Microeconomics 4

7/29/2019 Microeconomics 4

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Copyright 2004 South-Western

4Supply, Demand,

and GovernmentPolicies


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Copyright 2004 South-Western/Thomson Learning

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



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


(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


(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



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



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.




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.




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.



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.



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


(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



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


(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


(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



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.



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



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


Quantity of

Labor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage


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Figure 5 How the Minimum Wage Affects the Labor Market


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.

Microeconomics 4

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