intervention is a pervasive structural characteristic of all
industries and markets. The form and nature of that
intervention takes varying forms. Bankruptcy, environmental,
financial, health & safety, incorporation, labour and protection
of persons & property are just some of the areas in which
Government plays an active role in every industry. I will first
argue that equity provides both the legal and economic rationale
for governmental intervention. I will then highlight non-market
forces unleashed by certain forms of governmental intervention,
specifically price setting.
The economic concept of Equity evolved out
of a distinct strand of English legal history. Together with the Common
Law, Equity emerged during the reign of Henry II (1133 –1189). Those
interested in the legal origins of Equity, please see
The Common Law is concerned with right and
wrong, guilt or innocence. Equity is concerned with fairness. Economic
concepts of Equity derive from legal Equity. Thus the Chancellor of the
Exchequer (in Canada called ‘the Minister of Finance’) exercised
concurrent jurisdiction in Equity with the Lord Chancellor’s Court.
There are two economic definitions of
Equity, each reflecting its historical roots. First, there is Equity as
the financial capital of a limited liability corporation which, after
deducting liabilities to outsiders, belongs to the shareholders. Hence
shares in a limited liability corporation are known as equities. This
links back to the historical development of trusts under Equity.
Second, there is Equity as ‘fairness’.
While usually used with reference to taxation it is a general economic
concept. With respect to taxation Equity has three dimensions:
horizontal, vertical and overall. Horizontal Equity refers to ‘like
treatment of like’. Vertical refers to ‘unlike treatment of unlike’.
Overall Equity refers to the accumulated impact of all forms of
taxation. Crudely, it is the difference between earned and disposable
income, i.e., income net of all taxes – income, excise, sales,
et al. Equity is also used to justify market intervention by
Government, e.g., minimum wage and rent control.
Equity thus provides the legal and economic
rational for government intervention in the economy. Such
interventions include, of course, the Corporations Act and
Bankruptcy Act. It also justifies anti-trust and anti-combines
legislation to counter the exercise of Market Power.
We have seen that if a competitive
market is allowed to operate an equilibrium price/quantity
outcome will result from the interplay of market force. If
price is too high, Supply exceeds Demand and a surplus is
created. To get rid of the surplus producers must lower their
price, eventually to equilibrium. Similarly, if price is below
equilibrium then Demand exceeds Supply and a shortage is
created. Consumers wanting the good bid up its price back to
7th Ed Fig. 3.7; MKM
b). What happens, however, if
intervenes and does not allow market forces to function? I will
now consider such price setting intervention in agriculture,
housing, labour, prohibited goods and taxation.
Agriculture (MKM C5/111-113;
Agriculture is subject to significant
fluctuations in supply yet a relatively inelastic demand, people
have to eat. We begin by assuming only domestic production is
involved. In any given year, the supply is fixed and perfectly
inelastic, a harvest is the harvest is the harvest. In an
unregulated market (P&B 4th Ed.
Fig. 7.11), a bad harvest shifts supply
to the left. This raises prices and will actually increase
revenue to the farmer. A bumper crop, on the other hand, will
shift supply to the right, lower prices and reduce farm income.
Many agricultural commodities can be
stored, that is placed in inventory. Inventories serve to
stabilize prices between growing seasons. Without inventories
the above situation applies, that is a good harvest lowers
prices, a bad harvest raises prices. Inventories reduce these
price fluctuations (P&B 4th Ed.
Fig. 7.12). A good harvest can be used to
increase inventories, that is, not all output goes to market and
price decreases are moderated. In the case of a bad harvest,
inventories are sold, thereby increasing supply and reducing
A price floor acts like a minimum
wage. If the floor is less than market equilibrium, it has no
effect. If it is greater than equilibrium price it will create a
demand gap between the larger amount suppliers are willing to
provide at the floor price, and the quantity consumers are
willing to buy (P&B 4th Ed.
5-2; MKM Fig. 6.4
Quotas (on eggs, grain, beef, etc.)
act like a perfectly inelastic supply curve (P&B
7th Ed Fig. 6.11;.
If the quota output is less than equilibrium output the price
will be higher and the supply lower. This creates a supply gap
where producers have an incentive to exceed their quota. This
can lead to increased
Subsidies act like a reverse tax (P&B
7th Ed Fig. 6.12). The tend to shift the supply
curve to the right. Output increases and prices fall. Such
'supply-side' subsidies financially reward increased production
by offering subsidies per bushel of output or per acre planted.
This approach has led to a frightening subsidy spiral. In
effect, production subsidies reduce the final price of farm
output below the cost of production. This, in turn, means that
even efficient farmers cannot earn enough to maintain
operations. This, in turn, leads to more subsidies that lower
prices further. And, so on and so on and so on...
For a different approach please see my "Putting
Culture Back into Agriculture"
It must be noted, however, the graphics
hide the costs of enforcement of government intervention in agricultural
markets but also all of the following interventions in housing, labour,
prohibited goods and even taxation. Such enforcement costs are
paid usually not by consumers or producers but rather by taxpayers.
ii - Housing
Part of the short-run adjustment
process involves price, that is, if demand exceeds supply,
prices will tend to rise. In the case of rental property, which
tends to be the type of housing available to the poorer members
of a community, a price rise takes the form of rent increases.
If government decides for reasons of vertical equity (unlike
treatment of persons in unlike situations) that the poor need to
be protected from rent increases (or for political reasons,
there are more poor voters than landowners) then it may impose
rent controls in the form of a rent ceiling (P&B
Fig. 6.1 & Fig. 6.2;.
5-4; MKM Fig's 6.3
In effect, rent control imposes a
price which is less than that determined by the market. This
means that demand (the willingness of consumers to pay) exceeds
the supply (the willingness of producer to supply). This results
in a housing shortage. Because demand exceeds supply yet price
can not increase other forms of behaviour take the place of a
price increase. For example, given a shortage:
a) consumers must search harder and
harder to find supply when it does become available. Search
activity is costly; and/or,
b) consumers will 'bribe' supplier,
for example, by paying more 'on the side'; by accepting little
or no maintenance or support services; by accepting 'run down
The effect of rent control is to
reduce the return to suppliers. If they cannot cut back
production directly they may do so indirectly. First, new rental
accommodation will not be built which, if population continues
to grow, accentuates the shortage. Second, existing rental
property will be allowed to 'run down', eventually into 'slum
condition'. With excess demand and a fixed price, the supplier
can recoup his or her opportunity cost by running the building
down until it is uninhabitable, then tear it down and build
private homes or condos for sale on an open and competitive
market without price controls. This again accentuates the
Low wages for unskilled labour may
create a question of vertical equity (or political reasons).
Government may decide that with such low wages unskilled workers
cannot support themselves, their children and/or other
dependents above the 'poverty line'. Accordingly government may
intervene by establishing a 'minimum wage rate'.
If this rate is below market
equilibrium rate such a minimum has no real effect. If, however,
it is above the market equilibrium price (P&B
MKM Fig's 6.1
b) the supply of willing workers
exceeds the demand of producers. As in the case of rent
controls, if the price cannot adjust, other forms of behaviour
will evolve. For example, some workers will offer to work some
hours 'off the books'.
iv - Prohibited Goods
While some goods like recreational
drugs are illegal and hence prohibited, a market exist. To
understand the effect of prohibition, we begin with market
equilibrium assuming no prohibition (P&B
7th Ed Fig. 6.13;
MKM Fig's 5.9
b). A prohibition affect both
demand and supply. It imposes penalties, that is costs, on both.
The effect is to shift the supply curve up to the left and shift
the demand curve down to the left.
v - Taxation
To finance public spending (a
pleasure), government must raise revenue through taxes (a pain).
This pleasure/pain of public finance is described in the
Introduction: The Pleasure & Pain of Public Finance to my paper
Radical Analysis of 'Personal' Taxation."
An increasingly important source of tax revenue is sales tax,
for example, the GST and provincial sales tax. The question
arises: who pays Is it the consumer or the producer or both?
Consumer demand does not change if a
sales tax is imposed. The demand curve reflects the quantity of
a good or service consumers are willing to buy at a given price.
If the price goes up, one slides up the demand curve; if the
price goes down, one slides down the demand curve - all things
being equal. Accordingly, to the consumer the real price of a
good is its retail price plus any associated taxes.
A sales tax does, however, shift the
supply curve up to the left. Producers are willing to supply a
certain quantity of goods or services if the receive a given
price. With sales tax, such goods and services are offered for
sale at a higher price (P&B
7th Ed Fig. 6.5;
R&L 13th Ed Fig.
The supply curve shifts and a new equilibrium is established at
a higher price and a lower quantity than before the tax.
As to who pays the tax, the answer
depends on the elasticity of supply and demand. If there is
perfectly inelastic demand, for example for a 'necessity', the
demand curve is vertical (P&B 4th Ed.
7th Ed Fig. 6.7;
In this case the consumer pays the full tax. If, on the other
hand, demand is perfectly elastic ((P&B 4th Ed.
5th Ed. Fig. 6.7;
7th Ed Fig. 6.8;
R&L 13th Ed Fig.
then the producer pays the whole tax.
In the case of supply elasticity, the
situation is reversed (P&B
7th Ed Fig. 6.9a &
If supply is totally inelastic, that is the supply curve is
vertical, then the supplier bares the full tax. If supply is
perfectly elastic, however, the consumer will pay the tax.