1. Chapter 4 The Market Strikes Back ©2010  Worth Publishers Slides created by Dr. Amy Scott

2. BIG CITY, NOT - SO - BRIGHT IDEAS What happens when the logic of the market is defied?  Example: Rent Control  Introduced during World War II to protect the interests of tenants  Unexpected result – apartment shortages In this chapter, we will examine what happens when governments try to control prices

3. 1.Consumer Surplus and the Demand Curve 2.Producer Surplus and the Supply Curve 3.Total Surplus 4.Government Intervention in Markets A.Price Controls B.Quantity Controls C.Deadweight Loss D.Who benefits and who loses from market interventions Chapter Objectives

4.  A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good.  Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. Consumer Surplus can also be stated as: Buyer’s Willingness to Pay – Price Paid or Area below demand curve but above price Consumer Surplus and the Demand Curve

5. Willingness to Pay and Consumer Surplus Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. The term consumer surplus is often used to refer to both individual and total consumer surplus.

6. Consumer Surplus in the Used Textbook Market Price = $30 Aleisha’s consumer surplus: $59-$30=$29 Brad’s consumer surplus: $45-$30=$15 Claudia’s consumer surplus: $35-$30=$5 The total consumer surplus is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia - equal to $29 + $15 + $5 = $49.

7. Consumer Surplus in the Used Textbook Market

8. Consumer Surplus The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. D Consumer surplus 1 million0 $1,500 Price of computers Quantity of computers Price = $1,500

9. A fall in the price of a good increases consumer surplus through two channels: 1) A gain to consumers who would have bought at the original price and 2) A gain to consumers who are persuaded to buy by the lower price. How Changing Prices Affect Consumer Surplus

10. Producer Surplus and the Supply Curve  A potential seller’s cost is the lowest price at which he or she is willing to sell a good.  Individual producer surplus is the net gain to a seller from selling a good. Price Received – Seller’s Cost or Area above the supply curve but below price  Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.

11. Producer Surplus in the Used Textbook Market Betty’s producer surplus Andrew’s producer surplus Carlos’s producer surplus Price = $30 543210 S $45 35 30 25 5 15 Price of book Quantity of books Engelbert Donna Carlos Betty Andrew

12. Producer Surplus The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. S Producer surplus $5 1 million0 Price of wheat (per bushel) Quantity of wheat (bushels) Price = $5

13. An increase in the price of a good increases producer surplus through two channels: 1) The gains of those who would have supplied the good even at the original, lower price and 2) The gains of those who are induced to supply the good by the higher price. Changes in Producer Surplus

14. Putting It Together: Total Surplus  The total surplus generated in a market is: total net gain to consumers and producers from trading in the market or sum of the producer and the consumer surplus.  The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.

15. Total Surplus S D Price of book Quantity of books 1,000 $30 0 Equilibrium quantity Equilibrium price Producer surplus Consumer surplus E

16. Consumer Surplus, Producer Surplus, and Gains from Trade  The previous graph shows that both consumers and producers are better off because there is a market for this good, i.e. there are gains from trade.  These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient.  But are we as well off as we could be? This brings us to the question of the efficiency of markets.

17. Why Governments Control Prices  The market price moves to a level where quantity supplied = quantity demanded, however this equilibrium price may not necessarily please every buyer or seller.  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.

18. Price Ceilings  Price Ceiling: Maximum Price sellers are allowed to charge for a good or a service  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.  Ex.: US. Government imposed ceilings on aluminum and steel during World War II, Rent control in New York

19. The Market for Apartments in the Absence of Government Controls 1.61.701.81.92.02.22.12.32.4 $1,400 1,300 1,200 1,100 1,000 900 800 700 600 Quantity of apartments (millions) Monthly rent (per apartment) D E S $1,400 1,300 1,200 1,100 1,000 900 800 700 600 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 Quantity supplied Quantity demanded Monthly rent (per apartment) Quantity of apartments (millions)

20. The Effects of a Price Ceiling 1.601.82.02.22.4 $1,400 1,200 1,000 800 600 Quantity of apartments (millions) Monthly rent (per apartment) D S E BA Housing shortage of 400,000 apartments caused by price ceiling Price ceiling

21. How Price Ceilings Cause Inefficiency  Inefficiently Low Quantity -lower than quantity in unregulated market, creates Deadweight Loss (DWL)  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. Triangle shaped area. Overall loss to society.

22. A Price Ceiling Causes Inefficiently Low Quantity 1.601.82.02.22.4 $1,400 1,200 1,000 800 600 Quantity of apartments (millions) Monthly rent (per apartment) D S E Deadweight loss from fall in number of apartments rented Price ceiling Quantity supplied with rent control Quantity supplied without rent control

23. Price Ceilings also cause:  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.  Wasted resources: people expend money, effort and time to cope with the shortages caused by the price ceiling.  Inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price.  Black Markets where goods or services are bought and sold illegally.

24. Winners, Losers and Rent Control  Price controls create winners and losers:  The winners are those with rent controlled apartments: In 2005, Cyndi Lauper paid $989 a month for an apartment that would have been worth $3,750 if unregulated. Mia Farrow’s apartment, which, when it lost its rent- control status, rose from the bargain rate of $2,900 per month to $8,000.  The losers are the working class renters the system was intended to help.

25. Winners and Losers from Rent Control 1.601.82.02.22.4 $1,400 1,200 1,000 800 600 Monthly rent (per apartment) S D E Consumer surplus Producer surplus (a) Before Rent Control 01.61.82.02.22.4 $1,400 1,200 1,000 800 600 S D E Price ceiling (b) After Rent Control Deadweight loss Producer surplus Consumer surplus transferred from producers Monthly rent (per apartment) Quantity of apartments (millions) Consumer surplus

26. So Why Are There Price Ceilings? Case: 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!

27. Price Floors  Price Floor: Minimum Price allowed to charge for a good or a service  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.

28. The Market for Butter in the Absence of Government Controls $1.40 $1.30 $1.20 $1.10 $1.00 $0.90 $0.80 $0.70 $0.60 14.0 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5 12.0 Quantity of butter (millions of pounds) Price of butter (per pound) Quantity supplied Quantity demanded Quantity of butter (millions of pounds ) 670891011131214 $1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 Price of butter (per pound) D S E

29. The Effects of a Price Floor 6089101214 $1.40 1.20 1.00 0.80 0.60 D S E BA Butter surplus of 3 million pounds caused by price floor Price floor Quantity of butter (millions of pounds) Price of butter (per pound)

30. How a Price Floor Causes Inefficiency  The persistent surplus that results from a price floor creates missed opportunities—inefficiencies—similar to those created by the persistent 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 offered by sellers  Temptation to break the law by selling below the legal price

31. A Price Floor Causes Inefficiently Low Quantity 6089101214 $1.40 1.20 1.00 0.80 0.60 D S E Quantity demanded with price floor Quantity demanded without price floor Deadweight loss Price floor Quantity of butter (millions of pounds) Price of butter (per pound)

32. 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.  Sellers determine the actual quantity sold, because buyers can’t force unwilling sellers to sell and vice versa.

33. Quantity Control  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.  Ex.: taxi medallion system in New York has generated a shortage of taxis in the city.  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.

34. The Market for Taxi Rides in the Absence of Government Controls 679081011131214 $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 D S E Quantity of rides (millions per year) Fare (per ride) $7.00 $6.50 $6.00 $5.50 $5.00 $4.50 $4.00 $3.50 $3.00 14 13 12 11 10 9 8 7 6 6 7 8 9 11 12 13 14 Quantity of rides (millions per year) Fare (per ride) Quantity supplied Quantity demanded

35. Effect of a Quota on the Market for Taxi Rides $7.00 $6.50 $6.00 $5.50 $5.00 $4.50 $4.00 $3.50 $3.00 14 13 12 11 10 9 8 7 6 6 7 8 9 11 12 13 14 Quantity of rides (millions per year) Fare (per ride) Quantity supplied Quantity demanded A B 670891011121314 $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 D S E Deadweight loss The “wedge” Quota Quantity of rides (millions per year) Fare (per ride)

36. 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.  Equals the market price of the license when the licenses are traded.

37. The Costs of Quantity Controls  Deadweight loss because some mutually beneficial transactions don’t occur.  Incentives for illegal activities.