1. Price Controls and Quotas: Meddling with Markets
THIRD EDITION
ECONOMICS
and
MICROECONOMICS Paul Krugman | Robin Wells
Chapter 5
Price Controls and Quotas: Meddling with Markets

2. WHAT YOU WILL LEARN IN THIS CHAPTER
The meaning of price controls and quantity controls, two kinds of government interventions in markets
How price and quantity controls create problems and can make a market inefficient
What deadweight loss is
Why the predictable side effects of intervention in markets often lead economists to be skeptical of its usefulness
Who benefits and who loses from market interventions, and why they are used despite their well-known problems
WHAT YOU
WILL LEARN
IN THIS CHAPTER

3. Why Governments Control Prices
The market price moves to the level at which the quantity supplied equals the quantity demanded. But, this equilibrium price does not necessarily please either buyers or sellers.
Therefore, the government intervenes to regulate prices by imposing price controls, which are legal restrictions on how high or low a market price may go.
Price ceiling is the maximum price sellers are allowed to charge for a good or service.
Price floor is the minimum price buyers are required to pay for a good or service.

4. Price Ceilings
Price ceilings are typically imposed during crises—wars, harvest failures, natural disasters—because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few.
Examples:
U.S. government–imposed ceilings on aluminum and steel during World War II
Rent control in New York City

5. The Market for Apartments in the Absence of Government Controls
Monthly rent (per apartment)
Quantity of apartments
Monthly rent (per apartment)
(millions) S
$1,400
Quantity demanded
Quantity supplied
1,300
1,200
$1,400
1.6
2.4
1,300
1.7
2.3
1,100 E
1,200
1.8
2.2
1,000
1,100
1.9
2.1
900
1,000
2.0
2.0
800
900
2.1
1.9
800
2.2
1.8
Figure Caption:
Figure 5-1: The Market for Apartments in the Absence of Government Controls
Without government intervention, the market for apartments reaches equilibrium at point E with a market rent of $1,000 per month and 2 million apartments rented.
700
700
2.3
1.7
600 D
600
2.4
1.6
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
Quantity of apartments (millions)

6. The Effects of a Price Ceiling
Monthly rent (per apartment) S
$1,400
1,200 E
1,000
Price ceiling A B
800
Figure Caption:
Figure 5-2: The Effects of a Price Ceiling
The black horizontal line represents the government-imposed price ceiling on rents of $800 per month. This price ceiling reduces the quantity of apartments supplied to 1.8 million, point A, and increases the quantity demanded to 2.2 million, point B. This creates a persistent shortage of 400,000 units: 400,000 people who want apartments at the legal rent of $800 but cannot get them
Housing shortage of 400,000 apartments caused by price ceiling
600 D
1.6
1.8
2.0
2.2
2.4
Quantity of apartments (millions)

7. How Price Ceilings Cause Inefficiency
Inefficiently low quantity
Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity
Inefficient allocation to customers
Wasted resources
Inefficiently low quality
Black markets

8. A Price Ceiling Causes Inefficiently Low Quantity
Monthly rent
(per apartment)
Deadweight loss from fall in number of apartments rented S
$1,400
1,200 E
1,000
Price ceiling
800
Figure Caption:
Figure 5-3: A Price Ceiling Causes Inefficiently Low Quantity
A price ceiling reduces the quantity supplied below the market equilibrium quantity, leading to a deadweight loss. The area of the shaded triangle corresponds to the amount of total surplus lost due to inefficiently low quantity transacted.
600 D
1.6
1.8
2.0
2.2
2.4
Quantity of apartments (millions)
Quantity supplied with rent control
Quantity supplied without rent control

9. FOR INQUIRING MINDS Winners, Losers, and Rent Control
Price controls create winners and losers:
In 2005, Cyndi Lauper paid $989 a month for an apartment that would have been worth $3,750 if unregulated.
Mia Farrow’s apartment, when lost its rent-control status, rose from the bargain rate of $2,900 per month to $8,000 per month.
The losers are the working class renters the system was intended to help.
We can use the concepts of consumer and producer surplus to graphically evaluate the winners and the losers from rent control.

10. Winners and Losers from Rent Control
Monthly rent (per apartment)
(a) Before Rent Control
Monthly rent
(per apartment)
(b) After Rent Control
Consumer surplus
Consumer surplus S
Consumer surplus transferred from producers S
$1,400
$1,400
1,200
1,200
Price ceiling E E
1,000
1,000
800
800
600
600
Producer surplus
Producer surplus
Deadweight loss
Figure Caption:
Figure 5-4: Winners and Losers from Rent Control
Panel (a) shows the consumer surplus and producer surplus in the equilibrium of the unregulated market for apartments—before rent control. Panel (b) shows the consumer and producer surplus in the market after a price ceiling of $800 has been imposed. As you can see, for those consumers who can still obtain apartments under rent control, consumer surplus has increased but producer surplus and total surplus have decreased. D D
1.6
1.8
2.0
2.2
2.4
1.6
1.8
2.0
2.2
2.4
Quantity of apartments (millions)
Quantity of apartments (millions)

11. How Price Ceilings Cause Inefficiency
Price ceilings often lead to inefficiency in the form of inefficient allocation to consumers: 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.
Price ceilings typically lead to inefficiency in the form of wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling.

12. How Price Ceilings Cause Inefficiency
Price ceilings often lead to inefficiency in that the goods being offered are of inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price.
A black market is 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.

13. FOR INQUIRING MINDS Rent Control, Mumbai Style
How far would you go to keep a rent-controlled apartment?
In May 2006, three people were killed when four floors in a rent-controlled apartment building in Mumbai collapsed.
Despite demands by the city government to vacate the deteriorating building, 58 tenants refused to leave.
Rent control began in Mumbai in 1947 to address a critical shortage that was caused by a flood of refugees fleeing the conflict between Hindus and Muslims. It was extended 20 times and now it applies to about 60% of the buildings in the city center.

14. FOR INQUIRING MINDS Rent Control, Mumbai Style
Tenants pass apartments onto their heirs or sell the right to occupy to other tenants.
Landlords of rent-controlled buildings have suffered financially.

15. So Why Are There Price Ceilings?
Rent Control in New York
Price ceilings hurt most residents but give a small minority of renters much cheaper housing than they would get in an unregulated market (those who benefit from the controls are typically better organized and more influential than those who are harmed by them).
When price ceilings have been in effect for a long time, buyers may not have a realistic idea of what would happen without them.
Government officials often do not understand supply and demand analysis!

16. ECONOMICS IN ACTION Hunger and Price Controls in Venezuela
Supermarket shopping in Caracas, Venezuela, is a bizarre experience. Shelves are fully stocked with scotch whiskey and imported cheese, but basic staples like black beans and beef are often absent because of price controls.
Since 1998, the president pursued policies favoring the poor and working classes, such as price controls on basic foods (beans, chicken, sugar, etc.).

17. ECONOMICS IN ACTION Hunger and Price Controls in Venezuela
These policies in turn led to sporadic shortages, higher spending by consumers and sharply rising prices for goods whose prices were not controlled. There was an increase in demand for price-controlled goods.
On the other hand, a sharp decline in the value of Venezuela’s currency led to a fall in imports of foreign foods. The result was empty shelves in the nation’s food stores.

18. Price Floors
Sometimes governments intervene to push market prices up instead of down.
The minimum wage is a legal floor on the wage rate, which is the market price of labor.
Just like price ceilings, price floors are intended to help some people but generate predictable and undesirable side effects.

19. The Market for Butter in the Absence of Government Controls
Price of butter
(per pound)
Quantity of butter
Price of butter
(millions of pounds)
(per pound)
Quantity demanded
Quantity supplied
$1.40
8.0
14.0 S
$1.40 $
1.30
8.5
13.0 $
1.20
9.0
12.0
1.30 $
1.10
9.5
11.0
1.20 $
1.00
10.0
10.0 $
0.90
10.5
9.0
1.10 E $
0.80
11.0
8.0
1.00 $
0.70
11.5
7.0 $
0.60
12.0
6.0
0.90
Figure Caption:
Figure 5-5: The Market for Butter in the Absence of Government Controls
Without government intervention, the market for butter reaches equilibrium at a price of $1 per pound with 10 million pounds of butter bought and sold.
0.80
0.70
0.60 D 6 7 8 9 10 11 12 13 14
Quantity of butter (millions of pounds)

20. The Effects of a Price Floor
Price of butter (per pound)
Butter surplus of 3 million pounds caused by price floor S
$1.40
1.20 A B
Price floor E
1.00
0.80
Figure Caption:
Figure 5-6: The Effects of a Price Floor
The dark horizontal line represents the government-imposed price floor of $1.20 per pound of butter. The quantity of butter demanded falls to 9 million pounds, and the quantity supplied rises to 12 million pounds, generating a persistent surplus of 3 million pounds of butter.
0.60 D 6 8 9 10 12 14
Quantity of butter (millions of pounds)

21. FOR INQUIRING MINDS Price Floors and School Lunches
When you were in grade school, did your school offer free or very cheap lunches? If so, you were probably a beneficiary of price floors.
During the 1930s, when the U.S. economy was going through the Great Depression, prices were low and farmers were suffering.
To aid the farmers, the U.S. government imposed price floors on agricultural products like beef, sugar, pork, etc.
Note to Instructors:
This is from previous edition.

22. FOR INQUIRING MINDS Price Floors and School Lunches
Price floors are meant to create a surplus. Government reduces supply by paying farmers not to grow crops and also buys the surplus, thus taking excess surplus off the market.
The government then gives away this excess surplus to schools as free or cheap lunches.
Note to Instructors:
This is from previous edition.

23. How a Price Floor Causes Inefficiency
The persistent surplus that results from a price floor creates missed opportunities—inefficiencies—that resemble those created by the shortage that results from a price ceiling.
These include:
Deadweight loss from inefficiently low quantity
Inefficient allocation of sales among sellers
Wasted resources
Inefficiently high quality
Temptation to break the law by selling below the legal price

24. A Price Floor Causes Inefficiently Low Quantity
Price of butter (per pound) S
$1.40
1.20
Deadweight loss
Price floor E
1.00
0.80
Figure Caption:
Figure 5-7: A Price Floor Causes Inefficiently Low Quantity
A price floor reduces the quantity demanded below the market equilibrium quantity and leads to a deadweight loss.
0.60 D 6 8 9 10 12 14
Quantity of butter (millions of pounds)
Quantity demanded with price floor
Quantity demanded without price floor

25. How a Price Floor Causes Inefficiency
Price floors lead to inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it.
Price floors often lead to inefficiency in that goods of inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price. 25

26. PITFALLS Ceilings, Floors, and Quantities
A price ceiling pushes the price of a good down.
A price floor pushes the price of a good up.
Both floors and ceilings reduce the quantity bought and sold.
If sellers don’t want to sell as much as buyers want to buy, it’s the sellers who determine the actual quantity sold, because buyers can’t force unwilling sellers to sell.
If buyers don’t want to buy as much as sellers want to sell, it’s the buyers who determine the actual quantity sold, because sellers can’t force unwilling buyers to buy.

27. GLOBAL COMPARISON: Low Wages (2011)

28. ECONOMICS IN ACTION “Black Labor” in Southern Europe
Minimum wages in many European countries have been set much higher than in the United States.
The persistent surplus that results from this price floor appears in the form of high unemployment.
In countries where enforcement of labor law is lax, it results in widespread evasion of the law.

29. ECONOMICS IN ACTION “Black Labor” in Southern Europe
In Italy and Spain, workers are employed by companies that pay them less than the minimum wage and fail to provide health care and retirement benefits. Many jobs also go unreported.
In fact, Spaniards waiting to collect checks from the unemployment office have been known to complain about the long lines that keep them from getting back to work.

30. Controlling Quantities
A quantity control, or quota, is an upper limit on the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit. An example is the taxi medallion system in New York.
A license gives its owner the right to supply a good.
The demand price of a given quantity is the price at which consumers will demand that quantity.
The supply price of a given quantity is the price at which producers will supply that quantity.

31. The Market for Taxi Rides in the Absence of Government Controls
Fare
(per ride)
Quantity of rides
Fare
(millions per year)
(per ride)
Quantity demanded
Quantity supplied S
$7.00
$7.00 6 14 $
6.50 7 13
6.50 $
6.00 8 12
6.00 $
5.50 9 11
5.50 E $
5.00 10 10
5.00 $
4.50 11 9
4.50 $
4.00 12 8
4.00 $
3.50 13 7
3.50 $
3.00 14 6
Figure Caption:
Figure 5-8: The Market for Taxi Rides in the Absence of Government Controls
Without government intervention, the market reaches equilibrium with 10 million rides taken per year at a fare of $5 per ride.
3.00 D 6 7 8 9 10 11 12 13 14
Quantity of rides (millions per year)

32. Effect of a Quota on the Market for Taxi Rides
Fare
(per ride)
Quantity of rides
Fare
(millions per year)
(per ride)
Quantity demanded
Quantity supplied S
Deadweight loss
$7.00
$7.00 6 14
6.50 A $
6.50 7 13
6.00 $
6.00 8 12
The “wedge”
5.50 E $
5.50 9 11
5.00 $
5.00 10 10
4.50 $
4.50 11 9
4.00 B $
4.00 12 8
3.50 $
3.50 13 7
3.00 $
3.00 14 6
Figure Caption:
Figure 5-9: Effect of a Quota on the Market for Taxi Rides
The table shows the demand price and the supply price corresponding to each quantity: the price at which that quantity would be demanded and supplied, respectively. The city government imposes a quota of 8 million rides by selling licenses for only 8 million rides, represented by the black vertical line. The price paid by consumers rises to $6 per ride, the demand price of 8 million rides, shown by point A. The supply price of 8 million rides is only $4 per ride, shown by point B. The difference between these two prices is the quota rent per ride, the earnings that accrue to the owner of a license. The quota rent drives a wedge between the demand price and the supply price. And since the quota discourages mutually beneficial transactions, it creates a deadweight loss equal to the shaded triangle. D
Quota 6 7 8 9 10 11 12 13 14
Quantity of rides (millions per year)

33. The Anatomy of Quantity Controls
A quantity control, or quota, drives a wedge between the demand price and the supply price of a good; that is, the price paid by buyers ends up being higher than that received by sellers.
The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the good. It is equal to the market price of the license when the licenses are traded.

34. The Costs of Quantity Controls
There is deadweight loss because some mutually beneficial transactions don’t occur.
There are incentives for illegal activities.

35. ECONOMICS IN ACTION The Clams of New Jersey
In the 1980s, excessive fishing threatened to wipe out New Jersey’s clam beds.
To save the resource, the U.S. government introduced a clam quota, which set an overall limit on the number of bushels of clams to be caught and allocated licenses to owners of fishing boats based on their history of catches.

36. SUMMARY
Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects consisting of various forms of inefficiency and illegal activity.

37. SUMMARY
A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Because the price is maintained below the equilibrium price, the quantity demanded is increased and the quantity supplied is decreased relative to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation to consumers, wasted resources, and inefficiently low quality. It also encourages illegal activity as people turn to black markets to get the good.

38. SUMMARY
A price floor, a minimum market price above the equilibrium price, benefits successful sellers but creates persistent surplus. Price floors lead to inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity and black markets. The most well-known price floor is the minimum wage, but price floors are also commonly applied to agricultural products.

39. SUMMARY
Quantity controls, or quotas, limit the quantity of a good that can be bought or sold. The quantity allowed for sale is the quota limit. The government issues licenses to individuals, the right to sell a given quantity of the good. Economists say that a quota drives a wedge between the demand price and the supply price; this wedge is equal to the quota rent. Quantity controls lead to deadweight loss in addition to encouraging illegal activity.

40. KEY TERMS Price controls Inefficient allocation of sales among sellers
Price ceiling
Inefficiently high quality
Price floor
Quantity control
Deadweight loss
Quota
Inefficient allocation to consumers
Quota limit
Wasted resources
License
Inefficiently low quality
Demand price
Black markets
Supply price
Minimum wage
Wedge
Quota rent