Chapter 4 Summary

Tip #1. Students often find it confusing to remember the difference between a price floor and a price ceiling.

A floor is a surface that you stand on and that is solid. A price floor is the lowest price that can be charged for a good. Figure 4.1 illustrates a price floor. To be effective, a price floor must be set at a price that is greater than the equilibrium price. At PF, Q1 units will be supplied and Q2 units will be demanded. An effective price floor always results in a surplus of the good. A ceiling is a surface that you hope is solid and stays above your head. A price ceiling is the highest price that can be charged for a good. Figure 4.2 illustrates a price ceiling. To be effective, a price ceiling must be set at a price that is less than the equilibrium price. At PC, Q1 units will be supplied and Q2 units will be demanded. An effective price ceiling always results in a shortage of the good.

Tip #2. A quota, or quantity control, is a policy implemented by the government to set a maximum amount of the good or service that can be sold in a market.

A quota has no effect if it is set at a level greater than the equilibrium quantity; to be effective a quota must be set at a level lower than the equilibrium quantity. Figure 4.3 illustrates an effective quantity control, or quota, where the maximum allowed quantity is set by the government at Q1. At Q1 demanders are willing to pay P1 for each unit of the good they consume, while suppliers are willing to supply the good at price P2. This difference, P1 − P2, is referred to as a wedge. This wedge corresponds to the quota rent the license holder of the good receives when the quantity control is imposed in a market. This quota rent represents the additional compensation the license holder receives from selling the good in a market where the quantity of the good has been artificially restricted.

Objective #9.

A quota or quantity control creates a wedge between the price consumers are willing to pay for the good and the price at which producers are willing to supply the good. The difference between these two prices is the quota rent, or the income that the license holder receives from their ownership of a valuable commodity (the license).

Objective #2.

An effective price ceiling in a competitive market creates a situation of excess quantity demanded. If the price ceiling is set above the equilibrium price in the market, the price ceiling will not be effective and therefore will have no effect on the equilibrium price and the equilibrium quantity in the market.

Objective #3.

An effective price ceiling prevents a market from being efficient because the price ceiling prevents transactions from occurring that would make some people better off without making other people worse off. In particular, an effective price ceiling prevents demanders who are willing to pay more for the good from consuming the good since the good's supply is artificially limited by the imposed price ceiling. Inefficiency arises because the price ceiling: • reduces the quantity of the good available; • reduces the value of total surplus; • misallocates the good or service among consumers; • wastes resources, as consumers spend resources searching for the good that is artificially scarce due to the price ceiling; and • reduces the quality of the available units that would have been supplied in the absence of the price ceiling.

Objective #5.

An effective price floor in a competitive market creates a situation of excess quantity supplied. If the price floor is set below the equilibrium price in the market, the price floor will have no effect on the equilibrium price and the equilibrium quantity in the market.

Objective #6.

An effective price floor results in market inefficiency because it prevents transactions from occurring that would make some people better off without making other people worse off. In particular, an effective price floor prevents suppliers who are willing to supply the good from selling the good since the good's demand is artificially limited by the imposed price floor. Inefficiency arises because the price floor: • reduces the quantity of the good demanded; • reduces the value of total surplus; • misallocates the provision of the good or service by sellers; • wastes resources, as suppliers search the market for a potential demander of the good; and • increases the quality of the available units above the level that would have been demanded in the absence of the price floor.

Objective #4.

Price ceilings provide incentives for illegal activities. Price ceilings are primarily instituted because they benefit some particular group of demanders.

Objective #1.

Price controls refer to the government's intervention in a market to set the price of the good or service at some level other than the equilibrium price. A price ceiling is the maximum price for a good or service allowed by the government, and a price floor is the minimum price for a good or service allowed by the government.

Objective #7.

Price floors provide an incentive for illegal or black market activities, including the bribery and corruption of government officials. Price floors are primarily instituted because they benefit a particular group of sellers.

Objective #10.

Quantity controls are inefficient because they prevent some mutually beneficial transactions from occurring, since the demand price for a given quantity (the quota amount) is greater than the supply price for that quantity. These missed transactions create an incentive to evade the quota limit, often through illegal activity.

Objective #8.

The government may also implement quantity controls or a quota in a market. In this case the government sets a limit on the total quantity of the good that can be bought and sold in the market. This quantity is usually limited through the selling of licenses that legally grant the holder of the license the right to supply the good. Quantity controls always set a maximum amount allowed. To be binding in the market, the quota must be set below the equilibrium quantity.

wasted resources

a form of inefficiency in which people expend money, effort, and time to cope with the shortages caused by a price ceiling.

inefficient allocation to consumers

a form of inefficiency in which 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; often a result of a price ceiling.

inefficiently high quality

a form of inefficiency in which sellers offer high-quality goods at a high price even though buyers would prefer a lower quality at a lower price; often the result of a price floor.

inefficiently low quality

a form of inefficiency in which sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price; often a result of a price ceiling. black market a market in which goods or services are bought and sold illegally, either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling.

inefficient allocation of sales among sellers

a form of inefficiency in which sellers who would be willing to sell a good at the lowest price are not always those who actually manage to sell it; often the result of a price floor.

minimum wage

a legal floor on the wage rate. The wage rate is the market price of labor.

price ceiling

a maximum price sellers are allowed to charge for a good or service; a form of price control.

price floor

a minimum price buyers are required to pay for a good or service; a form of price control.

quota

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

quantity control

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

price controls

legal restrictions on how high or low a market price may go.

demand price

the price of a given quantity at which consumers will demand 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 quantity control that can be legally transacted.