Chapter 5 Price Controls & Market Efficiency PDF

Preview

Summary

Chapter 5 Price Controls & Market Efficiency...

Description

CHAPTER 5: PRICE CONTROLS AND MARKET EFFICIENCY 5.1 GOVERNMENT CONTROLLED PRICES ● Government price controls attempt to hold the price at some disequilibrium value. ○ Some hold the market price below its equilibrium value, creating a shortage at the controlled price. ○ Some hold the market price above its equilibrium value, creating a surplus at the controlled price. ● What determines the quantity actually traded at some disequilibrium value? ○ In a free market, this question doesn’t have to be posed as price adjusts to quantity demanded and quantity supplied. ○ At any disequilibrium price, quantity exchanged is determined by the lesser of quantity demanded or quantity supplied. ■ If quantity demanded exceeds quantity supplied (shortage), supply will determine the amount exchanged. ■ If quantity supplied exceeds quantity demanded (surplus), demand will determine the amount exchanged. ● A price floor is the minimum permissible price that can be charged for a particular good or service.

○ If it is set below or at the equilibrium price, it will have no effect because the free market equilibrium remains attainable. ○ If it is set above the equilibrium price, however, it will raise the price, in which case it is said to be binding.

○ The government may establish the price floor by making it illegal to sell products below a prescribed price, as in the case of minimum wage. ○ The government can also establish the price floor by announcing that it will purchase any excess supply, such as in the case of agriculture. ○ Binding price floors lead to excess supply. Either an unsold surplus will exist or someone (usually the government) must enter the market and buy the excess supply. ○ The consequences of excess supply vary from product to product. ■ If the product is labour, subject to minimum wage, excess supply translates to unemployment. ■ If the product is something like wheat, excess wheat will end up being stored in mills or government warehouses. This can be costly. ○ Why might the government want to incur these consequences? Because suppliers who succeed in selling their goods are better off than if they had to accept the lower equilibrium price. ■ Workers and farmers are among the politically active and organized groups who have gained much by persuading governments to establish price floors. ■ If demand is inelastic, which is usually the case for agricultural products, farmers earn more income even if they sell a lesser quantity. The losses are spread across the many customers who each suffers only a small loss. ● A price ceiling is the maximum price at which certain goods and services may be legally exchanged. ○ If it is set above or at the equilibrium price, it will have no effect because the free market equilibrium remains attainable. ○ If it is set below the equilibrium price, however, it will lower the price, in which case it is said to be binding. ○ Binding price ceilings lead to excess demand, with the quantity exchanged being less than in the free market equilibrium. ■ In free markets, excess demand is eliminated as prices are allowed to rise. For instance, because many desired purchases cannot be made, rivalry between would-be purchasers may lead them to offer more than the

original price in order to outbid other purchasers. Also, sellers might ask a higher price for the quantities that they do have to sell. ■ However, when there are price ceilings, other methods of allocation must be considered such as first-come, first-served. This is often done in the case of concert or sporting event tickets. ■ Another method that could be adopted is the under the counter method, which simply consists of suppliers choosing who the product is sold to. This has to do with seller’s preferences. ■ Another method that could be adopted, this time by the government, is to ration. This is done through the distribution of coupons. Would-be purchasers in this case would need both coupons and money to purchase the product. ○ Binding price ceilings always create the potential for a black market because a profit can be made by buying a product at the controlled price and selling it at the illegal black market price. A black market is a situation in which products are sold at prices that violate the legal price control.

■ Price ceiling is established and excess demand is created. ■ If all the available supply of to consumers would rise to

were sold on a black market, the price

Q2 P2

.

■ If black marketeers buy at the ceiling price of market price of

P1 and sell at the black

P2 , their profits are represented by the shaded area.

○ Three common goals that governments have when imposing price ceilings are:

■ To restrict production. ■ To keep specific prices down. (Black markets frustrate this objective since actual prices are not kept down. If the price ceiling is set below

P0 ,

black market prices will be higher than equilibrium free market prices). ■ To satisfy notions of equity in the consumption of a product that is temporarily in short supply. (With an active black market, it is likely that much of the product will be purchased only by people who can afford the high black market price).

5.2 RENT CONTROLS (A CASE STUDY OF PRICE CEILINGS) ● Rent controls provide a vivid illustration of the short and long term effects of price ceilings. ● Possible effects of price ceilings include: ○ Shortage of rental housing as quantity demanded will exceed quantity supplied. The available quantity of rental housing will be less than if free market rents would be charged. ○ This shortage will lead to alternate allocation schemes. Landlords may begin allocating by seller’s preferences or the government may intervene. ○ Black markets may appear. Landlords may illegally require tenants to pay “key money” reflecting the difference in value between the free market and the controlled rents. In the absence of government intervention, landlords may kick out tenants when their lease expires in order to extract a significant entrance fee from new tenants. ● Because apartments are a highly durable product, the immediate effects of rent controls are typically different from the long run effects. ○ The short run supply response to rent controls is quite limited as the quantity of apartments does not change much. The supply curve for rental housing is inelastic in the short run. This causes only a moderated housing shortage. Indeed, most of the shortage comes from quantity demanded rather than quantity supplied. ○ In the long run, however, the response can be quite dramatic. If the expected rate of return from building new rental housing falls significantly below what can be earned on other investments, funds will go elsewhere. Therefore, construction will be halted, old buildings will be converted to other uses or will simply be left to

deteriorate. The supply curve for rental housing is elastic in the long run. Here, there is an extreme shortage caused mostly by decreases in supply.

● Along with the growing housing shortage comes an increasingly inefficient use of rental accommodation. ○ Existing tenants will be forced to stay where they are regardless of their location of employment, family size, or economic circumstances. They will prefer to pay low-rent rather than move elsewhere that is better suited for their needs. ○ Individuals and families who are just entering the housing market will be led to the black market. ● Who wins and who loses? ○ Existing tenants in rent controlled accommodations are the principal gainers from a policy of rent control. As the gap between the controlled and the free-market rents grows and as the stock of available housing falls, those who are lucky enough to live in rent-controlled housing gain more and more. ○ Landlords suffer because they do not get the rate of return they expected on their investments. The value of their savings is diminished. ○ Potential future tenants also suffer . The housing shortage will hurt many of them because the rental housing they require will not exist in the future. These people will likely end in apartments situated in places that are inappropriate to their situations. ● Alternative solutions to the growing rents involve the government. ○ The government could subsidize the production of housing (at taxpayer expense).

○ The government could produce public housing directly (at taxpayer expense). ○ The government could provide income assistance to households with low income.

5.3 AN INTRODUCTION TO MARKET EFFICIENCY ● The supply and demand curves could be looked in a different way. ○ We can consider the highest price consumers are willing to pay and the lowest price sellers are willing to accept for any given unit of the product. ○ Viewing demand and supply curves in this manner allows us to think about how society as a whole benefits by producing and consuming any given amount of some product. ● The reason why the demand curve is downward sloping based on this angle is because every consumer is different. ○ Using pizza as an example, some consumers value pizza so highly that they are prepared to pay $20 for a pizza. Others barely value pizza so they are only prepared to pay $5. ○ We can conclude that for each unit of a product, the price on the market demand curve shows the value to consumers from consuming that unit. ● The reason why the supply curve is upward sloping based on this angle is because every producer is different. ○ Some are excellent at producing pizzas so they are willing to receive a price of $5 per pizza. However, some might not be able to produce pizza as easy so the amount they are willing to receive is much higher like $15. ○ We can conclude that for each unit of a product, the price on the market supply curve shows the lowest acceptable price to firms for selling that unit. ● For any given quantity of a product, the area below the demand curve and above the supply curve shows the economic surplus associated with the production and consumption of that product. ○ Economic surplus is the net value that society as a whole receives by producing and consuming a given quantity of a product. ■ It arises because firms and consumers have taken resources that have a lower value and transformed them into something valued more highly. ■ In the example below, the value of producing pizzas is less than the value obtained by consuming pizzas. The act of producing and consuming adds

value and generates benefits for society.

■ The demand curve shows the value consumers place on each additional pizza consumed. ■ The supply curve shows the additional cost associated with producing each pizza. ■ Economic surplus in the pizza market above is maximized at equilibrium. Here, economic surplus is equal to the three shaded areas put together. ● The market for any good is said to be efficient if the quantity of the product produced and consumed is such that economic surplus is maximized. ○ This refers to total surplus but not its distribution between producers and consumers ● What would happen if the quantity produced and consumed of pizzas were to rise from 250 units to 300? ○ Here, the value placed on these pizzas by consumers is less than the additional costs associated with their production. Producing an extra 50 pizzas would decrease the amount of economic surplus and the market would be inefficient as producers would be taking highly valued resources and transforming them into something that is valued less. ● The case for price ceilings and floors:

○ A binding price floor: In the free market case, each of the units of output between

Q 0 and Q 1 generates some economic surplus. However, when the floor is set, each of these units stops generating economic surplus as they stop being produced or consumed. Thus, deadweight loss is created. The size of the deadweight loss reflects the inefficiency in the market. ○ A binding price ceiling: In the free market case, each of the units of output between

Q 0 and

Q 2 generates some economic surplus. However, when

the ceiling is set, each of these units stops generating economic surplus as they stop being produced or consumed. Thus, deadweight loss is created. The size of the deadweight loss reflects the inefficiency in the market. ● Output quotas, which establish a maximum output level of a given product, are another example of a type of government intervention that leads to inefficiency. ○ When the government introduces these, it restricts total output and then distributes quotas (licenses to produce) among the producers. ○ When these are established, price increases from

P 0 to

P1 (the price

consumers are willing to pay for the product). This creates deadweight loss and therefore a loss of economic surplus.

○ If demand for a product is inelastic, total income to producers rises as a result of the reduction in output. ○ Since output falls, costs of production are also reduced. ○ However, there is a catch. Quotas are very expensive and producers may incur a very high cost in purchasing them. Not every producer has to buy them though, some get them for free. ● In advocating such policies (ceilings, floors and quotas), the government is making normative judgements regarding which groups in society deserved to be helped at the expense of others....