ECON 208 Chapter Notes - Chapter 5: Demand Curve, Deadweight Loss, Efficient-Market Hypothesis

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Chapter 5 - Markets in Action
Interaction among markets:
- Individual markets don’t exist in isolation
- Changes in one market affect other markets (feedback)
- partial-equilibrium analysis: analysis of a single market in isolation, ignoring
any feedbacks that may come from induced changes in other markets
- general-equilibrium analysis: analysis of all the economy’s markets
simultaneously, recognizing different markets’ interactions
- Small markets won’t cause major effects on other markets (use partial
Government controlled prices:
- Governments sometimes fix the price that a product must be sold/bought in
the domestic market (i.e. MA water crisis in Boston, May 2010)
- In free markets: equilibrium price equates quantity demanded and quantity
- Government price controls are policies that attempt to hold the price at a
disequilibrium value
- Some controls hold the market price below its equilibrium value to create a
shortage at the controlled price
- Some controls hold the market price above its equilibrium value to create a
surplus at the controlled price
Disequilibrium prices:
- what determines the quantity actually traded on the market?
- determining is irrelevant in a free market because supply/demand are self-
- any voluntary market transaction requires a willing buyer and a willing seller
- if QD < QS, demand will determine the amount actually exchanged and the rest of
the unsold commodities will remain with the unsuccessful suppliers
- if QD > QS, supply will determine the amount actually exchanged, the rest of the
demand will represent unsatisfied demand of would-be buyers
- at any disequilibrium price, quantity exchanged is determined by the less of the QD
or QS
Price floors:
- minimum permissible price that can be charged for a particular good or service
- seen with minimum wage and agriculture (disadvantages: government has to pay
for storage of goods, more unemployment)
- one set at/below the equilibrium price has no effect because the free-market
equilibrium remains attainable
- if the price floor is set above the equilibrium it will raise the price (aka binding)
- may make it illegal to sell the product below the prescribed price (i.e. minimum
- government may establish a price floor by guaranteeing to buy excess supply
- binding price floors lead to excess supply
- there will be unsold surplus whereby usually the government will have to purchase
- consequences of excess supply differ from product to product:
- min. wage: excess supply = unemployed people
- non-perishable foods: storage needed to house surplus
- consequences may or may not be worthwhile
- still inevitable in a competitive market whenever a price floor is set above the
equilibrium price
- why governments want to incur the consequences:
- people who succeed in selling products at the price floor are better off than if
they had to accept the lower equilibrium price
- when demand is inelastic producers earn more income, the losses are spread
across the large and diverse set of purchasers
Price ceilings:
- maximum price at which certain goods and services may be exchanged
- see with oil, natural gas, and rent (disadvantage: excess demand, allocate excess
with first-come-first-serve basis)
- if the ceiling is set above the equilibrium price it has no effect because free market
equilibrium remains attainable
- if its set below the free market equilibrium, the price is lowered (aka binding)
- binding prices lead to excess demand with the quantity exchanged less than in the
free market equilibrium
- allocating a product in excess demand:
- prices cannot rise to eliminate excess demand with binding prices
- when sellers decide to whom they will and will not sell their scarce supplies to,
allocation = sellers’ preferences
- if the government dislikes this allocation it can chose to ration the product,
prints ration coupons to match the quantity supplied at the price ceiling and
distributes the coupons (equally or to a category of people)
- minimum wages and unemployment:
- employment = x-axis
- hourly wage rate = y-axis
- without government implemented min. wage: equilibrium is at point w0, e0
- with a min. wage that’s greater than w0 (wage increases): unemployment
- unemployment = area above equilibrium point
- minimum wage reduces employment and increases labor supply
- minimum wages causes firms to be worse off because they have to pay
higher wages
- the workers that keep their jobs are better off
- black markets:
- price ceilings give rise to them
- where products are sold illegally at prices that violate the legal price control
- do black markets defeat the goals of the price ceiling? Depends on what
government goals are:
1. Restrict production (i.e. use resources for something else)
2. Keep specific prices down
3. Satisfy notions of equity in the consumption of a product that is temporarily in
short supply
Rent controls: case study on price ceilings
- predicted effects of rent controls:
- housing shortage: QD > QS, rents are held below their free market levels,
available quantity of rental housing will be less than if free market rents had
been charged
short-run: limited shortage, inelastic supply
long-run: dramatic shortage, elastic supply
- shortage will lead to alternative allocation schemes (landlord or government
- black markets will occur
- rent controls are applied to a highly durable good that provides services to
consumers for long periods
- immediate effects of rent control are typically quite different from long-term
- short-run and long-run effects of legislated rent controls:
- housing shortages worsen
- controlled rent forces rent below free market equilibrium
- short-run supply of housing is inelastic
- long-run supply of housing is elastic
- government interventions that cause prices to deviate from equilibrium are
- who gains and who loses:
- existing tenants in rent-controlled accommodations are the gainers
- landlords lose because they don’t get the rate of return they expected
- potential future tenants also suffer
- policy alternatives
1. shortages can be reduced if the government subsidize housing production
(with tax payers $) or produces public housing
2. government can provide lower income households with income assistance
(i.e. welfare)
- however every new policy involves a resource cost (usually transferring the
cost from one person to another)
Intro to market efficiency
- imposition of controlled prices generates benefits for some and costs for