Chapter 4 government controls

CHAPTER 4 Government Controls: How Management Incentives Are Affected Without bandying jargon or exhibiting formulae, without being superficial or condescending, the scientist should be able to communicate to the public the nature and variety of consequences that can reasonable be expected to flow from a given action or sequence of actions. In the case of the economist, he can often reveal in an informal way, if not the detailed chain of reasoning by which he reaches his conclusions, at least the broad contours of the argument. E. J. Mishan arlier chapters showed how the models of competitive and monopolistic markets illuminate the economic effects of market changes, such as an increase in the price of oil. This chapter will examine the use of government controls to soften the impact of such changes. We will consider four types of government control: excise taxes, price controls, consumer protection laws, and minimum-wage laws. As we will see, government controls can inspire management reactions that negate some of the expected effects of the controls. Who Pays the Tax? Most people are convinced that consumers bear the burden of excise (or sales) taxes. They believe producers simply pass the tax on to consumers at higher prices. Yet every time a new (or increased) excise tax is proposed producers lobby against it. If excise taxes could be passed on to consumers, firms would have little reason to spend hundreds of thousands of dollars opposing them. In fact, excise taxes do hurt producers. Figure 4.1 shows the margarine industry’s supply and demand curves, S 1 and D. In a competitive market, the price will end toward P2 and the quantity sold toward Q 3 . If the state imposes a $0.25 tax on each pound of margarine sold and collects the tax from producers, it effectively raises the cost of production. The producer must now pay a price not just for the right to use resources, such as equipment and raw materials, but for the right to continue production legally. The supply curve, reflecting this cost increase, shifts to S 2 . The vertical difference between the two curves, P 2 and P 1 , represents the extra $0.25 cost added by the tax. E Chapter 4 Government Controls: How Management Incentives Are Affected 2 2 ____________________________________ Figure 4.1 The Economic Effect of an Excise Tax An excise tax of $0.25 will shift the supply curve for margarine to the left, from S 1 to S 2 . The quantity produced will fall from Q 3 to Q 2 ; the price will rise from P 2 to P 3 . The increase, $0.20, however, will not cover the added cost to the producer, $0.25. Given the shift in supply, the quantity of margarine produced falls to Q 2 and the price rises to P 3 . Note, however, that the price increase (P 1 to P 2) is less than the vertical distance between the two supply curves (P 2 to P 1 ). That is, the price increases by less than the amount of the tax that caused the shift in supply. Clearly, the producer’s net has fallen. If the tax is $0.25, but the price paid by consumers rises only $0.20 ($1.20 - $1.00), the producer loses $0.50. It now nets only $0.95 on a product that used to bring $1.00. In other words, the tax not only reduces the quantity of margarine producers can sell, but makes each sale less profitable. Incidentally, butter producers have a clear incentive to support a tax on margarine. When the price of margarine increases, consumers will seek substitutes. The demand for butter will rise, and producers will be able to sell more butter and charge more for each pound. The $0.25 tax in our example is divided between consumers and producers, although most of it ($0.20) is paid by consumers. Why do consumers pay most of the tax? Consumers bear most of the tax burden because consumers are relatively unresponsive to the price change. The result, as depicted in Figure 4.1, is that consumers bear most of the tax burden while producers pay only a small part (20 percent) of the tax. If consumers were more responsive to the price change, then a greater share of the tax burden would fall on producers who would then have more incentive to oppose the tax politically. Indeed, we should that the amount of money producers would be willing to spend to oppose taxes on their product (through campaign contributions or lobbying) will depend critically on the responsiveness of consumers to a price change. The more responsive consumers are, the more producers should be willing to spend to oppose the tax. Chapter 4 Government Controls: How Management Incentives Are Affected 3 3 Price Controls Price controls are by no means a modern invention. The first recorded legal code, the four-thousand-year-old Code of Hammurabi, included regulations governing the maximum wage, housing prices, and rents on property such as boats, animals, and tools. And in A.D. 301, the Roman Emperor Diocletian issued an edict specifying maximum prices for everything from poultry to gold, and maximum wages for everyone from lawyers to the cleaners of sewer systems. The penalty for violating the edict was death. More recently, wage and price controls have been used both in wartime (during the Second World War and the Korean War) and in peacetime. President Richard Nixon imposed an across-the-board wage-price freeze in 1971. Prime Minister Pierre Trudeau imposed controls on the Canadian economy in 1975. President Jimmy Carter controlled energy prices in 1977 and later proposed the decontrol of natural gas. Wage and price controls are almost always controversial. Like attempts to control expenditures, they often create more problems than they solve. We will examine both sides of the issue, starting with the argument in favor of controls. Figure 4.2 The Effect of an Excise Tax When Demand is More Elastic Than Supply If demand is much more elastic than supply, the quantity purchased will decline significantly when supply decreases from S 1 to S 2 in response to the added cost of the excise tax. Producers will lose $0.20; consumers will pay only $0.05 more. The Case for Price Controls The case for price ceilings on particular products is complex. On the most basic level, many people believe that prices should be controlled to protect citizens from the harmful effects of inflation. When prices start to rise, redistributing personal income and disrupting the status quo, it seems unfair. Price controls may seem especially legitimate to people, like the elderly, who must live on fixed incomes, and have little means of compensating for the effects of price increases on goods like oil and gas. Chapter 4 Government Controls: How Management Incentives Are Affected 4 4 Unearned Profits Many proponents of price controls view the supply curve for a controlled good as essentially vertical. They believe that a price rise will not affect the quantity produced. Consumers will get nothing more in the way of goods, but producers will reap a windfall profit. Instead of an incentive to produce more, profit is seen as an economic rent—an exploitative surplus received by companies fortunate enough to be in the market at the right time. Administered Prices A technical argument for price controls is most often advanced by economists and public officials. Many economists maintain that a significant segment of the business and industrial community—the larger firms that control a sizable portion of industry sales— no longer responds to the forces of supply and demand. Firms in highly concentrated industries like steel, automobiles, computers, and tobacco can override market forces by manipulating their output so as to set price levels. Furthermore, they can manage the demand for their products through advertising campaigns. With market forces ineffective, control must come from the government. Price controls are the only way to avoid the production inefficiencies and inequitable distribution of income that result from concentration of industry. As John Kenneth Galbraith, a leading advocate of price controls, has put it, “Controls are made necessary because planning has replaced the market system. That is to say that the firm and the union have assumed the decisive power in setting prices and wages. This means that the decision no longer lies with the market and thus with the public.” 1 Monopoly Power Later in the course, we will see how a monopolist can be expected to restrict output in order to push up its price in order to earn greater profits. The case for price controls under monopoly conditions is, for many advocates of controls, a matter of “fairness.” The controls give back to consumers what they “deserve” in terms of lower prices. However, as we will see, under monopoly conditions, if the producer is forced to charge a (somewhat) lower price, the producer will rationally choose to increase the output level. Hence, price controls benefit consumers in two ways, first through lower prices and then through greater output. The Case Against Price Controls Just as the case for price controls is tied closely to the existence of monopoly power, the case against controls rests heavily on the competitive market model. Economists who 1 John Kenneth Galbraith, Economics and the Public Purpose (Boston: Houghton Mifflin, 1973), p. 315. Chapter 4 Government Controls: How Management Incentives Are Affected 5 5 oppose controls feel that competition is sufficient to govern business behavior, including pricing decisions. Opponents of controls also stress the individual’s right to act without government interference—a right they see as crucial to a society’s ability to adjust to social and environmental change. When we say that the prices of certain products should be controlled by government, what do we mean by “government”? Can government as we know it consistently reflect the public interest? Is government immune to human failings? Opponents of price controls emphasize that the pricing decisions made by any government agency will reflect the will of its staff. Personal preference will loom large in their decisions on what constitutes a just price and a just allocation of goods and services. Political considerations may also play a role. Firms with a talent for political maneuvering will have an advantage under a price control system. In other words, competitive behavior is not necessarily reduced by price controls, though its form of expression may be changed. If price controls are complemented by a system of government allocation of supplies, then strikes, demonstrations, and violence may also influence government decisions. During the energy crisis of 1973—1974, and again in 1978, the federal government regulated the allocation of crude oil between gasoline and diesel fuel producers. When truckers received less fuel than they claimed they needed, independent drivers stuck, threatening to paralyze the nation’s commerce unless they got more fuel at lower prices. To ensure cooperation among drivers, the strikers blocked roads, vandalized the equipment of nonstrikers, and shot at drivers who ventured out on the road. One trucker was killed, and others were seriously injured. At least for a short time, such tactics were productive. The government agreed to earmark more crude oil for diesel fuel production and to lower the federal excise tax on diesel fuel. (Courts later declared those decisions illegal.) Shortages and the Effective Price of a Product In a competitive market, any restriction on the upward movement of prices will lead to shortages. Consider Figure 4.3, which shows supply and demand curves for gasoline. Initially, the supply and demand curves are S 1 and D, and the equilibrium price is P 1 . Now suppose that the supply of gasoline shifts to S 2 , and government officials, believing that the new equilibrium price is unjust, freeze the price at P 1 . What will happen to the market for gasoline? At price P 1 , which is now below equilibrium, the number of gallons demanded by consumers is Q 2 , but the number of gallons supplied is much lower, Q 1 . A shortage of Q 2 -- Q 1 gallons has developed. As a result, some consumers will not get all the gasoline they want. Some may be unable to get any. Because of the shortage, consumers will have to wait in line to get whatever gasoline they can. To avoid a long line, they may try to get to the service station early— but others may do the same. To assure themselves a prime position, consumers may have to sit at the pumps before the station opens. In winter, waiting in line may mean wasting gas to keep warm. The moral of the story: although the pump price of gasoline may be Chapter 4 Government Controls: How Management Incentives Are Affected 6 6 held constant at P 1 , the effective price -- the sum of the pump price and the values of time lost waiting in line -- will rise. Shortages can raise the effective price of a product in other ways. With a long line of customers waiting to buy, a service station owner can afford to lower the quality of his service. He can neglect to clean windshields or check oil levels, and in general treat customers more abruptly than usual. As a result, the effective price of gasoline rises still higher. Again, during he energy crises of 1973-1974 and 1978, some service station owners started closing on weekends and at night. A few required customers to sign long- term contracts and pay in advance for their gasoline. The added interest cost of advance payment raised the price of gasoline even higher. Figure 4.3 The Effect of Price Controls on Supply If the supply of gasoline is reduced from S 1 to S 2 , but the price is controlled at P 1 , a shortage equal to the difference between Q 1 and Q 2 will emerge. Black Markets and the Need for Rationing Besides such legal maneuvers to evade price controls, some businesses may engage in fraud or black marketeering. During the winter of 1973—1974, a good many gasoline station owners filled their premium tanks with regular gasoline and sold it at premium prices. At the same time, a greater-than-expected shortage of heating oil developed. Truckers, unable to get all the diesel fuel they wanted at the controlled price, had found they could use home heating oil in their trucks. They paid home heating oil dealers a black market price for fuel oil, thus reducing the supply available to homeowners. As always, government controls bring enforcement problems. To assure fair and equitable distribution of goods in short supply, some means of rationing is needed. If no formal system is adopted, supplies will be distributed on a first- come, first-served basis—in effect, rationing by congestion. A more efficient method is to issue coupons that entitle people to buy specific quantities of the rationed good at the prevailing price. By limiting the number of coupons, government reduces the demand for the product to match the available supply, thereby eliminating the shortage and relieving the congestion in the marketplace. In Figure 4.4, for example, demand is reduced from D 1 to D 2. Chapter 4 Government Controls: How Management Incentives Are Affected 7 7 The coupon system may appear to be fair and simple, but how are the coupons to be distributed? Clearly the government will not want to auction off the coupons, for that would amount to letting consumers bid up the price. Should coupons be distributed equally among all consumers? Not everyone lives the same distance from work or school. Some, like salespeople, must travel much more than others. Should a commuter receive more gas than a retired person? If so, how much more? Should the distribution of coupons be based on the distance traveled? (And if such a system is adopted, will people lie about their needs?) These are formidable questions that must be answered if a coupon system is to be truly equitable. By comparison, the pricing system inherently allows people to reflect the intensity of their needs in their purchases. Once the coupons are distributed, should the recipients be allowed to sell them to others? That is, should legal markets for coupons be permitted to spring up? If the deals made in such a market are voluntary, both parties to the exchange will benefit. The person who buys coupons values gasoline more than her money. The person who sells his coupons may have to cut back on driving, but he will have more money to buy other things. The seller must value those other things more than lost trips, or he would not agree to make the exchange. The positive (and often high) market value of coupons shows that price controls have not really eliminated the shortage. __________________________________________ Figure 4.4 The Effect on Rationing on Demand Price controls can create a shortage. For instance, at the controlled price P 1 , a shortage of Q 2 -- Q 1 gallons will develop. By issuing a limited number of coupons that must be used to purchase a product, government can reduce demand and eliminate the shortage. Here rationing reduces demand from D 1 to D 2 , where demand intersects the supply curve at the controlled price. Furthermore, if the coupons have a value, the price of a gallon of gasoline has not really been held constant. If the price of an extra coupon for one gallon of gasoline is $0.50 and the pump price of that gallon is $1.25, the total price to the consumer is $1.75 ($0.50 + $1.25). The existence of a coupon market means that the price of gasoline has risen. In fact, the price to the consumer will be greater under a rationing system than under a pricing system. This is because the quantity supplied by refineries will be reduced. Chapter 4 Government Controls: How Management Incentives Are Affected 8 8 Perhaps the most damaging aspect of a rationing system is that the benefits of such a price increase are not received by producers—oil companies, refineries, and service stations—but by those fortunate enough to get coupons. Thus the price increase does not provide producers with an incentive to supply more gasoline. (If the increase went to producers, their higher profits would encourage them to search for new sources of oil and step up their production plans.) Consumer Protection Less than one hundred years ago the general rule of the marketplace was caveat emptor— “let the buyer beware.” The individual consumer was held responsible for the safety, quality, and effectiveness of his purchases. The seller could assume liability for the safety and effectiveness of goods and services, but only through a contract endorsed by both parties. The same rule applied to contracts: the buyer was responsible for what he signed. Although consumers could sue sellers for breach of contract or for fraud, no government agency would initiate the suit. Nor did government protect citizens in other ways from the products they bought. During this century, however, product liability has gradually shifted from the consumer to the producer and the seller. Both court decisions and changes in the law have contributed to this shift. Many now see consumer protection as a government function. The Case for Consumer Protection The argument for relieving consumers of product liability resembles the argument for regulation of utilities in many respects. Both cases hinge on the costs of gaining information and the problems created by external benefits and costs and monopoly power. External Benefits When two cars collide, both cars will sustain less damage and both drivers less injury if just one of the cars is equipped with protective bumpers. Thus people who do not buy protective bumpers can benefit from others’ investments. If many car buyers ignore the benefits others may receive from their purchases, the quantity of shock-absorbing bumpers sold will be less than the socially desirable or economically efficient amount. This analysis of external benefits can be extended to include the concept of consumer protection. Suppose the supply curve in Figure 4.5 is the industry’s willingness to offer protective bumpers. The demand curve D 1 represents consumer demand based on the private benefits to consumers, while D 2 represents private plus public (external) benefits. Under competitive conditions, the quantity produced and sold in the marketplace will be Q 1 —even though up to Q 2 , the total benefits of bumpers exceed their cost. The private benefits of the bumpers are small enough that many people cannot justify purchasing them. Chapter 4 Government Controls: How Management Incentives Are Affected 9 9 Graphically, the vertical distance between the two demand curves, ab, represents the external benefits per bumper sold that are not being captured by the market. Government can close this gap by setting product standards. By requiring new cars to have shock-absorbing bumpers, government effectively increases demand from D 1 to D 2. It forces people to expand their purchases from Q 1 to Q 2 , thus capturing the external benefits shown by the shaded area abc. __________________________________________ Figure 4.5 The External Benefits of Consumer Protection Private demand for shock-absorbing bumpers is shown by the demand curve D 1 : total demand (private plus public, or external, benefits), by D 2. The vertical distance between the two curves represents the social benefits from each bumper. In a free market, Q 1 bumpers will be sold. If all benefits are considered, however, the efficient output level will be Q2. By requiring people to purchase Q 2 bumpers, government can capture the external benefits shown by the shaded area abc. If the government requires consumers to buy more than Q 2 bumpers, however, excess costs will be incurred. If Q 4 bumpers are purchased, their excess social cost, shown by the shaded area cde, will offset their social benefits (abc). The net social gain will be zero. This approach can be extended to a wide range of goods and services that offer significant external benefits, from safety caps for drugs to protective devices for explosives. This argument does not justify unlimited government intervention, however. We cannot conclude, for example, that all automobiles must have shock-absorbing bumpers. Such a requirement might result in the purchase of far more than Q 2 bumpers. Beyond Q 2 , the marginal cost of safety bumpers is greater than their marginal benefit. An excess burden, or net social cost, is incurred when the public must purchase more than Q 2 . If the public is required to purchase Q 4 bumpers, for instance, the excess burden will be equal to the shaded area cde. The social cost of extending purchases to Q 4 just equals the social benefits of extending purchases to Q 2 (shown by the area abc). Consequently, there is no real net social benefit in moving to Q 4 . If the required number of bumpers is greater than Q 2 but less than Q 4 , some net social benefit will be realized. At Q 3 , the excess social cost cfg is smaller than the social benefit abc. Some net benefit will be realized. Up to a point, then, consumer protection can be socially beneficial. Society, however, can end up purchasing too much of a good thing. It is possible to make the world so safe that few resources are available for any other purpose. Chapter 4 Government Controls: How Management Incentives Are Affected 10 10 Nevertheless, governments tend to require safety devices for all products in a category. Determining the optimum quantity is so difficult and costly that a blanket rule is preferable. Yet as opponents of consumer protection point out, the blanket rule itself may be extremely costly if it requires more than the socially beneficial quantity to be produced. Ultimately, the question comes down to the actual costs and benefits of particular product standards. External Costs The argument for consumer protection based on external costs is closely related to the argument for pollution control (a point to be taken up later in the book). If the consumers who use a product do not bear all the costs associated with its use, they will tend to consume more of the good than is socially desirable. In the process they will impose a cost on others. For example, a person who buys a spray deodorant incurs a private cost equal to its money price. If the release of the chemicals used in aerosol sprays has a harmful effect on the earth’s ozone layer, as many scientists believe, however, the use of such products imposes an external cost on nonusers. At the very least, the public incurs a risk cost from the use of aerosol sprays. Curve D in Figure 4.6 shows the market demand for spray deodorant. The supply curve S 1 shows the marginal cost of producing the good, not counting the ozone effect. In a competitive market, the quantity of spray deodorant purchased will be Q 2 . If producers have to compensate those who bear the external costs of their product, however, their supply curve will shift to S 2 , and the quantity purchased will drop to Q 1 . The vertical distance between the two supply curves represents the external, or ozone, cost of each can sold. By including this cost in the price of the product, the government reduces social costs by the shaded area. ____________________________________ Figure 4.6 The External Costs of Consumer Protection Curve S 1 represents the supply curve for spray deodorant, not including external costs. Curve S 2 represents the total cost, including harm to the earth’s ozone layer. Thus the vertical distance between S 1 and S 2 shows the external cost of producing each can of spray deodorant. In a free market, Q 2 cans will be produced—more than the efficient level, Q 1 . Government can eliminate over- production by internalizing the external costs of production, shown by the shaded area. The argument does not necessarily demonstrate that spray cans should be banned. The amount of government regulation should depend on the degree of external cost. If