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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
Copyright © Pearson Education Canada Inc. 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.
Copyright © Pearson Education Canada Inc. 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
Copyright © Pearson Education Canada Inc. Regional Linkages Regionally 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
Copyright © Pearson Education Canada Inc. 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. SASA SASA SBSB SBSB DADA DBDB pA1pA1 pB0pB0 QA1QA1 QA0QA0 Quantity of A Price Quantity of BQB0QB0 QB1QB1 pA0pA0 pB1pB1 Slide 5-6 A collapse in the anchovy catch raises their price The higher price of cattle feed then reduces the supply of beef
Copyright © Pearson Education Canada Inc. 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.
Copyright © Pearson Education Canada Inc. SASA S´ X SXSX DADA DXDX wA1wA1 wX0wX0 Employment in Aerospace Industry Hourly Wage wA0wA0 wX1wX1 Employment in Other Industries EA1EA1 EA0EA0 EX1EX1 EX0EX0 D´ A Hourly Wage 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. 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
Copyright © Pearson Education Canada Inc. 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
Copyright © Pearson Education Canada Inc. Price Floors S D Price floor Excess supply p1p1 p0p0 q1q1 q0q0 q2q2 Quantity Price E 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?
Copyright © Pearson Education Canada Inc. Price Ceilings S D Price ceiling Excess demand p1p1 p0p0 q1q1 q0q0 q2q2 Quantity Price E 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 p 1 ? This is when we see black markets.
Copyright © Pearson Education Canada Inc. 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
Copyright © Pearson Education Canada Inc. 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.
Copyright © Pearson Education Canada Inc. 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
Copyright © Pearson Education Canada Inc. Temporary Versus Permanent Increases in Demand D1D1 D0D0 S SLSL E 1 E 2 q0q0 q1q1 q2q2 Quantity of Rental Accommodations Rent p1p1 p2p2 p0p0 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
Copyright © Pearson Education Canada Inc. Policy Alternatives As an alternative to rent controls, housing shortages can be removed if the government (at taxpayers 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
Copyright © Pearson Education Canada Inc. 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.
Copyright © Pearson Education Canada Inc. 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.
Copyright © Pearson Education Canada Inc. The Theory of Agricultural Policy S q1q1 q0q0 q2q2 Quantity Price pwpw Changes in growing conditions cause fluctuations in supply 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. 0 Slide 5-19
Copyright © Pearson Education Canada Inc. S D Support Price Average required addition to storage pSpS p0p0 q1q1 q0q0 q2q2 Quantity Price E 0 0 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!
Copyright © Pearson Education Canada Inc. S D p2p2 p0p0 q1q1 q0q0 Quantity Price 0 p1p1 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 goods 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 System Output Quota
Copyright © Pearson Education Canada Inc. Agricultural Policy in Canada The 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. Copyright © 2002 Pearson Education Canada Inc.
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