products like peanuts, barley or milk, are designed to ensure a minimum level of profit to the producers. In these cases, little attention is usually given to the overall level of the activity.

Overall government interventions in markets will usually result in one of two possible outcomes. Government interventions in markets often drive a wedge between the consumer's price and the producer's price, or drive a wedge between the quantity demanded and the quantity supplied. Along the way there are unintended consequences. Depending on the policy picked, helping some producer of a good can hurt or help a consumer of that good. And, most importantly, keep in mind that nothing is free. Even a policy that helps both sides of a market has costs. Those costs just occur outside the market, so in the market analysis they are masked.

This provides a basis for policy analysis. In the remainder of this chapter we will explore the technical effects of different policies, and then utilize the analysis again to understand goal-driven policy making. We will start with direct policies, those applied directly on price or quantity. We will then move onto the indirect policies of taxes and subsidies.

Direct Policies on Prices

The Wall Street Journal (June 13, 1990, page A15) had an interesting opinion piece about rent controls in New York City. When Jerold Ziman bought a $280,000 four story house, broken up into rent controlled apartments, a plethora of laws designed to protect tenants of apartments that have controlled rent prevented him from using the house for his family. Accompanying statistics to the story were shocking. The typical landlord of rent controlled apartments in 1985 owned one building, was an immigrant, and had an annual income of between 10 and 40 thousand dollars. Tenants of these apartments are from a different class. Rent controlled apartments are most often found in middle- and upper-class neighborhoods. So much so that a legislator (from outside New York City) introduced a bill to eliminate rent control on any family with an income of $100,000 or more. Clearly, it is not only the poor being protected here. Among those mentioned in the article as benefiting from rent control are Mayor Dinkins, ex-Mayor Koch, judges, Mia Farrow and Alistair Cooke. As a result, owners of rental property in New York City are abandoning property at the rate of 1500 units per year. Quite simply, suppliers of housing cannot make an adequate return.
 

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Price ceilings are designed pure and simple to ensure that consumers can afford a good. In figure 3.1 we show a typical market model of supply and demand. Left alone, the market would achieve equilibrium at a quantity of Q₀ and a price of P₀. If a policy maker (for some reason or another) decides that this price is too high, the result could be a legally mandated price ceiling. In New York City (and other places), for example, rapidly expanding rents provided the political muscle for rent controls.

The impacts of a price ceiling are easily seen. In figure 3.2, a price ceiling of P₁ imposes a wedge between quantity demanded and quantity supplied. Being able to get only P₁, sellers supply only Q_s units (as determined by the supply curve). But the quantity demanded is Q_d, resulting in a persistent shortage of the good. While the price is lower, consumers cannot get as much of the good as they would like. Those customers who actually get to purchase the good are better off, but some consumers, who are closed out of the market, are hurt.

The tradeoffs becomes clear as we analyze the welfare implications of a price ceiling. Recall from chapter 2 that a measure of benefits is surplus value. Price ceilings unambiguously lower the seller's surplus in the market, and have uncertain affects on total consumer's surplus.

Figure 3.3 illustrates a market prior to and subsequent to the imposition of a price ceiling. Before the ceiling equilibrium price is P₀ and equilibrium quantity is Q₀. At that point consumer's surplus is the area of the triangle abP₀, and seller's surplus is the triangle P₀bc. When a price ceiling of P₁ is imposed, the quantity demanded increases to Q_d while the quantity supplied falls to Q_s. Clearly, since you cannot buy what is not available, the quantity actually sold will be the latter, at the ceiling price of P₁. At this point seller's surplus is the (much smaller) triangle P₁dc, while consumer's surplus is the quadrangle aedP₁. The net change for consumer's surplus is area of the rectangle P₀fdP₁ minus the area of the triangle efb. So, seller's surplus falls, while the change in total consumer's surplus is uncertain.

Even if the overall change in consumer's surplus is positive, it is not clear that consumers as a group are better off. That is because we have assumed several things. First, the analysis just performed presumes that units are bought ordinally according to the demand curve. That is, the consumer with the highest reservation price buys the first unit, that with the second highest reservation price the second unit, and so on as long as the good is available. While incentives are such that such an outcome is possible, it is an unlikely one that gives an upper bound on consumer's surplus with a price ceiling. If in fact the consumer with the highest reservation price does not get a unit, but instead someone with a reservation price near P₁ gets a unit instead, actual consumer's surplus will be smaller.

Second, we have been presumptuous to compare the consumer's surplus enjoyed by those who get the good to those who do not. In fact, such comparisons - called the interpersonal comparison of utility - is a major problem of economics. While overall consumers as a group may be better, some consumers are better off (enjoying a larger surplus value) and some are worse off (losing the surplus value illustrated by triangle efb). It is difficult to establish the net gain or loss for the entire group. In the context of the Pareto concepts developed in chapter 1, the market with and without price ceilings are Pareto Noncomparable outcomes.

Price ceilings are also deficient on efficiency grounds. Recall that the total surplus value (consumer's plus producer's) gives a measure of the gains from trade. Without the ceiling the total surplus in the market was the triangle abc. After imposing a price ceiling it falls to the quadrangle aedc. There is a net loss of surplus value, called a dead-weight loss, since nobody picks it up, of the triangle ebd. Also, there are two groups of clear losers, the sellers of the good driven from the market by the artificially low price and the customers who are unable to get the good because of shortages. One group clearly gains, consumers who are able to purchase the good at the low price.

The relative distribution of gains and losses from price ceilings depends primarily on the slopes of the supply and demand curves. Overall, the potential gain in consumer's surplus for those that get to purchase the good is larger if the demand curve is steep. In panel (a) of figure 3.4 the demand curve is drawn relatively flat. Since the supply curve determines the quantity under an effective price ceiling, if price is restricted to P_c, quantity supplied (and consumed) will be Q_c. The maximum potential consumer's surplus (assuming consumers buy the good in the descending order of reservation price) is the quadrangle abcP_c. In panel (b), the same supply curve and price ceiling is matched with a steeper demand curve. Here, the potential consumer's surplus (again the area of abcP_c) is larger. Of course, the analysis is much more complicated than looking at just the potential consumer's surplus. The dead-weight loss is larger with the steeper demand curve, and the lost consumer's surplus for those consumers closed out of the market is larger as well.

Likewise, the slope of the supply curve affects the distribution of benefits and costs from a price ceiling. In figure 3.5, panel (a), the supply curve is relatively flat. A price ceiling of P_c,drastically reduces quantity from Q_e to Q_s. But if the supply curve is not so flat, as shown in panel (b), there is not so strong an effect on quantity. And, with the flatter supply curve, the net gain in consumer's surplus is apt to be negative. In both panels, the overall gain is the rectangle P_efcP_c minus the triangle bfd. In panel (a) this is negative, while in panel (b) it is positive. Finally, the dead-weight loss is much larger with the flatter supply curve, as a consequence of the larger quantity response to price.

In all the discussions on price ceiling one underlying factor is that the market is not in equilibrium - the quantity demanded exceeds the quantity supplied at the mandated price. Two outcomes often result. The first is that available goods are rationed in a manner that is not based on price. A second possible result is the occurrence of a "black market" where the good is sold illegally at a price higher than the ceiling.

Just as price ceilings are designed to assure that consumers can afford a good, price floors are intended to guarantee a minimum price to sellers of a good. Figure 3.6 shows that a minimum price above the equilibrium price results in a surplus of the good. The market would be in equilibrium if the price were P_e, in which case the quantity demanded and the quantity supplied would both equal Q_e. But with a minimum price of P_m the quantity supplied, Q_s, exceeds the quantity demanded, Q_d. In this case the consumers are the controlling factor, and only Q_d will be sold in the market. Sellers are stuck with Q_s minus Q_d units of the good. And the minimum price prevents them from lowering the price to attract new customers.

In the agricultural price supports example discussed in the previous chapter the federal government served as a purchaser of last resort. In that case, sellers were able to dispose of the surplus at the price minimum. But sometimes there is no purchaser for excess supplies of a good. One example of this is the minimum wage. If figure 3.6 were representing the market for low wage workers, the imposition of a minimum wage of P_m would increase the number of unemployed by the new excess supply in the market. Notice that part of the unpurchased supply was already in the market at a price of P_e, but there is new unsold supply of Q_s minus Q_e.

The effects on consumer's and producer's surpluses show the winners and losers from price minimums. An unfettered market, with equilibrium price of P_e and equilibrium quantity of Q_e gives a consumer's surplus of triangle acP_e and a seller's surplus of P_ecf (figure 3.7). The price minimum of P_m lowers the actual amount sold (bought) to Q_d. Maximum potential seller's surplus becomes the quadrangle P_mbef (again assuming ordinal sales based on the reservation sales price) and consumer's surplus falling to abP_m. There is a dead-weight loss of at least bce, and a transfer from consumers to sellers of P_mbdP_e in surplus value. Moreover, sellers who used to sell the good but now cannot find buyers suffer a surplus loss of triangle dce.

It is important to realize how significant these lost sales can be. In the late 1980s Congress pushed through an increase of the minimum wage, from $3.35 per hour to $3.85 per hour. The Bureau of Labor Statistics estimated that at the time there were about 2.6 million workers earning the minimum wage. The Congressional Budget Office estimated that upwards to 500,000 of those workers might lose their jobs with the increase. While those that kept their jobs clearly gained, those fired (because employers did not want to purchase the labor at the higher wage) got no benefit at all, and actually suffered a loss, from the minimum wage increase.

To what extent sales of goods really diminish from price minimums depends of the slope of the demand curve, and how much sellers who do manage to sell their goods actually gain from price minimums depends on the slope of the supply curve, much as the analysis of price ceilings and the distribution of gains and losses did. The particulars are left for an end of chapter exercise. But the conclusion is the same. Price minimums create a Pareto Noncomparable situation when contrasted to an unimpeded market. The distribution of benefits and costs indicates that buyers always lose, but there are both winners and losers on the selling side of the market.
 

Indirect Policies: Taxes and Subsidies

Probably the most pervasive and powerful tools available to policy makers for altering market outcomes are taxes and subsidies. Subsidies have the clear purpose of encouraging some activity, or helping a particular group. Taxes, however, have at least two possible goals. Usually, the mere mention of taxes brings to mind that some level of government is trying to raise revenue to support its programs. Clearly, that is one primary purpose of taxation. But another possible goal, and an effect that accompanies taxes imposed for revenue raising purposes, is to discourage the activity being taxed. For example, when the city of Spokane (Washington) International Airport imposed a $1.00 per trip tax on taxis picking up passengers at its terminal, it was expected to both generate revenues for the airport and clear up congestion at the airport's transportation plaza. In this section we will explore the impacts taxes and subsidies have on market equilibrium.

Taxes and Equilibrium

One of the easiest taxes to impose (and understand the implications of) are per unit or excise taxes. Under this form of taxation, the customer (or seller) pays a given amount for each unit of a good bought (or sold). Automobile tires, for example, used to carry a $2.00 per tire tax on every tire sold (truck tires still do). And federal liquor taxes are based on the amount of alcohol in the product, not on its price. As a result, the amount a customer pays for each unit of the good differs from the amount the seller gets to keep. The difference goes to the government.

This price difference provides the key for understanding the impact of per unit taxes. In figure 3.12 an untaxed market for a good results in an equilibrium price of P_e and the quantity sold would be Q_e. The customers pay that price per unit, and the sellers get to keep all of it. If at tax of t per unit is imposed, however, the amount the seller sees (the amount per unit the seller gets to keep) would be t less than the amount the consumer must pay. That is, if the consumer pays P_c per unit, the price the seller sees is only P_s=P_c-t. An equilibrium occurs when at the price the seller actually receives the amount supplied equals the quantity demanded at the price the consumer pays. In figure 3.12 this would be at a quantity Q_t.

Notice, at a price per unit of P_c consumers want to purchase Q_t units of the good. Sellers, who actually receive only P_s=P_c-t, will supply Q_t as well. The result is an equilibrium, with consumers paying P_caQ_t0, sellers getting P_sbQ_t0 in revenue, The difference, P_cabP_s goes to the government as taxes.

One important thing to notice is that in general the tax incidence, that is who bears the burden of the tax, is shared by both the consumers and the sellers. The price the consumer must pay is higher than the nontax equilibrium price, and the price the seller gets to receive is lower. And both suffer because the quantity has diminished as well. In terms of surplus values, the consumers surplus falls from triangle abP_e in figure 3.16 to triangle adP_c. Sellers surplus falls from triangle P_ebc to P_sec. The rectangle P_cdeP_s is tax collections, coming out of what was previously surplus value, and the triangle dbe is dead-weight loss associated with the tax.

The relative distribution of the burden of the tax, and the amount of dead-weight loss, depends on the slopes of the supply and demand curves. In figure 3.17 the supply curve is relatively steep. Imposing a tax in that market forces most of the tax burden, in terms of lost surplus value, onto the sellers. Figure 3.18 shows the same tax and demand curve, but the supply curve is relatively flat. Here, most of the burden falls on the customers. Additionally, the tax revenue generated will be larger with the steeper supply curve, and the associated dead-weight loss would be smaller. Figures 3.19 and 3.20 demonstrate the affects of demand curve slope on tax incidence and welfare loss. As the demand curve gets steeper, consumers shoulder more of the burden, tax revenues are larger, and dead-weight loss is smaller.

The intuition behind the results about curve slope hinges on the responsiveness of the quantity demanded or the quantity supplied to price, which the slope embodies. Flatter slopes indicate a high degree of responsiveness, steeper ones, less responsiveness. If a tax is imposed on a market with flat (demand or supply) curves, the change in price (upward for consumers, downward for sellers) will bring about a large change in equilibrium quantity. But steep demand or supply curves, with quantities not particularly responsive to price, do not show such large changes.

These results provide some insights on policy. More revenue is raised, and there is less effect on market quantity, if the tax is focused on goods with steep demand or supply curves. And, if the desire is for business to pay the tax, rather than consumers, the demand curve better be flatter (in an absolute sense) than the supply curve. So cigarette taxes will raise lots of revenue, but fall primarily on consumers, since the demand curve for cigarettes is very steep. And since the long run supply for agricultural products is nearly horizontal, taxes in that market would also fall on consumers.