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Chapter 5
Policy Analysis
With Supply and Demand
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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Learning Objectives• What is a price floor?• What is the effect of minimum wage on the market?• What is a price ceiling?• What is rent control?• What is economics of a draft vs. voluntary enlistment?• What is economics of market for human organs?• What is economics of healthcare?• What is economics of parking meters?• What is economics of agricultural subsidies?
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Price Floor
• Price floor
= minimum legal price set by government.
• It affects only when set above the equilibrium price.
• Effective price floor creates surplus.
Price Floor
Supply
Demand
Price
Quantity supplied after the price floor is imposed.
Quantity demanded after the price floor is imposed.
Quantity786040
$12
$8
Surplus
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Minimum Wage and Market for Unskilled Labor
• Minimum wage
= price floor in labor market.• Minimum wage law
increases wages of unskilled workers with jobs.
• However it also creates surplus labor, which equals unemployment.
• It may cause firms to raise product prices.
Minimum wage
Supply
Demand
Wages per hour
Number of unskilled workers
20,00013,0008,000
$6
$4
Unemployment
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Elasticity of Demand and Minimum Wage
Number of workers employed with no minimum wage
Number of workers employed with minimum wage and inelastic demand curve
Number of workers employed with minimum wage and an elastic demand curve.
Number of Workers
Wage Rate Supply of
unskilled labor
An inelastic demand for unskilled labor
Minimum Wage
An elastic demand for unskilled labor
9,8
00
10
,00
0
2,0
00
• Inelastic demand= demand for labor is
not price sensitive.• Elastic demand= demand for labor is
very price sensitive.• The more elastic
demand for labor, the more jobs eliminated by minimum wage law.
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Minimum Wage• Minimum wages increase wages of workers with
jobs.• Surplus of labor created by minimum wage can
result in worse working conditions.• Minimum wages impose the greatest cost on
those with the least skills.• Minimum wages increases demand for skilled
workers and hence their wages.• Minimum wage law creates incentives for black
market and illegal workers.
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Price Ceiling
• Price ceiling
= maximum legal price set by government.
• It affects only when set below the equilibrium price.
• Effective price ceiling creates shortage.
Price ceiling
Supply
Demand
Price Quantity supplied after the price ceiling
is imposed.
Quantity demanded after the price ceiling
is imposed.
Quantity716050
$6
$8
Shortage
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Rent Control
• Rent control
= price ceiling in market for apartments.
• Rent control creates shortage of apartments, specially in the long run.
• The greater the price elasticity of demand, the greater the shortage.
Rent control
Supply of apartments
Demand for apartments
Monthly Rent
Quantity13,0007,100
$600
$900
Shortage
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Rent Control
• Landlords and potential tenants who can’t find apartments lose.
• Existing apartment holders can gain.• It creates incentives for individuals to take up
more housing space than they otherwise would.• It reduces individuals’ mobility.• It reduces quality of apartment buildings.• It creates incentives for black market and illegal
activities.
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Draft vs. Voluntary Enlistment
• With voluntary enlistment, the government has to pay market wages to get its desired number of soldiers.
• With a draft, the government can pay whatever wages it wants. Soldiers lose with lower wages.
• A draft forces transfer of wealth from soldiers to civilians not subject to the draft.
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Market for Human Organs
• In the U.S., market for human organs is illegal.
• So, legal price of human organs = $0.
• It creates shortage.• Free markets correct
shortages by raising prices.
• The ban promotes barter exchange, other illegal activities and black market in organ transfers.
15,000
Supply of Kidneys
Demand for Kidneys
$ Price of kidneys
Size of shortage if price is zero.
Quantity of kidneys
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Should Government Pay for Health Care?
• Free health care benefits create shortages for services with very price-elastic demand.
• Governments offering free healthcare limit costs by rationing services.
• Price controls over necessities create incentives for producers to develop luxury goods instead of necessities.
The point on the supply curve where quantity = 110,000
If price = $0 consumers will be here on their demand curve
An elastic demand for MRIs
Supply of MRIs
Price
$2,000
$1,000
Number of scans
110,00050,000
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Parking Meters
• Parking meter = government set parking price.
• Below equilibrium price creates shortage and deadweight loss of waiting on weekdays.
• Higher price eliminates shortage by reducing quantity demanded.
• Above equilibrium price creates surplus on weekends.
800
Demand for spaces on a weekend
Quantity
PriceSupply of parking spaces
Demand for spaces on a weekday
Government set parking price
1,9001,000
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Agricultural Subsidies• Government supported
price for agricultural produce is higher than equilibrium price.
• The greater the price elasticities of demand and supply, the higher cost of agricultural support price.
• Artificial agricultural prices lead to wastage of resources.
• Government can reduce supply by paying farmers not to grow crops.
Demand for wheat
Supply of wheat
Number of bushels in millions
302014
$4
$3
Price per bushel
Surplus
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Do You Know?
• When does a price floor have no effect on a market?Price floor will not be effective if it is set below the market equilibrium price.
• Why can the minimum wage law and rent control create black markets?The minimum wage law and rent control prevent markets from reaching equilibrium. Since it can not legally reach equilibrium, markets develop unofficial ways to do so.
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Do You Know?
• How does the elasticity of demand for health care affect the cost to a government that provide free health care to all of its citizens?
When a government offers it free, the price of health care is zero for its citizens. If the demand for health care is elastic, quantity demanded increases by manifolds. Hence, the government has to bear the higher costs.
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Summary
• Price floor = minimum legal price. • Price floor creates surplus.• Price ceiling = maximum legal price. • Price ceiling creates shortage.• Government distorts efficient functioning of
market by artificially controlling prices such as minimum wage law, rent control, military draft, ban on market for human organs, parking meters and agricultural subsidies.
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Coming Up
How is wealth created and destroyed?
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