Chapter 5:

Price Controls and

Market Efficiency

Copyright © 2017 Pearson Canada Inc.

 Chapter Outline/Learning Objectives

Section Learning Objectives

After studying this chapter, you will be able to

5.1 Government- 1. describe how the presence of legislated price ceilings and
Controlled Prices price floors affect equilibrium price and quantity.

5.2 Rent Controls: 2. compare the short-run and long-run effects of legislated
A Case Study of rent controls.
Price Ceilings

5.3 An Introduction 3. describe the relationship between economic surplus and

to Market Efficiency the efficiency of a market.
4. explain why government interventions that cause prices to
deviate from their market-clearing levels tend to be
inefficient for society as a whole.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 2

 5.1 Government-Controlled Prices

Disequilibrium Prices
Voluntary market transactions require both a willing buyer and a
willing seller.

If the quantity demanded is less than quantity supplied, demand will

determine the amount actually exchanged.

If the quantity demanded exceeds quantity supplied, supply will

determine the amount actually exchanged.

In disequilibrium, the quantity exchanged is determined by the lesser

of quantity demanded and quantity supplied.
Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 3
 Fig. 5-1 The Determination of Quantity Exchanged in Disequilibrium

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 4

 Price Floors

Fig. 5-2 A Binding Price Floor

A price floor is the
minimum permissible
price that can be charged
for a particular good or
service.

A binding price floor

leads to excess supply.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 5

 Price Floors
A minimum wage is an example of a price floor in the labour market.

In a competitive labour market, a binding minimum wage reduces

the level of employment and increases the quantity of labour
services employed.

Unemployment increases.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 6

 Price Floors
The owners of firms are made worse off since they are now required
to pay a higher wage than before the minimum age was imposed.

Some workers gain because they keep their jobs and they earn a
higher wage rate.

Other workers lose because they lose their jobs as a result of the
wage increase.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 7

 Price Ceilings
Free markets with flexible prices eliminate excess demand by
allowing prices to rise.

A price ceiling is the maximum price at which certain goods and

services may be legally exchanged.

With a binding price ceiling some other method of allocation must be

adopted.

First-come, first-served results in buyers waiting hours to get into the

store, only to find that supplies are exhausted before they are
served.

A binding price ceiling usually gives rise to a black market.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 8

 Black Markets

Fig. 5-3 A Price Ceiling and Black-Market Pricing

A black market is a
situation in which
products are sold at
prices that violate a
legal price control.

Profit can be made

by buying at the
controlled price and
selling at the (illegal)
black-market price.
Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 9
 Price Ceilings
Three common goals that governments have when imposing price
ceilings are:

• To restrict production
• To keep specific prices down
• To satisfy notions of equity in the consumption of a product
that is temporarily in short supply

To the extent that binding price ceilings give rise to a black

market, it is likely that the government’s objectives motivating
the imposition of the price ceiling will be thwarted.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 10

 5.2 Rent Controls: A Case Study of Price Ceilings

The Predicted Effects of Rent Controls

Binding rent controls are a specific form of price ceiling, which have
the following effects:

• a shortage of rental housing because quantity demanded

exceeds quantity supplied
• alternative allocation schemes
• black markets will appear

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 11

 Who Gains and Who Loses?

Existing tenants in rent-controlled accommodations are the principal

gainers from a policy of rent control.

Landlords lose because they do not receive the rate of return they
expected on their investments.

Potential future tenants also suffer because the rental housing they
will require will not exist in the future.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 12

 Policy Alternatives

Housing shortages can be reduced if the government, at taxpayers'

expense either subsidizes housing production or produces public
housing directly.

The government can make housing more affordable to lower-income

households by providing income assistance directly to these
households.

Whatever policy is adopted has a resource cost.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 13

 5.3 An Introduction to Market Efficiency

The imposition of a controlled price generates benefits for some

individuals and costs for others.

Does a policy of legislated minimum wages make society as a whole

better off because it helps workers more than it harms firms?

Does a policy of rent controls make society as a whole better off

because it helps tenants more than it harms landlords?

Economists us the concept of market efficiency to address such

questions.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 14

 Demand as "Value" and Supply as "Cost"

The market demand curve for any product shows, for each possible
price, how much of that product consumers want to purchase.

We can turn it around by starting with any given quantity and asking
about the price.

The demand curve tells us the highest price that consumers are
willing to pay for a given unit.

For each unit of a product, the price on the market demand curve
shows the value to consumers from consuming that unit.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 15

 Demand as "Value" and Supply as "Cost"

The market supply curve for any product shows how much producers
want to sell at each possible price.

We can turn it around by starting with any given quantity and asking
about the price.

The supply curve tells us the lowest price that producers are willing
to accept for a given unit.

For each unit of a product, the price on the market curve supply
shows the lowest acceptable price to firms for selling that unit. This
lowest acceptable price reflects the additional cost to firms from
producing that unit.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 16

 Reinterpreting the Demand Curve

Fig. 5-5(i ) Reinterpreting the Demand Curve for Pizza

For each pizza, the price

on the demand curve shows
the value consumers receive
from consuming that pizza.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 17

 Reinterpreting the Supply Curve

Fig. 5-5(ii) Reinterpreting the Supply Curve for Pizza

For each pizza, the price

on the supply curve shows
the additional cost to firms
of producing that pizza.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 18

 Economic Surplus and Market Efficiency

Fig. 5-6 Economic Surplus in the Pizza Market

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 19

 Economic Surplus and Market Efficiency

Economic surplus—the area

below the demand curve
and above the supply
curve—is maximized at the
free-market equilibrium
quantity. Total economic
surplus is maximized.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 20

 Fig. 5-7 Market Inefficiency with Price Controls

Production falls from Q0 to

Q1.

With a free market, each

unit of output from Q0 to Q1
generates economic surplus.

The purple area shows the

deadweight loss, which is
the overall loss of economic
surplus to society of the
binding price floor.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 21

 Fig. 5-7 Market Inefficiency with Price Controls

Production falls from Q0 to Q2.

With a free market, each unit of

output from Q0 to Q2 generates
economic surplus.

The purple area shows the

deadweight loss, which is the
overall loss of economic surplus to
society of the binding price floor.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 22

 One Final Application: Output Quotas

Fig. 5-8 The Inefficiency of Output Quotas

An output quota restricts output

to Q1.

The shaded area shows the

reduction in overall economic
surplus—the deadweight loss—
created by the quota system.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 23

 A Cautionary Word

Why does the government intervene in otherwise free markets when

the outcome is inefficient?

The answer in many situations is that the government policy is

motivated by the desire to help a specific group of people.

The overall costs are deemed to be a worthwhile price to pay to

achieve the desired effect.

Policymakers are making normative judgements.

The job of the economist is undertake positive analysis, emphasizing

the actual effects of the policy rather than what might be desirable.

Copyright © 2017 Pearson Canada Inc. Chapter 5, Slide 24