Microeconomics: Chapter 5

Deadweight loss

1/2 (the wedge x [the equilibrium price - quota)

Black Markets

A black market is a market in which goods or services are bought and sold illegally - either because they are prohibited or because the equilibrium price is illegal.

Price ceiling

A maximum price sellers are allowed to charge for a good or service (usually set BELOW equilibrium)

Price floor

A minimum price buyers are required to pay for a good or service (usually set ABOVE equilibrium)

Price ceilings, floors, and quotas: all decrease the amount traded

A price ceiling - pushes the price of a good down; fewer sellers will want to sell A price floor - pushes the price of a good up; fewer buyers will want to buy A quota, by definition, reduces sales If sellers don't want to sell as much as buyers want to buy, it's the sellers who determine the actual quantity sold, because buyers can't force unwilling sellers to sell and vice versa

Inefficiently Low Quality

At the controlled price, sellers have more customers than goods. In a free market, this would be an opportunity to profit by raising prices. - But when prices are controlled, sellers cannot. Sellers respond to this problem in two ways: - Reduce quality - Reduce service When did full service gas stations go away? During the price ceilings in the 1970s

Interference in markets has consequences

Distorted price signals cause resources to be misallocated. If prices are distorted, they cannot give good information to buyers and sellers.

Controlling Quantities

Governments sometimes control quantity instead of price

Inefficiently High Quality

Higher quality raises costs and reduces sellers' profit. Buyers get higher quality but would prefer a lower price. Price floors encourage sellers to waste resources: higher quality than buyers are willing to pay for it. Ex: most flyers prefer a lower ticket price (with no food included) than an expensive ticket with expensive/fancy food

Nonbinding Price Ceilings

If a price ceiling is set above equilibrium, it will have no effect - Nonbinding

Nonbinding Price Floors

If a price floor is set below equilibrium, it will have no effect (called nonbinding).

How to know the difference between a shift along a demand/supply curve or a shift of a demand/supply curve:

If it is the price that changes first, it is a shift ALONG the demand/supply curve. Price has already become a variable in your equation. The movement along a demand curve happens when the only factor that changes is price. The shift of the demand curve is actually caused by any actual changes in the determinants of the demand. (Shift of a demand/supply curve is because of any reason other than price)

Friends of homeowners near the stadium regularly attend games, even if they aren't big fans. But some serious fans have given up because of the parking situation caused by the imposition of a $7 price ceiling. What would you call this?

Inefficient allocation of goods

How price ceilings cause inefficiency

Inefficiently low quantity Inefficient allocation to customers Wasted resources Inefficiently low quality Black markets

Price controls

Legal restrictions on how high or low a market price may go. Two main types: price ceiling, price floor

The Cost of Quantity Controls

Like price controls, quotas impose losses on society - Deadweight loss (some mutually beneficial transactions don't occur) - Incentives for illegal activities

Binding, or Effective Price Ceilings

Only a price ceiling that forces price below equilibrium will have any effect (called binding or effect) --> causes a shortage.

Binding or Effective Price Floors

Only a price floor that forces price above equilibrium will have any effect

Inefficient allocation to customers

Price controls distort signals that would help the goods get allocated their highest-valued uses. - Consumers who value a good most don't necessarily get it. - So producers have no incentive to supply the good to the "right" people first. * As a result, good are misallocated. The first person willing to pay get its, but it doesn't necessarily mean someone who values it more will get it (may offer 1800 vs. normal 800 but you can't sell it!) if you always have to go off the idea of first come first serve, you're going to spend a lot of time waiting in line.

Wasted Resources (Price Ceilings)

Price controls that create shortages lead to bribery and wasteful lines. Shortages - not all buyers will be able to purchase the good. Normally, buyers would compete with each other by offering a higher price. If price is not allowed to rise, buyers must compete in other ways (waiting in line, illegal bribes and favors)

How a price floor causes inefficiency

Price floors cause predictable side effects: - Deadweight loss from inefficiently low quantity - Inefficient allocation of sales among sellers - Wasted resources - Inefficiently high quality - Temptation to break the law by selling below the legal price

Illegal Activity

Price floors encourage black markets. There are willing sellers (and buyers) at illegal prices, so they are tempted to break the law and trade with each other.

Wasted Resources (Price Floors)

Price floors encourage waste. To deal with the surplus generated by agricultural price floors, the US government sometimes buys back the excess and donates or destroys it.

Inefficient Allocation of Sales Among Sellers

Price floors misallocate sales by: - allowing high-cost firms to operate. - preventing low-cost firms from entering the industry. This may stop cost-efficient producers from entering the market. Price floors and regulation prevented Southwest (and 79 other firms) from entering the national market.

So why are there price floors?

Same as price ceilings: They do benefit some people (who are typically better organized and more vocal than those who are harmed by them) If the price floor is longstanding, buyers may not have a realistic idea of what would happen without it. Government officials often do not understand supply and demand analysis

Price Floors

Sometimes governments intervene to push market prices up instead of down. (Minimum prices) Ex: the generous minimum wage in many European countries has contributed to a high rate of unemployment and the flourishing of an illegal labor market

The effects of a price floor

Surplus

The Wedge, or Quota Rent

The difference between the demand price and the supply price at the quota limit. Equal to the market price of the license when the license is traded.

A price floor causes inefficiently low quantity

The lower quantity of quantity demanded and quantity supplied - the lower cost will determine which will be the quantity transacted.

So why are there price ceilings?

They do benefit some people (who are typically better organized and more vocal than those who are harmed by them) If the price ceiling is longstanding, buyers may not have a realistic idea of what would happen without it. Government officials often do not understand supply and demand analysis.

Some fans arrive several hours early in order to find parking after the imposition of a $7 price ceiling. What would you call this outcome? Shortage Wasted Resources Inefficiently Low Quality Black Markets

Wasted resource - wasting the time that you could have spent doing something else.

Inefficiently low quantity

When prices are held below the market price, shortages are created. The lower the controlled price relative to the market equilibrium price, the larger the shortage.

Quota

an upper limit, set by the government, on the quantity of some good than can be bought or sold; also referred to as a quantity controlled

Demand price

the price of a given quantity at which consumers will demand that quantity

Supply price

the price of a given quantity at which producers will supply that quantity

License

the right, conferred by the government, to supply a good

Quota limit

the total amount of a good under a quota or quota control that can be legally transacted