Chapter 4 The Market Strikes Back Slides created

BIG CITY, NOT - SO - BRIGHT IDEAS What happens when the logic of the market is defied? Ø Example: Rent Control Ø Introduced during World War II to protect the interests of tenants Ø 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 ØA consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good. Ø 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 n Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. n 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 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) A gain to consumers who would have bought at the original price and 2) 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 ØA potential seller’s cost is the lowest price at which he or she is willing to sell a good. ØIndividual 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 ØTotal 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 5 Betty’s producer surplus 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) The gains of those who would have supplied the good even at the original, lower price and 2) The gains of those who are induced to supply the good by the higher price.

Putting It Together: Total Surplus Ø Ø 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 Ø 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. Ø 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. Ø But are we as well off as we could be? This brings us to the question of the efficiency of markets.

e. Bay 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. § e. Bay 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. §

e. Bay and e. Fficiency (continued) ▪ ▪ e. Bay 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, e. Bay 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 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 surplus will increase will decrease will remain the same cannot be determined

Why Governments Control Prices Ø The market price moves to a level where quantity supplied = quantity demanded, however this equilibrium price may not necessarily please every buyer or seller. Ø 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. Ø Price ceiling is the maximum price sellers are allowed to charge for a good or service. Ø Price floor is the minimum price buyers are required to pay for a good or service.

Price Ceilings Ø Price Ceiling: Maximum Price sellers are allowed to charge for a good or a service Ø 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. Ø 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 demanded supplied 1. 6 1. 7 1. 8 1. 9 2. 0 2. 1 2. 2 2. 3 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 ØInefficiently Low Quantity -lower than quantity in unregulated market, creates Deadweight Loss (DWL) Ø 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: ØInefficient 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. ØWasted resources: people expend money, effort and time to cope with the shortages caused by the price ceiling. ØInefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price. ØBlack 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: n In 2005, Cyndi Lauper paid $989 a month for an apartment that would have been worth $3, 750 if unregulated. n 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) S Consumer surplus $1, 400 1, 200 E 1, 000 S Price ceiling E 1, 000 800 600 0 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 Ø Sometimes governments intervene to push market prices up instead of down. Ø The minimum wage is a legal floor on the wage rate, which is the market price of labor. Ø Just like price ceilings, price floors are intended to Ø 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) $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 0 D 6 7 8 9 10 11 12 13 14 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 Ø Ø 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: Ø Deadweight loss from inefficiently low quantity Ø Inefficient allocation of sales among sellers Ø Wasted resources Ø Inefficiently high quality offered by sellers Ø 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 demanded with demanded price floor without price floor 14 Quantity of butter (millions of pounds)

Ceilings, Floors and Quantities Ø Ø 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 Ø Ø 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. Ø 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) $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 6. 50 6. 00 5. 50 5. 00 S Deadweight loss A The “wedge” E 4. 50 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) 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 10 10 $4. 50 11 9 $4. 00 12 8 $3. 50 13 7 $3. 00 14 6

The Anatomy of Quantity Controls ØA 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. Ø The difference between the demand 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. Ø Equals the market price of the license when the licenses are traded.

The Costs of Quantity Controls ØDeadweight loss because some mutually beneficial transactions don’t occur. ØIncentives for illegal activities.

The Clams of New Jersey § In the 1980 s, 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.

Summary 1. 2. 3. 1 of 4 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