Lecture Presentation Price Controls

7/29/2019 Lecture Presentation Price Controls

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Lesson 1

Lesson 1

ECONOMICS

The Market Strikes Back


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1

ECONOMICS Chapter 4 1

Review: Supply and Demand

The previous lesson focused on demand and supply, we

studied the demand curve and the supply curve

P

Quantity

S

D

Quantity

P


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2


Review: Supply and Demand

and the market equilibrium:

P

Quantity

D

S

Peq

Qeq


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3


What we will learn in this chapter

The meaning ofprice controls and quantity controls,two kinds of government intervention in markets

How price and quantity controls create problems andmake a market inefficient

Why economists are often deeply skeptical of attemptsto intervene in markets

Who benefits and who loses from market interventions,and why they are used despite their well- known problems

What an excise tax is and why its effect is similar to a

quantity controlWhy the deadweight loss of a tax means that its true

cost is more than the amount of tax revenue collected


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4


Price controls

Price controls are legal restrictions on how

high or low a market price may go.

2 kinds of price controls:

1. Price Ceilings: a maximum price sellers are

allowed to charge for a good.Its an upper limit

for the price.

2. Price Floors: a minimum price buyers arerequired to pay for a good.Its a lower limit for

the price.


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5


Price controls

Why Price controls?

During crisis times, emergencies or wars the

government wants to protect the consumers from

rapidly increasing prices.

If the equilibrium wage given by supply and

demand for low skilled workers is below poverty

level, the government can set a minimum wagefor such category.


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6ECONOMICS Chapter 4 6

Price controls

But what happens if there are price controls on a

competitive market?

The reasons above regarded emergencies, or particular

moral situations.

We will consider only the competitive market in our

analysis, and we are only interested in efficiency issues,

not in equity issues (if its fair or not).

Lets compare the usual market equilibrium and the casewith a price ceiling in the icecream market.


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Price controls: price ceilings

Equilibrium Price ceiling

D

Quantity of

icecreams

Price

3

2

200

4

S

100

D

Quantity of

icecreams

Price

3

2

200 800

4

S

100

Shortage

Price

Ceiling


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Price controls: price ceilingsAnother example


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After these 2 examples, we can see that in every

case, when there is a price ceiling, there is a

shortage.

The shortage will lead to inefficiencies:

A market or an economy is inefficient if there are

missed opportunities: some people could be

made better off without making other peopleworse off.


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Lets take a look at the different possible

inefficiencies:

1. Inefficient Allocation to Consumers

2. Wasted Resources

3. Inefficiently Low Quality

4. Black Markets


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Inefficient Allocation to Consumers

Price ceilings often lead to inefficiency in the form ofinefficient allocation to consumers: people who really

want the good and are willing to pay a high price dont getit, and those who are not so interested in the good andare only willing to pay a low price do get it.

An efficient allocation would take into account suchdifferencies, who really want the good will get it, who

doesnt need it so urgently will not.

Example: rent control. In such case people get theappartment usually through luck or personal connections.


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Wasted Resources

Price ceilings typically lead to inefficiency in the form ofwasted resources: people spend money, time andexpend effort in order to deal with the shortages caused

by the price ceiling.

You waste a lot of time looking for a good (e.g. anappartment) in case of shortage, the time has its value!You can work or just rest, do something better than look

for a good you cant find. If the market works efficiently, you can find quickly the

goods you are looking for.


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Inefficiently Low Quality

Price ceilings often lead to inefficiency in that the goods

being offered are ofinefficiently low quality: sellers offer

low-quality goods at a low price even though buyerswould prefer a higher quality at a higher price.

In case of rent controls, the landlords will not improve the

conditions of the apartments, there is no incentive since

the rental fee is low but the main reason is that sincethere is a shortage, people are willing to rent the

apartment as it is, even in bad condition!


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Black Markets

A black market is a market in which goods orservices are bought and sold illegallyeither

because it is illegal to sell them at all or becausethe prices charged are legally prohibited by aprice ceiling.

If someone for example bribes (gives extra

money) to the flat owners he will get the flat, butthe honest people that dont break the law willnever find one this way!


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So many inefficiencies! But why are there price ceilings

then?

1. They may benefit some people: someone can get the

good cheaper. They benefit influential buyers.

2. When price ceilings have existed for long time (like in

New York), people dont know what will happen without

them. Black market prices may be an indication, but

such prices are usually higher than the price we would

have with a fully free market.

3. Government officials dont really understand supply and

demand!


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Price controls: price floors

Price Floors: a minimum price buyers are

required to pay for a good.Its a lower limit for

the price.

The minimum wage is a legal floor on the

wage rate, which is the market price of labor.


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Equilibrium Price floor

D

Quantity of

icecreams

Price

3

2

200

4

S

100

D

Quantity of

icecreams

Price

3

2

200 600

4

S

100

Surplus

Price

Ceiling


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Why a Price Floor Causes Inefficiency

Inefficient Allocation of Sales Among Sellers

Price floors lead to inefficient allocation of sales

among sellers: those who would be willing to sell thegood at the lowest price are not always those who

actually manage to sell

Wasted Resources

Like a price ceiling, a price floor generates inefficiency bywasting resources.


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Inefficiently High Quality

Price floors often lead to inefficiency in that goods

ofinefficiently high quality are offered: sellers

offer high-quality goods at a high price, eventhough buyers would prefer a lower quality at a

lower price.

Illegal Activity

Like price ceilings, price floors can provide an

incentive forillegal activity.


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So Why Are There Price Floors?

The reasons are similar to those for the price

ceilings.

Price floors may benefit some influential sellers.

Governments dont understand the supply and

demand model, or they think that it doesnt

describe reality well.


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Quota

A quantity control, orquota, 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 (bought and sold) is the quotalimit. Its a maximum quantity that can be bought

or sold.

A license gives its owner the right to supply (sell)

a good.


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Quota

Why? Usually to deal with a temporary problem,

crisis situation, protect the natural resources

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.


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Quota: model

Equilibrium With a quota

D

Quantity of

icecreams

Price

3

2

200

4

S

100

D

Quantity of

icecreams

Price

3

2

200

4S

100

wedgePrice Ceiling

A

B

E


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Quota

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. Thedifference 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. It is equal to themarket price of the license when the licenses are

traded.


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Quota

2 Prices, how is it possible?

Actually the owner of a license (Frank) is in 2 markets: themarket of icecreams and the market of licenses!

Imagine he can rent the license to Alex, for one day and

the license allows you to sell 1 icecream, the rent of willbe exactly 2 yuan.

But what if Frank is using the license personally? Well hecould have rented it for 2 yuan, the license has anopportunity cost of 2 yuan! Frank is giving up 2 yuan

quota rent when using the license personally. He canmake 2 yuan selling 1 icecream and 2 yuan from rentingthe license. The license has its own value, its a valuableasset!


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Quota

The Costs of Quantity Controls

Inefficiencies, or missed opportunities, in the

form of mutually beneficial transactions that dont

occur

Incentives for illegal activities: illegal taxies,

shops without license


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Tax

An excise tax is a tax on

sales of a good or service.

First consider the case

when the tax is payed bythe sellers. There is a shift

upward of the supply curve

by the amount of the tax (2

yuan).

The tax drives a wedge

between the demand price

and supply price.

Tax:

D

Quantity of

icecreams

Price

32

200

4

S

100

S


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28ECONOMICS Chapter 4

28

Tax

If the buyers are required t

pay a tax the demand

curve shifts downwards by

the amount of the tax (2

yuan).

The final effect is the same

as the excise tax!!D

Quantity of

icecreams

Price

32

200

4

S

100D


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29ECONOMICS Chapter 4

29

Tax

Incidence of a tax: who is really paying it?

It measures who really pays the tax. In both cases

we have a 1 yuan increase in the price buyers will

pay and a 1 yuan price decrease in the price thesellers will receive. It is evenly split, but this

doesnt always happen! The split depends on the

slopes of the demand curve and of the supply

curve.


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Revenue from a tax

In this example the

revenue is:

100x2yuan=200yuan

It is the green area in thegraph.

Tax revenue:

D

Quantity of

icecreams

Price

32

200

4

S

100

Lecture Presentation Price Controls

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