The Market Strikes Back 23 May 2019 ECONOMICS The Market Strikes Back

Review: Supply and Demand 23 May 2019 Review: Supply and Demand P Quantity S D

Review: Supply and Demand …and the market equilibrium: P Quantity D S Peq Qeq

Price controls Price controls are legal restrictions on how high or low a market price may go. 2 kinds of price controls: Price Ceilings: a maximum price sellers are allowed to charge for a good. Price Floors: a minimum price buyers are required to pay for a good.

Price controls Why price controls? During crises, emergencies or wars To protect certain industries If the equilibrium wage given by supply and demand for low skilled workers is below poverty level the government choses to set a minimum wage.

Price controls: price ceilings Equilibrium Price ceiling D Quantity of ice cream Price 3 2 200 800 4 S 100 Shortage Price Ceiling D Quantity of ice cream Price 3 2 200 4 S 100

Price controls: price ceilings Another example

Price controls: price ceilings When there is a price ceiling, there is always a shortage. The shortage will lead to inefficiencies: A market or an economy is inefficient if there are missed opportunities: some people could be made better off without making other people worse off.

Price controls: price ceilings Different possible inefficiencies: Inefficient Allocation to Consumers Wasted Resources Low Quality Black Markets

Price controls: price ceilings Inefficient Allocation to Consumers Price ceilings often lead to inefficiency in the form of inefficient allocation to consumers: people who really want the good and are willing to pay a high price don’t get it, and those who are not so interested in the good and are only willing to pay a low price do get it. Example: rent control. In such case people get the apartment usually through luck or personal connections.

Price controls: price ceilings Wasted Resources Price ceilings typically lead to inefficiency in the form of wasted resources: people spend money, time and expend effort in order to deal with the shortages caused by the price ceiling. You waste a lot of time looking for a good (e.g. an apartment) in case of shortage, the time has it’s value! You can work or just rest, do something better than look for a good you can’t find. If the market works efficiently, you can find quickly the goods you are looking for.

Price controls: price ceilings Low Quality Price ceilings often lead to inefficiency in that the goods being offered are of low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price. In case of rent controls, the landlords will not improve the conditions of the apartments, there is no incentive since the rent is low but the main reason is that since there is a shortage, people are willing to rent the flat as it is, even in bad condition!

Price controls: price ceilings Black Markets 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. If someone for example bribes to the flat owners he will get the flat, but the honest people that don’t break the law will never find one this way!

Price controls: price ceilings So many inefficiencies! But why are there price ceilings then? They may benefit some people: someone can get the good cheaper. They benefit influential buyers. When price ceilings have existed for long time (like in New York), people don’t know what will happen without them. Black market prices may be an indication, but such prices are usually higher than the price we would have with a fully free market. Government officials don’t really understand supply and demand!

Price controls: price floors Price Floors: a minimum price buyers are required to pay for a good. The minimum wage is a legal floor on the wage rate, which is the market price of labor.

Price controls: price floors Equilibrium Price floor D Quantity of icecreams Price 3 2 200 4 S 100 D Quantity of icecreams Price 3 2 200 600 4 S 100 Surplus Price Ceiling

Minimum Wage Law S Wm Minimum wage Unemployment We D QD QE QS

Price controls: price floors Price Floor Causes Inefficiencies Inefficient Allocation of Sales Among Sellers Those who want to sell at the lowest price cannot. Wasted Resources Like a price ceiling, a price floor generates inefficiency by wasting resources. Inefficiently High Quality 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. Illegal Activity Like price ceilings, price floors can provide an incentive for illegal activity.

Price controls: price floors So Why Are There Price Floors? The reasons are similar to those for the price ceilings. Price floors may benefit some influential sellers. Governments don’t understand the supply and demand model, or they think that it doesn’t describe reality well.