Optimal Market Policy

Bruno Salcedo

Economics 1021 · Principles of Microeconomics · Chapter 6 · Fall 2024

cbna

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four economic policies

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 four government policies

◮ Price Controls—rent controls, minimum wages, price caps

◮ Taxes—HST, income tax, carbon tax

◮ Subsidies—College tuition, food, gas

◮ Quotas—imported goods, drugs, prostitution, organs

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◮ Policy implications can depend on type of market
– Textbook largely focuses on perfect competition
– Market works well =⇒ policy has mostly downsides
– Wrong takeaway: government interventions are always bad

◮ Good public policy requires economics + politics to avoid

– Politician/voter’s incentives to get in the way
– Failure to achieve intended objectives
– Undesirable unintended side effects

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price floors

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 Definition — A price control is a rule that restricts the set
of prices at which trade can take place

◮ Price floors—minimum price limits

◮ Price ceilings—maximum price limits

◮ Typical examples:
– Minimum wage
– Rent controls
– Drug price caps
– Taxi and private transit fares

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 minimum wage

◮ Policy objectives
– Ensure minimum living standards
– Protect small employees from unequal bargaining
– Alleviate poverty (reduce crime, homelessness,. . . )
– Distributive justice

◮ Common policy objections:

– Unemployment
– Inflation
– Property rights
– Individual freedom

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 a competitive labour market

24.00

20.00 S

16.00

12.00 b

8.00

4.00 D

10 20 30 40 50 L

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 ineffective minimum wage

24.00

20.00 S

16.00

12.00 b

8.00 minimum wage

4.00 illegal D

10 20 30 40 50 L

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 effective minimum wage

24.00

20.00 S

16.00 minimum wage

12.00 b

8.00

4.00 illegal D

10 20 30 40 50 L

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 NJ and PA fast food wages

Card & Krueger (1993) “Minimum Wages and Employment: A Case Study of the
Fast-Food Industry in New Jersey and Pennsylvania.” American Economic Review,
84(4):772–793.
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 NJ and PA fast food wages

Card & Krueger (1993) “Minimum Wages and Employment: A Case Study of the
Fast-Food Industry in New Jersey and Pennsylvania.” American Economic Review,
84(4):772–793.
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 effective minimum wage

24.00

20.00 S

16.00 b
minimum wage

12.00 b

8.00

4.00 D

10 20 30 40 50 L

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 dead-weight loss

24.00

20.00 S

16.00 b
minimum wage

12.00 b

8.00

4.00 D

10 20 30 40 50 L

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 unemployment

24.00

20.00 S

16.00 b
minimum wage

12.00 b

8.00 b

4.00 D

10 20 30 40 50 L

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 change in worker surplus

W W W

b b

b b

L L L

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 change in worker surplus

W W W

b b

b b

L L L

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 effective minimum wage in a competitive market

◮ Increases the equilibrium wage

◮ Causes unemployment

◮ Generates dead-weight loss

◮ Decreases surplus of firms

◮ Increases surplus of employed workers

◮ Ambiguous effect on worker surplus

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 effective minimum wage in a competitive market

◮ Increases the equilibrium wage

◮ Causes unemployment. . . or does it?

◮ Generates dead-weight loss

◮ Decreases surplus of firms

◮ Increases surplus of employed workers

◮ Ambiguous effect on worker surplus

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 Card and Krueger (1993)

“Our empirical findings challenge the prediction that a rise in the mini-
mum [wage] reduces employment. Relative to stores in Pennsylvania, fast
food restaurants in New Jersey increased employment by 13 percent. . .

Stores that were unaffected by the minimum wage had the same em-
ployment growth as stores in Pennsylvania, while stores that had to in-
crease their wages increased their employment.”

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 elasticity of low-wage labour supply

https://economic.github.io/owe/

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price ceilings

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 rent controls

◮ Policy objectives
– Ensure access to housing
– Protect tenants from unequal bargaining
– Alleviate poverty (reduce crime, homelessness,. . . )
– Distributive justice

◮ Common policy objections:

– Supply-driven housing shortages
– Property rights
– Individual freedom

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 a competitive housing market

1500.00

1250.00 S

1000.00

750.00 b

500.00

250.00 D

50 100 150 200 250 L

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 effective rent control in a competitive market

1500.00

1250.00 S

1000.00 b

750.00 b

500.00 b b
maximum rent

250.00 D

50 100 150 200 250 L

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is real estate competitive?

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 a monopolistic housing market

1200.00

1000.00 MC

800.00 b

600.00

400.00

200.00 D

MR

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 ineffective rent control

1200.00

illegal
1000.00 MC
rent ceiling
800.00 b

600.00

400.00

200.00 D

50 100 150 200 250 L

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 effective rent control

1200.00

illegal
1000.00 MC

800.00 b

600.00 rent ceiling

400.00

200.00 D

50 100 150 200 250 L

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 added housing

1200.00

1000.00 MC

800.00 b

600.00 b
rent ceiling

400.00

200.00 D

50 100 150 200 250 L

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 welfare gains

1200.00

1000.00 MC

800.00 b

600.00 b
rent ceiling

400.00

200.00 D

50 100 150 200 250 L

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 effects of effective rent control

outcome perfect competition other markets

price decreases decreases

quantity decreases increases
consumer surplus ambiguous increases
producer surplus decreases decreases
total surplus decreases increases

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◮ Effective price controls can affect trade levels and total surplus

◮ The direction of the effect depends on the market

◮ Perfectly competitive markets =⇒ moves away from efficiency

◮ Every other market =⇒ can go away or closer to efficiency

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How do we find the optimal price ceiling for a monopoly?

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 marginal-cost price cap

1200.00

1000.00 MC

800.00

600.00 b
rent ceiling

400.00

200.00 D

50 100 150 200 250 Q

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 MC rule ideal if above ATC

1200.00

1000.00 MC

800.00

600.00 b ATC

400.00

200.00 D

50 100 150 200 250 Q

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 otherwise it leads to loses

1200.00

1000.00 MC

800.00
b
ATC
600.00 b
rent ceiling

400.00

200.00 D

50 100 150 200 250 Q

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 average-pricing price cap

1200.00

1000.00 MC

800.00
b ATC
600.00 b

400.00

200.00 D

50 100 150 200 250 Q

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 monopoly deadweight loss

P P P

b
b

Q Q Q
free market ATC price cap MC price cap

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 optimal price cap for monopolist

◮ Marginal cost pricing rule maximizes surplus

MC = P

◮ This might result in losses if

MC < LRAC

◮ Different possible solutions:

– Two-part tariffs (Econ 2261)
– Subsidize monopolist with government transfers
– Average cost pricing rule
P = LRAC

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 Hayek (1945)

“[T]he knowledge of the

circumstances of which we must
make use never exists in
concentrated or integrated form
but solely as the dispersed bits of
incomplete and frequently
contradictory knowledge which all
the separate individuals possess.”

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◮ How does the government know the MC/ATC?
– Accounting cost 6= economic cost
– Firms may not know their own economic cost
– Firms can misrepresent their true economic cost

◮ So what do we do?
– Best possible regulation given information constraints
– Mechanism design based on game theory
– Very recent technology (Laffont & Tirole, 1986)

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 Maskin (1993)

“The theory of mechanism design

can be thought of as the
‘engineering’ side of economic
theory.”

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Tirole (2018) “Economics for the Common Good.” Princeton University Press.

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taxes

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 Definition — taxes are a compulsory contribution to state
revenue

◮ Canada’s tax revenue ≈ 28.30% of economic activity

– Sales/value added
– Economic/financial gains
– Property taxes
– Tariffs

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tax revenue in Canada

37% Personal gains

15% Corporate gains
15% Social Security
13% Sales
11% Property
9% Other

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 sales tax

◮ Sales tax—contribution paid for each unit traded

◮ Tax rate
– Real life—percentage of transaction value
– This class—fixed number of dollars per unit sold

◮ Wedge between the unit price paid by sellers and received by buyers

Pbuyers = Psellers + T

◮ Tax revenue from sales tax

Tax Revenue = T × Q

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 a competitive market

1.50

1.25 S

1.00

0.75 b

0.50

0.25 D

100 200 300 400 500 Q

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 50 cents tax on sellers =⇒ shortage
P

1.50

1.25 S

1.00

0.75 b
wedge

0.50

0.25 b
D

100 200 300 400 500 Q

shortage

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 50 cents tax on sellers
P

1.50 S + tax

1.25 S

1.00

0.75 b
tax

0.50

0.25 b
D

100 200 300 400 500 Q

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 equilibrium with tax

1.50 S + tax

1.25 S

1.00 b
tax

0.75

0.50 b

0.25 D

100 200 300 400 500 Q

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 tax revenue

1.50 S + tax

1.25 S

1.00 b
tax

0.75

0.50 b

0.25 D

100 200 300 400 500 Q

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 total surplus

1.50 S + tax

1.25 S

1.00 b
tax

0.75

0.50 b

0.25 D

100 200 300 400 500 Q

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value added vs. final consumer

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 Who pays the sales tax?

Who should pay the sales tax?

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 tax sellers

1.50 S + tax

1.25 S

1.00 b

0.75 b

0.50 b

0.25 D

100 200 300 400 500 Q

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 tax buyers

1.50

1.25 S

1.00 b

0.75 b

0.50 b

0.25 D

D - tax
100 200 300 400 500 Q

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 Claim — Tax incidence is determined by the elasticity of
demand and supply, not by the text of the law.

◮ More elastic side of the market faces:

– Smaller change in prices
– Smaller drop in surplus

◮ More elastic market s result in =⇒ larger distortions

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 tax burden and incidence

1.50 S + tax

1.25 S

1.00 b

0.75 b

0.50 b

0.25 D

100 200 300 400 500 Q

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 demand elasticity and incidence

P P

S + tax S + tax

S S

b b

D
b

Q Q

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 supply elasticity and incidence

P P

S + tax
S + tax

S
b

S
b b

D D

Q Q

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 summary

◮ Taxes generate revenue for the government

◮ Taxes distort trade

– Positive taxes decrease trade
– Negative taxes (subsidies) increase trade

◮ Distortions and tax incidence are determined by elasticities

◮ In perfectly competitive markets, taxes generate dead-weight loss

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decreasing consumption

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 Definition — quotas are regulations that imposes economic
or legal sanctions for excessive consumption, production,
and/or trade of certain goods

◮ Legal with limits:

– Carbon credits
– Import quotas

◮ Completely illegal:
– Transactions—slavery, prostitution, gambling, organ trade
– Products—drugs, weapons, biological imports
– Applications—Google, TikTok, Uber

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 why prevent voluntary trade?

◮ Negative externalities (next chapter)

◮ Paternalism
– Misinformation
– Behavioral issues

◮ Moral/religious reasons

◮ “Public Interest”

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how do we reduce smoking?

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 Becker (1981)

“Imagine each family as a kind of

little factory–a multiperson unit
producing meals, health, skills,
children, and self-esteem from
market goods and the time, skills,
and knowledge of its members.”

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 tax vs. ban

◮ Both increase the cost of performing the activity

◮ Important differences in incentives

– Probability of getting caught
– Punishment if caught significantly worse
– Bans create moral incentives
– Crime can lead to issues

◮ Important differences in consequences

– Costly enforcement instead of revenue
– Social consequences of criminalizing behavior

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Should we target sellers, buyers, of both?

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 target sellers
P

1.50 S + CBL

1.25 S

1.00 b

0.75 b

0.50

0.25 D

100 200 300 400 500 Q

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 target buyers
P

1.50

1.25 S

1.00

0.75 b

0.50 b

0.25 D

D - CBL

100 200 300 400 500 Q

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 target both
P

1.50 S + CBL

1.25 S

1.00

0.75 b b

0.50

0.25 D

D - CBL

100 200 300 400 500 Q

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 5

2
prohibition 1920–1933
1
1920: 30%
0
1925: 65%
-1
1930: 71%
-2
1935: 100%
-3
Miron & Zwiebel (1991)
-4

-5
-5 -4 -3 -2 -1 0 1 2 3 4 5 75 / 85
 Smoking prevalence among Canadians 15+
b

0.6

b
b

0.5 b

b
males
b

overall
b
b
b
b b
b

b b

females
b
0.4 b
b

b b b b
b
b b
b
b b
b b
b b
b b b
b b b b
b
0.3 b b
b
b b
b
b b
b b b
b b
b b
b b b b
b b b
b b

0.2 b b b
b b
b
b
b b
b
b b

b b b b
b
b b b b
b
b b b b b b
b b b
b b
b
b b b
b b
b

0.1 b b
b

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
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Imtiaz, Sameer, et al. (2023) “Cannabis legalization and cannabis use, daily cannabis use and
cannabis-related problems among adults in Ontario, Canada (2001–2019),” Drug and Alcohol
Dependence.

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 800
US cannabis related arrests (1000 people) b

700
b b
possession
b
b b
600 b
b
b

500 b

400

300

200

100 b b b
distribution/manufacturing
b b
b b b b
b

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

https://drugabusestatistics.org/drug-related-crime-statistics/

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link to graph source from Our World in Data

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discussion

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optimal policy 6= real-life government policy

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BBC: Cancer children given water instead of
chemotherapy by Mexican governor

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◮ Market policies can target different goals:
– Prices
– Quantities
– Government revenue

◮ Effects can depend on market specifics—degree of competitiveness

◮ Economic models can help predict consequences

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 wrong takeaway

◮ All markets are efficient

◮ Government interventions distort markets

◮ We should have smaller governments

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 better takeaway

◮ Public policy can have unintended consequences

◮ All policies affect both quantities and prices

◮ Affecting quantities also affects total surplus

◮ These consequences must be taken into consideration

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