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Chapter 4
The Market Strikes Back
©2010 Worth Publishers
Slides created by Dr. Amy Scott
BIG CITY,
NOT - SO - BRIGHT IDEAS
What happens when the logic of the market is defied? Example: Rent Control Introduced during World War II to protect the interests of tenants
Unexpected result – apartment shortages
In this chapter, we will examine what happens when governments try to control prices
1. Consumer Surplus and the Demand Curve
2. Producer Surplus and the Supply Curve
3. Total Surplus
4. Government Intervention in Markets
A. Price Controls
B. Quantity Controls
C. Deadweight Loss
D. Who benefits and who loses from market interventions
Chapter Objectives
A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good.
Individual consumer surplus is the net gain to an individual buyer from the purchase of a good.
Consumer Surplus can also be stated as:
Buyer’s Willingness to Pay – Price Paid
or
Area below demand curve but above price
Consumer Surplus and the Demand Curve
Willingness to Pay and Consumer Surplus
Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good.
The term consumer surplus is often used to refer to both individual and total consumer surplus.
Consumer Surplus in the Used Textbook Market
Price = $30
Aleisha’s consumer surplus: $59-$30=$29
Brad’s consumer surplus: $45-$30=$15
Claudia’s consumer surplus: $35-$30=$5
The total consumer surplus is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia - equal to $29 + $15 + $5 = $49.
543210
Aleisha
Brad
Claudia
Darren
D
Edwina
$59
45
35
30
10
25
Price of book
Quantity of books
Consumer Surplus in the Used Textbook Market
Consumer SurplusThe total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price.
D
Consumer
surplus
1 million0
$1,500
Price of computers
Quantity of computers
Price = $1,500
A fall in the price of a good increases consumer surplus through two channels:
1) A gain to consumers who would have bought at the original price and
2) A gain to consumers who are persuaded to buy by the lower price.
How Changing Prices Affect Consumer Surplus
Each year, about 4,000 people in the United States die while waiting for a kidney transplant.
According to the current United Network for Organ Sharing guidelines, a donated kidney goes to the person who has waited the longest regardless of their age.
The UNOS is now devising a new set of guidelines where kidneys would be allocated on the basis of who will receive the greatest net benefit, where net benefit is measured as the increase in lifespan from the transplant. This would increase the recipients extra years by 11,000.
The “net benefit" concept is like consumer surplus: the individual consumer surplus generated from getting a new kidney.
A Matter of Life and Death
Producer Surplus and the Supply Curve
A potential seller’s cost is the lowest price at which he or she is willing to sell a good.
Individual producer surplus is the net gain to a seller from selling a good.
Price Received – Seller’s Cost or
Area above the supply curve but below price
Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.
Producer Surplus in the Used Textbook Market
Betty’s producer surplus
Andrew’s producer surplus
Carlos’s producer surplus
Price = $30
543210
S
$45
35
30
25
5
15
Price of book
Quantity of books
Engelbert
Donna
Carlos
Betty
Andrew
Producer Surplus
The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.
S
Producer surplus
$5
1 million0
Price of wheat (per bushel)
Quantity of wheat (bushels)
Price = $5
An increase in the price of a good increases producer surplus through two channels:
1) The gains of those who would have supplied the good even at the original, lower price and
2) The gains of those who are induced to supply the good by the higher price.
Changes in Producer Surplus
Putting It Together: Total Surplus
The total surplus generated in a market is:total net gain to consumers and producers from trading in the market
orsum of the producer and the consumer surplus.
The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.
Total SurplusS
D
Price of book
Quantity of books1,000
$30
0
Equilibrium quantity
Equilibrium price
Producer surplus
Consumer surplus E
Consumer Surplus, Producer Surplus, and Gains from Trade
The previous graph shows that both consumers and producers are better off because there is a market for this good, i.e. there are gains from trade.
These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient.
But are we as well off as we could be? This brings us to the question of the efficiency of markets.
Garage sales are an old American tradition: they are a way for people to sell items they don’t want to others who have some use for them, to the benefit of both parties. However, many potential beneficial trades are missed because they do not always live close to each other.
eBay provides a way for would-be-buyers and would-be -sellers of unique or used items to find each other even if they don’t live in the same neighborhood or city.
eBay and efficiency
▪ eBay was founded in 1995 by Pierre Omidyar, a programmer whose fiancée was a collector of Pez candy dispensers and wanted a way to find potential sellers. The company says that its mission is “to help practically anyone trade practically anything on earth.”
▪ The potential gains from trade were evidently large: by late 2007, eBay had 83.2 million active users, and in 2007, $60 billion in goods were bought and sold using the service. The Omidyars now possess a large collection of Pez dispensers. They are also billionaires.
eBay and eFficiency (continued)
Why Governments Control Prices
The market price moves to a level where quantity supplied = quantity demanded, however this equilibrium price may not necessarily please every buyer or seller.
Therefore, the government intervenes to regulate prices by imposing price controls, which are legal restrictions on how high or low a market price may go. Price ceiling is the maximum price sellers are
allowed to charge for a good or service. Price floor is the minimum price buyers are
required to pay for a good or service.
Price Ceilings Price Ceiling: Maximum Price sellers are
allowed to charge for a good or a service
Typically imposed during crises—wars, harvest failures, natural disasters—because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few.Ex.: US. Government imposed ceilings on
aluminum and steel during World War II, Rent control in New York
The Market for Apartments in the Absence of Government Controls
1.6 1.70 1.8 1.9 2.0 2.22.1 2.3 2.4
$1,400
1,300
1,200
1,100
1,000
900
800
700
600
Quantity of apartments (millions)
Monthly rent (per apartment)
D
E
S
$1,4001,3001,2001,1001,000
900800700600
2.42.32.22.12.01.91.81.71.6
1.61.71.81.92.02.12.22.32.4
Quantity supplied
Quantity demanded
Monthly rent (per apartment)
Quantity of apartments(millions)
The Effects of a Price Ceiling
1.60 1.8 2.0 2.2 2.4
$1,400
1,200
1,000
800
600
Quantity of apartments (millions)
Monthly rent (per apartment)
D
S
E
BA
Housing shortage of 400,000 apartments caused by price ceiling
Price ceiling
How Price Ceilings Cause Inefficiency
Inefficiently Low Quantity -lower than quantity in unregulated market, creates Deadweight Loss (DWL)
Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity. Triangle shaped area. Overall loss to society.
A Price Ceiling Causes Inefficiently Low Quantity
1.60 1.8 2.0 2.2 2.4
$1,400
1,200
1,000
800
600
Quantity of apartments (millions)
Monthly rent (per apartment)
D
S
E
Deadweight loss from fall in number of apartments rented
Price ceiling
Quantity supplied with rent control
Quantity supplied without rent control
Price Ceilings also cause:
Inefficient allocation to consumers: people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. Wasted resources: people expend money, effort and time to cope with the shortages caused by the price ceiling.Inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price.Black Markets where goods or services are bought and sold illegally.
Winners, Losers and Rent Control
Price controls create winners and losers: The winners are those with rent controlled
apartments: In 2005, Cyndi Lauper paid $989 a month for an
apartment that would have been worth $3,750 if unregulated.
Mia Farrow’s apartment, which, when it lost its rent-control status, rose from the bargain rate of $2,900 per month to $8,000.
The losers are the working class renters the system was intended to help.
Winners and Losers from Rent Control
1.60 1.8 2.0 2.2 2.4
$1,400
1,200
1,000
800
600
Monthly rent (per apartment)
S
D
E
Consumer surplus
Producer surplus
(a) Before Rent Control
0 1.6 1.8 2.0 2.2 2.4
$1,400
1,200
1,000
800
600
S
D
EPrice ceiling
(b) After Rent Control
Deadweight loss
Producer surplus
Consumer surplus transferred from producers
Monthly rent (per apartment)
Quantity of apartments (millions) Quantity of apartments (millions)
Consumer surplus
Hard Shopping in Caracas
Supermarket shopping in Caracas, Venezuela, is a bizarre experience. Shelves are stocked with scotch whiskey and imported cheese, but basic staples like black beans and beef are often absent because of price controls.
Since 1998, the president pursued policies favoring the poor by imposing price controls on basic foods (beans, chicken, sugar, etc.)
These policies in turn led to sporadic shortages, higher spending by consumers on price controlled goods and sharply rising prices for goods whose prices were not controlled. There was an increase in demand for price-controlled goods.
On the other hand, a sharp decline in the value of Venezuela’s currency led to a fall in imports of foreign foods. The result was empty shelves in the nation’s food stores.
So Why Are There Price Ceilings?
Case: Rent Control in New York Price ceilings hurt most residents but give a small
minority of renters much cheaper housing than they would get in an unregulated market (those who benefit from the controls are typically better organized and more influential than those who are harmed by them).
When price ceilings have been in effect for a long time, buyers may not have a realistic idea of what would happen without them.
Government officials often do not understand supply and demand analysis!
Price Floors
Price Floor: Minimum Price allowed to charge for a good or a service
Sometimes governments intervene to push market prices up instead of down.
The minimum wage is a legal floor on the wage rate, which is the market price of labor.
Just like price ceilings, price floors are intended to help some people but generate predictable and undesirable side effects.
The Market for Butter in the Absence of Government Controls
$1.40$1.30$1.20$1.10$1.00$0.90$0.80$0.70$0.60
14.013.012.011.010.09.08.07.06.0
8.08.59.09.5
10.010.511.011.512.0
Quantity of butter(millions of pounds)
Price of butter(per pound)
Quantity supplied
Quantity demanded
Quantity of butter (millions of pounds)
6 70 8 9 10 11 1312 14
$1.40
1.30
1.20
1.10
1.00
0.90
0.80
0.70
0.60
Price of butter (per pound)
D
S
E
The Effects of a Price Floor
60 8 9 10 12 14
$1.40
1.20
1.00
0.80
0.60 D
S
E
BA
Butter surplus of 3 million pounds caused by price floor
Price floor
Quantity of butter (millions of pounds)
Price of butter (per pound)
Price Floors and School Lunches
Did your grade school offer free or very cheap lunches? If so, you were probably a beneficiary of price floors.
During the Great Depression of the 1930s, prices were low and farmers were suffering. To aid the farmer, the U.S. government imposed price floors on agricultural products like beef, sugar, pork, etc.
Price floors are meant to create a surplus. Government reduces supply by paying farmers not to grow crops and also buys the surplus, thus taking excess surplus off the market.
The government then gives away this excess surplus to schools as free or cheap lunches.
How a Price Floor Causes Inefficiency
The persistent surplus that results from a price floor creates missed opportunities—inefficiencies—similar to those created by the persistent shortage that results from a price ceiling.
These include: Deadweight loss from inefficiently low quantity Inefficient allocation of sales among sellers Wasted resources Inefficiently high quality offered by sellers Temptation to break the law by selling below the
legal price
A Price Floor Causes Inefficiently Low Quantity
60 8 9 10 12 14
$1.40
1.20
1.00
0.80
0.60 D
S
E
Quantity demanded with price floor
Quantity demanded without price floor
Deadweight loss Price
floor
Quantity of butter (millions of pounds)
Price of butter (per pound)
How a Price Floor Causes Inefficiency
Price floors lead to inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it.
Price floors often lead to inefficiency in that goods of inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price.
Ceilings, Floors and Quantities
A price ceiling pushes the price of a good down.
A price floor pushes the price of a good up.
Both floors and ceilings reduce the quantity bought and sold.
Sellers determine the actual quantity sold, because buyers can’t force unwilling sellers to sell and vice versa.
Check Out Our Low, Low Wages!
As of September 1, 2009, the French minimum wage was almost twice as high as the U.S. rate.
The cost of hiring a bagger at the grocery store is much more expensive in France and consequently, the French almost always bag their own groceries.
The minimum wage in the United States is actually quite low compared with other rich countries.
Because minimum wages are set in national currencies, the comparison minimum wage depends on exchange rates.
“Black Labor” in Southern Europe
The minimum wage in many European countries is much higher than in the United States.
The persistent surplus that results from this price floor appears in the form of high unemployment.
In countries where enforcement of labor law is lax, it results in widespread evasion of the law.
In Italy and Spain, workers are employed by companies that pay them less than the minimum wage and fail to provide health care and retirement benefits. Many jobs also go unreported.
In fact, Spaniards waiting to collect checks from the unemployment office have been known to complain about the long lines that keep them from getting back to work!
Quantity Control A quantity control, or quota, is an upper limit on
the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit. Ex.: taxi medallion system in New York has
generated a shortage of taxis in the city. A license gives its owner the right to supply a
good. The demand price of a given quantity is the price
at which consumers will demand that quantity. The supply price of a given quantity is the price
at which producers will supply that quantity.
The Market for Taxi Rides in the Absence of Government Controls
6 7 90 8 10 11 1312 14
$7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00 D
S
E
Quantity of rides (millions per year)
Fare (per ride)
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
$3.50
$3.00
14
13
12
11
10
9
8
7
6
6
7
8
9
10
11
12
13
14
Quantity of rides(millions per year)
Fare(per ride)
Quantity supplied
Quantity demanded
Effect of a Quota on the Marketfor Taxi Rides
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
$3.50
$3.00
14
13
12
11
10
9
8
7
6
6
7
8
9
10
11
12
13
14
Quantity of rides(millions per year)
Fare(per ride)
Quantity supplied
Quantity demanded
A
B
6 70 8 9 10 11 12 13 14
$7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00 D
S
E
Deadweight loss
The “wedge”
Quota
Quantity of rides (millions per year)
Fare (per ride)
The Anatomy of Quantity Controls
A quantity control, or quota, drives a wedge between the demand price and the supply price of a good; that is, the price paid by buyers ends up being higher than that received by sellers.
The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the good.
Equals the market price of the license when the licenses are traded.
The Costs of Quantity Controls
Deadweight loss because some mutually beneficial transactions don’t occur.
Incentives for illegal activities.
The Clams of New Jersey
In the 1980s, excessive fishing threatened to wipe out New Jersey’s clam beds.
To save the resource, the U.S. government introduced a clam quota, which set an overall limit on the number of bushels of clams to be caught and allocated licenses to owners of fishing boats based on their historical catches.
1. The willingness to pay of each individual consumer determines the demand curve. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus.
2. Total consumer surplus in a market, is the sum of all individual consumer surpluses in a market. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus.
3. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus.
1 of 4
Summary
4. Total producer surplus in a market, is the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price.
5. Total surplus, is the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus.
6. Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects.
2 of 4
Summary
7. A price ceiling, a maximum market price, benefits successful buyers but creates persistent shortages. Price ceilings lead to inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation to consumers, wasted resources, and inefficiently low quality. They also encourage illegal activity as people turn to black markets.
8. A price floor, a minimum market price, benefits successful sellers but creates persistent surplus. Price floors lead to inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity and black markets.
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Summary
9. Quantity controls, or quotas, limit the quantity of a good that can be bought or sold. The quantity allowed for sale is the quota limit. The government issues licenses to individuals, the right to sell a given quantity of the good. Economists say that a quota drives a wedge between the demand price and the supply price; this wedge is equal to the quota rent. Quantity controls lead to deadweight loss in addition to encouraging illegal activity.
4 of 4
Summary
The End of Chapter 4
Coming attraction:Chapter 5:
Elasticity and Taxation
