Chapter 4: Price Controls and Quotas: Meddling With Markets

What are price controls?

Legal restrictions on how high or low a market price may go.

What are the two main types of price controls?

• Price ceiling: a maximum price sellers are allowed to charge for a good or service (usually set BELOW equilibrium)

• Price floor: a minimum price buyers are required to pay for a good or service (usually set ABOVE equilibrium.

Other Information on Price Controls

• Price control will create a situation where there's a persistent disequilibrium.

• A price ceiling impacts the market when it is set below what equilibrium would be

Why do governments control prices?

Market prices do not necessarily please buyers or sellers: they may lobby the government to help them by altering the price.

What are the predictable side effects of price ceilings that cause inefficiency?

1. Inefficiently low quantity

2. Inefficient allocation to consumers

3. Wasted resources, time and effort

4. Inefficiently low quality

5. Black market

Measuring Inefficiently Low Quantity

 The area of the shaded triangle corresponds to the amount of total surplus lost due to inefficiently low quantity transacted (deadweight loss)

Inefficient Allocation To Consumers

• Price controls distort signals that would help the goods get allocated their highest-valued uses.

  • Consumers who value a good most don't necessarily get it.

Wasted Resources: Price Ceilings

• Price controls that create shortages lead to bribery and wasteful lines

• Shortages: not all buyers will be able to purchase the good

• Normally buyers would compete with each other by offering a higher price

• If price is not allowed to rise, buyers must compete in other ways (waiting in line, illegal bribes and favors.

Inefficiently Low Quality

• At the controlled price, sellers have more consumers than goods

  • In a free market, this would be an opportunity to profit by raising prices

  • But when prices are controlled, sellers cannot

  • Sellers respond to this problem in two ways:

    • Reduce quality

    • Reduce service

Black Markets

A market in which goods or services are bought and sold illegally - either because they are prohibited or because the equilibrium is illegal.

Why are there price ceilings?

• They do benefit some people (who are typically better organized and more vocal than those who are harmed by them).

• If the price ceiling is longstanding, buyers may not have a realistic idea of what would happen without it.

• Government officials often do not understand supply and demand analysis

(Price ceiling is binding if set below equilibrium)

What predictable side effects can price floors cause that leads to inefficiency?

1. Inefficient allocation of sales among sellers

   • Price floors misallocate sales by allowing high-cost firms to operate and preventing low cost firms from entering the industry

2. Wasted resource

   • Price floors encourage waste

3. Inefficiently high quality

   • Higher quality raises costs and reduces sellers' profit

   • Buyers get higher quality but would prefer a lower price

   • Price floors encourage sellers to waste resources

   • Higher quality than buyers are willing to pay for

4. Temptation to break the law by selling below the legal price

   • Price floors encourage black markets

Why are there price floors?

Same as price ceilings

• They do benefit some people (who are typically better organized and more vocal than those who are harmed by them).

• If the price ceiling is longstanding, buyers may not have a realistic idea of what would happen without it.

• Government officials often do not understand supply and demand analysis

Do governments sometimes control quantity instead of price?

Yes!

What is a quota?

An upper limit, set by the government on the quantity of some good that can be bought or sold; also referred to as a quantity control.

What is a quota limit?

The total amount of a good under a quota or quantity control that can be legally transacted.

What is a license?

The right, conferred by the government, to supply a good.

What is demand price?

The price of a given quantity at which consumers will demand that quantity.

What is supply price?

The price of a given quantity at which producers will supply that quantity.

What is the wedge, or Quota, rent?

The difference between the demand price and the supply price at the quota limit. Equal to the market price of the license when the license is traded.

What losses on society do quotas impose?

• Deadweight loss (some mutually beneficial transactions don't occur)

• Incentives for illegal activities