Transcript Slide

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
1. Consumer Surplus and the Demand Curve
2. Producer Surplus and the Supply Curve
3. Total Surplus
4. Government Intervention in Markets
A. Price Controls
B. Quantity Controls
C. Deadweight Loss
D. Who benefits and who loses from market
interventions
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
Price of book
Aleisha’s consumer surplus:
$59-$30=$29
$59
Aleisha
Brad’s consumer surplus:
$45-$30=$15
45
Brad
Claudia’s consumer
surplus: $35-$30=$5
35
Claudia
30
Price = $30
25
Darren
10
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.
Edwina
D
0
1
2
3
4
5
Quantity of books
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.
Price of
computers
Consumer
surplus
Price = $1,500
$1,500
D
0
1 million
Quantity of computers
How Changing Prices Affect Consumer Surplus
A fall in the price of a good increases consumer
surplus through two channels:
1)
2)
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.
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
S
Price of book
$45
Engelbert
35
Donna
Price = $30
30
25
Betty
15
5
0
Carlos’s
producer
surplus
Carlos
Andrew’s
producer
surplus
Andrew
1
2
3
4
Betty’s
producer
surplus
5
Quantity of books
Producer Surplus
Price of wheat
(per bushel)
S
$5
Price = $5
Producer
surplus
0
The total producer
surplus from sales
of a good at a given
price is the area
above the supply
curve but below
that price.
1 million
Quantity of wheat (bushels)
Changes in Producer Surplus
An increase in the price of a good increases
producer surplus through two channels:
1)
2)
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
Equilibrium
price
$30
E
Producer
surplus
D
0
1,000
Equilibrium quantity
Quantity of books
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.

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.
Two consumers, Casey and Josey, want cheese-stuffed jalapeno peppers for
lunch. Two producers, Cara and Jamie, can provide them. The accompanying table
shows the consumers’ willingness to pay and the producers’ costs. Note that
consumers and producers in this market are not willing to consumer or produce
more than four peppers at any price.
The demanded quantity when price equals $0.90 is:
a.
1
b.
2
c.
3
d.
4
Two consumers, Casey and Josey, want cheese-stuffed jalapeno peppers for
lunch. Two producers, Cara and Jamie, can provide them. The accompanying table
shows the consumers’ willingness to pay and the producers’ costs. Note that
consumers and producers in this market are not willing to consumer or produce
more than four peppers at any price.
The supply schedule when P = $.70
a.
7
b.
6
c.
5
d.
4
Two consumers, Casey and Josey, want cheese-stuffed jalapeno peppers for
lunch. Two producers, Cara and Jamie, can provide them. The accompanying table
shows the consumers’ willingness to pay and the producers’ costs. Note that
consumers and producers in this market are not willing to consumer or produce
more than four peppers at any price.
The equilibrium price and quantity are?
A. P = $0.40, Q = 4
B. P = $.30, Q = 3
C. P = $0.20, Q = 2
D. P = $0.50, Q = 5
Two consumers, Casey and Josey, want cheese-stuffed jalapeno peppers for
lunch. Two producers, Cara and Jamie, can provide them. The accompanying table
shows the consumers’ willingness to pay and the producers’ costs. Note that
consumers and producers in this market are not willing to consumer or produce
more than four peppers at any price.
Total consumer surplus at equilibrium is:
a. $3
b. $2
c. $1
d. $0
Two consumers, Casey and Josey, want cheese-stuffed jalapeno peppers for
lunch. Two producers, Cara and Jamie, can provide them. The accompanying table
shows the consumers’ willingness to pay and the producers’ costs. Note that
consumers and producers in this market are not willing to consumer or produce
more than four peppers at any price.
Producer surplus at equilibrium is:
a. $0
b. $1.10
c. $2.20
d. $3.30
Two consumers, Casey and Josey, want cheese-stuffed jalapeno peppers for
lunch. Two producers, Cara and Jamie, can provide them. The accompanying table
shows the consumers’ willingness to pay and the producers’ costs. Note that
consumers and producers in this market are not willing to consumer or produce
more than four peppers at any price.
Total surplus (consumer surplus plus producer surplus) at
equilibrium is:
a. $2.10
b. $4.40
c. $6.50
d. $8.70
Suppose UNOS alters its guidelines for the allocation of donated kidneys.
It will no longer rely solely on the concept of ‘net benefit’ but also give
preference to patients with young children. If ‘total surplus’ in this case is
defined as the total life span of kidney recipients, what do you think will
happen to surplus?
a.
b.
c.
d.
Total
Total
Total
Total
surplus
surplus
surplus
surplus
will increase
will decrease
will remain the same
cannot be determined
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
The Market for Apartments in the Absence of
Government Controls
Monthly rent
(per
apartment)
S
$1,400
1,300
1,200
1,100
1,000
E
900
800
700
600
0
D
Monthly rent
(per apartment)
$1,400
1,300
1,200
1,100
1,000
900
800
700
600
1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4
Quantity of apartments (millions)
Quantity of apartments
(millions)
Quantity
Quantity
demanded
supplied
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
2.4
2.3
2.2
2.1
2.0
1.9
1.8
1.7
1.6
The Effects of a Price Ceiling
Monthly rent
(per apartment)
S
$1,400
1,200
E
1,000
A
B
Price
ceiling
800
Housing shortage of
400,000 apartments
caused by price
ceiling
600
0
1.6
1.8
2.0
D
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
$1,400
Monthly rent
(per apartment)
S
1,200
E
1,000
Price
ceiling
800
600
0
D
1.6
1.8
Quantity
supplied with
rent control
2.0
2.2
Quantity supplied
without rent control
2.4
Quantity of apartments (millions)
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 rentcontrol 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
(b) After Rent Control
(a) Before Rent Control
Monthly rent
(per apartment)
Monthly rent
(per apartment)
S
Consumer
surplus
$1,400
$1,400
1,200
1,200
E
1,000
S
Price
ceiling
E
1,000
800
800
600
0
Consumer
surplus Consumer surplus
transferred from
producers
600
Producer
surplus
1.6
1.8
Producer
surplus
D
2.0
2.2
2.4
Quantity of apartments (millions)
0
1.6
1.8
Deadweight
loss
2.0
2.2
D
2.4
Quantity of apartments (millions)
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
Price of butter
(per pound)
Price of butter
(per pound)
$1.40
S
1.30
1.20
1.10
E
1.00
0.90
$1.40
$1.30
$1.20
$1.10
$1.00
$0.90
$0.80
$0.70
$0.60
0.80
0.70
0.60
D
0
6
7
8
9
10
11
12
13
14
Quantity of butter (millions of pounds)
Quantity of butter
(millions of pounds)
Quantity
demanded
8.0
8.5
9.0
9.5
10.0
10.5
11.0
11.5
12.0
Quantity
supplied
14.0
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
The Effects of a Price Floor
Butter surplus of 3
million pounds caused
by price floor
Price of butter $1.40
(per pound)
1.20
A
S
B
Price
floor
E
1.00
0.80
0.60
0
D
6
8
9
10
12
14
Quantity of butter (millions of pounds)
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
Price of butter
(per pound)
S
$1.40
1.20
Deadweight
loss
Price floor
E
1.00
0.80
0.60
0
D
6
8
9
10
12
Quantity
Quantity
demanded with demanded
price floor
without price floor
14
Quantity of butter
(millions of pounds)
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.
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.
The Market for Taxi Rides in the Absence of
Government Controls
Quantity of rides
(millions per year)
Fare
(per ride)
Fare
(per ride)
$7.00
S
6.50
6.00
5.50
E
5.00
4.50
4.00
3.50
3.00
0
7
8
9
Quantity
supplied
$7.00
6
14
$6.50
7
13
$6.00
8
12
$5.50
9
11
$5.00
10
10
$4.50
11
9
$4.00
12
8
$3.50
13
7
$3.00
14
6
D
6
Quantity
demanded
10 11 12 13 14
Quantity of rides (millions per year)
Effect of a Quota on the Market
for Taxi Rides
Fare
(per ride)
$7.00
S
Deadweight
loss
Quantity of rides
(millions per year)
Fare
(per ride)
Quantity
demanded
Quantity
supplied
$7.00
6
14
$6.50
7
13
$6.00
8
12
$5.50
9
11
5.00
$5.00
10
10
4.50
$4.50
11
9
$4.00
12
8
$3.50
13
7
$3.00
14
6
6.50
6.00
5.50
A
The
“wedge”
E
4.00
B
3.50
3.00
D
Quota
0
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
1.
2.
3.
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
4.
5.
6.
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
7.
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.
8.
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
9.
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.
The End of Chapter 4
Coming attraction:
Chapter 5:
Elasticity and Taxation