SUMMARY

chapter:
4

>> Market Strikes Back

Krugman/Wells

©2009  Worth Publishers 1 of 35

WHAT YOU WILL LEARN IN THIS CHAPTER:
 The meaning of price controls and quantity
controls, two kinds of government interventions in
markets.
 How price and quantity controls create problems
and can make a market inefficient.
 What deadweight loss is.
 Why the predictable side effects of intervention in
markets often lead economists to be skeptical of its
usefulness.
 Who benefits and who loses from market
interventions, and why they are used despite their
well-known problems.
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Why Governments Control Prices
 The market price moves to the level at which the
quantity supplied equals the quantity demanded. BUT
this equilibrium price does not necessarily please
either buyers or sellers.
 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.
 Price ceiling is the maximum price sellers are
allowed to charge for a good or service.
 Price floor is the minimum price buyers are required
to pay for a good or service.

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 Price Ceilings
 Price ceilings are 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.

 Examples:
 U.S. Government imposed ceilings on aluminum and
steel during World War II
 Rent control in New York

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The Market for Apartments in the Absence of
Government Controls

Monthly rent
(per apartment)
Quantity of apartments
S (millions)
$1,400 Monthly rent
(per apartment) Quantity Quantity
1,300 demanded supplied
1,200 $1,400 1.6 2.4
1,100
1,300 1.7 2.3
E 1,200 1.8 2.2
1,000
1,100 1.9 2.1
900 1,000 2.0 2.0
800 900 2.1 1.9
700
800 2.2 1.8
700 2.3 1.7
600
D 600 2.4 1.6

0 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4

Quantity of apartments (millions)

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The Effects of a Price Ceiling
Monthly rent (per
apartment)

S
$1,400

1,200

E
1,000
Price
ceiling
A B
800

Housing shortage of
400,000 apartments
600 caused by price
ceiling D

0 1.6 1.8 2.0 2.2 2.4

Quantity of apartments (millions)

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 How Price Ceilings Cause Inefficiency
 Inefficiently Low Quantity
 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
 Inefficient Allocation to Customers
 Wasted Resources
 Inefficiently Low Quality
 Black Markets

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A Price Ceiling Causes Inefficiently Low Quantity
Monthly rent
(per apartment)

Deadweight loss S
$1,400 from fall in number
of apartments rented

1,200

E
1,000
Price
ceiling
800

600 D

0 1.6 1.8 2.0 2.2 2.4

Quantity of apartments (millions)
Quantity Quantity supplied
supplied with without rent control
rent control

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 Winners and Losers from Rent Control

Monthly rent (per (a) Before Rent Control Monthly rent (b) After Rent Control
apartment) (per apartment)

Consumer
Consumer S surplus S
Consumer surplus
surplus transferred from
$1,400 $1,400
producers
1,200 1,200 Price
E E ceiling
1,000 1,000

800 800

600 600
Producer Producer Deadweight
surplus D surplus loss D

0 1.6 1.8 2.0 2.2 2.4 0 1.6 1.8 2.0 2.2 2.4

Quantity of apartments (millions) Quantity of apartments (millions)

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How Price Ceilings Cause Inefficiency
 Price ceilings often lead to inefficiency in the form of
inefficient 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.

 Price ceilings typically lead to inefficiency in the form of

wasted resources: people expend money, effort and time to
cope with the shortages caused by the price ceiling.

 Price ceilings often lead to inefficiency in that the goods

being offered are of inefficiently low quality: sellers offer
low-quality goods at a low price even though buyers would
prefer a higher quality at a higher price.
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How Price Ceilings Cause Inefficiency
 A black market is a market in which goods or
services are bought and sold illegally—either
because it is illegal to sell them at all or because
the prices charged are legally prohibited by a
price ceiling.

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 So Why Are There Price Ceilings?
Case: Rent Control in New York
 Price ceilings hurt most residents but give a small minority of
renters much cheaper housing than they would get in an
unregulated market (those who benefit from the controls are
typically better organized and more influential than those who
are harmed by them).

 When price ceilings have been in effect for a long time,

buyers may not have a realistic idea of what would happen
without them.

 Government officials often do not understand supply and

demand analysis!
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►ECONOMICS IN ACTION
Hard Shopping in Caracas
 Supermarket shopping in Caracas, Venezuela, is a bizarre
experience. Shelves are fully stocked with scotch whiskey
and imported cheese, but basic staples like black beans and
beef are often absent because of price controls.
 Since 1998, the president pursued policies favoring the poor
and working classes like price controls on basic foods such
as beans, chicken, sugar, etc.
 These policies in turn led to sporadic shortages, higher
spending by consumers and sharply rising prices for goods
whose prices were not controlled. There was an increase in
demand for price-controlled goods.
 On the other hand, a sharp decline in the value of
Venezuela’s currency led to a fall in imports of foreign foods.
The result was empty shelves in the nation’s food stores.
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Price Floors
 Sometimes governments intervene to push market
prices up instead of down.

 The minimum wage is a legal floor on the wage

rate, which is the market price of labor.

 Just like price ceilings, price floors are intended to

help some people but generate predictable and
undesirable side effects.

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 The Market for Butter in the Absence of
Government Controls
Quantity of butter
Price of butter (millions of pounds)
(per pound) Price of butter Quantity Quantity
(per pound) demanded supplied
$1.40 8.0 14.0
S
$1.40 $1.30 8.5 13.0
$1.20 9.0 12.0
1.30
$1.10 9.5 11.0
1.20 $1.00 10.0 10.0
$0.90 10.5 9.0
1.10
E $0.80 11.0 8.0
1.00 $0.70 11.5 7.0
0.90 $0.60 12.0 6.0

0.80

0.70

0.60
D

0 6 7 8 9 10 11 12 13 14
Quantity of butter (millions of pounds)
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The Effects of a Price Floor
Price of butter
(per pound)

S
$1.40 Butter surplus of 3 million
pounds caused by price
floor

1.20
A B

E Price floor
1.00

0.80

0.60 D

0 6 8 9 10 12 14

Quantity of butter (millions of pounds)

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How a Price Floor Causes Inefficiency
 The persistent surplus that results from a price floor
creates missed opportunities—inefficiencies—that
resemble those created by the shortage that results
from a price ceiling. These include:
 Deadweight loss from 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

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A Price Floor Causes Inefficiently Low Quantity
Price of butter (per
pound)

S
$1.40

1.20
Deadweight
loss E Price floor
1.00

0.80

0.60
D

0 6 8 9 10 12 14
Quantity of butter
(millions of pounds)
Quantity Quantity demanded
demanded with without price floor
price floor

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►ECONOMICS IN ACTION
“Black Labor” in Southern Europe
 Minimum wages in many European countries have been set
much higher than in the United States.
 The persistent surplus that results from this price floor
appears in the form of high unemployment.
 In countries where enforcement of labor law is lax, it results
in widespread evasion of the law.
 In Italy and Spain, workers are employed by companies that
pay them less than the minimum wage and fail to provide
health care and retirement benefits. Many jobs also go
unreported.
 In fact, Spaniards waiting to collect checks from the
unemployment office have been known to complain about
the long lines that keep them from getting back to work!

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Controlling Quantities
 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. An example is
the taxi medallion system in New York.
 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.

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 The Market for Taxi Rides in the Absence of
Government Controls
Quantity of rides
Fare
(per ride) (millions per year)
Fare Quantity Quantity
(per ride) demanded supplied
S
$7.00 $7.00 6 14
6.50 $6.50 7 13
$6.00 8 12
6.00
$5.50 9 11
5.50 E
$5.00 10 10
5.00
$4.50 11 9
4.50
$4.00 12 8
4.00
$3.50 13 7
3.50
$3.00 14 6
3.00 D

0 6 7 8 9 10 11 12 13 14
Quantity of rides (millions per year)

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Effect of a Quota on the Market for Taxi Rides
Fare Quantity of rides
(per ride) (millions per year)
Fare Quantity Quantity
(per ride) demanded supplied
Deadweight loss S
$7.00 $7.00 6 14
6.50 $6.50 7 13
A
6.00 $6.00 8 12
The
5.50 “wedge” E $5.50 9 11
5.00 $5.00 10 10
4.50 $4.50 11 9
4.00 $4.00 12 8
B
3.50 $3.50 13 7
3.00 D $3.00 14 6
Quota

0 6 7 8 9 10 11 12 13 14

Quantity of rides (millions per year)

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The Anatomy of Quantity Controls
 A 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.

 The difference between the demand and 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. It is equal
to the market price of the license when the
licenses are traded.

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 The Costs of Quantity Controls
 Deadweight loss because some mutually
beneficial transactions don’t occur.

 Incentives for illegal activities.

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SUMMARY

1. 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.
2. A price ceiling, a maximum market price below the
equilibrium 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. It also encourages illegal activity as
people turn to black markets to get the good.

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SUMMARY

3. A price floor, a minimum market price above the

equilibrium 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. The most well-known
kind of price floor is the minimum wage, but price floors
are also commonly applied to agricultural products.

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SUMMARY

4. 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.

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The End of Chapter 5

Coming attraction:
Chapter 6:
Elasticity

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