The Market Price and Quantity
In a free and competitive market without government price controls, the equilibrium, or market, price and quantity occur at the intersection of the supply and demand curves. At this price, consumers are willing and able to buy the same amount that businesses are willing and able to sell. If the price is below this equilibrium intersection point, a shortage results. If the price is above the point, a surplus results.
In the graph above, the market is at equilibrium at a price of $11 and a quantity of 9. If the price were set at $7, a shortage of 7 products results. At $7 the quantity demanded is 13 (from $7 go straight over to the demand curve) and the quantity supplied is 6 (from $7 go straight over to the supply curve). Similarly, if the price were set at $14, a surplus of 5 units (11 minus 6) results.
For a video explanation of the equilibrium price and quantity, please watch:
Below are some supply and demand applications, in which we study what happens when the government, instead of the free market, determines the price.
The Case of Rent Control
Rent control is an example of a price set below the equilibrium point. This is called a price ceiling. In the graph below, the equilibrium (market) price of a rental unit is $1,800 per month. The city government wants the rental units priced at no more than $1,000 per month, so that more tenants can afford to live in the inner city. The lower-than-equilibrium rent causes the quantity supplied of rental units to decrease to 700 units, because suppliers have less incentive to build and own rental units at the lower price. The quantity demanded increases to 1,200, because the lower price encourages more buyers. This results in a shortage of 500 rental units (1,200 minus 700).
In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive to provide an excellent product, and because of the lower rent they have less rental income to maintain the rental properties. This usually leads to a deterioration of the rental units. Due to the shortage of rental units in the inner city, the demand for properties not subject to rent controls increases. This increases the price of non-rent-controlled properties.
Rent control also makes discrimination more likely. Hopefully, landlords don’t discriminate when they accept tenants. However, when landlords have a waiting list of people applying for the lower-rent units, landlords who want to discriminate can more easily do so. At market prices, this is less likely to be the case. As rents are higher, there are far fewer waiting lists, and landlords are more likely to accept tenants based on their ability to pay, rather than on their race, ethnic origin, and lifestyle. Despite these disadvantages, rent controls are still in existence in various big cities around the industrialized world. Politicians often focus on the short-term social benefits of helping the poor, but are not always aware of the long-term economic disadvantages. Furthermore, they receive pressure from tenants, who ask for lower rent and more-affordable housing. Politicians are tempted to oblige tenants’ wishes, because there are far more tenants who vote than landlords.
The Case of the Minimum Wage
The minimum wage is an example of a price set above the equilibrium point. This is called a price floor. In the graph below, the equilibrium price of labor (the market wage) is $6.00 per hour. The government determines that it wants firms to hire workers at a minimum of $7.50, so that workers can earn more money per hour and better afford their daily expenditures. The higher-than-equilibrium wage causes the quantity supplied of labor to increase to 1,100 workers, because workers have more incentive to work at a higher wage. The quantity demanded of labor decreases to 900 workers, because the higher wage discourages firms from hiring workers. This results in a surplus of workers (unemployment) of 200 workers (1,100 minus 900).
Minimum wage is a hotly debated topic. The graph above predicts that an increase in the minimum wage causes unemployment. Some studies, however, claim that an increase in the minimum wage has no significant effect on unemployment. Both studies can be correct, depending on the market conditions. Below is an example of a case study in which the minimum wage increases, but there is no effect on employment or unemployment.
The Case when the Market Wage is above the Minimum Wage
Let’s say that the equilibrium (market) wage in the New York metropolitan area for a certain type of worker is $10.00 per hour (see graph below). If the state government of New York raises the minimum wage from $7.50 to $8.50 (hypothetical example), the minimum wage will still be below the market wage. Therefore, there is no effect of an increase in the minimum wage on employment.
The Case when the Market Wage is below the Minimum Wage
If in another state the equilibrium (market) wage is $4.50 per hour, and the state government increases the minimum wage to $6.50 per hour, then businesses are required to pay many workers more per hour compared to what they were paying at the market wage. This will increase the incomes of workers who are able to keep their jobs. And it will lead to unemployment of workers (especially full-time workers), because the higher wage decreases the quantity demanded of labor and increases the quantity supplied.
Critically Analyzing Minimum Wage Studies
As you can see, the effect of an increase in the minimum wage differs, depending on whether the market wage is above or below the minimum wage. Another reason for discrepancies in studies on the minimum wage is that employment definitions vary. Economists Card and Krueger concluded in their study on the minimum wage that after the minimum wage increased in New Jersey, employment actually rose. The measure of employment they used was “the number of jobs held by people.” However, another measure of employment, which they did not use, is “the number of hours worked by people.” Using the latter definition, employment decreased. To illustrate this difference, consider the following example.
Let’s say that as a result of an increase in the minimum wage, the number of full-time jobs decreases by 400, and the number of part-time jobs increases by 500. This can be expected as businesses, faced with a higher wage, decide to replace full-time workers with part-time workers in order to save money on benefits and reduce the total hours worked. Assuming that full-time workers work a 40-hour week, and part-time workers work a 20-hour week, the total number of hours worked declines by 16,000 (400 workers times 40) hours, and increases by 10,000 (500 times 20) hours. On balance, the number of hours worked decreases by 6,000. However, the total number of jobs increases by 100. As you can see, measuring employment by the total number of jobs (this is how our nation’s unemployment rate is calculated and this is the definition Card and Krueger used – see Unit 1, section 7 on critical thinking) can be deceiving and can lead to bad government policy.
For a video explanation of how the minimum wage affects employment, please watch: