ECON A1001 AEF/A121F

Tutorial Notes (Topic 5 Ch 7)

Government Actions in Markets
Outline
• Price Ceilings • Price Supports in Agriculture
• Rent Ceiling • How Governments Intervene
• Are Rent Ceilings in Markets for Farm Products
Efficient? • Price Support: An Illustration
• Are Rent Ceilings Fair? • Is the Price Support Efficient?
• Price Floors • Effects on the Rest of the
• The Minimum Wage World
• Is the Minimum Wage • Discussion Questions
Efficient?
• Is the Minimum Wage
Fair?
Price Ceilings
• A price ceiling or price cap is a
government regulation that places an
upper limit on the price at which a
particular good, service, or factor of
production may be traded.
• In other words, the price charged
cannot rise above this price cap
• Example : a rent ceiling
• Trading above the price ceiling is
illegal.
• To be legally binding : a rent ceiling
must be below the market rent
• A rent ceiling above the market rent
will have NO binding effect
Are Rent Ceilings Efficient? Figure 1
• A binding (effective) rent ceiling will result in a
shortage
• Recall : a shortage arises when
Quantity Demanded > Quantity Supplied
• See Figure 1
• At the binding rent ceiling of $400 :
• Quantity demanded = 400 homes
• Quantity supplied = 200 homes
• Quantity demanded > Quantity supplied Rent Ceiling
• Shortage
= Quantity Demanded – Quantity Supplied
= 400 – 200 = 200
Are Rent Ceilings Efficient?
Figure 1
• Note that a binding rent ceiling creates market
inefficiency
• Why?
• Reason :
• Due to the rent ceiling : renters can only rent 200
homes although they would like to rent 400 homes
⚫ MB
• At 200 homes rented : MB = $800; whereas MC =
$400  MB > MC A
Rent
• This will create deadweight loss B ceiling
• Deadweight loss = ½ x $400 x 100 = $20,000 = $400
• Note that the efficient quantity of rented homes
⚫ MC
= 300
• At 200 homes (with rent ceiling)  underproduction and the
resultant deadweight loss (ie. triangle A & B)
• Total surplus—the sum of producer surplus and consumer
surplus—shrinks and a deadweight loss arises.
Are Rent Ceilings Efficient?
• Note too that the binding rent ceiling may lead
to :
• Black markets – market price may be
anywhere between $400 and $800
• A black market is an illegal market that
operates alongside a government-
regulated market.
• Increased search activity
• Search activity is the time spent looking
for someone with whom to do business.
• People who can’t find housing and landlords
who can’t offer housing at a lower rent lose.
Are Rent Ceilings Fair?
• Are the rules fair?
• Recall :
• Harvard philosopher, Robert Nozick, in
Anarchy, State, and Utopia (1974), argues
that the rules must be fair and must
respect two principles
• The state must enforce laws that
establish and protect private property.
• Private property may be transferred from
one person to another only by voluntary
exchange.
• Rent controls violate the fair rules view of
fairness because they block voluntary
exchange.
Are Rent Ceilings Fair?
• Are the results fair?
• Does blocking rent adjustments avoid scarcity?
• When the law prevents the rent from
adjusting and blocks the price mechanism
from allocating scarce housing – other
allocation mechanism must be used.
• If that mechanism were one that provided the
housing to the poorest, then the allocation
might be regarded as fair.
• However, mechanisms used seldom achieve
such outcomes
• Some mechanisms include : first-come, first-
served, discrimination based on race, ethnicity, or
sex, etc.; which do not deliver a fair outcome Bloomberg, Sept. 13, 2018
Price Floors
• A price floor is a government
regulation that places a lower limit
on the price at which a particular
good, service, or factor of
production may be traded.
• In other words, the price
charged/paid must NOT fall below
the price floor
• Trading below the price floor is
illegal.
• Example : minimum wages in labor
markets
The Minimum Wage
• A minimum wage law is a
government regulation that makes Binding
hiring labor for less than a specified
wage illegal.
• Example : Effective 1 May 2023 : the legal
minimum wage in Hong Kong will be
increased to HK$40 per hour (from the
current HK$37.50 per hour)
• Firms may pay above this rate, but paying Non-binding
minimum wage
below this rate will attract penalty W2
• To be binding : the minimum wage (or
price floor) must be set above the
market equilibrium wage (or price)
• A minimum wage at W1 is binding
• A minimum wage at W2 is not binding
The Effects of a Binding Minimum Wage
• A binding minimum wage will result
in :
• An increase in wage rate (ie. from W0 to
W1)
• Increases the quantity of labor supplied
from L0 to L1
• Decreases the quantity of labor
demanded from L0 to L2
• A surplus of labor (ie quantity
supplied of labor > quantity
demanded for labor)
 unemployment arises (ie. L1 – L2)
• Results in a deadweight loss equal to
the blue triangle as MB of hiring
labor = L2 (for firms) is greater than
the MC of supplying labor = L2 (by
labor/householders)
The Effects of a Binding Minimum Wage
• Two developments may
occur when a minimum
wage causes
unemployment :
• Increased search
activity
• Illegal hiring
Is the Minimum Wage Efficient?
• With a binding minimum wage,
total employment = L2
• At L2 (ie. the new quantity of
labor employed), marginal
benefit marginal benefit is
greater than marginal cost Deadweight
 deadweight loss arises Loss

• “Underproduction” (ie. L2 < L0)

– ie. too few workers are hired.
• The outcome is inefficient.
Is the Minimum Wage Fair?
• Is the rule fair?
• No – it blocks voluntary exchange.
• Firms are willing to hire more; and
people who are willing to work more
are not permitted by the minimum
wage law to do so.
• Is the result fair?
• The result is unfair because only
those people who find jobs benefit.
• The unemployed end up worse off;
whereas those who get jobs were
probably not the least well-off.
Price Supports in Agriculture & Government Intervention
• A price support is a price floor in an
agricultural market maintained by a
government guarantee to buy any
surplus output at that price.
• A common method used by
governments to support farms.
• To do implement a price support :
• Governments isolate the domestic
market from global competition
(ie. restricts imports)
• Introduce a price floor.
 How Governments Intervene in Markets for Farm Products
• A price floor set above the market
equilibrium price creates a surplus. Price Support in Agriculture
• Example :
• The market equilibrium price for cheese
is $3
• The government set a price support of $4
• Quantity demanded = QD Cost of
• Quantity supplied = Qs price
support to
• Surplus = Qs – QD government
• Government will then buy up this surplus.
• Cost of price support = Rectangle ABCD
= $4 x (Qs – QD )
Price Support : An Illustration
Figure 2 : Price Support and Deadweight Loss

• See Figure 2
• With no price support, the competitive
equilibrium price is $25 a ton and 25
million tons a year are grown.
• A price support is set at $35 a ton.
• The quantity produced is 30 million
tons a year.
• The quantity bought by domestic users
is 20 million tons a year.
• The government buys the surplus of 10
million tons at $35 a ton— ie.
equivalent to a subsidy of $350 million
a year.
• Cost of price support
= $35 x (30 -20 million) = $35 x 10
million = $350 million
• A deadweight loss arises.
Is the Price Support Efficient?
• NOT efficient.
• Reason :
• Marginal Benefit is LESS THAN
Marginal Cost at 30 million
tons (ie. quantity
produced/supplied)
• Overproduction at the price
support
• A deadweight loss results
Effects on the Rest of the World
• The Rest of the World suffers a double Restrictions on
blow from price support
• Import restrictions in advance economies
deny developing economies access to
markets in the advanced economies.
• The result is lower prices and smaller farm
production in developing countries.
• Advanced economies sell their surpluses
on the world market, which lowers the
prices of farm products in the rest
of the world even further.
Discussion Questions : Question 1
• Use Table 1, which shows the Table 1
demand for on-campus housing,
to answer Questions 1 - 3. Rent Quantity Quantity
(dollars per demanded supplied
• The college has 2000 rooms to month)
rent. (rooms)
500 2,500 2,000
• If the college puts a rent ceiling
550 2,250 2,000
on rooms of $650 a month, what
is the rent, how many rooms are 600 2,000 2,000
rented, and is the on-campus 650 1,750 2,000
housing market efficient? 700 1,500 2,000
750 1,250 2,000
 The college has 2000 rooms to rent.

Discussion Points If the college puts a rent ceiling on rooms of $650 a month, what is the rent,
how many rooms are rented, and is the on-campus housing market efficient?

• With quantity supplied = 2,000

• Quantity demanded = Quantity supplied Rent Quantity Quantity
= 2,000  Market equilibrium rent = $600 (dollars per demanded supplied
• A rent ceiling of $650 will NOT be binding on month)
the market. (rooms)
• Reason : a rent ceiling is an upper limit on the 500 2,500 2,000
price at which the on-campus housing may be
traded. 550 2,250 2,000
• In other words, the price charged cannot rise
above this price cap. 600 2,000 2,000
• As the rent ceiling ($650) > market equilibrium 650 1,750 2,000
price  the price of the on-campus housing is
$600 700 1,500 2,000
• A total of 2,000 rooms will be rented
750 1,250 2,000
• As MB = MC at market equilibrium : the on-
campus housing market is efficient.
Discussion Questions : Question 2
• If the college puts a strictly Table 1
enforced rent ceiling on Rent Quantity Quantity
rooms of $550 a month, (dollars per demanded supplied
month)
what is the rent, how many (rooms)
rooms are rented, and is 500 2,500 2,000

the on-campus housing 550 2,250 2,000

600 2,000 2,000
market efficient? 650 1,750 2,000
• Explain why or why not. 700 1,500 2,000
750 1,250 2,000
 If the college puts a strictly enforced rent ceiling on rooms of $550 a month, what is the
rent, how many rooms are rented, and is the on-campus housing market efficient?

Discussion Points Explain why or why not.

Rent Quantity Quantity

(dollars per demanded supplied
• A rent ceiling of $550 is binding on the on- month) (rooms)
campus housing market. 500 2,500 2,000
• Reason : rent ceiling ($550) < market 550 2,250 2,000
equilibrium rent ($600) 600 2,000 2,000
• Although students want to rent 2,250 650 1,750 2,000
rooms, only 2,000 rooms are supplied  a 700 1,500 2,000
shortage arises 750 1,250 2,000
• Shortage = 2,250 – 2,000 = 250 rooms
• The on-campus housing market is still Price S perfectly inelastic
efficient because the supply of on-campus is
perfectly inelastic in this case  quantity
transacted = 2,000 (ie. efficient quantity is
transacted and there is no underproduction)
$600
• Nevertheless, search activity will increase
due to the shortage; and students will have $550 D
to spend more time looking for on-campus
accomodation
2,000 2,250
Quantity
Discussion Questions : Question 3
• Suppose that with a
strictly enforced rent Table 1
ceiling on rooms of $550 a Rent Quantity Quantity
(dollars per demanded supplied
month, a black market month)
develops. (rooms)

• How high could the black 500 2,500 2,000

550 2,250 2,000
market rent be and would
600 2,000 2,000
the on-campus housing
650 1,750 2,000
market be fair?
700 1,500 2,000
• Explain your answer. 750 1,250 2,000
 Suppose that with a strictly enforced rent ceiling on rooms of $550 a month, a black

Discussion Points market develops. How high could the black market rent be and would the on-campus
housing market be fair? Explain your answer.

Rent Quantity Quantity

• The black market price would go as (dollars per demanded supplied
high as $600 – ie. the maximum price a month) (rooms)
500 2,500 2,000
student is willing to pay for the 2,000th 550 2,250 2,000
room 600 2,000 2,000
• The black market price may be between 650 1,750 2,000
700 1,500 2,000
$550 to $600 750 1,250 2,000
• The on-campus housing market may
not be fair. S perfectly inelastic
Price
• Using the “fair results” approach, the
market is not fair because the poorest
students cannot afford the higher black
market rent. $600
• Using the “fair rules” approach, the market
is not fair because the rent ceiling blocks $550 D
some voluntary exchanges.
2,000 2,250
Quantity
Discussion Questions : Question 4
• Figure 1 shows a market for private Figure 1 : The Market for Private Economic Tutors
Economics tutors in Chicago organized by
the Students’ Union.
• a. What is the wage rate that Economics
tutors earn and how many are hired at
market equilibrium?
• b. If the Students’ Union sets the minimum
wage for private Economics tutors at $8 an
hour, how many tutors are employed and
what wage rate do they earn?
• c. If the Students’ Union sets the minimum
wage for private Economics tutors at $15 an
hour, how many tutors are employed and
what wage rate do they earn?
• d. Is the minimum wage of $15 an hour
efficient? Is it fair?
 a. What is the wage rate that Economics tutors earn and how

Discussion Points many are hired?

b. If the Students’ Union sets the minimum wage for private
Economics tutors at $8 an hour, how many tutors are
employed and what wage rate do they earn?

• The market equilibrium wage rate = $10

per hour; and 200 tutors will be hired.
• A minimum wage of $8 an hour is non-
binding.
• Reason :
• A minimum wage law is a
government regulation that makes Non-binding
hiring labor for less than a specified ⚫ Emarket Minimum Wage
$8
wage illegal.
• As market wage rate ($10) is higher
than the minimum wage ($8)
 the wage rate earned = $10 per hour
 c. If the Students’ Union sets the minimum wage for private Economics
tutors at $15 an hour, how many tutors are employed and what wage

Discussion Points rate do they earn?

d. Is the minimum wage of $15 an hour efficient? Is it fair?

• Wage rate earned = $15 per hour; and 100 tutors

will be employed.
• Note that there are 100 tutors becomes
unemployed @ wage rate = $15 per hour (ie. 200 –
100 tutors)
• Surplus of labor = 200 (ie. 300 – 100) Binding Minimum
• The minimum wage rate of $15 an hour is inefficient Wage

because marginal benefit exceeds the marginal cost

and there is a deadweight loss.
• Deadweight loss = ½ x $10 x 100 = $500
• The outcome is unfair.
• It benefits only the tutors who get the jobs and the
unemployed tutors earn nothing.
• Students are unable to hire the tutors they want.
Multiple Choice Questions
• Question 1

• When a price ceiling below the equilibrium price is imposed on a good,

production of the good
• [Link].
• [Link].
• [Link] not change.
• [Link] increases or decreases depending on whether the supply of the
good increases or decreases when the price ceiling is imposed.
Multiple Choice Questions
• Question 2

• A price ceiling in the market for gasoline that is below the equilibrium
price will lead to
• A. the quantity demanded of gasoline exceeding the quantity supplied.
• [Link] increase in the demand for gasoline.
• C.a decrease in the supply of gasoline.
• [Link] quantity supplied of gasoline exceeding the quantity demanded.
Multiple Choice Questions
• Question 3
• Which of the following statements is not correct?
• A. A price ceiling imposed below the equilibrium price creates a black market
in which the price might equal or exceed the equilibrium price.
• B. When a black market is created, there is no further shortage of the good.
• C. The creation of a black market leads to increased search activity, due to the
shortage of the good.
• D. Producer surplus increases for those suppliers who charge black market
rates.
Multiple Choice Questions
• Question 4

• A price floor makes prices

• A. below the equilibrium price illegal.
• B. above the equilibrium price illegal.
• C. below the price floor illegal.
• D. above the price floor illegal.
Multiple Choice Questions
• Question 5

• In the labor market, as wages rise, households

• A. decrease the quantity of labor demanded.
• B. increase the quantity of labor demanded.
• C. decrease the quantity of labor supplied.
• D. increase the quantity of labor supplied.
Multiple Choice Questions
• Question 6
• A minimum wage set above the market equilibrium wage rate
.
• [Link] both employment and the quantity of labor supplied
• [Link] unemployment and raises the wage rate of those
employed
• [Link] the wage rate of those employed and increases the supply
of jobs
• D. increases unemployment and decreases employment
Multiple Choice Questions
• Question 7
• Price supports are generally used in
• A. labor markets.
• B. industrial markets.
• C. agricultural markets.
• D. housing markets.
Multiple Choice Questions
• Question 8

• To keep the price at the level set by a price support, the government
must
• A. sell some of the good.
• B. buy some of the good.
• C. receive a subsidy from the producers.
• D. be careful to always set the price support below the equilibrium
price.
Multiple Choice Questions
• Question 9
• When a price support is set above the equilibrium price, producers
the quantity supplied and consumers the quantity
demanded.
• [Link]; increase
• [Link]; decrease
• [Link]; increase
• [Link]; decrease
Multiple Choice Questions
• Question 10

• A price support for peanut growers will positively affect and negatively
affect .
• A. domestic peanut growers; foreign peanut growers and domestic consumers
• B. domestic consumers; foreign peanut growers
• C. domestic peanut growers and foreign peanut growers; domestic consumers
• D. foreign peanut growers; domestic peanut growers and consumers