Microeconomics Chapter 5: Price Controls and Quotas

Fundamentals of Government Market Intervention

• Market Equilibrium vs. Government Intervention:

  • Under free-market conditions, the market price naturally moves to an equilibrium level where the quantity supplied equals the quantity demanded ($Q_s = Q_d$).

  • Market equilibrium maximizes efficiency, but the resulting market-clearing price may not satisfy buyers or sellers.

  • Buyers typically desire lower prices, while sellers desire higher prices. When political pressure from either group is sufficiently strong, governments step in to regulate prices.

• Definitions of Key Control Mechanisms:

  • Price Controls: Legal restrictions imposed by governments on how high or low a market price may go.

  • Price Ceiling: A legal maximum price that sellers are allowed to charge for a good or service.

  • Price Floor: A legal minimum price that buyers are required to pay for a good or service.

  • Quantity Control (Quota): An upper limit established by government regulation on the quantity of a good or service that can be bought or sold.

Price Ceilings

• Rationale and Historical Context:

  • Price ceilings are typically introduced during severe crises such as wars, harvest failures, or natural disasters.

  • These emergency events cause sudden supply disruptions or demand spikes that lead to rapid price increases. Uncontrolled price spikes harm broad populations while producing concentrated gains for a small number of sellers.

• Real-World Examples of Price Ceilings:

  • World War II Controls in Canada: The Canadian government imposed broad price ceilings on essential raw materials and consumer goods, including aluminum, steel, sugar, and milk.

  • Prescription Drug Pricing: Imposed through mechanisms such as the Pan-Canadian Pharmaceutical Alliance to cap pharmaceutical costs.

  • Rent Control: Legislative caps on rental rates, such as Ontario's Fair Housing Plan, which limits annual rent increases allowed for tenants.

• Market Dynamics of Rent Control without Controls vs. With Ceilings:

• Unregulated Market Schedule for Apartments:

  • Monthly rent of $\\text{1400}$: Quantity demanded = $1.6\text{ million}$, Quantity supplied = $2.4\text{ million}$

  • Monthly rent of $\\text{1300}$: Quantity demanded = $1.7\text{ million}$, Quantity supplied = $2.3\text{ million}$

  • Monthly rent of $\\text{1200}$: Quantity demanded = $1.8\text{ million}$, Quantity supplied = $2.2\text{ million}$

  • Monthly rent of $\\text{1100}$: Quantity demanded = $1.9\text{ million}$, Quantity supplied = $2.1\text{ million}$

  • Monthly rent of $\\text{1000}$: Quantity demanded = $2.0\text{ million}$, Quantity supplied = $2.0\text{ million}$ (Equilibrium point $E$)

  • Monthly rent of $\\text{900}$: Quantity demanded = $2.1\text{ million}$, Quantity supplied = $1.9\text{ million}$

  • Monthly rent of $\\text{800}$: Quantity demanded = $2.2\text{ million}$, Quantity supplied = $1.8\text{ million}$

  • Monthly rent of $\\text{700}$: Quantity demanded = $2.3\text{ million}$, Quantity supplied = $1.7\text{ million}$

  • Monthly rent of $\\text{600}$: Quantity demanded = $2.4\text{ million}$, Quantity supplied = $1.6\text{ million}$

• Impact of a Binding Price Ceiling:

  • A price ceiling is binding only if set below the equilibrium price.

  • If the government imposes a legal maximum rent of $\\text{800}$ per month (below the equilibrium price of $\\text{1000}$):

  • Quantity demanded expands to $2.2\text{ million}$ apartments (point $B$).

  • Quantity supplied contracts to $1.8\text{ million}$ apartments (point $A$).

  • Resulting shortage: $2.2\text{ million} - 1.8\text{ million} = 0.4\text{ million}$ ($400,000$ apartments).

How Price Ceilings Cause Inefficiency

• Inefficiently Low Quantity and Deadweight Loss:

  • Because landlords supply only $1.8\text{ million}$ apartments at the rent control price of $\\text{800}$, the total number of apartments rented drops below the market equilibrium level of $2.0\text{ million}$.

  • Deadweight Loss: The loss in total surplus (consumer surplus plus producer surplus) that occurs whenever an action or policy reduces the quantity transacted below the efficient market equilibrium quantity.

  • The triangle formed between the supply and demand curves from the controlled quantity ($1.8\text{ million}$) to the equilibrium quantity ($2.0\text{ million}$) represents lost mutually beneficial transactions.

• Inefficient Allocation to Consumers:

  • Price ceilings do not allocate scarce goods to those who value them most.

  • Individuals who urgently need housing and are willing to pay a higher market price (e.g., $\\text{1200}$) may end up without an apartment.

  • Individuals who place a relatively low value on the housing and are only willing to pay a lower price (e.g., $\\text{800}$) may end up securing an apartment.

• Wasted Resources:

  • Shortages force consumers to expend substantial effort, time, and monetary resources coping with the deficit.

  • Examples include spending hundreds of hours searching for vacant units, standing in long lines, or offering side payments.

• Inefficiently Low Quality:

  • Sellers have no incentive to offer high quality because price ceilings prevent them from charging higher prices to cover improvement costs.

  • Landlords under rent control allow buildings to deteriorate, ignoring necessary maintenance, painting, and repair work. Buyers would prefer higher quality at higher prices, but the law prevents this transaction.

• Black Markets:

  • Black Market Defined: A market in which goods or services are bought and sold illegally—either because selling them is illegal altogether or because the prices charged violate legal price ceilings.

  • Under rent control, black market activities include illegal sub-leasing, non-refundable kickbacks ("key money"), and forced bribes paid to secure leases.

• Welfare Analysis (Winners and Losers):

  • Producer Surplus: Significantly reduced. Producers lose surplus due to the lowered price and the reduction in quantity sold.

  • Consumer Surplus: Some producer surplus is transferred directly to consumers who manage to rent apartments at the lowered price. However, consumers as a group lose surplus due to the deadweight loss.

  • Overall total economic surplus falls.

• Reasons for the Persistence of Price Ceilings:

  • Although price ceilings hurt many residents and reduce market efficiency, they deliver large benefits to a concentrated group of sitting tenants who obtain housing far below market rates.

  • Beneficiaries are often well-organized and politically vocal compared to those who are harmed or shut out of the market.

  • Policy makers and public officials frequently fail to understand or apply basic supply and demand analysis.

Price Floors

• Rationale and Function:

  • Governments intervene to establish a minimum price when producers or workers exert political pressure complaining that market equilibrium prices are unfairly low.

  • A price floor is binding only if set above the market equilibrium price.

• Real-World Examples of Price Floors:

  • Minimum Wage: A legal floor on wage rates (the market price of labor).

  • Supply Management: Systems operating in Canadian agricultural sectors, such as dairy and poultry markets.

  • Common Agricultural Policy (CAP): Extensive agricultural price support programs implemented in the European Union.

• Market Dynamics in the Butter Market:

• Unregulated Market Schedule for Butter:

  • Price per kg of $\\text{1.40}$: Quantity demanded = $8.0\text{ million kg}$, Quantity supplied = $14.0\text{ million kg}$

  • Price per kg of $\\text{1.30}$: Quantity demanded = $8.5\text{ million kg}$, Quantity supplied = $13.0\text{ million kg}$

  • Price per kg of $\\text{1.20}$: Quantity demanded = $9.0\text{ million kg}$, Quantity supplied = $12.0\text{ million kg}$

  • Price per kg of $\\text{1.10}$: Quantity demanded = $9.5\text{ million kg}$, Quantity supplied = $11.0\text{ million kg}$

  • Price per kg of $\\text{1.00}$: Quantity demanded = $10.0\text{ million kg}$, Quantity supplied = $10.0\text{ million kg}$ (Equilibrium point $E$)

  • Price per kg of $\\text{0.90}$: Quantity demanded = $10.5\text{ million kg}$, Quantity supplied = $9.0\text{ million kg}$

  • Price per kg of $\\text{0.80}$: Quantity demanded = $11.0\text{ million kg}$, Quantity supplied = $8.0\text{ million kg}$

  • Price per kg of $\\text{0.70}$: Quantity demanded = $11.5\text{ million kg}$, Quantity supplied = $7.0\text{ million kg}$

  • Price per kg of $\\text{0.60}$: Quantity demanded = $12.0\text{ million kg}$, Quantity supplied = $6.0\text{ million kg}$

• Impact of a Binding Price Floor:

  • If the government imposes a price floor of $\\text{1.20}$ per kg of butter (above the $\\text{1.00}$ equilibrium):

  • Quantity supplied rises to $12.0\text{ million kg}$ (point $B$).

  • Quantity demanded drops to $9.0\text{ million kg}$ (point $A$).

  • Resulting persistent surplus: $12.0\text{ million kg} - 9.0\text{ million kg} = 3.0\text{ million kg}$ of butter.

• Government Handling of Excess Supply:

  • Canadian Dairy Industry: Avoids systemic overproduction by issuing production quotas to producers; occasional surpluses are donated as foreign assistance.

  • European Union CAP: Government agencies buy up unwanted surpluses and store or destroy them; pay export subsidies to sell surplus products at a loss overseas; or pay farmers directly not to produce.

Minimum Wage as a Price Floor

• Labor Market Structure:

  • In labor markets, workers act as suppliers of labor and employers act as demanders of labor.

  • A minimum wage sets a price floor above the equilibrium wage rate ($W_e$).

• Graphical Analysis of Minimum Wage:

  • Market equilibrium wage rate: $W_e = \\text{8.50}$ per hour; Equilibrium employment quantity: $Q_e = 1,000,000$ workers ($1000\text{ thousand}$).

  • Legal minimum wage floor set at: $\\text{10.00}$ per hour.

  • At $\\text{10.00}$ per hour:

  • Labour supplied by workers = $1,200,000$ ($1200\text{ thousand}$).

  • Labour demanded by firms = $900,000$ ($900\text{ thousand}$).

  • Surplus of labor (unemployment) = $1,200,000 - 900,000 = 300,000$ workers ($300\text{ thousand}$).

• Canadian Minimum Wages by Province/Territory (as of July 1, 2014):

  • Alberta: $\\text{9.95}$

  • British Columbia: $\\text{10.25}$

  • Manitoba: $\\text{10.45}$

  • New Brunswick: $\\text{10.00}$

  • Northwest Territories: $\\text{10.00}$

  • Newfoundland and Labrador: $\\text{10.00}$

  • Nova Scotia: $\\text{10.40}$

  • Nunavut: $\\text{11.00}$

  • Ontario: $\\text{11.00}$

  • Prince Edward Island: $\\text{10.00}$

  • Quebec: $\\text{10.35}$

  • Saskatchewan: $\\text{10.00}$

  • Yukon: $\\text{10.72}$

How Price Floors Cause Inefficiency

• Inefficiently Low Quantity and Deadweight Loss:

  • Price floors reduce the quantity of the good demanded below the equilibrium level, reducing the total volume transacted and causing a deadweight loss of total economic surplus.

• Inefficient Allocation of Sales Among Sellers:

  • Sellers who are willing to supply the product at the lowest cost are not always the ones who get to sell.

  • In labor markets, workers willing to take jobs at lower pay rates remain unemployed while others secure job slots at minimum wage.

• Wasted Resources:

  • Government funds spent purchasing and storing or destroying surplus products waste public wealth.

  • Job-seekers waste excessive energy and time searching for scarce employment opportunities.

• Inefficiently High Quality:

  • Sellers offer goods with expensive high quality to attract buyers, even though buyers would prefer lower quality at a lower price.

  • Examples include luxury features added to agricultural goods or premium perks offered to customers when price competition is legally blocked.

• Temptation to Break the Law:

  • Persistent surpluses create incentives to circumvent the law through illegal arrangements, such as workers accepting under-the-table cash wages below the statutory minimum wage.

Summary Comparison: Ceilings, Floors, and Quantities

• Direction of Price Effect:

  • Price ceilings push prices downward relative to equilibrium.

  • Price floors push prices upward relative to equilibrium.

• Impact on Transacted Quantity:

  • Both binding price ceilings and binding price floors reduce the total quantity of goods bought and sold in the market.

• Determination of Transacted Quantity:

  • Shortage (Price Ceiling): Buyers want to purchase more than sellers are willing to supply ($Q_d > Q_s$). Because buyers cannot force unwilling sellers to supply goods, sellers determine the actual quantity transacted ($Q_{\text{transacted}} = Q_s$).

  • Surplus (Price Floor): Sellers want to supply more than buyers want to purchase ($Q_s > Q_d$). Because sellers cannot force unwilling buyers to purchase goods, buyers determine the actual quantity transacted ($Q_{\text{transacted}} = Q_d$).

Quantity Controls (Quotas)

• Definitions and Mechanics:

  • Quantity Control (Quota): An upper limit established by legal policy on the quantity of a good or service that can be bought or sold in a market.

  • Quota Limit: The exact maximum total amount of the good that can legally be transacted.

  • Licence: An official permit granted by the government that confers upon its owner the legal right to supply a unit of the good or service.

• Examples of Quantity Controls:

  • Taxi Medallion/Licence Systems: Mandated in cities like New York, Toronto, and Vancouver to cap taxi service capacity.

  • Lobster Fishing Licences: Issued in Atlantic Canada to prevent overfishing and protect marine resources.

• Market Dynamics in the Taxi Ride Market:

• Unregulated Taxi Market Schedule:

  • Fare of $\\text{7.00}$ per ride: Quantity demanded = $6\text{ million}$, Quantity supplied = $14\text{ million}$

  • Fare of $\\text{6.50}$ per ride: Quantity demanded = $7\text{ million}$, Quantity supplied = $13\text{ million}$

  • Fare of $\\text{6.00}$ per ride: Quantity demanded = $8\text{ million}$, Quantity supplied = $12\text{ million}$

  • Fare of $\\text{5.50}$ per ride: Quantity demanded = $9\text{ million}$, Quantity supplied = $11\text{ million}$

  • Fare of $\\text{5.00}$ per ride: Quantity demanded = $10\text{ million}$, Quantity supplied = $10\text{ million}$ (Equilibrium point $E$)

  • Fare of $\\text{4.50}$ per ride: Quantity demanded = $11\text{ million}$, Quantity supplied = $9\text{ million}$

  • Fare of $\\text{4.00}$ per ride: Quantity demanded = $12\text{ million}$, Quantity supplied = $8\text{ million}$

  • Fare of $\\text{3.50}$ per ride: Quantity demanded = $13\text{ million}$, Quantity supplied = $7\text{ million}$

  • Fare of $\\text{3.00}$ per ride: Quantity demanded = $14\text{ million}$, Quantity supplied = $6\text{ million}$

• Impact of Imposing a Quota Limit of $8\text{ million}$ Rides:

• Pricing Concepts Under Quantity Controls:

  • Demand Price: The exact price at which consumers demand the specific quota quantity. At $8\text{ million}$ rides, Demand Price = $\\text{6.00}$ per ride (point $A$).

  • Supply Price: The price at which producers are willing to supply the specific quota quantity. At $8\text{ million}$ rides, Supply Price = $\\text{4.00}$ per ride (point $B$).

• The Wedge and Quota Rent:

  • A quota drives a legal gap between the demand price and supply price at the quota limit.

  • Wedge (Quota Rent): The difference between the demand price and the supply price at the quota limit:     $\text{Quota Rent} = \text{Demand Price} - \text{Supply Price} = \\text{6.00} - \\text{4.00} = \\text{2.00}\text{ per ride}$

  • Economic Function of Quota Rent:

  • Quota rent represents the earnings that accrue to the licence-holder purely from holding the legal right to sell the good.

  • When licences are bought, sold, or leased in a competitive secondary market, the market price of the licence equals the value of the quota rent.

• Costs and Inefficiencies of Quantity Controls:

  • Deadweight Loss: Prevents mutually beneficial transactions between willing buyers (willing to pay up to $\\text{6.00}$) and willing suppliers (willing to supply for as low as $\\text{4.00}$) for quantities between $8\text{ million}$ and $10\text{ million}$ rides.

  • Incentives for Illegal Activity: Drivers operate unlicensed taxis or sell rides on black markets to capture unallocated consumer demand.

Case Study: The Lobsters of Atlantic Canada

• Industry Scope:

  • The Atlantic Canadian lobster fishery supports thousands of livelihoods across New Brunswick, Newfoundland and Labrador, Nova Scotia, Prince Edward Island, and Quebec.

  • Generated over $\\text{1 billion}$ in export sales in 2012.

• Market Shocks:

  • Softening US Demand: The United States imports $80\%$ of Canadian lobster exports; economic downturns in the US reduced seafood demand.

  • Currency Appreciation: Appreciation of the Canadian dollar (CAD) relative to the US dollar made Canadian lobster more expensive for foreign buyers, further reducing export demand.

• Economic Consequences:

  • Lobster prices dropped sharply from ranges of $\\text{9.00} - \\text{14.00}$ per kg in 2005 down to $\\text{7.15}$ per kg in 2014.

  • At $\\text{7.15}$ per kg, many fishers were unable to cover their operating costs.

• Status of Government Controls:

  • Commercial fishing licences impose quotas on catches.

  • Because market demand declined severely, market equilibrium volume fell below the quota limit. Consequently, the regulatory quota became non-binding.

  • Persistent low prices triggered calls from fishers for policy reforms, such as intentionally lowering legal catch quotas or opening new domestic and foreign markets to restore prices.