Useful Notes on the Government Regulations for Destabilising Equilibrium

i. Rent control and its implications:

Rent control refers to fixation of ‘rent ceiling’ by the government. It is, therefore, a special case of price ceiling. With a view to keeping the rentals below the level of the free market rents, governments in many countries have attempted policies of rent control through Rent Control Legislation. Before we proceed any further, let us outline some implications of such legislation.

There will be a shortage of rental accommodations. Quantity demanded at the controlled rent will exceed the quantity supplied by Q₂ – Q_t [Figure 3.17].

Quantity of accommodation occupied under rent ceiling will be less than that under free market, i.e., Q₁ < Q₀ [Figure 3.17].

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Black markets will emerge. Landlords may ask for lump-sum entry-fee (like pagarhi, in India) from new tenants and may resort to unfair practices to evict the old tenants so as to earn such entry fees. They may even work out an arrangement with tenants to secretly collect the excess of the market rent over the controlled rent from the tenants in cash on monthly basis. The practice is quite common in India. Landlords charge the market rate of rent from the tenants but issue the receipt for lesser amount (equal to the controlled rent). Even the old tenants may sublet a part or whole of the premises to new tenants, charging the market rate of rent from them and paying the controlled rate of rent to their landlords.

Governments in many countries have passed legislation for the security of the tenure of old tenants so that landlords may not force eviction on them through illegal harassment. Such legislation protects the existing tenants from illegal eviction and gives them priority over the potential new tenants.

Effective rent control leads to shortage of housing, as the rental incomes to the landlords under controlled rentals are not quite lucrative.

Let us now analyse rent control in short and long run.

ii. Rent control in short and long run:

“Rent control causes housing shortages that worsen as the time passes.”. The statement implies that rent ceiling leads to curtailment of supply of housing in short run and worsens it even in the long run. Figure 3.19 explains the point. The short-run supply curve of accommodation is inelastic (steeper, SS) while that of the long-run is elastic (flatter LS). Both intersect the demand curve for housing at point E₀, where rent is r₀ and quantity of housing demanded and supplied is Q₀.

Now suppose that government fixes rent at r_c with the result that the quantity supplied falls from Q₀ to Q₁ while that demanded rises from Q₀ to Q₂. The magnitude of the excess demand is (Q₂ – Q₁). In the long run, this, as explained in the figure, increases to Q₂ – Q₁ in the event of government failure to supplement the supply of housing and of strict implementation of their rent control policies. Thus, housing shortages worsen in the long run due to rent control policies of the government.

Fig. 3.19: Short run supply curve (SS) is inelastic. It intersects the demand curve DD at E₀ where demand for housing is equal to its supply (Q₀) and the equilibrium rent is r₀ Now rent is controlled at r_c by the government. In short run, supply of housing drops to Q₁ while its demand rises to Q₂ with the result that an excess demand worth (Q₂ – Q₁) arises. If government fails to supplement the existing supply of Q₁ so that it may rise to the level of demand Q₂ an upward pressure on rent would develop, which if suppressed by government as a part of their rent control policy, would serve as a restraint on the suppliers of housing to further restrict the supply to Q’₁ in the long run. Thus, rent control worsens the housing shortages in the long run.

(iii) Trade protection through import quota or tariff:

A number of countries resort to protectionism mainly to safeguard the interests of the domestic industries against foreign competition. This is generally true in respect of the underdeveloped but developing countries. World prices are usually lower than domestic prices in these countries. This is due to the smaller scale of operation of their domestic industries. If trade is free (laissez-faire), domestic consumers would resort to the import of commodities from the rest of the world as the same would prove much cheaper to them. In consequence, domestic price would fall to the world level and the domestic industry would suffer losses. As a safeguard against this, governments of such countries resort to the levy of tariff on the imports so that their prices may be raised to the level of domestic prices of these commodities. The objective is to discourage imports so that the domestic industry is protected against foreign competition. Figure 3.20 explains the mechanism.

Fig. 3.20: Let the domestic price be P₀ and the domestic demand at this price be Q₀. Also, let the world price be P_w(P_w < P₀) Under free trade, consumers would consume Q_D at this price, of which, Q_s would be supplied by the domestic industry and FG’ by the rest of the world. In consequence, the domestic industry would suffer a loss of the producers’ surplus worth the area of the trapezium A (P₀P_W, F E).

The gain of the consumers’ surplus would be the area of the trapezium P₀P_wGE (= A + B). The net gain of social welfare is worth the area of the triangle EFG (B). The loss of the producers’ surplus would discourage the domestic industry, which might decide to shut down. To prevent the premature closure of the domestic industry, government has two alternatives first, impose a ban on imports, and I or second, levy enough tariff on imports so that the import price rises at least to the level of the domestic price P₀.

In either case, domestic price and domestic sales are both restored at P₀ and Q₀ respectively and so is the producers’ surplus of A’ but consumers lose their surplus by the regions A’ & ‘B’. The net effect an social welfare is a loss of the region ‘B’. This is the deadweight loss. To see this, let us determine the changes in the consumers’ and the producers’ surpluses which are, respectively,

ΔCS = – area of trapezium P₀P_w GE (A + B), and

ΔPS = + area of the trapezium, A (P₀P_WFE).

The producers’ gain (A) but the consumers lose (A + B). The net loss of the social welfare (deadweight loss) is equal to the area of the triangle B (EFG).

In summary, free trade raises social welfare by the area of the triangle B (EFG) while trade protection lowers it by the same area.

This would lead anybody to believe that underdeveloped but developing countries should never resort to trade protection. In fact, that is what the developed world always advises the underdeveloped world. But a little thought would reveal that such liberalisation proves quite fatal to the underdeveloped developing world. It leads the domestic industries to premature death. Most of them have to set a high price due to higher costs of small-scale production.

If forced to sell at P_w which is what they would have to do in the event of free trade (liberalisation), substantial losses might force them to close down before reaching the level of production at which they may earn economies of large-scale production. If domestic industries die a premature death like this, the country would have to rely on imports, to buy which, it would have no income. After all income arises from production of goods and services only.

As an alternative, the government may choose a policy of import tariff or import quota so that imports may not be eliminated completely. You will study this in higher classes.

iv. Government stabilisation of the producers’ income under fluctuating outputs:

In Figure 3.14, we saw that producers’ income can be stabilised if they are allowed to vary their price to suit the fluctuations in outputs, and if the demand curve they face is a rectangular hyperbola. Normally, government has little to do with fluctuations in producers’ income unless it has to protect the interests of producers such as the producers of food grains (farmers). The mechanism is explained in Figure 3.21.

Fig. 3.21: Let AD represent the actual demand curve for corn faced by cultivators. Further, let SS is the supply curve of corn. SS intersects AD at the point E₀. At this point, quantity of corn bought and sold is Q₀ at a price of P₀ yielding an income of (P₀ × Q₀) for the cultivators. Let income stabilising demand curve be the rectangular hyperbola, DD, passing through the intersection E₀ of AD and SS. E₀ thus, lies on the income stabilising demand curve DD, actual demand curve AD and the supply curve SS.

Cultivators’ income is stabilised at every point on DD and is numerically equal to the area of the rectangle subtended by each one of them on the two axes. For example, rectangle subtended by the point E₀ on the two axes is E₀Q₀OP₀ and its area is = OQ_g × 0P₀ = (P₀ × Q₀). Now, suppose that farm output fluctuates between Q₁ and Q₄. When output is Q₄ price would be as low as P₄ and cultivators income as low as P₄ × Q₄ in the free market. Given the output Q₄ the income-stabilising-price would correspond to DD and would be P₃. Government, therefore, must ensure this price to the cultivators. This would necessitate a demand of (Q₄ – Q₃) to be made by government at P₃ as actual demand at this price is only Q₃. Thus, the part of Q₄ bought by the free market is Q₃ and the rest, bought by government, is (Q₄ – Q₃). Cultivators earn an income P₃ × Q₄ = P₀ × Q₀ (all the rectangles subtended by the points on DD on the two axes have the same area).

Hence when output exceeds market demand, government must ensure a price higher than the market price so that it corresponds to the rectangular hyperbola; and, as a follow- up, must purchase the unsold supply to stabilise cultivators income. When output is Q₁ the actual price is P₁ and income (P₁ × Q₁) which is higher than the income required, under the income stabilisation scheme.

The government, therefore, must ensure a price P₂ lower than P₁ so that it corresponds to the rectangular hyperbola, and as a follow-up, must supply (Q₂ – Q ₁) at P₂ from their own sources (may be from the stocks purchased by them when farm-output exceeded market demand) to stabilise the cultivators’ income. Thus, when output is Q₁ the market demand is Q₂ of which Q₁ is supplied by the cultivators and the rest, (Q₂ – Q₁), by the government. Producers’ income is stabilised at P₂ × Q₁ = P₀ × Q₀ = Q₄ × P₃.

Note that the actual demand at price P₂ is Q₃ and not just Q₁ Government, therefore, must supplement the supply from their buffer stocks by an amount equal to (Q₂– Q₁). Thus when output fluctuates and the government intends to stabilise the producers’ income, they must let the prices corresponding to these outputs vary along the rectangular hyperbola and must buy or sell an amount equal to the horizontal distance between the actual demand and the income stabilising demand (the rectangular hyperbola).