welcome back to the foundation course in managerial economics we started with the demand and supply
framework and we have been discussing about elasticity about demand supply framework and
in the very beginning of this section on demand and supply i said that this demand supply
framework is a very useful tool to understand uh lot of changes or dis disruptions or disturbances
in the economy and any external impact or external shock that comes to the system of
the equilibrium that can be understood through the supply demand framework and in this module
todays module we are going to see or we are going to apply the supply demand framework
to understand certain policies of the government so we are going to uh utilize couple of modules
to understand different policies of the government .
now uh in the very first lecture when we discussed about the various principles of economics
you might remember that there was in one of the principles was that uh market is usually
a good way of allocating resources market usually allocates the resources most efficiently
in the (mark) in the economy and uh then we went on to say that there are however exceptions
exceptions where markets fail and we said that uh although market is usually a good
way of doing things where basically the supply and demand they match in the market and we
get equilibrium price we get equilibrium quantity and in the process basically the allocation
the the very scarce resources available in the economy they get allocated into producing
what is demanded most in the market and into producing what the suppliers would like to
supply in the market or have the ability to supply in the market most efficiently
so this is what we discussed and then we went on to say that markets are usually a good
way but not always and when are they not uh the best uh the the best choice to allocate
resources in situations where the market fails that is that there could be situations where
the market outcome is not desirable in the economy
say for example uh say india is a very hugely populated economy with lots of people looking
for jobs and very high level of poverty many people are poor they are hungry and they are
basically looking for jobs and there are not enough jobs uh around so in such a situation
one might imagine that many of the people would like to work at a very low uh amount
of wage now what happens so in the framework of demand
and supply the market is going to clear at a very low level of wage where many people
would be willing to work and obviously the the producers who are going to employ these
people will be very happy to give work to these people at a very low wage
but then the question is uh is this wage acceptable is this wage acceptable to society to people
in general to the government because this wage could be so low that it may not be sufficient
for even to uh maintain a subsistence level of consumption for the people so in these
situations the market clearance that is happening the price quantity equilibrium that is reaching
through the demand supply framework of the market is not a outcome which is desirable
to us so in such a situation the government may
intervene and we also discussed about other situations of market failure where we said
that there could be externalities uh say for example there could be some pollution happening
because of some production process which is not directly harming the producer or the consumer
so neither of the parties is actually paying any cost or assigning any cost to that uh
negative impact of the production process but maybe that production is generally in
general its harming the environment and the other people who are neither directly involved
in the production or purchase of the goods they are not happy about it so what happens
who takes care of that cost that the economy in general is bearing because the production
process is there so this is again a situation of externality
where basically the government steps in and government imposes a tax on the producer or
the consumer and says that uh see this basically the the principle behind the tax is that the
government is trying to impose a cost on the producer and the uh consumer of basically
engaging in a production process which is harming the other people
so uh so in a nutshell government basically intervenes or is supposed to intervene where
the market is failing and government usually is supposed to do a good job out of it and
uh take care of the concerns that is happening because of the market outcome if it is left
to itself so uh as i said market sometimes fail and then government needs to intervene
and this also comes from a very difficult trade off that the society faces
we talked about this also in the first class we said that the very difficult tradeoff that
society faces is the tradeoff between efficiency and equity we would like everyone to have
similar opportunities similar access to resources similar amount of income uh so we would like
that to happen in a society but at the same time uh what happens is usually all resources
go to someone who is more efficient efficiency attracts the resources and they
are the ones who get richer so uh this is this is another very difficult trade off that
the society faces and the government often and the example of the wage that i talked
about is a similar example is a similar example and so government may raise the price in some
cases and may lower it in others so basically what we are saying is uh since
lot of outcome market outcome in the economy is not uh acceptable or desirable to the society
in general the government may step in and in certain situations government may raise
the price uh through various means say for example the government can actually impose
a tax say by increasing the and that that eventually raises the price for a commodity
or the what the government can do is it can set a price floor or a price ceiling
so is also what the government can do and in all these cases market equilibrium is disrupted
so in all these cases market equilibrium is disrupted so obviously what the government
the price that the government is setting or the tax that the government is imposing is
resulting in a outcome of price and hence a outcome of output produced and purchased
which is different from the price quantity equilibrium that a free market is going to
arrive at . so uh ill uh explain through diagrams uh but
before that so when we discussed demand and supply framework and we discussed the different
policies through it the questions that we are primarily asking are how does the government
intervene in the market what does the government actually do and how does it intervene in the
market then already i mentioned these terms price
ceilings and price floors what are they what are price ceilings and price floors and how
do they affect the market outcome i already said that the price ceiling price floor taxes
which the government impose they are going to shift the market equilibrium elsewhere
but how exactly does that happen uh and how do they affect the market outcome that is
what we are going to see and how do taxes affect market outcome uh
again taxes could be imposed either on the buyer or seller or even both so is there any
difference in outcome if the taxes imposed on the buyer or the seller should the government
have a preference who to tax the buyer or the seller what does that depend on does that
depend on the kind of product it is taxing or um is the government revenue going to be
different if it taxes the 2 uh 2 uh stakeholders uh differently
so these are the questions that we are going to ask and what is the incidence of a tax
and what determines the incidence incidence of tax means how much of the tax burden is
basically shared by the buyer or the seller how much if the government is imposing a tax
what is the burden that the tax burden that the buyer actually ends up bearing or the
seller actually ends up bearing that is the incidence of tax and uh some some people may
think that that tax the incidence of the tax should be equal to the tax uh we will see
so what happens . so these are the government interventions
the different kinds of government interventions they can can be much more complex and much
more intricate government interventions but uh in this module we are going to discuss
only about the price controls and taxes so price controls can be of 2 types one is the
price ceiling a legal maximum price set by the government for a particular good or service
for example rent control or price cap on drugs so price ceiling is basically the government
says that the price of this product cannot go up beyond a certain level so the government
basically wants the prices to not go up too high and basically the governments objective
is that this particular good or service should be affordable to most of the people so so
that is probably the objective of the government and that is the reason the government puts
a price uh cap or price ceiling on it say for example rent control where government
says that uh housing should be affordable to most people so this is a rent control the
rent cannot go up beyond a certain level or price cap on essential drug essential medicines
so the government says that uh the medicine should be affordable to everyone uh most people
should uh have access to the medicines so the prices of the medicines cannot go too
high up so there are numerous examples of price control
price ceilings rather the government can also impose price ceilings on essential in most
cases the price ceiling is on essential commodities where basically the objective is that it should
be affordable accessible to uh most people and energy fuel these are also examples where
the government uh all over the world governments have imposed price controls with objective
that energy being the fuel for growth in a economy in fuels a lot of industries manufacturing
units and peoples houses so uh so that is the reason that this is a very essential fundamental
commodity which should be uh affordable and accessible to all people
another example is just the opposite which is the price floor price floor is basically
the government is saying that the price cannot fall below a certain level price cannot fall
below a certain level and price floor is defined as a legal minimum price set by the government
for a particular good or service for example minimum wage or price floor on say agricultural
products price floor on say agricultural products so here the government is basically trying
to protect the producer its trying to protect the supplier so minimum wage i gave the reason
earlier when i said that i am going to again illustrate the price floor with example of
the labour market and price floor on agricultural product is also a very common example whether
because of technological improvement uh etc basically the farmers production or yield
out of a piece of land is increasing over days but agricultural product is such a commodity
which is a essential product and to relate it to the elasticity we talked about in the
previous class agricultural product basically if the price falls too much if there is a
whole lot of production in the economy and price rapidly falls because there is too much
supply in the economy uh consumption of the product is not going to go up too much
just in the previous class we talked about price elasticity and revenue and this is just
to relate to that uh the price elasticity of agricultural agricultural food grain for
example agricultural product uh they are very low low low in the sense that if the price
goes down too much people are not going to raise their consumption of say wheat or food
grains etc so in such a situation what happens if there
is a bumper production of crops and if it is left to the free market prices are going
to go down and leading to drastic fall in income of the farmer to so to basically to
protect the farmers the government can impose a price floor where it says that uh okay price
of wheat cannot go below this level even if the production of wheat is huge in the economy
so this is example of price floor another uh instrument in the hands of the
government to intervene in any kind of market equilibrium is taxes taxes it can be on buyers
or it can be on sellers for the same commodity the government can decide to tax either the
seller or it can decide to tax the buyers and again taxes can be of various types and
very uh this is a very common uh example that i am giving here can be a percentage of the
price of a good it can be the percentage of a price of a good or a specific amount per
unit purchased or sold so physical quantity sold or purchased of
the unit basically the government is charging a flat uh tax per unit of that output so it
can be of various types so these are very broadly the definitions and examples of taxes
and uh price controls so uh lets first try to understand what happens in case of a price
ceiling . so uh so let me uh
say for example this is a price ceiling say this is for rent control say this is this
is example of rent control where there is a if the market is left to itself this is
the demand for houses this is demand for houses for rent and this is the supply of houses
which are uh put up on rent and this is the equilibrium price and equilibrium uh quantity
or the number of houses that are uh up on rent and this is the equilibrium price
now what happens if there is a price ceiling if there is a price ceiling now the market
was clearing at a rent of p 1 and now the government says that this is uh too high or
uh okay say say for example okay the the government says that the the rent is too high uh it cannot
go up beyond this that is p 0 p 0 is the max rent that you can charge in the market if
you are a home own house owner and you want to put up your house on rent you cannot charge
a rent which is which is more than p 0 or p 0
now what happens in that case but before that what happens if the government says that p
2 is the price ceiling what happens in that case if the price ceiling is put at a price
or at a level which is higher than the market equilibrium in that case this price ceiling
is not binding this price ceiling is not binding why because the market in any case is clearing
at a level which is lower than the price ceiling so it doesnt matter if the government says
that the the highest rent that you can charge is p 2 but no one is actually or the market
is not clearing at p 2 market is clearing at a much lower level so no one bothers if
the there is a rent control which says that it has to be maximum p 2 so we are not talking
about that part of the diagram . what we are really interested in seeing is
what happens if the price control or price ceiling is binding if the price ceiling is
binding or the price ceiling is at a level which is below the equilibrium if the price
ceiling is at a level below the equilibrium then what happens now what happens in this
case is since the rent the prevailing rent in the market is too low lot of people would
like to rent houses like they will be responding along the demand curve
so along the demand curve if the rent is p 0 q 0 amount of houses are demanded for rent
so this i the amount of houses which people are looking for this is the amount of houses
people are looking out for rent but uh so what? now if even if so many people are looking
for rent how much is available in the market what will be available in the market will
be as per the supply curve so people who have put up their houses for rent in the market
so they are going to only till here people who are willing to supply their houses on
rent till the level of p 0 they will put up their houses up for rent in the market so
beyond these every supplier on the supply curve every supplier is seeking a price which
is higher than p 0 so they will leave the market
they will say that uh this this rent is too low its not possible for me to supply my house
in the market i i dont want to put my house up for rent at this such a low level of rent
so they will be out of the market and that will so basically now there are lot of people
who are looking for houses in the for rent and very little people very little number
of suppliers who are actually interested in renting out their houses
so that will lead to a shortage in the market that leads to a shortage of houses in the
market so basically what rent control is doing is it is reducing the supply in the market
and it is increasing the demand in the market and thus creating a shortage in the market
so that then that is a problem that is a problem okay and what is what is more uh interesting
is this shortage is going to increase in the long run .
in the long run what will happen is this in the long run if you think carefully you
will be able to understand that in the long run the demand curve is more elasticity and
the supply curve is also more elasticity so in the long run the supply curve is more elastic
and the demand curve is more elastic and as a result because of the same price ceiling
the shortage is going to increase shortage is going to increase
now why why is the demand curve and the supply curve flatter in the long run the demand and
the supply curves are flatter in the long run because people both buyers and sellers
both groups of people they get more time to adjust they get more time to adjust to the
prices and they basically adjust their preferences now in the long run people who are looking
for houses they are going to be really really interested in uh renting houses because they
know that the rents have gone down because people because government has imposed a rent
control and government has fixed the rent at a very low level so more number of people
are going to enter the market looking for houses for rent
so they have a flat demand curve and in the case of the supply curve what happens is in
the long run the many of the suppliers who were stuck with their houses for rent in the
short run and could not take a uh quick decision or could not uh adjust their supply uh they
gradually leave the market in the long run and more and more and more number of people
who have houses which could be put up on rent they leave the market maybe they find some
alternatives to their houses and they leave the market and they basically don’t want
to put put the houses up for rent so in the long run they have a flatter supply curve
and this policy so leads to increasing shortage in the economy for houses
so this is what happens and this this example can be uh this the the similar argument we
can have in case of say energy consumption also say for example if the government puts
a uh price ceiling on electricity and says that you know like the electricity prices
are cannot increase more than this what happens in the long run uh suppliers will find it
less attractive to supply electricity in the market so basically they reduce their capacity
and they are not too much interested to be in the supply in the production of electricity
and on the other hand since prices are too low of electricity consumers are going to
adjust their demand and they will shift to more and more consumption of more electricity
intensive consumption uh behaviour so that is what they are going to do because they
know that the its cheap to consume electricity so this is what happens so what are the impacts
of price ceiling . now so the impact of price ceiling is basically
it leads to shortages and whenever there is shortage how is this fixed amount is how is
this little amount of q 0 with so many people looking for houses or so many people looking
for electricity and production only uh limited to this much as per the supply curve how is
that little amount of quantity to be distributed among so many people looking for the product
because had it been a market equilibrium prices would have adjusted
there would be a pressure on prices upwards and basically many people would be leaving
the market all these people would be leaving the market and prices would be going up and
similarly more suppliers would be entering the market as prices would go up but that
is not happening here here price is controlled so there is no way price can increase so who
is going to get this limited amount of production that is happening in the economy and that
has to be some kind of rationing has to be there
so how does the rationing happen as we have seen in case of uh lot of rationing we are
familiar in developing countries especially uh at the site of people queuing up in front
of the say uh gas stations in front of the petrol pump there people queuing up for the
uh the the to fuel their tanks because basically the price is low and too many people would
like to fill up their tanks so that is one way of rationing and another
is at sellers whims so if i like you i am going to rent out my house to you otherwise
i am not so this is so basically it depends on sellers whims or on first come first serve
basis so this results in inefficiency in the market why do i say that it results in inefficiency
in the market its because that a efficient outcome would be where all the people who
are willing to pay at the market price they get the product
but here all these people they are willing to pay a higher price but they are not able
to pay a higher price and all these suppliers are willing to pay willing to produce at a
higher price they are not able to produce at a higher price so both demand is distorted
and supply is controlled in the market and that is where lot of resources are wasted
in the economy that is these resources could have been put to production and that would
have satisfied the demand of lot of people and lot of suppliers would be happy to sell
it to the market at a slightly higher price but that is not happening so that results
in inefficiency in the market so in the next class we are going to talk about price floors
thank you