Lecture 4 Part-1 Impact of govt. policies

Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. Price control is an important policy of govt. which can significantly affect the peoples welfare.

CONTROLS ON PRICES Price control is usually enacted when policymakers believe the market price is unfair to buyers or sellers. There are two types of price control: 1) Price ceilings 2) Price floors.

Price Ceiling – A legal maximum on the price at which a good can be sold. Effects of Price Ceilings A price ceiling creates shortages of the product because Q D > Q S. Example: Price ceiling of some of the essential products during Ramadan. The result of price ceiling is rationing.

A Market with a Price Ceiling Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

Why prices of essentials go on rising during Ramadan and how govt. control price Every year, wholesale and retail prices of essentials shoot up during the holy fasting month of Ramadan not only in Bangladesh but also in many other Muslim countries. Traders do it, taking advantage of the anticipated spike in local demand. Prices start to take vertical drift leaving the common and especially marginal people beyond their purchasing capacity. Initiatives are taken each and every year; however, we lose the battle in containing soaring prices due to excessive profit motives of someA businessmen and lack of proper monitoring by the government ahead of the Ramadan. Under these circumstances (like any other year) in 2013 govt. took initiative to control price. Govt. decided to set ceiling prices for some of the essential commodities. For example govt. fixed the retail price of lentils at Tk per kg, chickpeas at Tk. 62 per kg and dates at Tk per kg.

Price Floor – A legal minimum on the price at which a good can be sold. The price floor is a price which is set above the equilibrium price, leading to a surplus of the product as Q S > Q D. Examples: The minimum wage, agricultural price supports

A Market with a Price Floor Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

Example of Price Floor: Minimum Wage Law An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

Part-2 The Theory of Consumer Behavior Utility Maximization

Utility Definition: Utility refers to the satisfaction derived from consuming a good or a service. Utility is a way to describe to preference of a consumer. This implies that if I derive higher satisfaction or utility from a good then I will prefer to consume the good more. For example: If I get more utility from good A than good B then I will prefer good A to good B.

The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive form having or consuming it at the point of making a consumption (consumer) choice. In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called utility. Consumers, however, cannot have every thing they wish to have. Consumers choices are constrained by their incomes. Within the limits of their incomes, consumers make their consumption choices by evaluating and comparing consumer goods with regard to their utilities.

Cardinal Utility vs. Ordinal Utility Cardinal Utility: Assigning numerical values to the amount of satisfaction Ordinal Utility: Not assigning numerical values to the amount of satisfaction but indicating the order of preferences, that is, what is preferred to what

How to Measure Utility Measuring utility in utils (Cardinal): Jack derives 10 utils from having one slice of pizza but only 5 utils from having a burger. Measuring utility by comparison (Ordinal): Jill prefers a burger to a slice of pizza and a slice of pizza to a hotdog. Often consumers are able to be more precise in expressing their preferences. For example, we could say: Jill is willing to trade a burger for four hotdogs but she will give up only two hotdogs for a slice of pizza. We can infer that to Jill, a burger has twice as much utility as a slice of pizza, and a slice of pizza has twice as much utility as a hotdog.

Total Utility versus Marginal Utility Marginal utility is the utility a consumer derives from the last unit of a consumer good she or he consumes (during a given consumption period). Total utility is the total utility a consumer derives from the consumption of all of the units of a good or a combination of goods over a given consumption period, ceteris paribus. Total utility = Sum of marginal utilities

Marginal Utility: As we consume more and more of a good our utility usually increases. This implies we get additional satisfaction or utility from our additional consumption. This increment to our utility is known as marginal utility.

As we consume more and more of a good our utility usually increases. But utility increases at a decreasing rate. This implies that the total utility will grow at a slower and slower rate. In the given example the utility increase from first unit of the good is 4. But utility increase from the second unit of good is 3. So the rate at which utility is increasing is falling. This happens because of the law of diminishing marginal utility.

Law of Diminishing Marginal Utility Law of Diminishing Marginal Utility: This law states that the amount of marginal utility declines as a person consumes more and more of a good. The demand curve slopes downward because of the law of diminishing marginal utility. Question: Can the marginal utility be negative? Yes.