Price and Quality Controls

Price Controls Legal restrictions on how high or low a market may go Price Ceilings 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

Price Ceilings Typically imposed during a crisis because these events often lead to sudden price increases that hurt many people but benefit a few Ex. WWII – aluminum and steel in demand for the war and price controls were in place to avoid a few earning large profits Ex. Oil embargo in 1973, rent controls

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

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)

Effects of Price Ceilings Don’t always cause a shortage If a price ceiling is set above the equilibrium price, it won’t have any effect But sometimes price ceilings can cause inefficiency

How Price Ceilings Cause Inefficiency The effects of Rent Controls: Reduces the quantity of apartments rented below the efficient level Leads to misallocation of apartments among would-be renters Leads to wasted time and effort as people search for apartments Leads to landlords maintaining apartments in inefficiently low quality or conditions

How Price Ceilings Cause Inefficiency Rent controls reduce the number of apartments supplied and they reduce the number of apartment rented

A Price Ceiling Causes Inefficiently Low Quantity Monthly rent (per apartment) 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. 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

Deadweight Loss Key concept in economics Occurs whenever an action or a policy leads to a reduction in the quantity transacted below the efficient market equilibrium quantity Deadweight loss is a loss to society – a reduction in the total surplus, a loss in surplus that accrues to no one as a gain Not the same as a loss in surplus to one person that then accrues as a gain to someone else – that is a transfer of surplus

Price Ceilings Causing Inefficient Allocation to Consumers 2.2 million people wanted to rent an apartment at $800 month Only 1.8 million apartments are available Of the 2.2 million people, some want an apartment so bad they will pay anything Some are only willing to pay a low price and will wait for one to be available An efficient allocation of apartments would reflect these differences, one who wants one urgently will get one and people who can wait will not get one BUT….this does not happen

Inefficient Allocation to Consumers Instead, in an inefficient distribution of apartments, people who aren’t in a hurry will get one and those who are, won’t. WHY????

Price Ceilings Causing Wasted Resources Price ceilings typically lead to inefficiency in of wasted resources People expend money, effort, and time to cope with the shortages caused by the price ceiling Ex. 1979, price controls on gasoline Lead to shortages that forced many to spend hours each week waiting in lines and missing out on wages and leisure time – opportunity cost

Price Ceilings Causing Goods to be of Low Quality Sellers offer low-quality goods at a low price even though buyers would rather have higher quality and are willing to pay for it

Price Ceilings Causing Illegal Activities Price Ceilings can lead to goods being bought and sold illegally Black Markets are a market in which goods or services are bought and sold illegally – either because it is illegal to sell that at all or because the prices charged are legally prohibited by a price ceilings

Why are there Price Ceilings? They do benefit some people Buyers may not even know the goods they are using/buying have price controls And (according to textbooks and economists) government officials do not understand supply and demand analysis

Price Floors Government intervention to push market prices up instead of down Minimum Wage is a legal floor on the wage rate which is the price of labor

The Market for Butter in the Absence of Government Controls Quantity of butter (millions of pounds) 6 7 8 9 10 11 13 12 14 $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 Price of butter Quantity demanded Quantity supplied (per pound) $1.40 8.0 14.0 $ 1.30 8.5 13.0 $ 1.20 9.0 12.0 $ 1.10 9.5 11.0 $ 1.00 10.0 10.0 $ 0.90 10.5 9.0 $ 0.80 11.0 8.0 $ 0.70 11.5 7.0 $ 0.60 12.0 6.0 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. Quantity of butter (millions of pounds)

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)

Effects of a Price Floor Price floors do not always lead to an unwanted surplus Some price floors are irrelevant If a price floor is binding (permanent) what happens to the unwanted surplus?

Price Floors Causes Low Quantity Price floors raise the price of a good to consumers Price floors also reduce the quantity of that good demanded – sellers can’t sell more units of a good than buyers are willing to pay Price floors reduces the quantity of a good bought and sold below the market equilibrium quantity and leads to a deadweight loss

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

Price Floors Causes Inefficient Allocation of Sales Among Sellers Price ceilings can lead to inefficient allocation Price floors can cause 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 Cause Wasted Resources Government purchasing of unwanted surplus of agricultural products Surplus is destroyed or it is stored and will go bad eventually Price floors also lead to wasted time and effort Minimum wage jobs

Price Floors Cause Inefficiency in the Quality of Goods Produced Sellers offer high-quality goods at a high price, even though buyers would prefer a low quality at a lower price People want quality but only if it is worth the price

Price Floors Cause Illegal Activity Price floors cause incentives for illegal activity Working off the books for employers Bribing Government Inspectors

Controlling Quantities Quantity control (quota) is an upper limit on the quantity of some good that can be bought or sold. Ex. Taxi Medallions

Controlling Quantities The total amount of the good than can be transacted under the quantity control is a quota limit Controlling quantity is done though a license, an owner is given the right to supply a good

The Market for Taxi Rides in the Absence of Government Controls Quantity of rides Fare (per ride) (millions per year) Fare Quantity demanded Quantity supplied (per ride) 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 Supply Price – a given quantity is the price at which producers will supply that quantity 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 Demand Price – a given quantity is the price at which consumers will demand that quantity 6 7 8 9 10 11 12 13 14 Quantity of rides (millions per year)

Controlling Quotas NYC limits the quantity of taxi rides to 8 million per year (assumption for analysis) Medallions are available to selected drivers for a total of 8 million rides Medallion holders can drive their own taxi or rent their medallions to others for a fee

Effect of a Quota on the Market for Taxi Rides Fare (per ride) Quantity of rides (millions per year) Fare Quantity demanded Quantity supplied (per ride) S $7.00 Deadweight loss $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 $ 4.00 12 8 B 3.50 $ 3.50 13 7 3.00 D $ 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. Quota 6 7 8 9 10 11 12 13 14 Quantity of rides (millions per year)

Controlling Quotas How can the price received (quantity supplied) be different from the price paid (quantity demanded)? Two transactions and thus two prices The transactions in taxi rides and the price at which these occur The transaction of medallions and the price at which these occur

Controlling Quotas In every case at which the supply of goods is legally resticted there is a wedge A wedge between the demand price of the quantity transacted and the supply price of the quantity transacted This line represents the quota rent which is 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 license are traded

Quantity Controls Side Effects Deadweight loss because some mutually beneficial transactions don’t occur Incentives for illegal activities

Price and Quality Controls Notes

Price Controls Legal restrictions on how high or low a market may go Price Ceilings is Price Floor is

Price Ceilings Typically imposed during a crisis because these events often lead to sudden price increases that hurt many people but benefit a few

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

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 600 D 1.6 1.8 2.0 2.2 2.4 Quantity of apartments (millions)

Effects of Price Ceilings Don’t always cause a shortage If a price ceiling is set above the equilibrium price, it won’t have any effect But sometimes price ceilings can cause _________________

How Price Ceilings Cause Inefficiency The effects of Rent Controls: Reduces the quantity of apartments rented below the efficient level Leads to misallocation of apartments among would-be renters Leads to wasted time and effort as people search for apartments Leads to landlords maintaining apartments in inefficiently low quality or conditions

How Price Ceilings Cause Inefficiency Rent controls reduce the number of apartments supplied and they reduce the number of apartment rented

A Price Ceiling Causes Inefficiently Low Quantity Monthly rent (per apartment) Deadweight Loss is 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

Deadweight Loss Key concept in economics Occurs whenever an action or a policy leads to a reduction in the quantity transacted below the efficient market equilibrium quantity Deadweight loss is a loss to society –

Price Ceilings Causing Inefficient Allocation to Consumers 2.2 million people wanted to rent an apartment at $800 month Only 1.8 million apartments are available Of the 2.2 million people, An efficient allocation of apartments would reflect these differences, one who wants one urgently will get one and people who can wait will not get one BUT….this does not happen

Inefficient Allocation to Consumers Instead, in an inefficient distribution of apartments, people who aren’t in a hurry will get one and those who are, won’t. WHY????

Price Ceilings Causing Wasted Resources Price ceilings typically lead to inefficiency in of wasted resources People expend money, effort, and time to cope with the shortages caused by the price ceiling

Price Ceilings Causing Goods to be of Low Quality

Price Ceilings Causing Illegal Activities Price Ceilings can lead to goods being bought and sold illegally Black Markets are

Why are there Price Ceilings? They do benefit some people Buyers may not even know the goods they are using/buying have price controls And (according to textbooks and economists) government officials do not understand supply and demand analysis

Price Floors Government intervention to push market prices up instead of down

The Market for Butter in the Absence of Government Controls Quantity of butter (millions of pounds) 6 7 8 9 10 11 13 12 14 $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 Price of butter Quantity demanded Quantity supplied (per pound) $1.40 8.0 14.0 $ 1.30 8.5 13.0 $ 1.20 9.0 12.0 $ 1.10 9.5 11.0 $ 1.00 10.0 10.0 $ 0.90 10.5 9.0 $ 0.80 11.0 8.0 $ 0.70 11.5 7.0 $ 0.60 12.0 6.0 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. Quantity of butter (millions of pounds)

The Effects of a Price Floor Price of butter (per pound) 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)

Effects of a Price Floor Price floors do not always lead to an unwanted surplus Some price floors are irrelevant If a price floor is binding (permanent) what happens to the unwanted surplus?

Price Floors Causes Low Quantity Price floors raise the price of a good to consumers Price floors also reduce the quantity of that good demanded – sellers can’t sell more units of a good than buyers are willing to pay Price floors reduces the quantity of a good bought and sold below the market equilibrium quantity and leads to a deadweight loss

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

Price Floors Causes Inefficient Allocation of Sales Among Sellers Price ceilings can lead to inefficient allocation Price floors can cause inefficient allocation of sales among sellers

Price Floors Cause Wasted Resources Government purchasing of unwanted surplus of agricultural products Surplus is destroyed or it is stored and will go bad eventually Price floors also lead to wasted time and effort

Price Floors Cause Inefficiency in the Quality of Goods Produced Sellers offer high-quality goods at a high price, even though buyers would prefer a low quality at a lower price

Price Floors Cause Illegal Activity Price floors cause incentives for illegal activity

Review: The state legislature mandates a price floor for gasoline of Pf per gallon. Assess the following statements and illustrate your answer using the figure provided.

Proponents of the law claim it will increase the income of gas station owners. Opponents claim it will hurt gas station owners because they will lose customers. Proponents claim consumers will be better off because gas stations will provide better service. Opponents claim consumers will be generally worse off because they prefer to buy gas at cheaper prices. Proponents claim that they are helping gas station owners without hurting anyone else. Opponents claim that consumers are hurt and will end up doing things like buying gas in a nearby state or on the black market.

Controlling Quantities Quantity control (quota) is an upper limit on the quantity of some good that can be bought or sold.

Controlling Quantities The total amount of the good than can be transacted under the quantity control is a quota limit Controlling quantity is done though a license, an owner is given the right to supply a good

The Market for Taxi Rides in the Absence of Government Controls Quantity of rides Fare (per ride) (millions per year) Fare Quantity demanded Quantity supplied (per ride) 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)

Controlling Quotas NYC limits the quantity of taxi rides to 8 million per year Medallions are available to selected drivers for a total of 8 million rides Medallion holders can drive their own taxi or rent their medallions to others for a fee

Effect of a Quota on the Market for Taxi Rides Fare (per ride) Quantity of rides (millions per year) Fare Quantity demanded Quantity supplied (per ride) S $7.00 Deadweight loss $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 $ 4.00 12 8 B 3.50 $ 3.50 13 7 3.00 D $ 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. Quota 6 7 8 9 10 11 12 13 14 Quantity of rides (millions per year)

Controlling Quotas How can the price received (quantity supplied) be different from the price paid (quantity demanded)? Two transactions and thus two prices

Controlling Quotas In every case at which the supply of goods is legally restricted there is a wedge A wedge between the demand price of the quantity transacted and the supply price of the quantity transacted This line represents the quota rent which is 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 license are traded

Quantity Controls Side Effects