Chapter 5 Markets in Action Copyright © 2002 Pearson Education Canada Inc. Slide 5-1.

Chapter 5

Markets in Action

Copyright © 2002 Pearson Education Canada Inc.

Slide 5-1

Copyright © Pearson Education Canada Inc.

Learning Objectives• Understand that individual markets do not exist in isolation, and that changes in one market typically have repercussions in other markets.

• Understand the operation of a market that is subject to price ceilings or price floors.

• Recognize who benefits and who loses from price controls.• Recognize legislated rent controls as an example of a price ceiling.

• Understand the different short-run and long-run effects of such controls.

• Examine various ways that governments intervene in agricultural markets in an effort to both stabilize and raise farmers’ incomes.

Slide 5-2


The Interaction Among Markets

Partial and General Equilibrium

Partial-equilibrium analysis examines a single market in situations where the feedback effects from all other markets are small enough to be ignored. This is appropriate when the single market is small relative to the economy as a whole.

Slide 5-3

No market exists in isolation. When something changes in Market X, there will be some impact on other markets. As those markets change, there will be some feedback effects back onto Market X.

Most of microeconomics uses partial-equilibrium analysis.


Slide 5-4

When economists study all markets together they use what is called general-equilibrium analysis.

General-equilibrium analysis is much more difficult because it involves taking account of all of the interactions -- the feedback effects -- between the many markets in the economy.

For now, we emphasize some simple ways that markets are linked together without doing a complete general-equilibrium analysis. We look at three types of linkages:

• regional linkages

• input-output linkages

• linkages through resource constraints


Regional LinkagesRegionally separate markets may be connected by two different linkages, mobile supply and mobile demand.

The mobility of supply means the ease with which suppliers can move their products from one market to another. This depends on the product in question and the distance between the two markets.

Mobility of demand means the extent to which consumers view products in the two regions as substitutes.

If demand or supply is mobile, then a shock in one market will tend to push prices in the same direction in all markets. See the example in the text (Figure 5-1) of Hurricane Andrew and the price of plywood.

Slide 5-5


Input-Output Linkages

There are also linkages between markets of very different products. Linkages arise because some products are used as inputs to the production of other products. Example: anchovies are used as a protein supplement for beef cattle.

Changes in the price of one product lead to similar changes in the prices of goods that use that product as an input.

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Slide 5-6

A collapsein the anchovy catch raises their price

The higher price of cattle feed then reduces the supply of beef


Linkages Through Resource Constraints

Demand-side resource constraints link markets because consumers have only so much income to spend. If consumers with constant incomes increase their demand for one good, they must reduce their demand for another.

In an economy with fully employed resources, an increase in resources devoted to producing one product must imply a reduction in resources devoted to producing other products.

Slide 5-7

More subtle, but equally important, are supply-side resource constraints.

Here is an example about whether subsidies to individual firms can “create” jobs.


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A subsidy to the aerospace industry will raise employment and wages in that industry. But the “new” workers must come from somewhere. Employment in other industries will be reduced.

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Slide 5-8

The subsidy increases the demand for labour and drives up the wage in this industry

As wages rise in the Aerospace industry, workers leave other industries, thus reducing supply


Government-Controlled Prices

Disequilibrium Prices

When controls hold the price at some disequilibrium value, the quantity actually traded is determined by the lesser of the quantity demanded or the quantity supplied.

If quantity supplied exceeds quantity demanded, demand will determine the amount actually exchanged.

Conversely, if quantity demanded exceeds quantity supplied, supply will determine the amount actually exchanged.

Slide 5-9


Price Floors

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Price floors make it illegal to sell the product below the controlled price, as in the case of a legislated minimum wage.

Effective price floors lead to excess supply.

Slide 5-10

APPLYING ECONOMIC CONCEPTS 5-1

Minimum Wages and Unemployment

Do legislated minimum wages lead to unemployment?


Price Ceilings

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A price ceiling is the maximum price at which goods and services may be exchanged, as in the case of rental housing.

Effective price ceilings lead to excess demand.

Slide 5-11

What happens when some consumers are prepared to pay much more than the legislated ceiling price of p1? This is when we see black markets.


Effective price ceilings create the potential for a black market because a profit can be made by buying at the controlled price and selling at the black market price.

• To restrict production.

• To keep specific prices down.

• To satisfy notions of equity in the consumption of a product that is temporarily in short supply.

A black market is any market in which goods are sold illegally at prices that violate a legal price control.

A government might have three main goals for imposing a price ceiling.

Slide 5-12


Rent Controls: A Case Study of Price Ceilings

The Predicted Effects of Rent Controls

Binding rent controls are a specific form of price ceiling. We can use the previous diagram to predict the effects:

• There will be a housing shortage since quantity demanded will exceed quantity supplied.

Slide 5-13

• The shortage will lead to alternative allocation schemes. Allocation by sellers’ preferences is common.

• Black markets will appear. Illegal schemes like “key money” are common.


Who Gains and Who Loses?

Existing tenants in rent-controlled accommodations are made better off from a policy of rent control. As the gap between the controlled and free-market rent grows, existing tenants gain more and more.

Landlords suffer because they do not get the return that they had expected on their investments.

Potential future tenants also suffer from rent controls because housing they will require in the future will not exist due to the ongoing (and worsening) housing shortages.

Slide 5-14


Temporary Versus Permanent Increases in Demand

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Rent controls prevent a temporary skyrocketing of rents when demand rises but also prevent the long-term supply adjustment when it is required.

Slide 5-15


Policy Alternatives

As an alternative to rent controls, housing shortages can be removed if the government (at taxpayer’s expense) either subsidizes housing production or produces public housing directly.

The government may also provide lower-income households with income assistance, allowing them to access better housing than they would otherwise be able to afford.

Whatever policy is adopted, it is important to recognize that providing greater access to rental accommodations has a resource cost.

Slide 5-16


Agriculture and the Farm Problem

Long-Term and Short-Term Problems

Long-term problems have resulted from rapid productivity growth and generous agricultural subsidies (internationally), which together have caused the supply curve for agricultural products to shift outward.

Demand for agricultural products has been increasing more slowly than supply, so prices have declined in real terms.

Slide 5-17

Depressed farm incomes signal the need for resources to move out of agricultural and into other sectors. However, the response is slow and painful particularly for displaced farmers.


Short-term problems come mainly from the large annual fluctuations that farmers face due to variable domestic weather conditions and volatile world prices for agricultural commodities.

Slide 5-18

In the case of products destined for the domestic market, the fluctuations in weather are important because demand is typically inelastic.

The inelastic demand implies that a domestic bumper crop can reduce prices so much that farm income may actually fall.


The Theory of Agricultural Policy

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When domestic farmers sell in world markets, their incomes fluctuate in the same direction as their fluctuations in output.

When world prices fluctuate, domestic farmers’ incomes fluctuate in the same direction as the fluctuations in world prices.

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Slide 5-19


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Slide 5-20

When farmers sell their products in domestic markets, the government can try to raise farm incomes by introducing a support price.

Price Supports

Farmers will naturally increase their output at the high price, so the government must buy and store the surplus.

Taxpayers and consumers pay the bill!


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The government could instead institute a quota system. This guarantees that farmers will receive income equal to the quota output times the market price at that restricted level of output.

The free-market price of a quota will be such that the profitability of that good’s production will, after deducting the cost of the quota, be no more than the profitability of the other lines of activity carrying similar risks.

Slide 5-21

A Quota SystemOutputQuota


Agricultural Policy in CanadaThe main tools of agricultural stabilization in Canada are marketing boards and income supplement programs.

There are two types of government marketing boards. The first seeks to influence prices by controlling supply. The second takes prices as given and acts as a selling agency for producers.

The current system of income supplements to farmers includes the Net Income Stabilization Account (NISA) and the Gross Revenue Insurance Program (GRIP). These two programs make up what might be called the “safety net programs” for Canadian farmers.

Slide 5-22

The Future of Agricultural Policy

The full benefit of increases in agricultural productivity, that permit the same output to be produced with fewer resources, will be felt only when resources flow out of the agricultural sector and begin producing valuable goods and services in other sectors.

Slide 5-23

Most economists believe that, rather than subsidizing farmers to remain where they are, it would be more efficient to assist farmers in making the slow transition to other industries.



Slide 5-24

Chapter 5 Markets in Action Copyright © 2002 Pearson Education Canada Inc. Slide 5-1.

Documents

supply slide

markets partial

supply of beef slide

price controls

individual markets

agricultural markets

separate markets

price ceilings