Chapter 15 APPLIED COMPETITIVE ANALYSIS MICROECONOMIC THEORY BASIC

Chapter 15 APPLIED COMPETITIVE ANALYSIS MICROECONOMIC THEORY BASIC PRINCIPLES AND EXTENSIONS EIGHTH EDITION WALTER NICHOLSON Copyright © 2002 by South-Western, a division of Thomson Learning. All rights reserved.

Price Controls • Sometimes the government may seek to control prices at below equilibrium levels – will lead to a shortage • We can look at the changes in producer and consumer surplus from this policy to analyze its impact on welfare

Price Controls Price Initially, the market is in long-run equilibrium at P 1, Q 1 SS LS P 1 Demand increases to D’ D’ D Q 1 Quantity

Price Controls Price SS In the short run, price rises to P 2 LS P 3 P 1 D’ Firms would begin to enter the industry The price would end up at P 3 D Q 1 Quantity

Price Controls Price Suppose that the government imposes a price ceiling at P 1 SS LS P 3 P 1 D’ There will be a shortage equal to Q 2 - Q 1 D Q 1 Q 2 Quantity

Price Controls Price Some buyers will gain because they can purchase the good for a lower price SS LS P 3 P 1 D’ This gain in consumer surplus is the shaded rectangle D Q 1 Q 2 Quantity

Price Controls Price The gain to consumers is also a loss to producers who now receive a lower price SS LS P 3 P 1 D’ D Q 1 Q 2 The shaded rectangle therefore represents a pure transfer from producers to consumers No welfare loss there Quantity

Price Controls Price SS LS P 3 P 1 This shaded triangle represents the value of additional consumer surplus that would have been attained without the price control D’ D Q 1 Q 2 Quantity

Price Controls Price SS LS P 3 P 1 This shaded triangle represents the value of additional producer surplus that would have been attained without the price control D’ D Q 1 Q 2 Quantity

Price Controls Price SS LS P 3 This shaded area represents the total value of mutually beneficial transactions that are prevented by the government P 1 D’ This is a measure of the pure welfare costs of this policy D Q 1 Q 2 Quantity

Disequilibrium Behavior • Assuming that observed market outcomes are generated by Q(P 1) = min [QD(P 1), QS(P 1)] suppliers will be content with the outcome but demanders will not • This could lead to black markets