When Governments Intervene - Taxes, Price & Quantity Regulations

You're listening to Think Like an Economist, a Himalaya learning production. For exclusive content like bonus episodes and supplemental materials for this podcast and others like it, go to Himalaya.com/econ and enter promo code E-Con-E-C-O-N, a checkout to get your first 14 days free. It's time. Think Like an Economist. This is Think Like an Economist and I'm Betsy Stevenson. And I'm Justin Morfus. We're on a mission to teach you the tools of economics that will transform your life and help you make the best decisions for you. Our friend Nashtran Tavakoli Far studied economics and she joins us. So I was buying some grapes at the grocery store and the price had gone up and I did buy a lot less than I usually do. So I could see my demand for grapes is pretty elastic. Nas, you're thinking like an economist. Today we're going to add another element to the mix. What happens when governments get involved in markets? We've learned that supply and demand determine the prices and quantities of the things we buy and sell, but for many of the things you buy or sell, in most countries, governments going to have some kind of impact in the market. Let's take something as simple as soda. Betsy doesn't like me to drink it in front of the kids, but the truth is, I love it. It's terrible for you and the government tries to help me out by making soda more expensive so Justin will drink less. So it's not just Justin Koch and our local grocer who are interacting in determining the price of soda. The government is right there in the mix by regulating some of the ingredients, parts of the production process and often taxing soda. So if I think about it, it seems the government is involved in some way in everything I buy. Government is pretty pervasive. I mean, as one example, taxes can be used to get people to buy less of things that are bad for your health like cigarettes, alcohol and soda, but the government also needs revenue to pay for things that we want in society. There's a long history of taxing things like tea and whiskey to raise that revenue. Betsy, you aren't going to start singing Hamilton lyrics, are you? Hey, people do get a little frisky over taxes. In this episode, we're going to try to understand the effect that government regulations and taxes have on markets. We're going to put aside the question of when these government actions help and when they hurt because we're going to dig into that in future episodes. And I know people have a lot of strong views about it. That's why it helps to ask what effect government has before trying to decide if it's a good or a bad effect. OK. And what are the ways that governments can influence things like how much we buy and sell and also prices? The government has three main tools. It can tax things, it can use price regulations which constrain the price that can be charged and it can use quantity regulations that limit the quantity of a good that people can buy or sell. Here's the big idea, none of these government policy lovers are going to suspend the forces of supply and demand so everything we've learned about how buyers and sellers make choices still applies. The government also matters though because taxes and regulations shape the costs and benefits of the different choices that buyers and sellers might make. Let's start with taxes. So here's an example, Philadelphia put a tax on sweetened beverages. So that means that there's a 30 cent tax on a 20 ounce bottle of soda. It's been really controversial because a lot of people stop buying soda. That's just the law of demand at work. If taxes raise the price of soda, I'll buy less. So one way for the government to get people to buy less soda is to put a tax on it. Hang on, doesn't it depend on who has to pay the tax? I mean, I'd only cut back on my soda consumption if I had to pay the tax. If it's a tax that a company like Coke pays, why would I care? Well, let's think through what would happen if a seller just tried to add the 30 cent tax to their old price. Try to pass that whole tax on to the consumer, you know, because they were assigned to pay it. So a $1 soda becomes $1.30, I don't think I'd buy it at that price. Bingo! This is where market forces take over. Coke still wants to supply as much soda as before, but you don't want to buy as much. So there'd be a surplus and a glut of soda on the market. And what's that going to do to the price of Coke? A surplus means there's more soda for sale than people want to buy. That will lead the price to fall. You bet! And how far will it have to fall? It's going to have to keep falling until the quantity that people want to buy rises enough and the quantity that sellers want to supply falls enough, and then we have a new equilibrium price. Remember that the law of demand says that we tend to buy less of something when the price is higher, and the price elasticity of demand tells us how much less we will buy when the price goes up. So if the demand for soda is elastic, buyers will respond a lot to a small change in price, whereas if it's inelastic, they won't respond much at all. Yes, so I remember if there's a lot of substitutes for sweetened beverages, like water or coffee, people are going to buy less soda. Now put yourself in the shoes of sellers. You tried passing a tax on to your customers, but they ended up buying a lot less soda. So now let's look at the other extreme. What happens if sellers don't pass on any of the tax to their customers? So imagine that the sellers in Philadelphia didn't change their prices at all. They have to pay a 30 cent tax on each bottle of soda, so their marginal cost just rose by 30 cents a bottle. That higher marginal cost means that they'll want to sell us, but if consumers are seeing the same prices, they haven't changed how much they want to buy. So there will be shortages, and the shortage will push the price up. You got it. It's the exact same process we talked about when describing how the market gets to equilibrium. The only difference is that the government has introduced a new cost in the market. This raises the marginal cost of soda. So even when sellers have to mail the tax into the government, it leads buyers to pay more and sellers to receive less after tax. The market finds a new equilibrium in which the tax is shared. Now here's the really mind blowing part. The market finds the exact same equilibrium, regardless of whether it's the buyer or the seller who has to send the tax into the government. This is because it's market forces, and the price elasticity of demand and supply that determine the price the buyers pay, and the seller receives once we account for the tax. The thing is, once a government puts a tax on something, market forces take over, and it's those market forces, rather than the government, that determines who'll actually end up paying more. So governments intervene, but the market sets the price and the new quantity of how much will be bought and sold. Yeah, so even if the price that buyers pay for a soda initially spikes from $1 to $1.30, it'll then start to fall because the ensuing soda glut will push the price of soda down. So instead of paying $1.30 for a soda, you might end up paying, say, $1.20. So I get that both me and the seller paid the 30 cent tax between us, but I'm still unclear on who pays how much. There's been some really careful studies about what happened in Philadelphia, and it turns out that buyers paid roughly two-thirds of that soda tax, and sellers one-third. What does this mean in practice? It means that the new price of the soda, including the tax, may have risen from $1 to $1.20, so buyers were paying $0.20 more. Now remember, if that $1.20, $0.30 goes to the tax man, and only $0.90 goes to the seller, so the amount the seller is getting has fallen by $0.10. So Nez, one thing you might be wondering is, who pays the big half, and why? And what that really comes down to is how much you're willing to change your behavior. What we've learned with Philadelphia is that consumers didn't stop buying soda, a lot of them kept buying it, and the more you keep buying, well, the more of the tax you're going to pay. And so sellers, if they're willing to stock their shelves with something else to get water in the store, put chips on the shelf, then they're going to pay less of the tax. So it's really about how buyers and sellers change their behavior in response to changes in price. Or to say that in economics, who ultimately bears the burden of the tax depends on the relative elasticity of demand and supply. Justin said that it doesn't matter whether we're taxing the buyers or the sellers of soda that we get the same outcome either way, but I still find this kind of crazy. Nez, I'm going to admit something. This was the hardest concept in all of economics for me to understand. I mean, intuitively, it just seems like it should matter. But eventually I was able to explain it to you, right? Eventually. The way I finally got this point was by imagining the government just had a jar at the counter that 30 cents needs to be deposited into that jar anytime a soda was purchased. If the seller had to pay the tax, then the buyer pulls out a dollar 20 from their pocket and hands it to the seller. The seller puts 90 cents into the cash register and 30 cents into the tax jar. And what happens if the buyer has to pay the tax? Well, again, the buyer will take a dollar 20 out of their pocket and now the buyer will put 30 cents into the tax jar and they'll hand the seller 90 cents, who puts 90 cents into the cash register again. Same tax, same price for the buyer, same price for the seller. It doesn't matter who's the one who puts the money in the tax jar. The reason this imagery finally helped Justin get it is because it would be kind of weird if you pulled more money out just because you were the one dropping the money into the jar. Or if you pulled less money out because the seller was the one dropping the money into the jar. Then it seems like it shouldn't matter whose hand puts the money in the jar. This all becomes intuitive once you get used to thinking about market forces as determining what happens. Look, this idea that it doesn't matter which side is assigned to pay a tax is really important. Policymakers often think they can control the outcome by doing things like assigning the tax to one side or the other or even splitting it between, say, employers and workers. The reality is that most of the time, these choices have no effect on the outcomes. But wait, government does regulate prices. They could say that the price of soda can't go above a certain level. That's right. In fact, this is something we see in housing all the time. Rent control is a classic example of this, whereas city government will say that rent shouldn't go above a certain amount. So let's say that we're thinking about a market which normally the rent for a two bedroom apartment would be $2,000 a month. Asset by the dynamic between buyers and sellers without any government rules. Yes. So then let's consider what happens if the government decides to try to help make housing affordable by restricting the price of those apartments to no more than $1,500 a month. What do you think will happen, Naz? Price is lower, so more people want apartments at $1,500 a month for rent. Landlords are probably less keen to rent their apartments out at this lower price, therefore we have a shortage of apartments. Yes. So we've got this shortage, well, what's going to happen? People may bribe landlords to get apartments, so that secretly pushes the price back up. Or landlords may try to save money by not doing things like paying for repairs, and that pushes the quality down. Which is like an effective rise in the price. So sadly, the government's benevolent plan to help renters out can actually end up doing more harm, because there's now fewer places to rent, and there's less transparency in the pricing. And governments sometimes do the opposite. They said what we call a price floor, which is a price above the equilibrium price. And let me guess, a surplus can arise. You got it. The government does this all the time with agricultural products, setting the price high. But then the farmers aren't able to sell everything. What happens with the surplus? Well, it would normally cause the prices to fall, but the government actually steps in and buys up the surplus, which prevents the market from pushing the prices back down. So you said there are three ways the government gets involved in markets. We talked about two, taxes and regulating prices. What's the third? The third is by setting rules on the quantity that people can buy or sell. For example, alcohol can't be sold at all to people under the drinking age. That limits the quantity to zero for some people. And sometimes they set a minimum quantity like everyone who drives must buy car insurance. So everyone must buy a quantity of one insurance policy. A mandate requires you to buy or sell a minimum amount. Right now, everyone is thinking about mandates and masks, should we require people to wear a mask? If the government requires you to wear a mask, it increases demand for masks because your marginal benefit from buying a mask now includes being in compliance with the law. So the increase in demand means that people want to buy more masks at every price. And again, we see that when governments are mandating the quantity supplied or demanded, market forces are still going to be unleashed to determine the prices that buyers pay and the price that sellers receive. We've talked of tax, but where do government subsidies fit in? So you might also be thinking that the government affects the economy through subsidies. That's dead right. The way economists think about this is a subsidy, when they pay you to do something, is just a negative tax. So you can work through the same market forces that we just did with the tax when you think about a subsidy. And what you'll find is that no matter who the government gives a subsidy to, that subsidy is going to be shared between buyers and sellers. The big difference? It's that a tax leads people to do less of something, while a subsidy leads them to do more. It's important to remember that we haven't considered whether these policies are helping improve welfare, potentially making the economy bigger and more efficient or fair. Regardless of whether government is hurting or helping, it shapes the market and sellers know it. For example, during the COVID crisis, I heard from a friend who makes COVID tests, and he was complaining that it was hard to know what market demand and supply was going to look like because he didn't yet know the government policy around tests. Are they going to subsidize them? Are they going to require them for certain activities? In these cases, he should make more. For him, the government is important because he knew that demand for his product will ultimately depend on government policy. It seems there are lots of ways that governments get involved in the economy. Yeah, NAS, there are, and there are often really good reasons for those actions. But there are two important things to take away. The first is that the government doesn't suspend market forces. The government changes incentives by shaping costs and benefits, and market forces then determine what happens. The second big takeaway is that when the government tries to influence prices, then quantities will adjust. And when it tries to influence quantities, prices will adjust. This means that the government can get the same result in the market with many types of actions, through taxes, quantity regulation, or price regulation. It's actually why you see so much lobbying, because everybody wants the regulation that benefits them the most, and no one wants taxes, because the government gets the money. Well, taxpayers want taxes. They want other taxpayers to pay them. And so over the next few days, is there any way we can stop practicing thinking about the ways the government intervenes in markets? In past episodes, I've asked you, as you go about your daily economic life, to think about demand and to think about supply and how they shape the choices you're making. This time, what I want you to do is think about the role that governments play in the things that you buy. Food safety, childcare centers, financial products, just about everything in the economy is touched by the government in some way. And think about how those touches by the government end up shaping the purchase decisions that you make. Betsy, Justin, I'm going to start thinking about the ways government shows up. Thank you. Hey, NAS, it was great talking with you today. And remember, while government might be everywhere, so are market forces. And I hope you didn't find this episode too taxing, NAS. Oh, my God. Stop with the puns. Stop. To get the most out of this show, check out our bonus episodes and supplemental materials, available only on the Himalaya Learning Platform. Himalaya Learning provides bite-sized courses from world-class thinkers and industry experts such as Ariana Huffington, Malcolm Gladwell, Tim Ferris, and more for you to enjoy in the app on the go. Go to Himalaya.com/econ and enter promo code ECON, E-C-O-N, a check out for your first 14 days free. It's time to think like an economist.