THIS IN CHAPTER YOU WILL . . .
Examine the ef fects of government policies that place a ceiling on prices
Examine the ef fects of government policies that put a floor under prices
S U P P LY,
DEMAND,
AND
Consider how a tax on a good af fects the price of the good and the quantity sold
GOVERNMENT
POLICIES
Economists have two roles. As scientists, they develop and test theories to explain the world around them. As policy advisers, they use their theories to help change the world for the better. The focus of the preceding two chapters has been scientific. We have seen how supply and demand determine the price of a good and the quantity of the good sold. We have also seen how various events shift supply and demand and thereby change the equilibrium price and quantity. This chapter offers our first look at policy. Here we analyze various types of government policy using only the tools of supply and demand. As you will see, the analysis yields some surprising insights. Policies often have effects that their architects did not intend or anticipate. We begin by considering policies that directly control prices. For example, rentcontrol laws dictate a maximum rent that landlords may charge tenants. Minimumwage laws dictate the lowest wage that firms may pay workers. Price controls are
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Learn that taxes levied on buyers and taxes levied on sellers are equivalent
See how the burden of a tax is split between buyers and sellers
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usually enacted when policymakers believe that the market price of a good or service is unfair to buyers or sellers. Yet, as we will see, these policies can generate inequities of their own. After our discussion of price controls, we next consider the impact of taxes. Policymakers use taxes both to influence market outcomes and to raise revenue for public purposes. Although the prevalence of taxes in our economy is obvious, their effects are not. For example, when the government levies a tax on the amount that firms pay their workers, do the firms or the workers bear the burden of the tax? The answer is not at all clearuntil we apply the powerful tools of supply and demand.
CONTROLS ON PRICES
To see how price controls affect market outcomes, lets look once again at the market for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive market free of government regulation, the price of ice cream adjusts to balance supply and demand: At the equilibrium price, the quantity of ice cream that buyers want to buy exactly equals the quantity that sellers want to sell. To be concrete, suppose the equilibrium price is $3 per cone. Not everyone may be happy with the outcome of this free-market process. Lets say the American Association of Ice Cream Eaters complains that the $3 price is too high for everyone to enjoy a cone a day (their recommended diet). Meanwhile, the National Organization of Ice Cream Makers complains that the $3 pricethe result of cutthroat competitionis depressing the incomes of its members. Each of these groups lobbies the government to pass laws that alter the market outcome by directly controlling prices. Of course, because buyers of any good always want a lower price while sellers want a higher price, the interests of the two groups conflict. If the Ice Cream Eaters are successful in their lobbying, the government imposes a legal maximum on the price at which ice cream can be sold. Because the price is not allowed to rise above this level, the legislated maximum is called a price ceiling. By contrast, if the Ice Cream Makers are successful, the government imposes a legal minimum on the price. Because the price cannot fall below this level, the legislated minimum is called a price floor. Let us consider the effects of these policies in turn.
price ceiling a legal maximum on the price at which a good can be sold price floor a legal minimum on the price at which a good can be sold
HOW PRICE CEILINGS AFFECT MARKET OUTCOMES
When the government, moved by the complaints of the Ice Cream Eaters, imposes a price ceiling on the market for ice cream, two outcomes are possible. In panel (a) of Figure 6-1, the government imposes a price ceiling of $4 per cone. In this case, because the price that balances supply and demand ($3) is below the ceiling, the price ceiling is not binding. Market forces naturally move the economy to the equilibrium, and the price ceiling has no effect. Panel (b) of Figure 6-1 shows the other, more interesting, possibility. In this case, the government imposes a price ceiling of $2 per cone. Because the equilibrium price of $3 is above the price ceiling, the ceiling is a binding constraint on the market.
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(a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Price of Ice-Cream Cone Equilibrium price $3 2
(b) A Price Ceiling That Is Binding
Supply
Supply
$4 3 Equilibrium price
Price ceiling
Shortage Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones 0 75 Quantity supplied 125 Quantity demanded
Price ceiling Demand Quantity of Ice-Cream Cones
A M ARKET WITH A P RICE C EILING . In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded and only 75 are supplied, so there is a shortage of 50 cones.
Figure 6-1
The forces of supply and demand tend to move the price toward the equilibrium price, but when the market price hits the ceiling, it can rise no further. Thus, the market price equals the price ceiling. At this price, the quantity of ice cream demanded (125 cones in the figure) exceeds the quantity supplied (75 cones). There is a shortage of ice cream, so some people who want to buy ice cream at the going price are unable to. When a shortage of ice cream develops because of this price ceiling, some mechanism for rationing ice cream will naturally develop. The mechanism could be long lines: Buyers who are willing to arrive early and wait in line get a cone, while those unwilling to wait do not. Alternatively, sellers could ration ice cream according to their own personal biases, selling it only to friends, relatives, or members of their own racial or ethnic group. Notice that even though the price ceiling was motivated by a desire to help buyers of ice cream, not all buyers benefit from the policy. Some buyers do get to pay a lower price, although they may have to wait in line to do so, but other buyers cannot get any ice cream at all. This example in the market for ice cream shows a general result: When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers. The rationing mechanisms that develop under price ceilings are rarely desirable. Long lines are inefficient, because they waste buyers time. Discrimination according to seller bias is both inefficient (because the good does not go to the buyer who values it most highly) and potentially unfair. By contrast, the rationing mechanism
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in a free, competitive market is both efficient and impersonal. When the market for ice cream reaches its equilibrium, anyone who wants to pay the market price can get a cone. Free markets ration goods with prices.
CASE STUDY
LINES AT THE GAS PUMP
WHO IS RESPONSIBLE FOR THISOPEC OR U.S. LAWMAKERS?
As we discussed in the preceding chapter, in 1973 the Organization of Petroleum Exporting Countries (OPEC) raised the price of crude oil in world oil markets. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline. Long lines at gas stations became commonplace, and motorists often had to wait for hours to buy only a few gallons of gas. What was responsible for the long gas lines? Most people blame OPEC. Surely, if OPEC had not raised the price of crude oil, the shortage of gasoline would not have occurred. Yet economists blame government regulations that limited the price oil companies could charge for gasoline. Figure 6-2 shows what happened. As shown in panel (a), before OPEC raised the price of crude oil, the equilibrium price of gasoline P1 was below the price ceiling. The price regulation, therefore, had no effect. When the price of crude oil rose, however, the situation changed. The increase in the price of crude
(a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Price of Gasoline
(b) The Price Ceiling on Gasoline Is Binding
S2
2. . . . but when supply falls . . .
Supply, S1 1. Initially, the price ceiling is not binding . . .
S1 P2
Price ceiling
Price ceiling
P1
4. . . . resulting in a shortage.
P1
3. . . . the price ceiling becomes binding . . . Demand
Demand 0
Q1
Quantity of Gasoline
0
QS
QD
Q1
Quantity of Gasoline
Figure 6-2
T HE M ARKET FOR G ASOLINE WITH A P RICE C EILING . Panel (a) shows the gasoline market when the price ceiling is not binding because the equilibrium price, P1, is below the ceiling. Panel (b) shows the gasoline market after an increase in the price of crude oil (an input into making gasoline) shifts the supply curve to the left from S1 to S2. In an unregulated market, the price would have risen from P1 to P2. The price ceiling, however, prevents this from happening. At the binding price ceiling, consumers are willing to buy QD, but producers of gasoline are willing to sell only QS. The difference between quantity demanded and quantity supplied, QD QS, measures the gasoline shortage.
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IN THE NEWS Does a Drought Need to Cause a Water Shortage?
DURING THE SUMMER OF 1999, THE EAST coast of the United States experienced unusually little rain and a shortage of water. The following article suggests a way that the shortage could have been averted.
Tr i c k l e - D o w n E c o n o m i c s
BY TERRY L. ANDERSON AND CLAY J. LANDRY Water shortages are being blamed on the drought in the East, but thats giving Mother Nature a bum rap. Certainly the drought is the immediate cause, but the real culprit is regulations that dont allow markets and prices to equalize demand and supply. The similarity between water and gasoline is instructive. The energy crisis of the 1970s, too, was blamed on natures niggardly supply of oil, but in fact it was the actions of the Organization of Petroleum Exporting Countries, combined with price controls, that was the main cause of the shortages. . . .
Once again, regulators are responding to shortagesin this case of water with controls and regulations rather than allowing the market to work. Cities are restricting water usage; some have even gone so far as to prohibit restaurants from serving water except if the customer asks for a glass. But although cities initially saw declines in water use, some are starting to report increases in consumption. This has prompted some police departments to collect lists of residents suspected of wasting water. Theres a better answer than sending out the cops. Market forces could ensure plentiful water availability even in drought years. Contrary to popular belief, the supply of water is no more fixed than the supply of oil. Like all resources, water supplies change in response to economic growth and to the price. In developing countries, despite population growth, the percentage of people with access to safe drinking water has increased to 74 percent in 1994 from 44 percent in 1980. Rising incomes have given those countries the wherewithal to supply potable water. Supplies also increase when current users have an incentive to conserve their surplus in the marketplace. Californias drought-emergency water bank illustrates this. The bank allows farmers to lease water from other users during dry spells. In 1991, the first year the bank was tried, when the price was $125 per acre-foot (326,000 gallons), supply exceeded demand by two to one. That is,
many more people wanted to sell their water than wanted to buy. Data from every corner of the world show that when cities raise the price of water by 10 percent, water use goes down by as much as 12 percent. When the price of agricultural water goes up 10 percent, usage goes down by 20 percent. . . . Unfortunately, Eastern water users do not pay realistic prices for water. According to the American Water Works Association, only 2 percent of municipal water suppliers adjust prices seasonally. . . . Even more egregious, Eastern water laws bar people from buying and selling water. Just as tradable pollution permits established under the Clean Air Act have encouraged polluters to find efficient ways to reduce emissions, tradable water rights can encourage conservation and increase supplies. It is mainly a matter of following the lead of Western water courts that have quantified water rights and Western legislatures that have allowed trades. By making water a commodity and unleashing market forces, policymakers can ensure plentiful water supplies for all. New policies wont make droughts disappear, but they will ease the pain they impose by priming the invisible pump of water markets.
SOURCE: The Wall Street Journal, August 23, 1999, p. A14.
oil raised the cost of producing gasoline, and this reduced the supply of gasoline. As panel (b) shows, the supply curve shifted to the left from S1 to S2. In an unregulated market, this shift in supply would have raised the equilibrium price of gasoline from P1 to P2, and no shortage would have resulted. Instead, the price ceiling prevented the price from rising to the equilibrium level. At the
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price ceiling, producers were willing to sell QS, and consumers were willing to buy QD. Thus, the shift in supply caused a severe shortage at the regulated price. Eventually, the laws regulating the price of gasoline were repealed. Lawmakers came to understand that they were partly responsible for the many hours Americans lost waiting in line to buy gasoline. Today, when the price of crude oil changes, the price of gasoline can adjust to bring supply and demand into equilibrium.
CASE STUDY
RENT CONTROL IN THE SHORT RUN AND LONG RUN
One common example of a price ceiling is rent control. In some cities, the local government places a ceiling on rents that landlords may charge their tenants. The goal of this policy is to help the poor by making housing more affordable. Economists often criticize rent control, arguing that it is a highly inefficient way to help the poor raise their standard of living. One economist called rent control the best way to destroy a city, other than bombing. The adverse effects of rent control are less apparent to the general population because these effects occur over many years. In the short run, landlords have a fixed number of apartments to rent, and they cannot adjust this number quickly as market conditions change. Moreover, the number of people searching
(a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Rental Price of Apartment
(b) Rent Control in the Long Run (supply and demand are elastic)
Supply
Supply
Controlled rent Shortage Shortage Demand 0 Quantity of Apartments 0
Controlled rent Demand
Quantity of Apartments
Figure 6-3
R ENT C ONTROL IN THE S HORT R UN AND IN THE L ONG R UN . Panel (a) shows the shortrun effects of rent control: Because the supply and demand for apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of housing. Panel (b) shows the long-run effects of rent control: Because the supply and demand for apartments are more elastic, rent control causes a large shortage.
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for housing in a city may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements. Therefore, the short-run supply and demand for housing are relatively inelastic. Panel (a) of Figure 6-3 shows the short-run effects of rent control on the housing market. As with any price ceiling, rent control causes a shortage. Yet because supply and demand are inelastic in the short run, the initial shortage caused by rent control is small. The primary effect in the short run is to reduce rents. The long-run story is very different because the buyers and sellers of rental housing respond more to market conditions as time passes. On the supply side, landlords respond to low rents by not building new apartments and by failing to maintain existing ones. On the demand side, low rents encourage people to find their own apartments (rather than living with their parents or sharing apartments with roommates) and induce more people to move into a city. Therefore, both supply and demand are more elastic in the long run. Panel (b) of Figure 6-3 illustrates the housing market in the long run. When rent control depresses rents below the equilibrium level, the quantity of apartments supplied falls substantially, and the quantity of apartments demanded rises substantially. The result is a large shortage of housing. In cities with rent control, landlords use various mechanisms to ration housing. Some landlords keep long waiting lists. Others give a preference to tenants without children. Still others discriminate on the basis of race. Sometimes, apartments are allocated to those willing to offer under-the-table payments to building superintendents. In essence, these bribes bring the total price of an apartment (including the bribe) closer to the equilibrium price. To understand fully the effects of rent control, we have to remember one of the Ten Principles of Economics from Chapter 1: People respond to incentives. In free markets, landlords try to keep their buildings clean and safe because desirable apartments command higher prices. By contrast, when rent control creates shortages and waiting lists, landlords lose their incentive to be responsive to tenants concerns. Why should a landlord spend his money to maintain and improve his property when people are waiting to get in as it is? In the end, tenants get lower rents, but they also get lower-quality housing. Policymakers often react to the effects of rent control by imposing additional regulations. For example, there are laws that make racial discrimination in housing illegal and require landlords to provide minimally adequate living conditions. These laws, however, are difficult and costly to enforce. By contrast, when rent control is eliminated and a market for housing is regulated by the forces of competition, such laws are less necessary. In a free market, the price of housing adjusts to eliminate the shortages that give rise to undesirable landlord behavior.
HOW PRICE FLOORS AFFECT MARKET OUTCOMES
To examine the effects of another kind of government price control, lets return to the market for ice cream. Imagine now that the government is persuaded by the pleas of the National Organization of Ice Cream Makers. In this case, the government might institute a price floor. Price floors, like price ceilings, are an attempt by the government to maintain prices at other than equilibrium levels. Whereas a price ceiling places a legal maximum on prices, a price floor places a legal minimum.
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IN THE NEWS Rent Control in New York City
RENT CONTROL REMAINS A TOPIC OF HEATED debate in New York City, as the following article describes.
Threat to End Rent Control Stirs Up NYC
BY FRED KAPLAN NEW YORKOne recent lunch hour at Shopsins, a neighborhood diner in Manhattans West Village, conversation turned to the topic of the state Senate majority leader, Joseph L. Bruno. If he ever shows his face around here, well string him up, a customer exclaimed. The guy deserves death, another said matter-of-factly. Rarely has so much venom been aimed at a figure so obscure as an Albany legislator, but all over New York City, thousands of otherwise fairly civilized citizens are throwing similar fits. For Bruno is threatening to take away their one holy fringe benefitthe eternal right to a rent-controlled apartment. Massachusetts and California have abolished or scaled back their rentcontrol laws in recent years, but New York remains the last holdout, and on a scale that dwarfs that of the other cities. About 2 million residentsmore than a quarter of New York Citys popu-
lationlive in apartments covered by regulations that severely limit how much a landlord can raise the rent and under what conditions a tenant or even a tenants relatives can be evicted. Tales are legion of wealthy movie stars, doctors, and stock brokers paying a pittance for palatial dwellings in the more fashionable neighborhoods of Manhattan. Some of these tales were knocked off the books in 1993, when the state Legislature passed what many called the Mia Farrow lawin reference to the actress who was paying one-fifth the market price for a 10-room apartment on Central Park West. Still, the bill did not affect too many people. It lifted rent controls only from apartments going for more than $2,000 a month, and only if the tenantss annual household income exceeded $250,000 two years in a row. Far more plentiful are the unaffected cases. An investment banker, who earns more than $400,000 a year, pays $1,500 a month for a three-bedroom apartment near Lincoln Center. A securities trader, making well over $100,000 a year, pays $800 a month for a one-bedroom on the Upper West Side. In both cases, the units would fetch at least three times as much if placed on the open market. . . . But rent control helps more than the rich. A study by the city concludes that the average tenant of a rent-controlled apartment in New York City earns only $20,000 a year. Tenants groups say that ending controls would primarily raise the rents of those who can least afford to pay, resulting in wholesale eviction. However, Paul Grogan, president of the Local Initiatives Support Corp., a private organization that finances low-
income housing, said, In many poor neighborhoods, the landlord cant even get rents as high as the regulations allow. . . . Few economists and policy analysts, even liberal ones, support rent controlnot so much because it lets rich people pay far less than they can afford, but because it distorts the marketplace for everyone. Frank Roconi, director of the Citizens Housing and Planning Council, a public-policy research organization that supports some government intervention in the real-estate market, spelled out the classic case of this distortion: There is an elderly couple, their kids are gone, they have a threebedroom apartment, and they are paying $400 a month. Down the hall, there is a young family with two kids living in a onebedroom for $1,000 a month. In a rational price system, the elderly couple would have an incentive to move to a smaller, cheaper apartment, leaving vacant a larger space for the young family. Under the current system, though, if the elderly couple moves away, their children can claim the apartment at the same rent. Or, if it is left vacant, the landlord, by law, can charge only a few percentage points more than if the tenant had stayed. Therefore, Roconi noted, the landlord isnt going to let just anybody in. Hes going to let his brother-in-law have the apartment or his accountant or someone willing to give him a bribe. Theres a tremendous incentive for that apartment never to hit the open market.
SOURCE: The Boston Globe, April 28, 1997, p. A1.
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(a) A Price Floor That Is Not Binding Price of Ice-Cream Cone Equilibrium price $3 2 Price of Ice-Cream Cone
(b) A Price Floor That Is Binding
Supply
Supply Surplus
$4 3 Equilibrium price
Price floor
Price floor
Demand 0 100 Equilibrium quantity Quantity of Ice-Cream Cones 0
Demand Quantity of 80 120 Quantity Quantity Ice-Cream Cones demanded supplied
A M ARKET WITH A P RICE F LOOR . In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones.
Figure 6-4
When the government imposes a price floor on the ice-cream market, two outcomes are possible. If the government imposes a price floor of $2 per cone when the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 6-4. In this case, because the equilibrium price is above the floor, the price floor is not binding. Market forces naturally move the economy to the equilibrium, and the price floor has no effect. Panel (b) of Figure 6-4 shows what happens when the government imposes a price floor of $4 per cone. In this case, because the equilibrium price of $3 is below the floor, the price floor is a binding constraint on the market. The forces of supply and demand tend to move the price toward the equilibrium price, but when the market price hits the floor, it can fall no further. The market price equals the price floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds the quantity demanded (80 cones). Some people who want to sell ice cream at the going price are unable to. Thus, a binding price floor causes a surplus. Just as price ceilings and shortages can lead to undesirable rationing mechanisms, so can price floors and surpluses. In the case of a price floor, some sellers are unable to sell all they want at the market price. The sellers who appeal to the personal biases of the buyers, perhaps due to racial or familial ties, are better able to sell their goods than those who do not. By contrast, in a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price.
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CASE STUDY
THE MINIMUM WAGE
An important example of a price floor is the minimum wage. Minimum-wage laws dictate the lowest price for labor that any employer may pay. The U.S. Congress first instituted a minimum wage with the Fair Labor Standards Act of 1938 to ensure workers a minimally adequate standard of living. In 1999 the minimum wage according to federal law was $5.15 per hour, and some state laws imposed higher minimum wages. To examine the effects of a minimum wage, we must consider the market for labor. Panel (a) of Figure 6-5 shows the labor market which, like all markets, is subject to the forces of supply and demand. Workers determine the supply of labor, and firms determine the demand. If the government doesnt intervene, the wage normally adjusts to balance labor supply and labor demand. Panel (b) of Figure 6-5 shows the labor market with a minimum wage. If the minimum wage is above the equilibrium level, as it is here, the quantity of labor supplied exceeds the quantity demanded. The result is unemployment. Thus, the minimum wage raises the incomes of those workers who have jobs, but it lowers the incomes of those workers who cannot find jobs. To fully understand the minimum wage, keep in mind that the economy contains not a single labor market, but many labor markets for different types of workers. The impact of the minimum wage depends on the skill and experience of worker. the Workers with high skills and much experience are not affected, because their equilibrium wages are well above the minimum. For these workers, the minimum wage is not binding.
(a) A Free Labor Market Wage Wage
(b) A Labor Market with a Binding Minimum Wage
Labor supply Minimum wage Equilibrium wage Labor demand 0 Equilibrium employment Quantity of Labor 0
Labor supply Labor surplus (unemployment)
Labor demand Quantity demanded Quantity supplied Quantity of Labor
Figure 6-5
H OW THE M INIMUM WAGE A FFECTS THE L ABOR M ARKET. Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand. Panel (b) shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.
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The minimum wage has its greatest impact on the market for teenage labor. The equilibrium wages of teenagers are low because teenagers are among the least skilled and least experienced members of the labor force. In addition, teenagers are often willing to accept a lower wage in exchange for on-the-job training. (Some teenagers are willing to work as interns for no pay at all. Because internships pay nothing, however, the minimum wage does not apply to them. If it did, these jobs might not exist.) As a result, the minimum wage is more often binding for teenagers than for other members of the labor force. Many economists have studied how minimum-wage laws affect the teenage labor market. These researchers compare the changes in the minimum wage over time with the changes in teenage employment. Although there is some debate about how much the minimum wage affects employment, the typical study finds that a 10 percent increase in the minimum wage depresses teenage employment between 1 and 3 percent. In interpreting this estimate, note that a 10 percent increase in the minimum wage does not raise the average wage of teenagers by 10 percent. A change in the law does not directly affect those teenagers who are already paid well above the minimum, and enforcement of minimum-wage laws is not perfect. Thus, the estimated drop in employment of 1 to 3 percent is significant. In addition to altering the quantity of labor demanded, the minimum wage also alters the quantity supplied. Because the minimum wage raises the wage that teenagers can earn, it increases the number of teenagers who choose to look for jobs. Studies have found that a higher minimum wage influences which teenagers are employed. When the minimum wage rises, some teenagers who are still attending school choose to drop out and take jobs. These new dropouts displace other teenagers who had already dropped out of school and who now become unemployed. The minimum wage is a frequent topic of political debate. Advocates of the minimum wage view the policy as one way to raise the income of the working poor. They correctly point out that workers who earn the minimum wage can afford only a meager standard of living. In 1999, for instance, when the minimum wage was $5.15 per hour, two adults working 40 hours a week for every week of the year at minimum-wage jobs had a total annual income of only $21,424, which was less than half of the median family income. Many advocates of the minimum wage admit that it has some adverse effects, including unemployment, but they believe that these effects are small and that, all things considered, a higher minimum wage makes the poor better off. Opponents of the minimum wage contend that it is not the best way to combat poverty. They note that a high minimum wage causes unemployment, encourages teenagers to drop out of school, and prevents some unskilled workers from getting the on-the-job training they need. Moreover, opponents of the minimum wage point out that the minimum wage is a poorly targeted policy. Not all minimum-wage workers are heads of households trying to help their families escape poverty. In fact, fewer than a third of minimum-wage earners are in families with incomes below the poverty line. Many are teenagers from middle-class homes working at part-time jobs for extra spending money.
E VA L U AT I N G P R I C E C O N T R O L S
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually a good way to organize economic activity. This principle explains why
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economists usually oppose price ceilings and price floors. To economists, prices are not the outcome of some haphazard process. Prices, they contend, are the result of the millions of business and consumer decisions that lie behind the supply and demand curves. Prices have the crucial job of balancing supply and demand and, thereby, coordinating economic activity. When policymakers set prices by legal decree, they obscure the signals that normally guide the allocation of societys resources. Another one of the Ten Principles of Economics is that governments can sometimes improve market outcomes. Indeed, policymakers are led to control prices because they view the markets outcome as unfair. Price controls are often aimed at helping the poor. For instance, rent-control laws try to make housing affordable for everyone, and minimum-wage laws try to help people escape poverty. Yet price controls often hurt those they are trying to help. Rent control may keep rents low, but it also discourages landlords from maintaining their buildings and makes housing hard to find. Minimum-wage laws may raise the incomes of some workers, but they also cause other workers to be unemployed. Helping those in need can be accomplished in ways other than controlling prices. For instance, the government can make housing more affordable by paying a fraction of the rent for poor families. Unlike rent control, such rent subsidies do not reduce the quantity of housing supplied and, therefore, do not lead to housing shortages. Similarly, wage subsidies raise the living standards of the working poor without discouraging firms from hiring them. An example of a wage subsidy is the earned income tax credit, a government program that supplements the incomes of low-wage workers. Although these alternative policies are often better than price controls, they are not perfect. Rent and wage subsidies cost the government money and, therefore, require higher taxes. As we see in the next section, taxation has costs of its own. Q U I C K Q U I Z : Define price ceiling and price floor, and give an example of each. Which leads to a shortage? Which leads to a surplus? Why?
TA X E S
All governmentsfrom the federal government in Washington, D.C., to the local governments in small townsuse taxes to raise revenue for public projects, such as roads, schools, and national defense. Because taxes are such an important policy instrument, and because they affect our lives in many ways, the study of taxes is a topic to which we return several times throughout this book. In this section we begin our study of how taxes affect the economy. To set the stage for our analysis, imagine that a local government decides to hold an annual ice-cream celebrationwith a parade, fireworks, and speeches by town officials. To raise revenue to pay for the event, it decides to place a $0.50 tax on the sale of ice-cream cones. When the plan is announced, our two lobbying groups swing into action. The National Organization of Ice Cream Makers claims that its members are struggling to survive in a competitive market, and it argues that buyers of ice cream should have to pay the tax. The American Association of Ice Cream Eaters claims that consumers of ice cream are having trouble making ends meet, and it argues that sellers of ice cream should pay the tax. The town mayor, hoping to reach a compromise, suggests that half the tax be paid by the buyers and half be paid by the sellers.
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To analyze these proposals, we need to address a simple but subtle question: When the government levies a tax on a good, who bears the burden of the tax? The people buying the good? The people selling the good? Or, if buyers and sellers share the tax burden, what determines how the burden is divided? Can the government simply legislate the division of the burden, as the mayor is suggesting, or is the division determined by more fundamental forces in the economy? Economists use the term tax incidence to refer to these questions about the distribution of a tax burden. As we will see, we can learn some surprising lessons about tax incidence just by applying the tools of supply and demand.
tax incidence the study of who bears the burden of taxation
H O W TA X E S O N B U Y E R S A F F E C T M A R K E T O U T C O M E S
We first consider a tax levied on buyers of a good. Suppose, for instance, that our local government passes a law requiring buyers of ice-cream cones to send $0.50 to the government for each ice-cream cone they buy. How does this law affect the buyers and sellers of ice cream? To answer this question, we can follow the three steps in Chapter 4 for analyzing supply and demand: (1) We decide whether the law affects the supply curve or demand curve. (2) We decide which way the curve shifts. (3) We examine how the shift affects the equilibrium. The initial impact of the tax is on the demand for ice cream. The supply curve is not affected because, for any given price of ice cream, sellers have the same incentive to provide ice cream to the market. By contrast, buyers now have to pay a tax to the government (as well as the price to the sellers) whenever they buy ice cream. Thus, the tax shifts the demand curve for ice cream. The direction of the shift is easy to determine. Because the tax on buyers makes buying ice cream less attractive, buyers demand a smaller quantity of ice cream at every price. As a result, the demand curve shifts to the left (or, equivalently, downward), as shown in Figure 6-6.
Figure 6-6
A TAX ON B UYERS . When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to D2. The equilibrium quantity falls from 100 to 90 cones. The price that sellers receive falls from $3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even though the tax is levied on buyers, buyers and sellers share the burden of the tax.
Price of Ice-Cream Price Cone buyers pay $3.30 3.00 Price 2.80 without tax Price sellers receive
Supply, S1
Tax ($0.50)
Equilibrium without tax A tax on buyers shifts the demand curve downward by the size of the tax ($0.50).
Equilibrium with tax
D1 D2
0 90 100 Quantity of Ice-Cream Cones
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We can, in this case, be precise about how much the curve shifts. Because of the $0.50 tax levied on buyers, the effective price to buyers is now $0.50 higher than the market price. For example, if the market price of a cone happened to be $2.00, the effective price to buyers would be $2.50. Because buyers look at their total cost including the tax, they demand a quantity of ice cream as if the market price were $0.50 higher than it actually is. In other words, to induce buyers to demand any given quantity, the market price must now be $0.50 lower to make up for the effect of the tax. Thus, the tax shifts the demand curve downward from D1 to D2 by exactly the size of the tax ($0.50). To see the effect of the tax, we compare the old equilibrium and the new equilibrium. You can see in the figure that the equilibrium price of ice cream falls from $3.00 to $2.80 and the equilibrium quantity falls from 100 to 90 cones. Because sellers sell less and buyers buy less in the new equilibrium, the tax on ice cream reduces the size of the ice-cream market. Now lets return to the question of tax incidence: Who pays the tax? Although buyers send the entire tax to the government, buyers and sellers share the burden. Because the market price falls from $3.00 to $2.80 when the tax is introduced, sellers receive $0.20 less for each ice-cream cone than they did without the tax. Thus, the tax makes sellers worse off. Buyers pay sellers a lower price ($2.80), but the effective price including the tax rises from $3.00 before the tax to $3.30 with the tax ($2.80 + $0.50 = $3.30). Thus, the tax also makes buyers worse off. To sum up, the analysis yields two general lessons: N N Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium. Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good, and sellers receive less.
H O W TA X E S O N S E L L E R S A F F E C T M A R K E T O U T C O M E S
Now consider a tax levied on sellers of a good. Suppose the local government passes a law requiring sellers of ice-cream cones to send $0.50 to the government for each cone they sell. What are the effects of this law? In this case, the initial impact of the tax is on the supply of ice cream. Because the tax is not levied on buyers, the quantity of ice cream demanded at any given price is the same, so the demand curve does not change. By contrast, the tax on sellers raises the cost of selling ice cream, and leads sellers to supply a smaller quantity at every price. The supply curve shifts to the left (or, equivalently, upward). Once again, we can be precise about the magnitude of the shift. For any market price of ice cream, the effective price to sellersthe amount they get to keep after paying the taxis $0.50 lower. For example, if the market price of a cone happened to be $2.00, the effective price received by sellers would be $1.50. Whatever the market price, sellers will supply a quantity of ice cream as if the price were $0.50 lower than it is. Put differently, to induce sellers to supply any given quantity, the market price must now be $0.50 higher to compensate for the effect of the tax. Thus, as shown in Figure 6-7, the supply curve shifts upward from S1 to S2 by exactly the size of the tax ($0.50). When the market moves from the old to the new equilibrium, the equilibrium price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from
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Figure 6-7
Price of Ice-Cream Price Cone buyers pay $3.30 3.00 Price 2.80 without tax Price sellers receive Demand, D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50).
Equilibrium with tax Tax ($0.50)
S2 S1
Equilibrium without tax
A TAX ON S ELLERS . When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The equilibrium quantity falls from 100 to 90 cones. The price that buyers pay rises from $3.00 to $3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even though the tax is levied on sellers, buyers and sellers share the burden of the tax.
0
90 100
Quantity of Ice-Cream Cones
100 to 90 cones. Once again, the tax reduces the size of the ice-cream market. And once again, buyers and sellers share the burden of the tax. Because the market price rises, buyers pay $0.30 more for each cone than they did before the tax was enacted. Sellers receive a higher price than they did without the tax, but the effective price (after paying the tax) falls from $3.00 to $2.80. Comparing Figures 6-6 and 6-7 leads to a surprising conclusion: Taxes on buyers and taxes on sellers are equivalent. In both cases, the tax places a wedge between the price that buyers pay and the price that sellers receive. The wedge between the buyers price and the sellers price is the same, regardless of whether the tax is levied on buyers or sellers. In either case, the wedge shifts the relative position of the supply and demand curves. In the new equilibrium, buyers and sellers share the burden of the tax. The only difference between taxes on buyers and taxes on sellers is who sends the money to the government. The equivalence of these two taxes is perhaps easier to understand if we imagine that the government collects the $0.50 ice-cream tax in a bowl on the counter of each ice-cream store. When the government levies the tax on buyers, the buyer is required to place $0.50 in the bowl every time a cone is bought. When the government levies the tax on sellers, the seller is required to place $0.50 in the bowl after the sale of each cone. Whether the $0.50 goes directly from the buyers pocket into the bowl, or indirectly from the buyers pocket into the sellers hand and then into the bowl, does not matter. Once the market reaches its new equilibrium, buyers and sellers share the burden, regardless of how the tax is levied.
CASE STUDY
CAN CONGRESS DISTRIBUTE THE BURDEN OF A PAYROLL TAX?
If you have ever received a paycheck, you probably noticed that taxes were deducted from the amount you earned. One of these taxes is called FICA, an
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acronym for the Federal Insurance Contribution Act. The federal government uses the revenue from the FICA tax to pay for Social Security and Medicare, the income support and health care programs for the elderly. FICA is an example of a payroll tax, which is a tax on the wages that firms pay their workers. In 1999, the total FICA tax for the typical worker was 15.3 percent of earnings. Who do you think bears the burden of this payroll taxfirms or workers? When Congress passed this legislation, it attempted to mandate a division of the tax burden. According to the law, half of the tax is paid by firms, and half is paid by workers. That is, half of the tax is paid out of firm revenue, and half is deducted from workers paychecks. The amount that shows up as a deduction on your pay stub is the worker contribution. Our analysis of tax incidence, however, shows that lawmakers cannot so easily distribute the burden of a tax. To illustrate, we can analyze a payroll tax as merely a tax on a good, where the good is labor and the price is the wage. The key feature of the payroll tax is that it places a wedge between the wage that firms pay and the wage that workers receive. Figure 6-8 shows the outcome. When a payroll tax is enacted, the wage received by workers falls, and the wage paid by firms rises. In the end, workers and firms share the burden of the tax, much as the legislation requires. Yet this division of the tax burden between workers and firms has nothing to do with the legislated division: The division of the burden in Figure 6-8 is not necessarily fifty-fifty, and the same outcome would prevail if the law levied the entire tax on workers or if it levied the entire tax on firms. This example shows that the most basic lesson of tax incidence is often overlooked in public debate. Lawmakers can decide whether a tax comes from the buyers pocket or from the sellers, but they cannot legislate the true burden of a tax. Rather, tax incidence depends on the forces of supply and demand.
Figure 6-8
Wage
A PAYROLL TAX . A payroll tax places a wedge between the wage that workers receive and the wage that firms pay. Comparing wages with and without the tax, you can see that workers and firms share the tax burden. This division of the tax burden between workers and firms does not depend on whether the government levies the tax on workers, levies the tax on firms, or divides the tax equally between the two groups.
Labor supply
Wage firms pay Tax wedge Wage without tax Wage workers receive
Labor demand 0 Quantity of Labor
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E L A S T I C I T Y A N D TA X I N C I D E N C E
When a good is taxed, buyers and sellers of the good share the burden of the tax. But how exactly is the tax burden divided? Only rarely will it be shared equally. To see how the burden is divided, consider the impact of taxation in the two markets in Figure 6-9. In both cases, the figure shows the initial demand curve, the initial supply curve, and a tax that drives a wedge between the amount paid by buyers and the amount received by sellers. (Not drawn in either panel of the figure is the new supply or demand curve. Which curve shifts depends on whether the tax is levied on buyers or sellers. As we have seen, this is irrelevant for the incidence of
(a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . . Price buyers pay Supply
Figure 6-9
H OW THE B URDEN OF A TAX I S D IVIDED . In panel (a), the supply curve is elastic, and the demand curve is inelastic. In this case, the price received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of the tax. In panel (b), the supply curve is inelastic, and the demand curve is elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers rises only slightly. Thus, sellers bear most of the burden of the tax.
Tax Price without tax Price sellers receive 3. . . . than on producers. 0 Demand
2. . . . the incidence of the tax falls more heavily on consumers . . .
Quantity (b) Inelastic Supply, Elastic Demand
Price 1. When demand is more elastic than supply . . . Price buyers pay Price without tax Tax Supply 3. . . . than on consumers.
Price sellers receive
2. . . . the incidence of the tax falls more heavily on producers . . .
Demand
0
Quantity
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the tax.) The difference in the two panels is the relative elasticity of supply and demand. Panel (a) of Figure 6-9 shows a tax in a market with very elastic supply and relatively inelastic demand. That is, sellers are very responsive to the price of the good, whereas buyers are not very responsive. When a tax is imposed on a market with these elasticities, the price received by sellers does not fall much, so sellers bear only a small burden. By contrast, the price paid by buyers rises substantially, indicating that buyers bear most of the burden of the tax. Panel (b) of Figure 6-9 shows a tax in a market with relatively inelastic supply and very elastic demand. In this case, sellers are not very responsive to the price, while buyers are very responsive. The figure shows that when a tax is imposed, the price paid by buyers does not rise much, while the price received by sellers falls substantially. Thus, sellers bear most of the burden of the tax. The two panels of Figure 6-9 show a general lesson about how the burden of a tax is divided: A tax burden falls more heavily on the side of the market that is less elastic. Why is this true? In essence, the elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. A small elasticity of demand means that buyers do not have good alternatives to consuming this particular good. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. When the good is taxed, the side of the market with fewer good alternatives cannot easily leave the market and must, therefore, bear more of the burden of the tax. We can apply this logic to the payroll tax, which was discussed in the previous case study. Most labor economists believe that the supply of labor is much less elastic than the demand. This means that workers, rather than firms, bear most of the burden of the payroll tax. In other words, the distribution of the tax burden is not at all close to the fifty-fifty split that lawmakers intended.
CASE STUDY
WHO PAYS THE LUXURY TAX?
IF THIS BOAT WERE ANY MORE
EXPENSIVE, WE WOULD BE PLAYING GOLF.
In 1990, Congress adopted a new luxury tax on items such as yachts, private airplanes, furs, jewelry, and expensive cars. The goal of the tax was to raise revenue from those who could most easily afford to pay. Because only the rich could afford to buy such extravagances, taxing luxuries seemed a logical way of taxing the rich. Yet, when the forces of supply and demand took over, the outcome was quite different from what Congress intended. Consider, for example, the market for yachts. The demand for yachts is quite elastic. A millionaire can easily not buy a yacht; she can use the money to buy a bigger house, take a European vacation, or leave a larger bequest to her heirs. By contrast, the supply of yachts is relatively inelastic, at least in the short run. Yacht factories are not easily converted to alternative uses, and workers who build yachts are not eager to change careers in response to changing market conditions. Our analysis makes a clear prediction in this case. With elastic demand and inelastic supply, the burden of a tax falls largely on the suppliers. That is, a tax on yachts places a burden largely on the firms and workers who build yachts because they end up getting a lower price for their product. The workers, however, are not wealthy. Thus, the burden of a luxury tax falls more on the middle class than on the rich.
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The mistaken assumptions about the incidence of the luxury tax quickly became apparent after the tax went into effect. Suppliers of luxuries made their congressional representatives well aware of the economic hardship they experienced, and Congress repealed most of the luxury tax in 1993. Q U I C K Q U I Z : In a supply-and-demand diagram, show how a tax on car buyers of $1,000 per car affects the quantity of cars sold and the price of cars. In another diagram, show how a tax on car sellers of $1,000 per car affects the quantity of cars sold and the price of cars. In both of your diagrams, show the change in the price paid by car buyers and the change in price received by car sellers.
CONCLUSION
The economy is governed by two kinds of laws: the laws of supply and demand and the laws enacted by governments. In this chapter we have begun to see how these laws interact. Price controls and taxes are common in various markets in the economy, and their effects are frequently debated in the press and among policymakers. Even a little bit of economic knowledge can go a long way toward understanding and evaluating these policies. In subsequent chapters we will analyze many government policies in greater detail. We will examine the effects of taxation more fully, and we will consider a broader range of policies than we considered here. Yet the basic lessons of this chapter will not change: When analyzing government policies, supply and demand are the first and most useful tools of analysis.
Summary
N A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the price ceiling is below the equilibrium price, the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some way ration the good or service among buyers. A price floor is a legal minimum on the price of a good or service. An example is the minimum wage. If the price floor is above the equilibrium price, the quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers demands for the good or service must in some way be rationed among sellers. When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a market shrinks the size of the market. N A tax on a good places a wedge between the price paid by buyers and the price received by sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers receive less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. The incidence of a tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less elastic because that side of the market can respond less easily to the tax by changing the quantity bought or sold.
N
N
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