The Market Strikes Back Chapter 4 The Market Strikes Back Slides created by Dr. Amy Scott ©2010  Worth Publishers

BIG CITY, NOT - SO - BRIGHT IDEAS What happens when the logic of the market is defied? Example: Rent Control Introduced during World War II to protect the interests of tenants Unexpected result – apartment shortages In this chapter, we will examine what happens when governments try to control prices

Chapter Objectives Consumer Surplus and the Demand Curve Producer Surplus and the Supply Curve Total Surplus Government Intervention in Markets Price Controls Quantity Controls Deadweight Loss Who benefits and who loses from market interventions 3

Consumer Surplus and the Demand Curve A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good. Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. Consumer Surplus can also be stated as: Buyer’s Willingness to Pay – Price Paid or Area below demand curve but above price

Willingness to Pay and Consumer Surplus Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. The term consumer surplus is often used to refer to both individual and total consumer surplus.

Consumer Surplus in the Used Textbook Market 5 4 3 2 1 Aleisha Brad Claudia Darren D Edwina $59 45 35 30 10 25 Price of book Quantity of books Aleisha’s consumer surplus: $59-$30=$29 Brad’s consumer surplus: $45-$30=$15 The total consumer surplus is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia - equal to $29 + $15 + $5 = $49. Claudia’s consumer surplus: $35-$30=$5 Price = $30 Figure Caption: Figure 4-1: Consumer Surplus in the Used-Textbook Market At a price of $30, Aleisha, Brad, and Claudia each buy a book but Darren and Edwina do not. Aleisha, Brad, and Claudia get individual consumer surpluses equal to the difference between their willingness to pay and the price, illustrated by the areas of the shaded rectangles. Both Darren and Edwina have a willingness to pay less than $30, so they are unwilling to buy a book in this market; they receive zero consumer surplus. The total consumer surplus is given by the entire shaded area—the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia—equal to $29 + $15 + $5 = $49.

Consumer Surplus in the Used Textbook Market

Consumer Surplus The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. 1 million $1,500 Price of computers Quantity of computers D Consumer surplus Price = $1,500 Figure Caption: Figure 4-2: Consumer Surplus The demand curve for computers is smooth because there are many potential buyers. At a price of $1,500, 1 million computers are demand- ed. The consumer surplus at this price is equal to the shaded area: the area below the demand curve but above the price. This is the total net gain to consumers generated from buying and consuming computers when the price is $1,500.

How Changing Prices Affect Consumer Surplus A fall in the price of a good increases consumer surplus through two channels: A gain to consumers who would have bought at the original price and A gain to consumers who are persuaded to buy by the lower price.

A Matter of Life and Death Each year, about 4,000 people in the United States die while waiting for a kidney transplant. According to the current United Network for Organ Sharing guidelines, a donated kidney goes to the person who has waited the longest regardless of their age. The UNOS is now devising a new set of guidelines where kidneys would be allocated on the basis of who will receive the greatest net benefit, where net benefit is measured as the increase in lifespan from the transplant. This would increase the recipients extra years by 11,000. The “net benefit" concept is like consumer surplus: the individual consumer surplus generated from getting a new kidney. For example, a typical 25-year-old diabetic will gain an extra 8.7 years of life from a transplant, but a typical 55-year-old diabetic will gain only 3.6 extra years.

Producer Surplus and the Supply Curve A potential seller’s cost is the lowest price at which he or she is willing to sell a good. Individual producer surplus is the net gain to a seller from selling a good. Price Received – Seller’s Cost or Area above the supply curve but below price Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.

Producer Surplus in the Used Textbook Market 5 4 3 2 1 S $45 35 30 25 15 Price of book Quantity of books Engelbert Donna Carlos Betty Andrew Price = $30 Andrew’s producer surplus Betty’s producer surplus Carlos’s producer surplus Figure Caption: Figure 4-3: Producer Surplus in the Used-Textbook Market At a price of $30, Andrew, Betty, and Carlos each sell a book but Donna and Engelbert do not. Andrew, Betty, and Carlos get individual producer surpluses equal to the difference between the price and their cost, illustrated here by the shaded rectangles. Donna and Engelbert each have a cost that is greater than the price of $30, so they are unwilling to sell a book and so receive zero producer surplus. The total producer surplus is given by the entire shaded area, the sum of the individual producer surpluses of Andrew, Betty, and Carlos, equal to $25 +$15 +$5 =$45.

Price of wheat (per bushel) Quantity of wheat (bushels) Producer Surplus $5 1 million Price of wheat (per bushel) Quantity of wheat (bushels) The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. S Price = $5 Producer surplus Figure Caption: Figure 4-4: Producer Surplus Here is the supply curve for wheat. At a price of $5 per bushel, farmers supply 1 million bushels. The producer surplus at this price is equal to the shaded area: the area above the supply curve but below the price. This is the total gain to producers— farmers in this case—from supplying their product when the price is $5.

Changes in Producer Surplus An increase in the price of a good increases producer surplus through two channels: The gains of those who would have supplied the good even at the original, lower price and The gains of those who are induced to supply the good by the higher price.

Putting It Together: Total Surplus The total surplus generated in a market is: total net gain to consumers and producers from trading in the market or sum of the producer and the consumer surplus. The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.

Total Surplus S Price of book Consumer surplus E Equilibrium price $30 Quantity of books 1,000 $30 S D Producer surplus Consumer surplus Equilibrium quantity Equilibrium price E Figure Caption: Figure 4-5: Total Surplus In the market for used textbooks, the equilibrium price is $30 and the equilibrium quantity is 1,000 books. Consumer surplus is given by the blue area, the area below the demand curve but above the price. Producer surplus is given by the red area, the area above the supply curve but below the price. The sum of the blue and the red areas is total surplus, the total benefit to society from the production and consumption of the good.

Consumer Surplus, Producer Surplus, and Gains from Trade The previous graph shows that both consumers and producers are better off because there is a market for this good, i.e. there are gains from trade. These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient. But are we as well off as we could be? This brings us to the question of the efficiency of markets.

eBay and efficiency Garage sales are an old American tradition: they are a way for people to sell items they don’t want to others who have some use for them, to the benefit of both parties. However, many potential beneficial trades are missed because they do not always live close to each other. eBay provides a way for would-be-buyers and would-be -sellers of unique or used items to find each other even if they don’t live in the same neighborhood or city. 18

eBay and eFficiency (continued) eBay was founded in 1995 by Pierre Omidyar, a programmer whose fiancée was a collector of Pez candy dispensers and wanted a way to find potential sellers. The company says that its mission is “to help practically anyone trade practically anything on earth.” The potential gains from trade were evidently large: by late 2007, eBay had 83.2 million active users, and in 2007, $60 billion in goods were bought and sold using the service. The Omidyars now possess a large collection of Pez dispensers. They are also billionaires.

Why Governments Control Prices The market price moves to a level where quantity supplied = quantity demanded, however this equilibrium price may not necessarily please every buyer or seller. 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.

Price Ceilings Price Ceiling: Maximum Price sellers are allowed to charge for a good or a service Typically imposed during crises—wars, harvest failures, natural disasters—because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few. Ex.: US. Government imposed ceilings on aluminum and steel during World War II, Rent control in New York Just like the ceiling is the highest point in the classroom, a price ceiling is the highest price allowed to be charged

The Market for Apartments in the Absence of Government Controls Quantity of apartments Monthly rent (per apartment) S (millions) $1,400 Monthly rent (per apartment) Quantity demanded Quantity supplied 1,300 1,200 $1,400 1.6 2.4 1,300 1.7 2.3 1,100 E 1,200 1.8 2.2 1,000 1,100 1.9 2.1 900 1,000 2.0 2.0 800 900 2.1 1.9 800 2.2 1.8 Figure Caption: Figure 4.6: 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. 700 700 2.3 1.7 600 D 600 2.4 1.6 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 Quantity of apartments (millions)

The Effects of a Price Ceiling $1,400 Monthly rent (per apartment) 1,200 E 1,000 Price ceiling A B 800 Figure Caption: Figure 4.7: 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)

How Price Ceilings Cause Inefficiency Inefficiently Low Quantity -lower than quantity in unregulated market, creates Deadweight Loss (DWL) 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. Triangle shaped area. Overall loss to society.

A Price Ceiling Causes Inefficiently Low Quantity Deadweight loss from fall in number of apartments rented S $1,400 Monthly rent (per apartment) 1,200 E 1,000 Price ceiling 800 Figure Caption: Figure 4.8: 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

Price Ceilings also cause: Inefficient allocation to consumers: people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. Wasted resources: people expend money, effort and time to cope with the shortages caused by the price ceiling. Inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price. Black Markets where goods or services are bought and sold illegally.

Winners, Losers and Rent Control Price controls create winners and losers: The winners are those with rent controlled apartments: In 2005, Cyndi Lauper paid $989 a month for an apartment that would have been worth $3,750 if unregulated. Mia Farrow’s apartment, which, when it lost its rent-control status, rose from the bargain rate of $2,900 per month to $8,000. The losers are the working class renters the system was intended to help.

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 S Consumer surplus transferred from producers $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 Figure Caption: Figure 4.9: 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. D D 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)

Hard Shopping in Caracas Supermarket shopping in Caracas, Venezuela, is a bizarre experience. Shelves are stocked with scotch whiskey and imported cheese, but basic staples like black beans and beef are often absent because of price controls. Since 1998, the president pursued policies favoring the poor by imposing price controls on basic foods (beans, chicken, sugar, etc.) These policies in turn led to sporadic shortages, higher spending by consumers on price controlled goods and sharply rising prices for goods whose prices were not controlled. There was an increase in demand for price-controlled goods. On the other hand, a sharp decline in the value of Venezuela’s currency led to a fall in imports of foreign foods. The result was empty shelves in the nation’s food stores.

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!

Price Floors Price Floor: Minimum Price allowed to charge for a good or a service 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.

The Market for Butter in the Absence of Government Controls Quantity of butter (millions of pounds) Price of butter Quantity demanded Quantity supplied (per pound) Price of butter (per pound) $1.40 8.0 14.0 S $1.40 $ 1.30 8.5 13.0 $ 1.20 9.0 12.0 1.30 $ 1.10 9.5 11.0 1.20 $ 1.00 10.0 10.0 $ 0.90 10.5 9.0 1.10 E $ 0.80 11.0 8.0 1.00 $ 0.70 11.5 7.0 $ 0.60 12.0 6.0 0.90 Figure Caption: Figure 4.10: 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. 0.80 0.70 0.60 D 6 7 8 9 10 11 12 13 14 Quantity of butter (millions of pounds)

The Effects of a Price Floor Butter surplus of 3 million pounds caused by price floor S $1.40 Price of butter (per pound) 1.20 A B E Price floor 1.00 0.80 Figure Caption: Figure 4.11: 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)

Price Floors and School Lunches Did your grade school offer free or very cheap lunches? If so, you were probably a beneficiary of price floors. During the Great Depression of the 1930s, prices were low and farmers were suffering. To aid the farmer, the U.S. government imposed price floors on agricultural products like beef, sugar, pork, etc. Price floors are meant to create a surplus. Government reduces supply by paying farmers not to grow crops and also buys the surplus, thus taking excess surplus off the market. The government then gives away this excess surplus to schools as free or cheap lunches.

How a Price Floor Causes Inefficiency The persistent surplus that results from a price floor creates missed opportunities—inefficiencies—similar to those created by the persistent 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 offered by sellers Temptation to break the law by selling below the legal price

A Price Floor Causes Inefficiently Low Quantity $1.40 Price of butter (per pound) 1.20 Deadweight loss Price floor E 1.00 0.80 Figure Caption: Figure 4.12: 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

How a Price Floor Causes 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. 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. 37

Ceilings, Floors and Quantities A price ceiling pushes the price of a good down. A price floor pushes the price of a good up. Both floors and ceilings reduce the quantity bought and sold. Sellers determine the actual quantity sold, because buyers can’t force unwilling sellers to sell and vice versa.

Check Out Our Low, Low Wages! The minimum wage in the United States is actually quite low compared with other rich countries. Because minimum wages are set in national currencies, the comparison minimum wage depends on exchange rates. As of September 1, 2009, the French minimum wage was almost twice as high as the U.S. rate. The cost of hiring a bagger at the grocery store is much more expensive in France and consequently, the French almost always bag their own groceries.

“Black Labor” in Southern Europe The minimum wage in many European countries is much higher than in the United States. The persistent surplus that results from this price floor appears in the form of high unemployment. In countries where enforcement of labor law is lax, it results in widespread evasion of the law. In Italy and Spain, workers are employed by companies that pay them less than the minimum wage and fail to provide health care and retirement benefits. Many jobs also go unreported. In fact, Spaniards waiting to collect checks from the unemployment office have been known to complain about the long lines that keep them from getting back to work!

Quantity Control 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. Ex.: taxi medallion system in New York has generated a shortage of taxis in the city. 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. New York taxi licenses are known as “medallions,” and only taxis with medallions are allowed to pick up passengers. Although this system was originally intended to protect the interests of both drivers and customers, it has generated a shortage of taxis in the city. The number of medallions remained fixed for nearly 60 years, with no significant increase until 2004.

The Market for Taxi Rides in the Absence of Government Controls Quantity of rides (millions per year) Fare Quantity demanded Quantity supplied Fare (per ride) (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 4.13: 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)

Effect of a Quota on the Market for Taxi Rides Quantity of rides (millions per year) Fare Quantity demanded Quantity supplied Fare (per ride) (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 4.14: 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)

The Anatomy of Quantity Controls 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. Equals the market price of the license when the licenses are traded.

The Costs of Quantity Controls Deadweight loss because some mutually beneficial transactions don’t occur. Incentives for illegal activities.

The Clams of New Jersey In the 1980s, excessive fishing threatened to wipe out New Jersey’s clam beds. To save the resource, the U.S. government introduced a clam quota, which set an overall limit on the number of bushels of clams to be caught and allocated licenses to owners of fishing boats based on their historical catches.

1 of 4 Summary The willingness to pay of each individual consumer determines the demand curve. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus. Total consumer surplus in a market, is the sum of all individual consumer surpluses in a market. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus.

2 of 4 Summary Total producer surplus in a market, is the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. Total surplus, is the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. Even when a market is efficient, governments often intervene to pursue greater fairness 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.

3 of 4 Summary A price ceiling, a maximum market 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. They also encourage illegal activity as people turn to black markets. A price floor, a minimum market 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.

4 of 4 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.

Coming attraction: Chapter 5: Elasticity and Taxation The End of Chapter 4 Coming attraction: Chapter 5: Elasticity and Taxation