Question:
The Texas Minimum Construction Standards require that all plumbing fixtures be WaterSense certified. Examples of requirements under these standards include low-flow faucets, shower heads, and toilets.
Suppose, for the sake of argument, that before the requirement for low-flow toilets went into effect, installing a normal-flow toilet cost $250. Suppose also that installing a low-flow toilet costs plumbers an additional $100 under the regulations, and that their customers value the savings from low-flow toilets at $25 per toilet.
Illustrate how the demand and supply curves for toilets shift as a result of the law. What happens to the price of a new toilet (providing a range of new prices is sufficient)? Who gains from the law: plumbers, their customers, both, or neither? Justify your answer.
Solution:
I use this question in the classroom to highlight several ideas. For one, it’s not clear that product-quality mandates necessarily make consumers better off. I say not clear because such mandates may be intended to address an externality.
For instance, my former colleague at Texas Tech University, Adam Martin, once pointed out that West Texas—like several other areas of the American West—relies on the Ogallala Aquifer for water. Since no one owns the aquifer, pricing its use is difficult. In this case, we may get the standard tragedy of the commons outcome: each person considers only his or her own costs when using water rather than the full social cost. As a result, the aquifer may be depleted too quickly. For my answer, however, I’m going to ignore this possibility.
Another reason I use this question in the classroom is to show that if consumers truly valued the additional quality required by the mandate, firms would already have an incentive to provide it because doing so would be profitable. The question also offers a chance to discuss the incidence of the mandate. In effect, the regulation operates like a tax—but instead of generating revenue for the government, it generates revenue for the suppliers of low-flow toilets in this case, or more generally, for whoever provides the additional quality. Like a tax, the mandate creates a deadweight loss.
Since consumers value the water savings from low-flow toilets at $25 per toilet, we can think of the demand for low-flow toilets as being $25 higher than the demand for normal toilets. By the same logic, we can think of the mandate as reducing supply by $100. The additional cost plumbers incur when installing low-flow toilets. Since supply falls more than demand rises, fewer toilets will be installed, and the market price will increase by some amount between $25 and $100. Both plumbers and their customers are worse off: plumbers receive less net revenue after covering their higher costs, and customers pay more than the value they place on the improvement. The result is a deadweight loss, reflecting the reduction in mutually beneficial trades that would have occurred without the mandate.
We can illustrate this idea using the supply and demand diagram below.
Image by Bryan P. Cutsinger
The initial supply and demand curves, shown in black, reflect market conditions before the mandate takes effect. The mandate shifts the supply curve leftward by the additional cost of providing a low-flow toilet, illustrated by the red supply curve, S′. The red demand curve, D′, reflects consumers’ demand for low-flow toilets. The vertical distance between D′ and the initial demand curve, D, represents the additional value consumers place on the water savings from low-flow toilets.
We’re told that the initial price of a toilet is $250, so the mandate must raise the equilibrium price. How much it rises depends on the elasticities of supply and demand, but we know the new price will lie somewhere between $275 (if demand were perfectly elastic) and $350 (if supply were perfectly elastic).
