BA 210 Lesson I.6 Price and Quantity Controls Lesson Overview Chapter 5 Price and Quantity Controls Why Governments Control Prices Price Ceilings How Price Ceilings Cause Inefficiency So Why are there Price Ceilings? Price Floors How Price Floors Cause Inefficiency Quantity Controls Controversy: Minimum Wages Summary Review Questions BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Why Governments Control Prices 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 all buyers or all 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. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Price Ceilings Price ceilings are typically imposed during crises because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few. BA 210 Lesson I.6 Price and Quantity Controls

The Market for Apartments in the Absence of Government Controls Price Ceilings 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 Monthly rent (per apartment) (millions) 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 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. 900 2.1 1.9 800 2.2 1.8 700 2.3 1.7 600 2.4 1.6 BA 210 Lesson I.6 Price and Quantity Controls

Quantity of apartments (millions) Price Ceilings The Effects of a Price Ceiling Monthly rent (per apartment) S $1,400 1,200 E 1,000 Price ceiling A B 800 Housing shortage of 400,000 apartments caused by price ceiling 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) BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Price Ceilings 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 It is the guaranteed minimum loss from a price ceiling. Three other types of loss are likely. Inefficient Allocation to Customers Wasted Resources Inefficiently Low Quality BA 210 Lesson I.6 Price and Quantity Controls

Monthly rent (per apartment) Quantity of apartments (millions) Price Ceilings A Price Ceiling Causes Inefficiently Low Quantity First, assume only consumers with most value get the good. Deadweight loss from fall in number of apartments rented S Monthly rent (per apartment) $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 BA 210 Lesson I.6 Price and Quantity Controls

Winners and Losers from Rent Control Price Ceilings Winners and Losers from Rent Control (a) Before Rent Control (b) After Rent Control Monthly rent (per apartment) Monthly rent (per apartment) 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 D D 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. 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) BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls How Price Ceilings Cause Inefficiency Price ceilings often lead to inefficiency in the form of inefficient allocation to consumers: some people who are willing to pay the highest prices don’t get it, and those only willing to pay less do get it. If Abe is willing to pay $1,300 for an apartment but does not get it, and Burt is willing to pay only $1,100 and does get it, there is $200 lost surplus, in addition to deadweight loss. Price ceilings typically lead to inefficiency in the form of wasted resources: potential expend money, effort and time to be able to buy at the low ceiling prices. If Abe is willing to pay $1,300 for an apartment and Burt is willing to pay only $1,100 and does get it, then Abe is willing to pay up to $200 more than Burt in money, effort and time to be able to buy at the low ceiling prices. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls 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. Because there is a surplus of renters under rent control, if renters valued a renovation at $100 each, and the owner could provide the renovation for $40 each, that renovation will not be done because the owner cannot recoup any of the cost, even though the renovation would increase surplus by $60 for each renter. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls How Price Ceilings Cause Inefficiency 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. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls 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! BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls 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. BA 210 Lesson I.6 Price and Quantity Controls

The Market for Butter in the Absence of Government Controls Price Floors The Market for Butter in the Absence of Government Controls 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 Quantity of butter (millions of pounds) 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 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. $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 Quantity of butter (millions of pounds) BA 210 Lesson I.6 Price and Quantity Controls

The Effects of a Price Floor Price Floors The Effects of a Price Floor Butter surplus of 3 million pounds caused by price floor S Price of butter (per pound) $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) BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls How Price Floors Cause 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 BA 210 Lesson I.6 Price and Quantity Controls

A Price Floor Causes Inefficiently Low Quantity How Price Floors Cause Inefficiency A Price Floor Causes Inefficiently Low Quantity First, assume only suppliers with lowest cost supply the good. S Price of butter (per pound) $1.40 1.20 Deadweight loss Price floor E 1.00 0.80 0.60 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. D 6 8 9 10 12 14 Quantity of butter (millions of pounds) Quantity demanded with price floor Quantity demanded without price floor BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls How Price Floors Cause 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. If Abe’s cost to sell butter is $0.60 but does not get to sell, and Burt’s cost to sell butter is $0.80 and does get to sell, there is $0.20 lost surplus, in addition to deadweight loss. 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. Likewise, to complete for buyers, Abe may advertise his butter at a significant cost, which is lost surplus in addition to deadweight loss. BA 210 Lesson I.6 Price and Quantity Controls 18

BA 210 Lesson I.6 Price and Quantity Controls 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. BA 210 Lesson I.6 Price and Quantity Controls

Quantity of rides (millions per year) Quantity Controls The Market for Taxi Rides in the Absence of Government Controls S $7.00 Quantity of rides Fare (per ride) (millions per year) 6.50 Fare 6.00 Quantity demanded Quantity supplied (per ride) 5.50 E $7.00 6 14 5.00 $6.50 7 13 4.50 $6.00 8 12 4.00 $5.50 9 11 3.50 $5.00 10 10 3.00 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. D $4.50 11 9 $4.00 12 8 $3.50 13 7 $3.00 14 6 6 7 8 9 10 11 12 13 14 Quantity of rides (millions per year) BA 210 Lesson I.6 Price and Quantity Controls

Quantity of rides (millions per year) Quantity Controls Effect of a Quota on the Market for Taxi Rides Quantity of rides Deadweight loss $7.00 S (millions per year) Fare (per ride) 6.50 Fare A Quantity demanded Quantity supplied (per ride) 6.00 The wedge 5.50 E $7.00 6 14 5.00 $6.50 7 13 4.50 $6.00 8 12 4.00 $5.50 9 11 B 3.50 $5.00 10 10 3.00 $4.50 11 9 D $4.00 12 8 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 $3.50 13 7 $3.00 14 6 6 7 8 9 10 11 12 13 14 Quantity of rides (millions per year) BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls How Quantity Controls Work 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. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls The Costs of Quantity Controls Deadweight loss because some mutually beneficial transactions don’t occur. Incentives for illegal activities. BA 210 Lesson I.6 Price and Quantity Controls

Controversy: Minimum Wages BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Controversy: Minimum Wages A minimum wage is the lowest hourly, daily or monthly wage that employers may legally pay to employees or workers. Equivalently, it is the lowest wage at which workers may sell their labor. Although minimum wage laws are in effect in a great many jurisdictions, there are differences of opinion about the benefits and drawbacks of a minimum wage. Supporters of the minimum wage say that it increases the standard of living of workers and reduces poverty. Opponents say that if it is high enough to be effective, it increases unemployment, particularly among workers with very low productivity due to inexperience or handicap, thereby harming lesser skilled workers to the benefit of better skilled workers. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Controversy: Minimum Wages Question: Use demand and supply curves to show the following surplus looses from minimum wages designed to help unproductive workers: the lost producer surplus from the inefficient allocation of employment (some with higher opportunity costs are employed while other potential workers with lower costs are not employed) the lost total surplus as minimum wages reduce employment. the wasted resources from potential workers competing for employment. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Controversy: Minimum Wages Answer: The lost producer surplus if some with higher costs supply labor while others with lower costs do not sell labor. 1,000 $6 $7 $5 Quantity of labor S D Minimum wage Y X Loss in producer surplus if Yvonne successfully competes to sell labor instead of Xavier E Figure Caption: Figure 4-12: Reallocating Sales Lowers Producer Surplus Yvonne (point Y) has a cost of $35, $10 more than Xavier (point X), who has a cost of $25. At the market equilibrium price of $30, Xavier sells a book but Yvonne does not. If we rearrange sales by preventing Xavier from selling his book and compelling Yvonne to sell hers, producer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible producer surplus by assuring that those who sell the good are those who most value the right to sell it. BA 210 Lesson I.6 Price and Quantity Controls

The lost total surplus from reduced employment. Controversy: Minimum Wages The lost total surplus from reduced employment. S Wage rate (per hour) $1.40 1.20 Deadweight loss Minimum wage E 1.00 0.80 0.60 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. D 6 8 9 10 12 14 Employment of labor (millions of hours) Labor demanded with minimum wage Labor demanded without minimum wage BA 210 Lesson I.6 Price and Quantity Controls

Quantity of labor (days) Controversy: Minimum Wages The wasted resources of each unit of labor if they compete for jobs by waiting in line for each unit of employment. Only the first 800 units are employed, and they each pay $20 to compete for employment. 1,000 $60 $70 $50 Quantity of labor (days) S D Minimum wage E Figure Caption: Figure 4-12: Reallocating Sales Lowers Producer Surplus Yvonne (point Y) has a cost of $35, $10 more than Xavier (point X), who has a cost of $25. At the market equilibrium price of $30, Xavier sells a book but Yvonne does not. If we rearrange sales by preventing Xavier from selling his book and compelling Yvonne to sell hers, producer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible producer surplus by assuring that those who sell the good are those who most value the right to sell it. 800 BA 210 Lesson I.6 Price and Quantity Controls

Quantity of labor (days) Controversy: Minimum Wages Comment: If each unit of labor competes by waiting in line for each unit of employment, each pays $20 to compete and so is paid the minimum $70 but nets only $50, which is less than if there were no minimum wage. 1,000 $60 $70 $50 Quantity of labor (days) S D Minimum wage E Figure Caption: Figure 4-12: Reallocating Sales Lowers Producer Surplus Yvonne (point Y) has a cost of $35, $10 more than Xavier (point X), who has a cost of $25. At the market equilibrium price of $30, Xavier sells a book but Yvonne does not. If we rearrange sales by preventing Xavier from selling his book and compelling Yvonne to sell hers, producer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible producer surplus by assuring that those who sell the good are those who most value the right to sell it. 800 BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Summary Summary Even when a market is efficient, governments often intervene to pursue greater fairness (although putting needy people on welfare would be more effective) 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. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Summary Summary A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Price ceilings lead to 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 (tempting citizens to break the law) as people turn to black markets to get the good. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Summary 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 kind of price floor is the minimum wage, but price floors are also commonly applied to agricultural products. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Summary 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. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Review Questions Review Questions You should try to answer some of the following questions before the next class. You will not turn in your answers, but students may request to discuss their answers to begin the next class. Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls Review Questions Follow the link http://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set5Answers.pdf for review questions for Lesson I.6 that practices these skills: Identify the effective and ineffective price ceilings and floors. Compute the shortage and reduced supply from a price ceiling. Identify the inefficiencies from a price ceiling: loss from lowered quantity as some previous consumers no longer consume and some previous sellers no longer sell, an inefficient allocation to consumers (some with higher willingness to pay do not consume while others with lower willingness to pay consume), wasted resources from consumers competing to buy, inefficiently low quality. Compute the surplus and reduced demand from a price floor. Identify the inefficiencies from a price floor: an inefficient allocation to producers (some with higher costs produce while others with lower costs do not produce), wasted resources from producers competing to sell, inefficiently high quality. Compute the deadweight loss of a quota. Compute the quota rent, as the value of the right to sell under the quota. BA 210 Lesson I.6 Price and Quantity Controls

BA 210 Lesson I.6 Price and Quantity Controls BA 210 Introduction to Microeconomics End of Lesson I.6 BA 210 Lesson I.6 Price and Quantity Controls