14.7 Effect of Government Policies
The “ideal” model of perfect competition analyzes a situation in which buyers and sellers are more or less left alone to seek out profitable deals: the only role of a “government” is to support the market by enforcing contracts. Beyond that, buyers and sellers are free to conclude any mutually beneficial transaction they would like to. This is sometimes called laissez-faire capitalism, from the French phrase meaning to “let people do” whatever they wish, free from government interference.
In reality, for a variety of reasons, governments do involve themselves in markets, and their actions result in a different equilibrium than would otherwise occur. For the rest of the chapter we’ll look at two classic examples of this: taxes and subsidies and price controls.
Taxes and Subsidies
We’re all familiar with sales taxes: an amount that’s added on to the bill, which goes to one or more governing bodies. That is, if consumers pay $p_C$ and firms receive $p_F$, then in the presence of a tax $t$, \(p_C = p_F + t\) For example, when you eat at a restaurant, the bill usually includes the price listed on the menu, plus a tax. If you buy gas from a gas station, generally the posted price includes all taxes. (In many states, but not all, you’ll see a little sticker on every gas pump saying how much of the list price is going to local, state, and federal taxes.) In each case, the amount the consumer pays goes to two recipients: part of it goes to the seller, and part goes to the government.
A subsidy is like a negative tax: the government actually pays the seller (or the buyer) extra money to engage in the transaction. For example, solar panels in the United States currently enjoy a federal subsidy of approximately 30%. Again, this can work in one of two ways: the seller can charge a lower price because they will be reimbursed by the government, or the buyers can claim a credit on their federal income taxes. Either way, the amount firms receive from selling solar panels is actually more than the price consumers pay: in the presence of a subsidy $s$, \(p_F = p_C + s\)
There are different kinds of taxes and subsidies. Some are a fixed dollar amount per unit of the good: for example, since 1993, the federal government has imposed a tax of 18.4 cents a gallon regardless of the price of gas. Other taxes are a percentage of the listed price: for example, the State of California currently imposes a sales tax based on which county the sale takes place in; in Santa Clara County, it’s 9.125%. Mathematically, we would express this as \(p_C = 1.09125p_F\) or more generally, if the tax rate is $\tau$, as \(p_C = (1 + \tau)p_F\) where $\tau = 0.1$ would correspond to a 10% tax.
Price Controls
A tax or subsidy can be thought of as the government distorting incentives by changing the prices paid by buyers and received by sellers; however, once the tax or subsidy is imposed, the market can reach a new equilibrium in which the quantity demanded is equal to the quantity supplied. As we’ll see in a moment, a tax will generally reduce the equilibrium quantity of a good bought and sold in a market, while a subsidy will generally increase the equilibrium quantity.
By contrast, a price control involves the government directly imposing rules on the price at which a particular good may be sold. In some ways, this might seem less intrusive, since the government isn’t (necessarily) collecting any tax revenue or paying any subsidies. However, whenever supply and demand can’t equilibrate, you can get severe unintended consequences.
There are fundamentally three types of price controls:
- A specific (possibly zero) price dictated by the government. There are some goods for which the government sets the price directly. Sometimes, as in the case of public education, that price is zero: anyone has a legal right to go to their local public school at no cost. But governments can also set specific prices for goods: for example, in World War II, the U.S. Government rationed many goods, and consumers had to pay for those goods using ration stamps at a specified number of “ration points” for each good.
- A price floor specifying the lowest legal price for a good. For example, the State of California wanted to reduce the usage of single-use plastic bags by grocery stores. To achieve this, they imposed a “ban” that is actually a price floor of 10 cents per bag. Another classic example of a price floor are minimum wage laws, which specify that employers must pay a minimum hourly wages.
- A price ceiling specifying the highest legal price for a good. The classic example here is rent control, which limits how much a landlord can charge in rent for an apartment. More recently, many states have introduced price caps on insulin, a life-saving medication for diabetics which had risen dramatically in price over the past few decades.
Depending on the elasticity of supply and demand, as well as the degree to which markets were really competitive in the first place, these kinds of policies may have a greater or lesser effect. Let’s use the apparatus of the supply and demand model to analyze each of them in turn.