FALL 2013 Government Intervention in Supply and Demand

Why Governments Intervene Well? Why would they? Set maximum prices for some goods and services (price ceilings) and minimum prices (price floors) for others Why would economists view this as undesirable?

Price Ceilings Generally imposed in crisis situations to counteract rising prices – Set BELOW equilibrium price Create a shortage, as there is a gap between the quantity demanded at the new price and the quantity producers are willing to supply

Other Problems of Price Ceilings 1. Inefficient distribution to consumers – Not all who need it can get the product, some who could and would pay more get an advantage 2. Wasted resources – Time, money, and effort dealing with shortages 3. Inefficiently low quality – Because prices are held low, there is no incentive to offer high quality 4. Illegal activity – Black market transactions to get around controls

Price Floors Designed to keep prices from falling (for suppliers) – Set ABOVE equilibrium price Results in surplus, as there is a gap between the quantity being supplied at the new price and the amount buyers are willing to purchase

Other Problems of Price Floors 1. Inefficiently low quantity – Fewer sell than would sell in an uncontrolled market 2. Wasted resources - Governments tend to buy up surpluses (which they destroy or use inefficiently), or pay producers not to produce 3. Inefficiently high quality – No incentive to lower prices to compete, so producers offer higher quality than consumers want 4. Illegal activity – Transactions occurring below the price floor level

Why Price Controls Exist Interest groups benefit Fear of what might happen without controls Policymakers uneducated in economic theory

Quantity Controls When governments issue a limited number of licenses, they create a limit on supply (quota) – Set BELOW equilibrium quantity Prevents market reaching equilibrium, and two separate prices emerge: Supply price – price at which producers are willing to supply the limited number Demand price – price at which consumers are willing to purchase the limited number

Deadweight Loss Deadweight loss represents the transactions that would have occurred in a market without quantity controls Also, the problem of illegal activity E Supply price Demand price

Government Intervention: Practice #1 1. Graph a market for cell phones in which the equilibrium price is $200, but the government has set a price ceiling at $ Label on the graph: Equilibrium price Equilibrium quantity Price ceiling Surplus or shortage

Government Intervention: Practice #2 1. Graph a market for oil in which the equilibrium price is $2/gal, but the government has set a price floor at $3/gal. 2. Label on the graph: Equilibrium price Equilibrium quantity Price floor Surplus or shortage