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Lesson 1

ECONOMICS
The Market Strikes Back

Review: Supply and Demand


The previous lesson focused on demand and supply, we studied the demand curve and the supply curve
S P P

Quantity

Quantity

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Review: Supply and Demand


and the market equilibrium:

S P

Peq D

Qeq

Quantity

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What we will learn in this chapter


The meaning of price controls and quantity controls, two kinds of government intervention in markets How price and quantity controls create problems and make a market inefficient Why economists are often deeply skeptical of attempts to intervene in markets Who benefits and who loses from market interventions, and why they are used despite their well- known problems What an excise tax is and why its effect is similar to a quantity control Why the deadweight loss of a tax means that its true cost is more than the amount of tax revenue collected
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Price controls
Price controls are legal restrictions on how high or low a market price may go. 2 kinds of price controls:

1. Price Ceilings: a maximum price sellers are allowed to charge for a good.Its an upper limit for the price. 2. Price Floors: a minimum price buyers are required to pay for a good.Its a lower limit for the price.
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Price controls
Why Price controls?

During crisis times, emergencies or wars the government wants to protect the consumers from rapidly increasing prices. If the equilibrium wage given by supply and demand for low skilled workers is below poverty level, the government can set a minimum wage for such category.

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Price controls
But what happens if there are price controls on a competitive market? The reasons above regarded emergencies, or particular moral situations. We will consider only the competitive market in our analysis, and we are only interested in efficiency issues, not in equity issues (if its fair or not). Lets compare the usual market equilibrium and the case with a price ceiling in the icecream market.

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Price controls: price ceilings


Equilibrium
Price
4
3
D

Price ceiling
S Price 4
D

3
2 Shortage 100 200 Quantity of icecreams 100 200 800 Quantity of icecreams
Price Ceiling

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Price controls: price ceilings Another example

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Price controls: price ceilings


After these 2 examples, we can see that in every case, when there is a price ceiling, there is 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.

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Price controls: price ceilings


Lets take a look at the different possible inefficiencies:

1. Inefficient Allocation to Consumers

2. Wasted Resources
3. Inefficiently Low Quality 4. Black Markets

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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 dont get it, and those who are not so interested in the good and are only willing to pay a low price do get it. An efficient allocation would take into account such differencies, who really want the good will get it, who doesnt need it so urgently will not. Example: rent control. In such case people get the appartment usually through luck or personal connections.
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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 appartment) in case of shortage, the time has its value! You can work or just rest, do something better than look for a good you cant find. If the market works efficiently, you can find quickly the goods you are looking for.
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Price controls: price ceilings


Inefficiently Low Quality

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.
In case of rent controls, the landlords will not improve the conditions of the apartments, there is no incentive since the rental fee is low but the main reason is that since there is a shortage, people are willing to rent the apartment as it is, even in bad condition!
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Price controls: price ceilings


Black Markets

A black market is a market in which goods or services are bought and sold illegallyeither 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 (gives extra money) to the flat owners he will get the flat, but the honest people that dont break the law will never find one this way!
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Price controls: price ceilings


So many inefficiencies! But why are there price ceilings then?

1. They may benefit some people: someone can get the good cheaper. They benefit influential buyers. 2. When price ceilings have existed for long time (like in New York), people dont 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. 3. Government officials dont really understand supply and demand!
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Price controls: price floors

Price Floors: a minimum price buyers are required to pay for a good.Its a lower limit for the price.

The minimum wage is a legal floor on the wage rate, which is the market price of labor.

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Price controls: price floors


Equilibrium
Price 4
3
D

Price floor
S Price 4 3 2
Price Ceiling

Surplus
D

100 200

Quantity of icecreams

100

200

600

Quantity of icecreams

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Price controls: price floors


Why a Price Floor Causes Inefficiency Inefficient Allocation of Sales Among Sellers 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 Wasted Resources Like a price ceiling, a price floor generates inefficiency by wasting resources.

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Price controls: price floors


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.
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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 dont understand the supply and demand model, or they think that it doesnt describe reality well.

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Quota
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 (bought and sold) is the quota limit. Its a maximum quantity that can be bought or sold. A license gives its owner the right to supply (sell) a good.

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Quota
Why? Usually to deal with a temporary problem, crisis situation, protect the natural resources 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.

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Quota: model
Equilibrium
Price 4
3
D

With a quota
Price
D

wedge

Price Ceiling

100 200

Quantity of icecreams

100

200

Quantity of icecreams

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Quota
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.
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Quota
2 Prices, how is it possible? Actually the owner of a license (Frank) is in 2 markets: the market of icecreams and the market of licenses! Imagine he can rent the license to Alex, for one day and the license allows you to sell 1 icecream, the rent of will be exactly 2 yuan. But what if Frank is using the license personally? Well he could have rented it for 2 yuan, the license has an opportunity cost of 2 yuan! Frank is giving up 2 yuan quota rent when using the license personally. He can make 2 yuan selling 1 icecream and 2 yuan from renting the license. The license has its own value, its a valuable asset!
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Quota
The Costs of Quantity Controls Inefficiencies, or missed opportunities, in the form of mutually beneficial transactions that dont occur Incentives for illegal activities: illegal taxies, shops without license

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Tax
An excise tax is a tax on sales of a good or service. First consider the case when the tax is payed by the sellers. There is a shift upward of the supply curve by the amount of the tax (2 yuan). The tax drives a wedge between the demand price and supply price.
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Tax:
Price
D

S S

4
3

100 200

Quantity of icecreams

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Tax
If the buyers are required t pay a tax the demand curve shifts downwards by the amount of the tax (2 yuan).

Price S 4
3

The final effect is the same as the excise tax!!

2
D

D 100 200 Quantity of icecreams

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Tax
Incidence of a tax: who is really paying it?

It measures who really pays the tax. In both cases we have a 1 yuan increase in the price buyers will pay and a 1 yuan price decrease in the price the sellers will receive. It is evenly split, but this doesnt always happen! The split depends on the slopes of the demand curve and of the supply curve.

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Revenue from a tax


In this example the revenue is: 100x2yuan=200yuan It is the green area in the graph.
4
3

Tax revenue:
Price
D

100 200

Quantity of icecreams

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