Chapter 5 Flashcards
What is a disequilibrium price?
- Voluntary market transactions require both a willing buyer and a willing seller.
- If the quantity demanded is less than the quantity supplied, then the demand will determine the amount actually exchanged.
- If the quantity demanded exceeds the quantity supplied, supply will determine the amount actually exchanged.
- In disequilibrium, the quantity exchanged is determined by the lesser of quantity demanded and quantity supplied.
What is a price floor?
- A price floor is the minimum permissible price that can be charged for a particular good or service.
- A binding price floor leads to excess supply.
- The free-market equilibrium is at price E, with price P0 and quantity Q0. The government now establishes a binding price floor at P1. Actual quantity exchanged is then Q1, and there is excess supply equal to Q1Q2.
What is minimum wage and its goal?
- A minimum wage is an example of a price floor in the labour market.
- In a competitive labour market, a binding minimum wage reduces the level of employment and increases the quantity of labour services employed.
- Unemployment increases
- The owners of firms are made worse off since they are now required to pay a higher wage than before the minimum wage was imposed.
- Some workers gain because they keep their jobs and they earn a higher wage rate.
- Other workers lose because they lose their jobs as a result of the wage increase
What is a price ceiling and what may it lead to?
- Free markets with flexible prices eliminate excess demand by allowing prices to rise.
- A price ceiling is a maximum price.
- With a binding price ceiling some other method of allocation must be adopted.
- First-come, first-served allocation results in buyers waiting in lines, disappointed to discover supplies are exhausted.
- May lead to a black market, where products are sold at prices that violate a legal price control.
- Profit can be made by buying at the controlled price and selling at the (illegal) black-market price.
- The euilibrium point E, is at a price point of p0 andQ0. If a price ceiling is set at p1, the quantity demanded will rise to Q1, and the quantity supplied will be Q2. But if all available supply of Q2 were sold on a black market, the price to consumers would rise to p2. If the black marketeers buy at the ceiling price of p1 and sell at the black-market price of p2, their profits are represented by the shaded area.
- Profit can be made by buying at the controlled price and selling at the (illegal) black-market price.
What are the goals of price ceilings? [3]
- To restrict production
- To keep specific prices down
- To satisfy notions of equity in the consumption of a product that is temporarily in short supply
- Black markets thwart government’s objectives when imposing a price ceiling.
What are the predicted effects of rent controls?
- Binding rent controls are a specificy form of price ceiling, which have the following effects:
- a shortage of rental housing because quantity demanded exceeds quantity supplied.
- alternative allocation schemes
- black markets will appear
What are the short-run and long-run effects of rent controls?
Rent control causes housing shortages that worsen as time passes. The free-market equilibrium is at point E. The controlled rent of rc forces rents below their free-market equilibrium value of r1. The short-run supply of housing is shown by the perfectly inelastic curve Ss. Thus, quantity supplied remains at Q1 in the short run, and the housing shortage is Q1Q2. Over time, the quantity supplied shrinks, as shown by the long-run supply corve SL. In the long run, there are only Q3 units of rental accomodations supplied, fewer than when controls were instituted. The long-run housing shorage of Q3Q2 is larger than the initial shortage of Q1Q2.
Describe history of rent controls in Ontario.
- Instituted in 1975
- Permitted increases in rents only where these were needed to pass on cost increases.
- 1990s - shortage developed in the rental-housing market (acute in Metro Toronto)
- Ontario government loosens rent controls by exempting some units and permitting increases when tenants vacated apartments
- 2017 - Ontario government expanded its rent controls generating considerable opposition.
Who gains and who loses from rent controls?
- Existing tenants in rent-controlled accomodations are the principal gainers from a policy of rent control.
- Landlords lose because they do not receive the rate of return they expected on their investments.
- Potential future tenants also suffer because the rental housing they will require will not exist in the future.
What are policy alternatives to rent controls?
- Housing shortages can be reduced if the government at taxpayers’ expense, either subsidizes housing production or produces public housing directly.
- The government can make housing more affordable to lower-income households by providing income assistance directly to these households.
- Whatever policy is adopted has a resource cost.
What is market efficiency?
- The imposition of a controlled price generates benefits for some individuals and costs for others.
- Does a policy of legislated minimum wages make society as a whole better off because it helps workers more than it harms firms?
- Does a policy of rent controls make society as a whole better off because it helps tenants more than it harms landlords?
- Economists use the concept of market efficiency to address such questions.
Describe demand as ‘value’.
- The market demand curve for any product shows how much of that product consumers want to purchase.
- We can turn it around by starting with any given quantity and asking about the price.
- The demand curve tells us the highest price that consumers are willing to pay for a given unit.
- For each unit of a product, the price on the market demand curve shows the value to consumers from consuming that unit.
Describe supply as ‘cost’.
- The market supply curve for any product shows how much producers want to sell at each possible price.
- We can turn it around by starting with any given quantity and asking about the price.
- The supply curve tells us the lowest price that producers are willing to accept for a given unit.
- For each unit of a product, the price on the market suppy curve shows the lowest acceptable price to firms for selling that unit. This lowest acceptable price reflects the additional cost to firms from producting that unit.
What is economic surplus?
The area below the demand curve and above the supply curve; maximized at the free-market equilibrium quantity (i.e., total economic surplus is maximized)
- For any quantity of pizzas, the area below the demand curve and above the supply curve shows the economic surplus generated by the production and consumption of those pizzas. The demand curve shows the value consumers place on each additional pizza; the supply curve shows the additional cost associated with producing each pizza. For example, consumers value the 100th pizza at $20, whereas the additional cost to firms of producing that 100th pizza is $5. The economic surplus generated by producing and consuming this 100th pizza is therefore $15 ($20 - $5). For any range of quantity, the shaded area between the curves over that range shows the economic surplus generated by producing and consuming those pizzas. Economic surplus in the pizza market is maximized - and thus market efficiency is achieved - at the free-market equilibrium quantity of 250 pizzas and the price of $12.50. At this point, total economic surplus is the sum of the three shaded areas.
Describe market inefficiency with binding price floors.
- Production falls from Q0 to Q1.
- With a free market, each unit of output from Q0 to Q1 generates economic surplus.
- The purple area shows the deadweight loss, which is the overall loss of economic surplus to society of the binding price floor.
Describe market inefficiency with binding price ceilings.
- Production falls from Q0 to Q2.
- With a free market, each unit of output (from Q0 to Q2) generates economic surplus.
- The purple area shows the deadweight loss, which is the overall loss of economic surplus to society of the binding price ceiling.
Describe the inefficiency of output quotas.
- An output quota restricts output to Q1.
- The shaded area shows the reduction in overall economic surplus - the deadweight loss - created by the quota system.
Why does the government intervene in otherwise free markets when the outcome is inefficient? [4]
- The answer in many situations is that the government policy is motivated by the desire to help a specific group of people.
- The overall costs are deemed to be a worthwhile price to pay to achieve the desired effect.
- Policymakers are making normative judgements.
- The job of the economist is to undertake positive analysis, emphasizing the actual effects of the policy rather than what might be desirable.
Who are the winners and losers of price floors?
- Winners: some sellers, who sell Qd at P2
- Losers: buyers, and some sellers who don’t sell excess supply.
Who are the winners and losers of price ceilings?
- Winners: some buyers who buy Qs at P1.
- Losers: sellers, and some buyers who have excess demand.
Why do price ceilings create potential for black markets?
- Black market = products sold at price that violates legal price control (price is above legal price ceiling).
- Binding (legal) price ceiling set at P1 below Pe.
- Qs actually exchanged > smaller number rule
- Black marketeer buys Qs at P1 (controlled price)
- Black marketeer sells Qs at P2 (black market price)
- Black marketeer reaps monopoly profits (Qs-0)*(P2-P1)
- Price ceilings create an incentive for black markets.
Why is it that, over time, rent controls exacerbate the housing shortage?
Short run
- Initially, short run supply of housing is fixed (perfectly inelastic)
- Effectual rent ceiling, Rc, causes excess demand in the short run (Q1-Qe)
Long run
- Supply of housing depreciates; fewer new apartments built; more conversions to condos; supply becomes inelastic.
- Housing shortage
- Effectual rent ceiling, Rc, causes excess demand in the long run (Q1-Q2)
Who wins and who loses from minimum wages? And why?
- Minimum wage = effectual price floor = Wm
- creates an excess supply of labour = unemployment
- Note: in a competitive labour market (free market) = there will be no unemployment at Ne (Nd = Ns = Ne)!
Winners: existing workers
Losers: producers (cost of labour rises), and new workers (jobless!)
The consumer will continue to consume extra units as longs as…?
MB > MC
(until MB = MC = P)
Demand curve is a benefit curve.
The producer will continue to sell extra units until…?
MB > MC
(until MB = MC)
The price line (supply curve) is the cost.
What is the net benefit to society as a whole?
Economic surplus = cooperative surplus = total surplus
benefit minus cost
for each marginal unit, the area below demand and above supply
for society, sum of benefit to buyers - cost to sellers
society has transformed inputs of lower value into outputs of higher value
Describe the market inefficiency caused by a binding price floor. (i.e., minimum wages)
P1 = price floor
Q1 = actual amount exchanged
Dead weight social loss = reduction of total economic surplus (i.e., market inefficiency); redistribution from employers to workers.
