econs 305 - market regulation · 2017-10-18 · minimum wage. many countries impose a minimum wage...

EconS 305 - Market Regulation

Eric Dunaway

Washington State University

[email protected]

September 2, 2015

Eric Dunaway (WSU) EconS 305 - Lecture 5 September 2, 2015 1 / 41

Introduction

Today, we�re going to pick back up with market equilibrium and talkabout a few regulatory activities that can keep it out of its naturalequilibrium.


Regulation

Why regulate?

When a market is shocked, it is possible that the new equilibrium pricecould be either much higher or much lower than what is perceived asfair. The government can then step in to protect groups that are beinghurt by the shock.It�s also possible that outside interest groups are able to lobby forregulation in order to increase their pro�ts.


Regulation

What�s fair?

Fairness is in the eye of the beholder.What one person perceives as fair may not be what anyone elseperceives as fair.For example, were I a meaner microeconomist, I might �nd it fair forme to have all of the wealth in society and nobody else to have any.Or maybe I would only �nd it fair that everyone has the same amountof wealth in society.

The point is that there are many di¤erent "fair" allocations in society.Those designing policy will choose which one they prefer the most.


Regulation

The primary method for a government to regulate a market is toimpose price controls.

These price controls can go either way. It may be in society�s interestto have a price either higher or lower than the market equilibrium.The government can also impose quantity controls, but we will not becovering those.

We commonly refer to these two types of price controls as either aprice ceiling or a price �oor, depending on which direction the pricegoes.


Price Ceiling

A price ceiling occurs when the governments sets a maximum pricefor a good, which we�ll call p̄.

If this p̄ is above the market equilibrium price, which we call p�, thenwe have nothing to worry about, since we�ll hit equilibrium before wehit the ceiling.If not, we�ll have a price that�s below the equilibrium price, which willlead to excess demand, or shortage.


Price Ceiling

p

q

D S

q*

p*


Price Ceiling

p

q

D S

q*

p*

p

qS qD


Price Ceiling

When do temporary price ceilings happen?

War. During both World War II and the Korean War, the Unitedstates instituted price controls as a balance to the necessary rationinggoing on.Disasters. After many natural disasters, people post photos ofbusinesses trying to sell bottled water (for example) for exorbitantprices. Price ceilings often are implemented to prevent this.Market Shocks. During the late 1970s, the Organization of PetroleumExporting Countries (OPEC) stopped selling to the United States. Thiscaused a sudden surge in gas prices. The Nixon administrationresponded by implementing price controls.


Price Ceiling

What about permanent price ceilings?

The most common type of permanent price ceiling in the United Statesis rent control. Property owners in several large cities are only allowedto charge p̄ for rent, which is below the market value in severallocations.In other countries, price ceilings are used for basic goods like food andwater in order to help the poor. (For Example, before the Arab Springbegan in Egypt, the price for a loaf of bread was about 4 cents, onethird of the market value).


Price Ceiling

Consequences of Price Ceilings

There will be a shortage of the good being o¤ered to the market.Arbitrage. It means that sometimes, a person who isn�t willing to payas much for an item will buy it, then resell it to someone who is willingto pay a lot more, keeping the pro�ts for themselves. Think of sportingevent ticket scalpers or Ebay auction snipers.When the price is arti�cially low, some consumers will arbitrage thegood in a black market, selling it at a higher price to those willing topay.


Price Ceiling Example

Let�s look at an example. Consider the following supply and demandfunctions:

qS = �2+ 2pqD = 10� p

when we solve for the equilibrium, we �nd an equilibrium quantity andprice of

q� = 6 p� = 4



p

q

D

S

10

1

4

6



We can also calculate our welfare levels that we learned from lasttime.

CS =12(pMAX � p�)q�

=12(10� 4)(6) = 18

PS =12(p� � pMIN )q�

=12(4� 1)(6) = 9

W = CS + PS = 27

As we can see, this market has $27 of surplus.



p

q

D

S

10

1

4

6

CS

PS



What would happen if we implemented a price ceiling of p̄ = 3?

In this case, we could expect the producers to supply less to themarket, while the consumers want to buy more than the equilibriumvalue. In fact, we can calculate the excess demand (shortage) in themarket using the supply and demand functions.

qS = �2+ 2p̄ = �2+ 2(3) = 4qD = 10� p̄ = 10� 3 = 7

Excess Demand = qS � qD = 7� 4 = 3

and three units of the good would not be provided to the market.



p

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3

74

Shortage



What about welfare?

We�re going to be dealing with dead weight loss due to the distortioncause by the price ceiling.What is it going to look like?



p

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74

CS

PS

DWL



Again, we can calculate our consumer and producer surpluses usingour area formulas from yesterday.

As a note, this time our consumer surplus is in the shape of atrapezoid. I didn�t provide an explicit formula for this shape yesterday,but it will follow from the same logic as the producer surplus trapezoid.Speci�cally,

CS =12(

b1z }| {hpMAX � p�

i+

b2z }| {[pD � pS ])q�

To (easily) �nd our second base, we�ll need to solve for the inversesupply and demand functions, which are

p = 1+12qS

p = 10� qD



Now, plugging in our new equilibrium quantity will give us values forpS and pD ,

pS = 1+12q� = 1+

12(4) = 3

pD = 10� q� = 10� 4 = 6

and putting all of these values into our consumer surplus yields

CS =12(pMAX � p� + pD � pS )q�

=12(10� 3+ 6� 3)(4) = 20



For producer surplus, we can just use our simple triangle formula,

PS =12(p� � pMIN )q�

=12(3� 1)(4) = 4

yielding a total welfare level of

W = CS + PS = 20+ 4 = 24

Recall a few slides back that the undistorted welfare level is 27. Thus,our dead weight loss is the di¤erence between the undistorted anddistorted welfare levels

DWL = 27� 24 = 3

and the cost of this price ceiling is $3 of market surplus.



How bad is the dead weight loss?

It depends. When the policymakers design a price ceiling like this, theyweigh the amount of dead weight loss created to the bene�t created bythe policy, itself.

In other words, having the economy lose $3 in surplus could be o¤setby consumers�perception of lower prices, leading to happy voters.

The key in designing a policy like this is to carefully weigh the costsand bene�ts.



One last note about our price ceiling example. Recall that theequilibrium price without a ceiling is

p� = 4

What would happen if we tried to implement a price ceiling of p̄ = 5?



Nothing!

Since the price ceiling is above our equilibrium price, the price ceilingwill not be binding and will have no e¤ect on the market.

Let�s look at the other type of price control: a price �oor.


Price Floor

The opposite of a price ceiling is a price �oor. This is when thegovernment sets a minimum price, p, that is above the market price,p�.

This leads to excess supply (or surplus), as the suppliers are providingmuch more to the market than the consumers demand.


Price Floor

p

q

D S

q*

p*


Price Floor

p

q

D S

q*

p*

p

qSqD


Price Floor

What are common types of price �oors?

Minimum wage. Many countries impose a minimum wage in the labormarkets. This is due to a belief that the market wage being o¤ered isinsu¢ cient for low wage earners. With the minimum wage, moreworkers will enter the market and less �rms will o¤er jobs, leading toan excess supply of workers, or unemployment. More about this on thenext slide.Agriculture Markets. Several governments subsidize farmers for theircrops, paying a price higher than the market price. This is to encouragemore growth and to keep food reserve levels high. (The majority of theexcess food is donated as aid to other countries.)


Minimum Wage

I want to make a comment on minimum wage.

Remember that this model is oversimpli�ed. In the real world, noteverything else is held constant.Politicians like to use the content on the last slide to argue thatminimum wage increases unemployment. This argument is incomplete.

Does a minimum wage increase unemployment?

In the academic literature, the results are not conclusive. It all dependson how the models are designed.


Labor Market Example

In fact, let�s talk about the labor market for a little bit.

The labor market behaves just like a market for good and services.The big di¤erence is that now the �rms are consumers of labor and theindividuals are the suppliers of labor.There exists an equilibrium price for labor (the wage) and anequilibrium amount of labor provided to the market.



Consider a labor market with the following supply and demand curves.

qD = 20� 2wqS = �4+ w

where w represents the wage rate (the same thing as price in a goodsmarket). The equilibrium wage and quantity of labor are

q� = 4 w � = 8

In this market, we would say that 4 units of labor (workers) areconsumed and they are paid a wage of 8.



w

q

D S10

4

8

4



What would happen if we instituted a minimum wage, w , in thismarket?

Holding everything else constant, the higher wage would induce ahigher quantity of labor supplied to the market by additional workersseeking jobs.At the same time, the higher wage would cause �rms to reduce theirquantity demanded of labor.This would result in a surplus of workers, or what we know asunemployment.



w

q

D S10

4

8

4

w

qSqD

Unemployment



We can also perform a welfare analysis to �nd out how much surplusthe workers and the �rms are obtaining from this market.

It is important to remember in this case that producer surplus belongsto the individuals supplying labor and consumer surplus belongs to the�rms.

This is the opposite of a goods market.



w

q

D S10

4

8

4

w

qSqD

CS

PS

DWL


Concluding Remarks on Supply and Demand

Supply and Demand are powerful economic tools.

When can we use Supply and Demand?

When Everyone is a Price Taker. This means that no one personhas enough power in the market to in�uence the price. This conditiongets broken under monopoly.When Firms sell Identical Products. Di¤erent products havedi¤erent markets. They might be related, but they are still di¤erent.When Everyone has Full Information. If people don�t knoweverything about the products in the market, they can be takenadvantage of. This is the most common violation of the Supply andDemand model.When Costs of Trading are Low. If it�s hard to make trades, it maynot be possible for sellers and buyers to get matched up.


Summary

It may be in society�s interest to regulate markets when externalshocks are perceived as unfair.

Regulation leads to dead weight loss, which must be taken intoconsideration when creating policy recommendations.


Preview for Friday

We�re almost done with the supply and demand model.

On Friday, we�re going to talk about elasticities, or how sensitivequantity is to changes in price or other factors.

Perlo¤, Chapter 3.

Homework is due on Friday and will be collected at the start ofclass!


Assignment 5

1. Let�s return to the labor market example with the following supplyand demand curves:

qD = 20� 2wqS = �4+ w

a. Suppose the government wanted to implement a minimum wage of w= 9. How many unemployed workers would there be?

b. Calculate the consumer surplus, producer surplus, welfare level, anddead weight loss for this market.

c. Is this minimum wage actually helping the workers? Explain. Hint:Look at the producer surplus from both the regulated and unregulatedmarkets.


econs 305 - market regulation · 2017-10-18 · minimum wage. many countries impose a minimum wage...

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