ECONOMICS

1. ECONOMICS Chapter 4 The Market Strikes Back

2. Review: Supply and Demand

3. Review: Supply and Demand �and the market equilibrium:

4. 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

5. 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.It�s an upper limit for the price. Price Floors: a minimum price buyers are required to pay for a good.I�ts a lower limit for the price.

6. 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 fir such cathegory.

7. 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 analisys, and we are only interested in efficiency issues, not in equity issues (if it�s fair or not). Let�s compare the usual market equilibrium and the case with a price ceiling in the icecream market.

8. Price controls: price ceilings Equilibrium Price ceiling

9. Price controls: price ceilingsAnother example

10. 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.

11. Price controls: price ceilings Let�s take a look at the different possible inefficiencies: Inefficient Allocation to Consumers Wasted Resources Inefficiently Low Quality Black Markets

12. 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. An efficient allocation would take into account such differencies, who really want the good will get it, who doesn�t need it so urgently will not. Example: rent control. In such case people get the appartment usually through luck or personal connections.

13. 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 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.

14. 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 appartments, 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 flat as it is, even in bad condition!

15. 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 (gives extra money) 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!

16. 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!

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

18. Price controls: price floors Equilibrium Price floor

19. 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 it.Example: In your book p.93 Rosetta Wasted Resources Like a price ceiling, a price floor generates inefficiency by wasting resources.

20. 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.

21. 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.

22. 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. It�s a maximum quantity that can be bought or sold. A license gives its owner the right to supply (sell) a good.

23. 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.

24. Quota: model Equilibrium With a quota

25. 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.

26. 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 it�s own value, it�s a valuable asset!

27. Quota The Costs of Quantity Controls � Inefficiencies, or missed opportunities, in the form of mutually beneficial transactions that don�t occur � Incentives for illegal activities: illegal taxies, shops without license�

28. 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. Tax:

29. Tax If the buyers are required t pay a tax the demand curve shifts downwards by the amount of the tax (2 yuan). The final effect is the same as the excise tax!!

30. 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 doesn�t always happen! The split depends on the slopes of the demand curve and of the supply curve.

31. Revenue from a tax In this example the revenue is: 100x2yuan=200yuan It is the green area in the graph. Tax revenue: