FACT: Interference in Markets has Consequences
Example
Iraq 2003: gas prices are frozen at $0.05 per gallon. Mass shortages ensue.
FACT: distorted price signals cause resources to be misallocated
If prices are distorted, they cannot give good information to buyers and sellers
Price Controls (2 types)
legal restrictions on how high or low a market price may go
(1) price ceiling
(2) price floor
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
Price Ceilings cause inefficiency and predictable side effects such as:
- inefficiently low quantity
- inefficient allocation to customers
- wasted resources
- inefficiently low quality
- black markets
Non-binding Price Ceiling
if a price ceiling is set above equilibrium, it will have no effect
Binding/Effective Price Ceiling
only a price ceiling that forces price below equilibrium will have any effect
Inefficiently Low Quantity
- how are shortages created?
When prices are held below the market price......
The lower the controlled price relative to the market equilibrium price, the larger the shortage
Inefficient Allocation to Customers
- how are goods misallocated?
- 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
- so producers have no incentive to supply the good to the "right" people first
Wasted Resoucres
- 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 & favors)
Inefficiently Low Quality
- at the controlled price, sellers have more customers than good
- 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 t
1. reduce quality
2. reduce service
Black Markets
(define)
a market in which goods or services are bought and sold illegally ----- either because they are prohibited or because the equilibrium price 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 Floors
sometimes governments intervene to push market prices up instead of down
(the generous minimum wage in many European countries has contributed to a high rate of unemployment and the flourishing of an illegal labor market)
non-binding Price Floors
if a price floor is set below equilibrium, it will have no effect
binding/effective price floor
only a price floor that forces price above equilibrium will have any effect
How a Price Floor Causes Inefficiency
* price floors cause predictable side effects:
- inefficiently low quantity
- inefficient allocation of sales among sellers
- wasted resources
- inefficiently high quality
- temptation to break the law by selling below the legal price
How do price floors misallocate sales?
- allowing high-cost firms to operate
- preventing low-cost firms from entering the industry
Wasted Resources (price floors)
- price floors encourage waste
Inefficiently High Quality (price floors)
- higher quality raises costs and reduces sellers' profits
- buyers get higher quality but would prefer a lower price
fact
Price floors encourage sellers to waste resources: higher quality than buyers are willing to pay for
Illegal Activity (price floors)
- price floors encourage black markets
- willing sellers (and buyers) at illegal prices, so they are tempted to break the law and trade with each other
Which is NOT an inefficiency caused by price floors?
A. inefficiently low quality
B. wasted resources
C. illegal activity
D. inefficient allocation of sales among sellers
A. inefficiently low quality
WHY ARE THERE PRICE FLOORS???
* they do benefit some people (who are typically better organized and more vocal than those who are harmed by them)
- if the price floor 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
Controlling Quantities
* governments sometimes control quantity instead of price
quota, quota limits, license
Quota (quantity control)
an upper limit, set by the government, on the quantity of some good that can be bought or sold
Quota limit
the total amount of a good under a quota or quantity control that can be legally transacted
License
the right, conferred by the government, to supply a good
The Costs of Quantity Controls
* like price controls, quotas impose losses on society....
- some mutually beneficially transactions don't occur
- incentives for illegal activities