Post on 03-Apr-2018
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Copyright 2004 South-Western
4Supply, Demand,
and GovernmentPolicies
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Supply, Demand, and GovernmentPolicies
In a free, unregulated market system, market
forces establish equilibrium prices and
exchange quantities.
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CONTROLS ON PRICES
Are usually enacted when policymakers believe
the market price is unfair to buyers or sellers.
Result in government-created price ceilings and
floors.
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CONTROLS ON PRICES
Price Ceiling
A legal maximum on the price at which a good can
be sold.
Price Floor A legal minimum on the price at which a good can
be sold.
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How Price Ceilings Affect Market Outcomes
Two outcomes are possible when the
government imposes a price ceiling:
The price ceiling is notbinding if set above the
equilibrium price. The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
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Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Equilibrium
quantity
$4 Priceceiling
Equilibrium
price
Demand
Supply
3
100
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Figure 1 A Market with a Price Ceiling
Copyright2003 Southwestern/Thomson Learning
(b) A Price Ceiling That Is Binding
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Demand
Supply
2 Price
ceilingShortage
75
Quantity
supplied
125
Quantity
demanded
Equilibrium
price
$3
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How Price Ceilings Affect Market Outcomes
Effects of Price Ceilings
A binding price ceiling creates
Shortages because QD > QS.
Example: Gasoline shortage of the 1970s
Reduction in Product Quality
Wasteful Lines and Other Search Costs
Nonprice rationing Examples: Long lines, discrimination by sellers
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In 1973, OPEC raised the price of crudeoil in world markets. Crude oil is the
major input in gasoline, so the higher oil
prices reduced the supply of gasoline.
What was responsible for the long gas
lines?
CASE STUDY: Lines at the Gas Pump
Economists blame government
regulations that limited the price oilcompanies could charge for
gasoline.
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Figure 2 The Market for Gasoline with a Price Ceiling
Copyright2003 Southwestern/Thomson Learning
(a) The Price Ceiling on Gasoline Is Not Binding
Quantity of
Gasoline
0
Price of
Gasoline
1. Initially,the priceceilingis notbinding . . . Price ceiling
Demand
Supply, S1
P1
Q1
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Figure 2 The Market for Gasoline with a Price Ceiling
Copyright2003 Southwestern/Thomson Learning
(b) The Price Ceiling on Gasoline Is Binding
Quantity of
Gasoline
0
Price of
Gasoline
Demand
S1
S2
Price ceiling
QS
4. . . .resultingin ashortage.
3. . . . the price
ceiling becomesbinding . . .
2. . . . but whensupply falls . . .
P2
QD
P1
Q1
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Reduction in Product Quality
At the controlled price, sellers have more
customers than they have goods.
In a free market, this would be an opportunity to
profit by raising prices. When prices are controlled, however, sellers cannot
raise prices without violating the law.
Sellers respond to this problem and increase profitsin two ways:
Reduce quality
Reduce service
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Wasteful Lines and Other SearchCosts
Price controls that create shortages lead to bribery
and wasteful lines.
Shortages mean that not all buyers will be able to
purchase the good. In free markets buyers compete with other buyers
by offering a higher price.
Since price is not allowed to rise above the priceceiling, buyers must compete in other ways.
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Wasteful Lines and Other SearchCosts
Some buyers may be willing to bribe sellers inorder to obtain the good.
The maximum bribe a buyer would be willing to
pay is the difference between the willingness topay and the controlled price established by the
price ceiling.
If bribes are common, then the total price of the
good is the legal price plus the bribe.
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Wasteful Lines and Other SearchCosts
Buyers can also compete with each otherthrough their willingness to wait in line.
The maximum wait time (in monetary terms) for a
buyer is the difference between the willingness topay and the controlled price established by the
price ceiling.
Thus, the total price of the good is the legal price
plus the time costs.
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Misallocation of Resources
Price controls distort signals and eliminateincentives leading to a misallocation of
resources.
Consumers with high-value uses of the good arelegally prevented from signaling their high value by
offering sellers a price greater than the controlled
price.
Producers, therefore, have no incentive to supply
the good just to the highest-value uses.
As a result, in controlled markets goods are
misallocated.
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CASE STUDY:Rent Control in the Short Runand Long Run
Rent controls are ceilings placed on the rentsthat landlords may charge their tenants.
The goal of rent control policy is to help the
poor by making housing more affordable.
One economist called rent control the best way
to destroy a city, other than bombing.
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Figure 3 Rent Control in the Short Run and in the Long Run
Copyright2003 Southwestern/Thomson Learning
(a) Rent Control in the Short Run
(supply and demand are inelastic)
Quantity of
Apartments
0
Supply
Controlled rent
Rental
Price of
Apartment
Demand
Shortage
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How Price Floors Affect Market Outcomes
When the government imposes a price floor,two outcomes are possible.
The price flooris notbinding if set below the
equilibrium price.
The price flooris binding if set above the
equilibrium price, leading to a surplus.
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Figure 4 A Market with a Price Floor
Copyright2003 Southwestern/Thomson Learning
(a) A Price Floor That Is Not Binding
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Equilibrium
quantity
2
Price
floor
Equilibrium
price
Demand
Supply
$3
100
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Figure 4 A Market with a Price Floor
Copyright2003 Southwestern/Thomson Learning
(b) A Price Floor That Is Binding
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Demand
Supply
$4 Price
floor
80
Quantity
demanded
120
Quantity
supplied
Equilibrium
price
Surplus
3
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How Price Floors Affect Market Outcomes A price floor prevents supply and demand from
moving toward the equilibrium price and quantity.
When the market price hits the floor, it can fall no
further, and the market price equals the floor price.
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How Price Floors Affect Market Outcomes
A binding price floor causes . . .
a surplus because QS > QD.
nonprice rationingis an alternative mechanism for
rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price
supports
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The Minimum Wage
An important example of a price floor is theminimum wage. Minimum wage laws dictate
the lowest price possible for labor that any
employer may pay.
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Figure 5 How the Minimum Wage Affects the Labor Market
Copyright2003 Southwestern/Thomson Learning
Quantity of
Labor
Wage
0
Labordemand
LaborSupply
Equilibriumemployment
Equilibriumwage
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Figure 5 How the Minimum Wage Affects the Labor Market
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Quantity of
Labor
Wage
0
LaborSupplyLabor surplus
(unemployment)
Labordemand
Minimumwage
Quantitydemanded
Quantitysupplied
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Minimum wage effects
Minimum wage increases unemployment,especially among teenagers and minorities.
Henry Hazlitt:
You cannot make a man worth a given amount by making it illegalto offer him anything less. You merely deprive him of the right
to earn the amount that his abilities and situation would permit
him to earn, while you deprive the community even of the
moderate services he is capable of rendering. In brief, you
substitute a low wage for unemployment
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Summary
Price controls include price ceilings and pricefloors.
A price ceiling is a legal maximum on the price
of a good or service. An example is rentcontrol.
A price floor is a legal minimum on the price of
a good or a service. An example is theminimum wage.