THIRD EDITION

ECONOMICS
and

MICROECONO
MICS
Paul Krugman | Robin
Wells

Chapter 5
Price Controls and Quotas: Meddling with
Markets

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.
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.

Why Do Governments Control

Prices?
The market price moves to the level at which
the quantity supplied equals the quantity
demanded (i.e. to the equilibrium price).
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.
A price ceiling is the maximum price sellers are
legally allowed to charge for a good or service.
A price floor is the minimum price buyers are
legally required to pay for a good or service.

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:
The U.S. government imposed ceilings on
aluminum and steel during World War II.
The classic example: rent controls in New York City.

Price Ceilings

The Market for Apartments in the Absence of

Government Controls
Monthly rent
(per apartment)
S

$1,400
1,300
1,200
1,100
1,000

900
800
700
600

Monthly
rent (per
apartment)

Quantity of apartments
(millions)
Quantity
demanded

$1,400
1,300
1,200
1,100
1,000
900
800
700
600

1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4

Quantity of apartments (millions)

NOTE: Here we are making the simplifying assumption that all
apartments are the same.

1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4

Quantit
y
supplie
2.4
d
2.3
2.2
2.1
2.0
1.9
1.8
1.7
1.6

The Effects of a Price Ceiling

Monthly rent
(per
apartment)
S

$1,400

1,200
E
1,000
A

800

Housing shortage
of 400,000
apartments caused
by price ceiling

600

1.6

1.8

2.0

Price
ceiling

2.2
2.4
Quantity of apartments (millions)

The Effects of a Price Ceiling

Monthly rent
(per
apartment)
$1,400

If the price ceiling is set higher than the

equilibrium price, it is said to be nonbinding, and has no distortionary effect on
the market.
S

1,200
E
1,000

Price
ceiling

800

600

1.6

1.8

2.0

2.2
2.4
Quantity of apartments (millions)

How Price Ceilings Cause

Inefficiency
Inefficiently low quantity
Inefficient allocation to customers
Wasted resources
Inefficiently low quality
Black markets

KEY INTUITION:
Sometimes policies
that are politically
attractive are not
necessarily
economically efficient
this is particularly true
in the case of price
controls.
It is important to fully
under-stand the tradeoffs when deciding
whether to support or

A Price Ceiling Causes Inefficiently

Low Quantity
Monthly rent
(per
apartment)

Market equilibrium without a price

ceiling:
S

$1,400

1,200

Consumer
Surplus

1,000

800

Equilibrium
Price

Producer
Surplus

600

1.6

1.8

2.0

2.2

Equilibrium
Quantity

2.4
Quantity of apartments
(millions)

A Price Ceiling Causes Inefficiently

Low Quantity
Monthly rent
(per
apartment)
$1,400

With a price ceiling that is below the

equilibrium price, the amount bought
and sold in the market is defined by
S
the quantity supplied.

1,200
E

1,000

800

Price
ceilin
g

600

1.6

1.8

Quantity
supplied
with rent
control

2.0

2.2

Equilibrium
quantity

The efficient
quantity bought and
sold would be the
equilibrium quantity
at the equilibrium
price, but with a
price ceiling there
are many mutually
beneficial trades
that do not occur.
Many buyers who
would be willing to
pay more than $800
are unable to find
apartments to rent.

2.4
Quantity of apartments
(millions)

A Price Ceiling Causes Inefficiently

Low Quantity
Monthly rent
(per
apartment)

Effects on consumer surplus and

producer surplus:
S

$1,400

1,200

Consumer
Surplus

1,000

800

Price
ceilin
g
Producer
Surplus

600

1.6

1.8

Quantity
supplied
with rent
control

2.0

2.2

Equilibrium
quantity

Landlords are paid a

lower price, so those
who stay in the
market lose some
producer surplus.
Those consumers
who are able to find
apartments enjoy
greater consumer
surplus, but the
shortage of
apartments at the
capped price means
many consumers are
left out in the cold
literally, in this case.

2.4
Quantity of apartments
(millions)

A Price Ceiling Causes Inefficiently

Low Quantity
Monthly rent
(per
apartment)

Effects on consumer surplus and

producer surplus:
S

$1,400

1,200
Economic
surplus
transferred
from
producers to
consumers

Consumer
Surplus

1,000

800

Price
ceilin
g
Producer
Surplus

600

1.6

1.8

Quantity
supplied
with rent
control

2.0

2.2

Equilibrium
quantity

Landlords are paid a

lower price, so those
who stay in the
market lose some
producer surplus.
Those consumers
who are able to find
apartments enjoy
greater consumer
surplus, but the
shortage of
apartments at the
capped price means
many consumers are
left out in the cold
literally, in this case.

2.4
Quantity of apartments
(millions)

A Price Ceiling Causes Inefficiently

Low Quantity
Monthly rent
(per
apartment)

Effects on consumer surplus and

producer surplus:
S

$1,400
Deadweig
ht
loss

1,200

1,000

800

Consumer
Surplus

E
Price
ceilin
g

Producer
Surplus

600

1.6

1.8

Quantity
supplied
with rent
control

2.0

2.2

Equilibrium
quantity

Deadweight loss is
the loss in total
economic surplus
that occurs
whenever an action
or policy reduces the
quantity transacted
below the efficient
market equilibrium
quantity.

2.4
Quantity of apartments
(millions)

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 dont 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.

How Price Ceilings Cause

Inefficiency
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.
A black market is a market in which goods or
services are bought and sold illegallyeither
because it is illegal to sell them at all or because
the prices charged are legally prohibited by a
price ceiling.

Example Problem
Look at the supply-demand model for
economics textbooks. At a price
ceiling of $40, the market outcome
would be a _____ of _____ textbooks.
a.
b.
c.
d.

surplus; 30
surplus; 10
shortage; 30
shortage; 10

Calculate the deadweight loss in this

market of imposing a price ceiling of
$40.
0.5 x ($100 - $40) x (30 -10) =
$600

Price Floors
Sometimes governments intervene to keep
market prices up instead of down.
The minimum wage is a legal floor on the wage
rate, which is the market price of labor.
Historically, price floors have often been
implemented in agricultural markets, to keep the
prices of various crops artificially high.

Just like price ceilings, price floors are intended

to help some people but generate predictable
and undesirable side effects.

The Market for Butter in the Absence of

Government Controls
Quantity of butter
Price of butter (millions of pounds)
(per pound)
Quantity
Quantit
demande
y
d
supplie
$1.40
8.0
14.0
S
d
$1.30
8.5
13.0
$1.20
9.0
12.0
$1.10
9.5
11.0
$1.00
10.0
10.0
$0.90
10.5
9.0
$0.80
11.0
8.0
$0.70
11.5
7.0
$0.60
12.0
6.0

Price of
butter
(per pound)

$1.40
1.30
1.20
1.10

1.00
0.90
0.80
0.70
0.60

10

11

12

13 14

Quantity of butter (millions of pounds)

The Effects of a Price Floor

Price of
butter (per
pound)
Butter surplus of 3
million pounds
caused by price floor

$1.40

1.20

B
Price
floor

E
1.00

0.80

0.60

10

12

14

Quantity of butter (millions of pounds)

The Effects of a Price Floor

Price of
butter (per
pound)

If the price floor is set below the equilibrium

price, it is non-binding, and has no
distortionary effect on the market.

$1.40

1.20
E
1.00

Price
floor

0.80

0.60

10

12

14

Quantity of butter (millions of pounds)

How a Price Floor Causes

Inefficiency
The persistent surplus that results from a price
floor creates missed opportunitiesinefficiencies
that resemble those created by the shortage that
results from a price ceiling.
These include:

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

A Price Floor Causes Inefficiently

Low Quantity
Price of butter
(per pound)

Market equilibrium without a price

floor:
S

$1.40

1.20

Consumer
Surplus
E

1.00

0.80

Equilibrium
price

Producer
Surplus

0.60

10

12

Equilibrium
quantity

14

Quantity of butter
(millions of
pounds)

A Price Floor Causes Inefficiently

Low Quantity
Price of butter
(per pound)
$1.40

With a price floor that is above the

equilibrium price, the amount bought
and sold in the market is defined by
the quantity demanded.
S

1.20
Price
floor

1.00

0.80

0.60

8
Quantity
demanded
with price
floor

10

12

Quantity
demanded
without price
floor

14

The efficient
quantity bought
and sold would be
the equilibrium
quantity at the
equilibrium price,
but with a price
floor there are
many mutually
beneficial trades
that do
not occur.
Many
sellers
who
would be willing to
sell for less than
$1.20 cannot find
buyers at the
artificially high
price.
Quantity of butter
(millions of
pounds)

A Price Floor Causes Inefficiently

Low Quantity
Price of butter
(per pound)
$1.40

Effects on consumer surplus and

producer surplus:
S
Consumer
Surplus

1.20
Price
floor

1.00
Producer
Surplus
0.80

0.60

8
Quantity
demanded
with price
floor

10

12

Equilibrium
quantity

14

Consumers pay a
higher price, so
those who stay in
the market lose
some consumer
surplus.
Those sellers who
are able to sell
their output are
paid a higher price
and gain some
producer surplus,
but the excess
production in the
market means
many sellers do
not find a buyer.
Quantity of butter
(millions of
pounds)

A Price Floor Causes Inefficiently

Low Quantity
Price of butter
(per pound)
$1.40
Economic
surplus
1.20
transferred
from
consumers 1.00
to producers

Effects on consumer surplus and

producer surplus:
S
Consumer
Surplus

Price
floor

E
Producer
Surplus

0.80

0.60

8
Quantity
demanded
with price
floor

10

12

Equilibrium
quantity

14

Consumers pay a
higher price, so
those who stay in
the market lose
some consumer
surplus.
Those sellers who
are able to sell
their output are
paid a higher price
and gain some
producer surplus,
but the excess
production in the
market means
many sellers do
not find a buyer.
Quantity of butter
(millions of
pounds)

A Price Floor Causes Inefficiently

Low Quantity
Price of butter
(per pound)
$1.40

Deadweight loss resulting from the

price floor:
S

Deadweig
ht
loss

Consumer
Surplus

1.20

Price
floor

1.00
Producer
Surplus
0.80

0.60

8
Quantity
demanded
with price
floor

10

12

Equilibrium
quantity

14

Here also,
deadweight loss
occursa portion
total economic
surplus is lost
because the quantity
transacted is below
the efficient market
equilibrium quantity.
Quantity of butter
(millions of
pounds)

How a Price Floor Causes

Inefficiency
Price floors lead to inefficient allocation of
sales among sellers: those who would be
willing to sell the good at the lowest price are
not always those who actually manage to sell it.
Price floors often lead to inefficiency in that
goods of inefficiently high quality are
offered: sellers offer high-quality goods at a high
price, even though buyers would prefer a lower
quality at a lower price.

Example Problem

Based on the information given in the table, if the

government imposes a price floor of $0.90 per pound of
butter, the quantity of butter actually bought and sold will
be _____ million pounds.
a.
b.
c.
d.

10.5
9.0
1.5
10.0

SUMMARY of Price Controls

A price ceiling keeps the price of a good down.
price ceiling maximum allowed price

A price floor keeps the price of a good up.

price floor minimum allowed price

Both reduce the quantity bought and sold.

If the ceiling is below the equilibrium price:
Sellers wont want to sell as much as buyers want
to buy shortage.
If the floor is above the equilibrium price: Buyers
wont want to buy as much as sellers want to sell
surplus.

GLOBAL COMPARISON: Low

Wages (2011)

ECONOMICS IN ACTION
So what conclusions can we draw about the
minimum wage?

Many politicians argue for higher minimum wages in

the U.S.
Minimum wages in many European countries have
been set much higher than in the United States.
Some economists argue that the persistent high
unemployment rates in European countries are a
European
result of labor surpluses from
high minimum wages.
unemployment rates
Oct. 2013

ECONOMICS IN ACTION
So what conclusions can we draw about the minimum
wage?
While it is true that the basic model of a competitive labor
market says a minimum wage should reduce employment
for low-skilled workers, a number of empirical studies
have found that increases in the minimum wage have
NOT led to statistically significant reductions in
employment.
In their book, Myths and Measurement, economists David
Card and Alan Kreuger explain a number of reasons why
this might be the case.
One reason is that in many cases, minimum wage labor
markets may not be perfectly competitive among
employers.
Some firms have monopsony power that allows them to
attract workers based on non-wage characteristics, paying
them lower wages.1
For example, think of a small town with only one fast food
restaurant (although there are other non-wage

Controlling Quantities
A quantity control, or quota, is an upper limit
on the quantity of some good that can be bought
or sold.
There are different reasons why a government
might set a quota on a specific good or service.

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.
Licensing is an indirect way to control quantity.
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

The Market for Taxi Rides in the Absence of

Government Controls
Fare
(per ride)

Fare
(per ride)
S

$7.00
6.50
6.00
5.50

5.00
4.50
4.00
3.50
3.00

$7.00

$6.50

Quantit
y
supplie
14
d
13

$6.00

12

$5.50

11

$5.00

10

10

$4.50

11

$4.00

12

$3.50

13

$3.00

14

Quantity of rides
(millions per year)

9 10 11 12 13 14
Quantity of rides (millions per year)

Quantity
demanded

Effect of a Quota on the Market for

Taxi Rides

Fare
(per ride)

Fare
(per ride)
$7.00

Quantity
demande
6d

$6.50

Quantit
y
supplie
14
d
13

$6.00

12

$5.50

11

$5.00

10

10

$4.50

11

$4.00

12

$3.50

13

$3.00

14

S
$7.00
6.50
6.00
5.50
5.00

A
The
wedge

4.50
4.00

3.50
3.00

Quota

10

11

12

13

Quantity of rides
(millions per year)

14

Quantity of rides (millions per year)

Effect of a Quota on the Market

for Taxi Rides

As with a price control, a quota will result in

deadweight loss.
Fill in the blanks: With a quota, some economic
consum from
produc
surplus is transferred
________ to ________.
ers

ers

The Consequences 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 what sellers would be
willing to accept.
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.

Some mutually beneficial transactions dont

occur.
There are incentives for illegal activities.

ECONOMICS IN ACTION
The Clams of Jersey Shore

In the 1980s, excessive fishing threatened to wipe

out New Jerseys clam beds.
To save the resource, the U.S. government
introduced a clam quota, which set an overall limit
on the number of bushels of clams to be caught and
allocated licenses to owners of fishing boats based
on their history of catches.

ECONOMICS IN ACTION
The Cap and Trade System

The cap and trade (a.k.a. tradable permits) system

is an economic mechanism to control emissions
based on quota limits.
The government creates a market for emissions by
allocating to firms permits to generate emissions,
but sets a limit on the total number of permits (and
thus the amount of pollution).
Firms can then trade permits, ensuring that the
permit market allocates permits to the firms that
value them most (which are the firms that have the
highest cost of reducing emissions).
Firms with low costs of reducing emissions would
rather just reduce their emissions than pay for
permits.
The result is that emissions are constrained to the
amount associated with the permit limit.

ECONOMICS IN ACTION
The Cap and Trade System

Permit
Price,
$

Permit
Limit
Supply
of
Permits

Demand
for Permits

Emissio
ns
Permits

ECONOMICS IN ACTION
The Cap and Trade System

The Clean Air Act was amended in 1990 to include

reduction targets for sulphur dioxide (SO2)
emissions, which are the primary cause of acid
rain.
In Phase 1 of the plan, individual emissions limits
were assigned to the 263 largest SO2 emitters east
of the Mississippi Riverall were coal-fired power
plants.
The EPA allocated permits to each plant based on
coal usage over the period 1985-1987.
After January 1, 1995, plants could emit SO2 only if
they had enough permits to cover their emissions.
Phase 2 of the program brought all fossil-fuel
electricity plants into the system.

ECONOMICS IN ACTION
The Cap and Trade System

The SO2 permit trading system successfully reduced

emissions to target levels.
The total costs of reducing emissions to the target
levels were found to have been lower than what
would have occurred under alternative systems.
By creating a market for emissions and then setting
quota limits on that market, the EPA was able to
achieve a positive environmental outcome at the
lowest possible economic cost.

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
consisting of various forms of inefficiency and
illegal activity.
2. A price ceiling, a maximum market price
below the equilibrium price, benefits successful
buyers but creates persistent shortages.
3. If the price is maintained below the equilibrium
price
a. The quantity demanded is greater than the
quantity supplied a shortage occurs.
b. The quantity supplied is less than the

SUMMARY
4. This leads to inefficiently low quantity,
inefficient allocation to consumers,
wasted resources, and inefficiently low
quality.

Also encourages illegal activity as people turn to

black markets to get the good.

5. A price floor, a minimum market price above

the equilibrium price, benefits successful
sellers but creates persistent surplus.
6. Price floors lead to inefficiencies in the form of
inefficiently low quantity, inefficient
allocation of sales among sellers, wasted
resources, and inefficiently high quality.

Also encourages illegal activity and black

markets.

SUMMARY
7. The most well-known price floor is the
minimum wage, but price floors are also
commonly applied to agricultural products.
8. 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.
9. The government may issue licenses to
individuals, the right to sell a given quantity of
the good.
10.Economists say that a quota drives a wedge
between the demand price and the supply
price; this wedge is equal to the quota rent.
11.Quantity controls encourage illegal activity.

KEY TERMS

Price controls
Price ceiling
Price floor
Inefficient allocation to consumers
Wasted resources
Inefficiently low quality
Black markets
Minimum wage
Inefficient allocation of sales among sellers
Inefficiently high quality
Quantity control
Quota
Quota limit