Minimum wage and price controls · Economics 6th Year OL

Price ceilings and price floors

In a free market, the price settles where demand equals supply. Sometimes the Government thinks that price is unfair, so it steps in and sets a legal limit. There are only two kinds of limit.

A control only matters if it is binding, which means it is set on the "wrong" side of the equilibrium price.

A ceiling set below equilibrium is binding. A ceiling set above equilibrium changes nothing, because the market price is already lower.
A floor set above equilibrium is binding. A floor set below equilibrium changes nothing.

The pattern is the same in every case. The short side of the market decides how much is actually traded, because nobody can be forced to buy or sell more than they want.

With a binding ceiling, the price is held low, so quantity demanded is greater than quantity supplied. This is a shortage, and only $Q_s$ is traded.
With a binding floor, the price is held high, so quantity supplied is greater than quantity demanded. This is a surplus, and only $Q_d$ is traded.

Practice★☆☆

Define a "price ceiling" and a "price floor". Give one example of each from the Irish economy.

Solve

The national minimum wage

The wage is the price of labour, so a minimum wage is a price floor in the labour market. In Ireland the National Minimum Wage is set by law and applies to nearly all employees. The Government takes advice from the Low Pay Commission before changing it.

Here the "buyers" are employers (demand for labour, $Q_d$) and the "sellers" are workers (supply of labour, $Q_s$).

Read the diagram in this order:

Find the equilibrium wage $W^*$ and employment where demand meets supply.
Draw the minimum wage above it. It is binding.
Employers now hire only the number on the demand curve at that wage.
More people want to work at that wage (the supply curve). The gap between the two is unemployment.

Why does this happen? A higher wage makes each worker more expensive, so firms hire fewer. At the same time, the higher wage attracts more people into the labour market.

Worked example: effect of a minimum wage

Demand for low-skilled workers is $Q_d = 9{,}000 - 300W$ and supply is $Q_s = 1{,}000 + 500W$, where $W$ is the hourly wage in euro. A minimum wage of €12 is introduced. Find the effect on employment, unemployment and total wages.

Equilibrium. Set $Q_d = Q_s$: $9{,}000 - 300W = 1{,}000 + 500W$, so $8{,}000 = 800W$ and $W = 10$. Then $Q = 9{,}000 - 300(10) = 6{,}000$ workers.

Is it binding? €12 is above the equilibrium wage of €10, so yes.

Employment. At €12, employers demand $9{,}000 - 300(12) = 5{,}400$ workers. Employment is the short side, so 5,400 workers are employed.

Unemployment. At €12, the supply is $1{,}000 + 500(12) = 7{,}000$ workers. Unemployment is $7{,}000 - 5{,}400 = 1{,}600$.

Total wage bill (per hour, all workers working one hour). Before: $10 \times 6{,}000 = \text{€}60{,}000$. After: $12 \times 5{,}400 = \text{€}64{,}800$. The wage bill rises by €4,800.

Your turn: do the workers who keep their jobs gain as a group? Does the group that lost jobs gain? Write one sentence about each before you check.

Workers still in jobs gain: they are paid more in total, even though there are fewer of them. The 600 workers who lost their jobs (6,000 down to 5,400) lose their earnings. The extra people drawn into the market (the 1,000 extra workers who would have supplied labour at €12) cannot find jobs. So the 1,600 unemployed are the 600 who lost their jobs plus these 1,000 new job-seekers. So the policy helps some low-paid workers and hurts others.

Does the total wage bill rise or fall? Elasticity of labour demand

In the example, the wage rose by 20% and employment fell by only 10%. Demand for labour was inelastic over that range, so the wage bill rose.

If labour demand is inelastic (firms cannot easily replace workers or cut back), a minimum wage costs few jobs and raises the incomes of workers overall.
If labour demand is elastic (firms can use machines, cut hours, or sell in a very price-sensitive market), the same rise costs many jobs and the total wage bill may fall.

This is why the effect is bigger in sectors such as hospitality and retail, where employers have tight margins and customers are very price-sensitive.

The monopsony argument

So far we assumed many employers competing for workers. In a monopsony there is only one dominant employer (a single large employer in a small town, for example). It can pay workers less than the competitive wage, because workers have nowhere else to go. In that case, a minimum wage set at a sensible level can actually raise employment as well as pay: the higher wage draws more workers in, and the employer has no reason to cut back until the minimum wage rises above the competitive level, where the wage equals the marginal revenue product (MRP) of labour.

Arguments for and against

In favour	Against
Raises incomes of low-paid workers and may reduce poverty	May reduce employment, especially for young and low-skilled workers
Makes work more attractive than relying on welfare	Raises firms' costs, which may mean higher prices (inflation) or cuts to hours
Counters monopsony power and exploitation	Not well targeted: many minimum wage earners live in households that are not poor
Increases spending power and demand	May push firms towards automation or the hidden economy

Practice★☆☆

The market equilibrium wage for cleaners in a town is €11 per hour. The Government sets a national minimum wage of €13 per hour. At €13, employers demand 4,000 workers…

The market equilibrium wage for cleaners in a town is €11 per hour. The Government sets a national minimum wage of €13 per hour. At €13, employers demand 4,000 workers and 5,500 workers offer to work.

a) Is the minimum wage binding? Explain.

b) How many workers are unemployed as a result?

Solve

Practice★☆☆

State two arguments in favour of and two arguments against a national minimum wage.

Solve

Practice★★☆

Demand for low-skilled workers in a sector is $Q_d = 12{,}000 - 400W$ and supply is $Q_s = 2{,}000 + 600W$, where $W$ is the hourly wage in euro. a) Find the equilibrium…

Demand for low-skilled workers in a sector is $Q_d = 12{,}000 - 400W$ and supply is $Q_s = 2{,}000 + 600W$, where $W$ is the hourly wage in euro.

a) Find the equilibrium wage and employment.

b) A minimum wage of €12 is introduced. Calculate employment and unemployment.

c) Calculate the change in total wages paid to employed workers and say whether employed workers as a group gain.

Solve

Rent caps: a price ceiling in housing

When rents rise sharply, governments are tempted to cap them. In Ireland, Rent Pressure Zones limit how much a landlord can raise the rent on an existing tenancy each year. A strict cap on the rent level is the textbook price ceiling, and it shows the standard result.

Worked example: a rent cap

Demand for rented flats in a town is $Q_d = 3{,}000 - P$ and supply is $Q_s = 600 + 0.5P$, where $P$ is the monthly rent in euro. A cap of €1,200 is introduced. Find the shortage.

Equilibrium. $3{,}000 - P = 600 + 0.5P$, so $2{,}400 = 1.5P$ and $P = 1{,}600$. Then $Q = 3{,}000 - 1{,}600 = 1{,}400$ flats.

Is the cap binding? €1,200 is below €1,600, so yes.

Quantity demanded at the cap: $3{,}000 - 1{,}200 = 1{,}800$.

Quantity supplied at the cap: $600 + 0.5(1{,}200) = 1{,}200$.

Shortage $= 1{,}800 - 1{,}200 = 600$ flats. Only 1,200 flats are rented, 200 fewer than before.

Your turn: tenants in the 1,200 flats pay €400 less per month than before. Why can this still be a bad outcome for renters as a whole?

Because 600 households who want a flat at €1,200 cannot get one, and the number of flats actually available fell from 1,400 to 1,200. Those who keep a flat gain, but the shortage means long queues, and some tenants pay hidden costs.

Who loses, and how? Unintended consequences

When the price cannot clear the market, other things adjust instead.

Fewer homes and lower quality. Landlords have less reason to build, to let, or to spend on maintenance. Some sell up. Fewer flats are available and repairs may be neglected.
Rationing by other means. With more applicants than flats, landlords choose by queue, connections or "key money". Prices can reappear in other forms.
Insiders and outsiders. Existing tenants gain. Newcomers and young people looking for their first flat lose.

Deadweight loss

A binding ceiling means that some trades that would have benefited both sides do not happen. That lost surplus is the deadweight loss. On the diagram it is the triangle between the demand curve, the supply curve and the quantity actually traded.

The area of the triangle is $\tfrac{1}{2} \times \text{base} \times \text{height}$. The base is vertical (the gap between the demand price and the supply price at the traded quantity), and the height is horizontal (the gap between the traded quantity and the equilibrium quantity).

Short run and long run

Elasticity changes with time. In the short run, the supply of housing is highly inelastic: you cannot build flats overnight, so the cap reduces the quantity supplied only a little (and tenants gain). In the long run, supply is elastic: developers stop building and landlords exit the market, so the supply curve is flatter and the shortage and the fall in the stock of housing are much larger.

Alternatives to a cap

Governments often try to tackle affordability without the same distortions: increasing the supply of housing (planning reform, social and affordable housing), rent subsidies or housing supports for low-income tenants, and tax measures to reward long-term lettings. These target the problem directly, but they cost the taxpayer money and subsidies in a market with inelastic supply may simply push rents up.

Practice★★☆

The market for rented flats in Cork city has demand $Q_d = 4{,}000 - 2P$ and supply $Q_s = 1{,}000 + 1P$, where $P$ is the monthly rent in euro and $Q$ is the number of…

The market for rented flats in Cork city has demand $Q_d = 4{,}000 - 2P$ and supply $Q_s = 1{,}000 + 1P$, where $P$ is the monthly rent in euro and $Q$ is the number of flats.

a) Calculate the equilibrium rent and quantity.

b) The Government introduces a rent cap at €900 per month. Calculate the quantity demanded, the quantity supplied and the shortage.

c) Explain two possible consequences for the quality and availability of rental housing.

Solve

Practice★★★

A rent cap is applied to a city's housing market in which demand is relatively inelastic in the short run and supply is highly inelastic in the short run but elastic in…

A rent cap is applied to a city's housing market in which demand is relatively inelastic in the short run and supply is highly inelastic in the short run but elastic in the long run.

a) Explain the short-run and long-run effects of the cap on the quantity of rented housing available.

b) Calculate the deadweight loss if the demand function is $P = 2{,}000 - 0.5Q$, supply is $P = 500 + 0.25Q$ and the cap is €800. (Assume the quantity traded equals quantity supplied at the cap.)

c) Discuss two alternative policies that could address affordability without the same distortions.

Solve

Minimum prices for goods: milk and alcohol

A price floor can also be set on a product. There are two common reasons.

To protect producers' incomes. Farm products are an example. Under the EU's Common Agricultural Policy, support prices have been used to keep farmers' incomes up.
To discourage consumption. Ireland has introduced a minimum unit price for alcohol, so that very cheap, strong drinks cannot be sold below a set price per gram of alcohol.

The market effect is a surplus. Someone has to deal with it.

Worked example: a surplus of milk

In a market for milk (in millions of litres), $Q_d = 100 - 10P$ and $Q_s = 20 + 30P$, with $P$ in euro per litre. The Government sets a minimum price of €3 per litre.

Equilibrium. $100 - 10P = 20 + 30P$, so $80 = 40P$ and $P = 2$, $Q = 80$. The floor of €3 is above €2, so it binds.

At €3. Demand is $100 - 30 = 70$ and supply is $20 + 90 = 110$. The surplus is $110 - 70 = 40$ million litres.

Cost of buying the surplus at the minimum price: $40 \times \text{€}3 = \text{€}120$ million.

Your turn: name two other ways of dealing with the surplus and say who pays.

The surplus could be stored (storage costs fall on taxpayers, and the milk may go to waste), exported or sold on world markets at a lower price (taxpayers cover the loss), or the Government could set production quotas or pay farmers to produce less (consumers lose choice or taxpayers pay subsidies). In each case, taxpayers or consumers bear part of the cost, and farmers get higher prices than the market would give.

Minimum unit pricing for alcohol

In this case the aim is health, not income. A minimum price on cheap alcohol raises the price for heavy drinkers of cheap drink, and is meant to cut consumption and harm. The effects depend on elasticity: if demand for alcohol is inelastic, consumption falls little and drinkers just spend more. Producers and shops that sell cheap alcohol lose. The Government may gain tax revenue and lower health costs. Some people may switch to other cheap substances or buy across the border.

Practice★★☆

The Government sets a minimum price of €1.20 per litre of milk, above the equilibrium of €0.90. At €1.20, farmers supply 600 million litres and consumers demand 450…

The Government sets a minimum price of €1.20 per litre of milk, above the equilibrium of €0.90. At €1.20, farmers supply 600 million litres and consumers demand 450 million litres.

a) Calculate the surplus.

b) If the Government buys the entire surplus at the minimum price, calculate the cost.

c) Describe two alternative ways of dealing with the surplus and the effects on taxpayers.

Solve

Evaluating price controls

In the Leaving Certificate, "evaluate" means weighing evidence on both sides and reaching a judgement. For price controls, use this checklist.

Diagram. Is the control binding? Is there a shortage or a surplus?
Elasticity. How big is the effect? Elastic demand or supply means big quantity changes.
Who gains? Those who can still buy or sell at the controlled price.
Who loses? Those who can no longer buy or sell, and those who bear the cost.
Unintended consequences. Lower quality, queues, black markets, higher taxes, inflation.
Alternatives and judgement. Is a better-targeted policy available? Under what conditions is the control worthwhile?

Minimum wage, poverty, employment and inflation

Use the checklist for the national minimum wage.

Poverty. It helps if low-paid workers are the main earners in poor households and few jobs are lost. It is less effective when many minimum wage earners (for example part-time students) are in households that are not poor, and it does nothing for people who cannot find work.

Employment. Effects depend on the elasticity of labour demand and on monopsony power. Where employers have market power, a moderate minimum wage may not reduce employment at all.

Inflation. If firms pass higher costs on to customers, prices rise, especially in labour-intensive sectors. The effect is small if the minimum wage is a small share of costs.

A good conclusion is conditional: a moderate minimum wage can reduce poverty at small cost, but a high one risks job losses.

Effectiveness. Judge the policy against its aim. If the aim is to raise the pay of low-paid workers, it works for those who keep their jobs. If the aim is to reduce household poverty, it is only partly effective, because it is poorly targeted and does not help the unemployed. Tax credits or other income supports can be better targeted but cost the Exchequer money.

Question: why do economists disagree about the effect of a minimum wage on employment?

Show answer

Because the effect depends on factors that differ between markets and over time: how far the minimum wage is above the equilibrium wage, how elastic labour demand is, and whether employers have monopsony power. Different studies cover different markets, so they find different results.

Practice★★★

Evaluate the effectiveness of a national minimum wage in Ireland. In your answer, use a labour market diagram described in words, consider the elasticity of labour…

Evaluate the effectiveness of a national minimum wage in Ireland. In your answer, use a labour market diagram described in words, consider the elasticity of labour demand, discuss the monopsony argument, and refer to the effects on poverty, employment and inflation.

Solve

Practice★★★

"Price controls always make the intended beneficiaries worse off." Evaluate this statement with reference to (i) a minimum wage, (ii) a maximum price (rent control) and…

"Price controls always make the intended beneficiaries worse off."

Evaluate this statement with reference to (i) a minimum wage, (ii) a maximum price (rent control) and (iii) a minimum price for alcohol. In each case, identify who benefits, who loses and any unintended consequences.

Solve

Let's practice! 9 exercises in this section

★☆☆ Define a "price ceiling" and a "price floor". Give one example of each from the Irish…★☆☆ The market equilibrium wage for cleaners in a town is €11 per hour. The Government sets a…★☆☆ State two arguments in favour of and two arguments against a national minimum wage.

Summary

A price ceiling limits how high a price can go. A price floor limits how low it can go. Each is binding only if it is set on the "wrong" side of equilibrium.
A binding ceiling creates a shortage and a binding floor creates a surplus. The short side of the market decides the quantity traded.
The national minimum wage is a price floor in the labour market. It raises pay for those in work but can cause unemployment. The effect depends on the elasticity of labour demand and on monopsony power.
A rent cap is a ceiling in the housing market. It helps existing tenants, but it creates a shortage, lower quality and a deadweight loss, and the effect is bigger in the long run when supply is elastic.
A minimum price for milk or alcohol creates a surplus. The Government must buy it, store it, export it or limit supply, and taxpayers often pay.
When you evaluate a price control, use a diagram, discuss elasticity, name who gains and loses and the unintended effects, and finish with a conditional judgement.
Back to Aoife and Conor: the minimum wage may raise Aoife's pay with little risk to her job if labour demand is inelastic, and a rent cap may help Conor if he already has a tenancy, but it could make it harder for him to find a flat in the first place.