Distorting Policies-Regulated Prices

The analysis of regulated prices needs to consider two general cases: "high" prices, in which regulations require increased payments to factors relative to their free-market levels; and "low" prices, in which existing factor prices are reduced relative to socially efficient values. Figure 4.1 considers the impact of a legislated increase in the payment to a particular factor. The legislation is assumed to provide minimum wages for unskilled labor. Initial equilibrium is determined by the intersection of the demand curve for labor, DD, and the supply curve for labor, SAS. If one assumes that no other divergences are present in the economy, the equilibrium wage rate, w_s, is the social value of labor. The government considers this wage rate too low and mandates an increase in the wage to _wP.

If the new wage rate can be enforced, producers will adopt it in their choice of inputs and use lesser amounts of labor that provide a higher marginal value product (equal to _wP). This employer response will result in a decline in total labor demand, from L_s to L_p. The policy will increase the income of employed workers, and it could have increased the total income of the labor force (if _wP x L_P had been larger than w_s x L_s) and thus altered income distribution in favor of employed workers. The cost of the policy is represented by the unemployment created, which will be greater the more elastic the demand for unskilled labor. Additional costs of enforcement are incurred to ensure that employers comply with regulations. If these costs are so large that enforcement is not effective, private market wage rates will bear no relationship to _wP and instead will remain at or near w_s.

Most legislation to reduce factor prices applies to the capital market. Three motivations for controlling interest rates can be identified. First, low interest rates are seen as beneficial to economic growth because they encourage increased investment. Second, controls on credit availability may be a principal instrument of monetary policy. By reducing aggregate demand through credit controls, the monetary authority hopes to limit inflation. In many cases, policy-makers' concerns that the limited volume of credit will become too costly result in the simultaneous establishment of low interest rates and credit rationing. Third, interest rates may be lowered to encourage investment and adoption of new technology by low-income borrowers, such as small farmers.

Figure 4.2 illustrates the impacts of controlled prices in the credit market. The demand for capital reflects the marginal value product of investment; the domestic supply of capital is provided by savings. The supply curve is drawn with a positive elasticity to indicate the ability of consumers to reduce current consumption levels as the reward to savings increases. Initial equilibrium is represented by price r_s and quantity K_s. If no divergences are present, rs represents the social value of capital. A legislated reduction in the interest rate has two effects. The demand for capital increases to K_PD, because more investments are possible when the cost of capital (the rate of return) is reduced. The supply of capital declines to K_ps, because providers of capital are encouraged to favor current consumption over saving.

The lower interest rate creates an excess demand for credit, equal to KP_DS- K_PS. The government has three options to resolve the excess demand. First, it can choose not to enforce the regulated rate; investment levels and rates or return would then move back to their original equilibrium.

A second option is to increase available supplies of credit for investment. This increase could be achieved by borrowing in external credit markets or receiving external aid, by channeling tax revenues into domestic credit markets, or by raising domestic interest rates to savers through government subsidy. When supplies are increased to meet all the demand for credit, the private market rate of return is r_P.

If the government cannot afford the cost of the savings subsidy or the budget is too constrained to shift financial resources into the credit program, a third option, rationing, becomes necessary. Available supplies of credit are limited to K_PS, and the government introduces some mechanism to allocate the supply among users. In this circumstance, the private rate of return can be higher or lower than the social rate of return. The demand schedule shows that the marginal private rate of return to a total investment of K_PS can be as high as r'. This rate would prevail if the rationing program allocated capital to uses that would provide the highest return.

Successful bribery could result in a similarly high private rate of return. The difference between the rate of return and the borrowing cost represents excess profit, and potential investors might be willing to use some of the excess to ensure access to credit. Because investors with the highest rate of return have the greatest ability to bribe, the marginal private rates of return may again be as high as r'. But if officials in charge of credit allocation are not corrupt, other allocation procedures will be used. The private rate of return may range anywhere from r_P to r' .

Legislation to reduce factor prices can also be found in the land rental market; in this case, low prices are intended to ensure that wealthy landowners will not exploit poor tenants. Analysis of regulations on land rental rates is analogous to that of regulations involving the capital market. As in Figure 4.2, the supply curve is portrayed as upward sloping. The supply of land to the rental market varies because rental rates affect the landowners' choices between self-cultivation and off-farm employment. Rental rates below equilibrium levels again create excess demands. The disequilibrium is resolved either by the creation of a parallel market, in which private rental rates rise above their social values, or by the forced exclusion of potential tenants, so that the private rental rate is held equal to the legislated price. In both cases, private prices diverge from their social values.

Distorting Policies-Taxes and Subsidies

A second group of distortions consists of employer taxes or subsidies on factors. When supplies of factors are inelastic, direct taxes on the owners of factors are relatively efficient ways to raise government revenue. If the supply of labor is perfectly inelastic, for example, personal income taxes can be levied without reducing the labor supply. But policy-makers are usually unable or unwilling to meet a large share of government revenue needs with direct factor income taxes; monitoring and enforcement costs are common constraints to increased tax collection. Another way to tax factors is to levy taxes on employers of factors. Perhaps the most common examples of these policies are social security taxes; both employers and employees are required to contribute to some benefit plan that provides unemployment insurance, health insurance, or retirement pensions. Because these taxes raise the cost of labor to the employer, employment is reduced until marginal value products equal the tax-inclusive wage rate. This result is illustrated in Figure 4.3a. Private market wage rates exceed social wage rates by the amount of the tax.

In some circumstances, however, the tax may be passed back to the factor, becoming similar to an income tax. If the supply of the factor is perfectly inelastic, workers would be willing to perform the same jobs at wages lower than ws; wages could decline as low as the wage represented by line segment SA (the subsistence wage) before labor supplies would decline. In this case, employer taxes are indirectly paid by the employee, because competition for employment causes money wages to decline by the amount of the tax. After the tax, employers still pay ws in total compensation; private and social costs remain equal. Now, however, this amount goes to the government treasury. Full employment is maintained, but at a lower rate of employee remuneration (although employees may receive future benefits from these taxes in the form of retirement or insurance programs). Because the taxes are set in proportional terms, government enforcement will be unable to prevent deterioration in the wage paid to the factor; instead, enforcement only reinforces the decline.

Figure 4.3b illustrates the relationship between private and social values in the event of a factor subsidy. Demand for labor, as represented in the figure, is insufficient to absorb all supplies at the subsistence wage rate. A wage subsidy, equal to w_s-w_p per unit, increases labor demand to meet full employment. This case reemphasizes the potential disparity between efficiency prices and optimal economic policy. Subsistence wages with full employment are a goal most governments desire. Because the social value of labor at full employment is only w_p, the policy

created divergence between private and social prices might be seen as desirable by policy-makers.

Efficient Policies-Offsetting Market Failures

Monopsony and oligopsony are common failures in factor markets, asserted to exist usually in the context of local labor markets. In this circumstance, only a single buyer (or group of colluding buyers) is bidding in the labor market. These market conditions provide the employer with an opportunity to pay labor a wage rate less than labor's marginal value product. Observed (private market) wage rates thus understate the social value of this labor.

Figure 4.4 provides a graphical portrait of a labor market for two regions. Initial equilibrium is w₁*, and total labor supply is L₁ + L₂. The labor supply curve in each region is drawn with an upward slope. As wages in region 1 rise above w₁* (caused, for example, by a rightward shift in labor demand), labor migrates from region 2 to region 1 and employment increases in region 1. This migration causes a leftward shift of the labor supply curve in region 2, which continues until the wage rates are equal in the two regions. Although total employment, L₁ +L₂ is fixed, the distribution of employment has shifted toward region 1. When only a single buyer is present in one region, however, the supply curve is not the only relevant information for the hiring decision. The

marginal cost of a worker is now considered, and this cost is larger than the wage rate. Hiring beyond L₁ requires that the employer pay a wage higher than w₁* to all workers. Hence, the marginal expenditure on labor is larger than the wage rate at each level of employment. This relationship is represented for region 1 by the marginal expenditure curve, ME. The profit-maximizing level of employment results when the marginal value product, indicated by the demand for labor (D), equals the marginal expenditure on labor; this point is represented in the diagram by employment level L₁ and wage rate w₁. An amount of labor, L₁ - L'₁, migrates from region 1 to region 2, shifting region 2's supply from S₂ to S'₂ and lowering wages in that region to w₂. The employer in region 1 realizes an excess profit of L' (Z - w'₁); this amount is the difference between the marginal value product and the wage rate, multiplied by total employment.

The results of calculations based on Figure 4.4 also show that the single buyer in one region is not sufficient to make monopsony an effective tool for exploiting the labor force. Either labor must be inflexible about moving between regions, or the region under monopsony must contain a substantial portion of the labor force, so that a reduction in wages within the region causes an outflow of labor sufficient to depress the wage rate in the other region. If, instead, region 1 were very small compared to region 2, attempts to force down region 1 wages would create an outflow of labor that would hardly affect wages in region 2. The supply of labor in region 1 would continue to decline (supply curve S₁ would shift leftward) until wage rates were equalized, in essence destroying the monopsony.

The second principal category of factor market failures consists of limits to the regional mobility of domestic factors. These constraints, usually termed institutional market failures, cause divergences between private and social prices regardless of the degree of competition among buyers of the factor input. In capital markets, rates of return to investment vary widely by region, sizes of investors, and production activity. Some of these differences exist because of deliberate policy-induced distortions. The market failures arise when institutions are absent because of government oversight or a lack of public investment funds to undertake necessary complementary investment. As a result, road and communication facilities are insufficient for banks and other financial institutions to enter particular regions. Insufficient legal codes of conduct or the absence of insurance provisions inhibit certain borrowing, lending, and savings transactions. These circumstances can cause unnecessary fragmentation in the capital market.

The consequences of fragmentation are illustrated in Figure 4.5, which portrays capital markets fragmented between two geographical regions. Other types of capital market fragmentation involve size of borrower (small farmer versus large farmer) or type of productive activity (agriculture versus industry). The demand curves for the two regions, D, and D2, portray the relationships between rates of return and total investment (K). The supply curve represents the provision of investment funds by savers plus the transaction costs necessary to move funds from savers to borrowers. Region 1 is characterized by ample investment opportunities and limited availability of funds relative to region 2. As a result, the private interest rate in region 1 (r,) is higher than in region 2 (r₂). Because of the market failure, the private rate of return in region 1 is above its social value; in region 2, the relationship between private and social values is reversed. If the capital market were integrated, supplies of capital would move freely from one region to the other. Each borrower of capital would face a single supply schedule. The market equilibrium and social rate of return would be r", found at the intersection of S, + S₂ and D, + D₂ (not shown in Figure 4.5). Total investment would increase in region 1 (K, to K;) and decline in region 2 (K₂ to K2).