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Can Congress repeal the law
of market forces?
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Government Actions
in Markets
7
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain how a price ceiling works and show how a
rent ceiling creates a housing shortage, inefficiency, and
unfairness.
2 Explain how a price floor works and show how the minimum
wage creates unemployment, inefficiency, and unfairness.
3 Explain how a price support in the market for an agricultural
product creates a surplus, inefficiency, and unfairness.
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7.1 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.
An example is a price ceiling on housing rents.
Trading above the price ceiling is illegal.
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7.1 PRICE CEILINGS
A Rent Ceiling
A rent ceiling is a regulation that makes it illegal to
charge more than a specified rent for housing.
The effect of a rent ceiling depends on whether it is
imposed at a level above or below the market
equilibrium rent.
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7.1 PRICE CEILINGS
Figure 7.1 shows a
housing market.
1. At the market
equilibrium
2. The equilibrium rent is
$550 a month and
3. The equilibrium
quantity is 4,000 units
of housing.
If a rent ceiling is set above
$550 a month, nothing will
change.
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7.1 PRICE CEILINGS
Figure 7.2 shows how a
rent ceiling creates a
shortage.
A rent ceiling is imposed
at $400 a month, which is
below the market
equilibrium rent.
1. The quantity of
housing supplied
decreases to 3,000
units.
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7.1 PRICE CEILINGS
2. The quantity of
housing demanded
increases to 6,000
units.
3. A shortage of 3,000
units arises.
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7.1 PRICE CEILINGS
When a rent ceiling creates a housing shortage, two
developments occur:
• A black market
• Increased search activity
A black market is an illegal market that operates
alongside a government-regulated market.
Search activity is the time spent looking for someone
with whom to do business.
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7.1 PRICE CEILINGS
Figure 7.3 shows how a
rent ceiling creates a
black market and housing
search.
With a rent ceiling of $400
a month:
1. 3,000 units of housing
are available.
2. Someone is willing to
pay $625 a month for
the 3,000th unit of
housing.
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7.1 PRICE CEILINGS
3. Black market rents
might be as high as
$625 a month and
resources get used up
in costly search
activity.
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7.1 PRICE CEILINGS
Are Rent Ceilings Efficient?
With a rent ceiling, the outcome is inefficient.
Marginal benefit exceeds marginal cost.
Total surplus—the sum of producer surplus and
consumer surplus—shrinks and a deadweight loss
arises.
People who can’t find housing and landlords who can’t
offer housing at a lower rent lose.
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7.1 PRICE CEILINGS
Figure 7.4(a) shows an
efficient housing market.
1. The market is efficient
with marginal benefit
equal to marginal cost.
2. Consumer surplus
plus ...
3. Producer surplus is as
large as possible.
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7.1 PRICE CEILINGS
Figure 7.4(b) shows the
inefficiency of a rent
ceiling.
A rent ceiling restricts the
quantity supplied and
marginal benefit exceeds
marginal cost.
1. Consumer surplus
shrinks.
2. Producer surplus
shrinks.
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7.1 PRICE CEILINGS
3. A deadweight loss
arises.
4. Other resources are
lost in search activity
and evading and
enforcing the rent
ceiling law.
Resource use is
inefficient.
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7.1 PRICE CEILINGS
Are Rent Ceilings Fair?
Are the rules fair?
Are the results fair?
Does blocking rent adjustments avoid scarcity?
What mechanisms allocate resources when prices don’t
do the job?
Are those non-price mechanisms fair?
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7.1 PRICE CEILINGS
If Rent Ceilings Are So Bad, Why Do We Have
Them?
Current renters gain and lobby politicians.
Renters out-number landlords, so rent ceilings can tip an
election.
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7.2 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.
An example is the minimum wage in labor markets.
Trading below the price floor is illegal.
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7.2 PRICE FLOORS
Figure 7.5 shows a
market for fast-food
servers.
1. The demand for and
supply of fast-food
servers determine the
market equilibrium.
2. The equilibrium wage
rate is $7 an hour.
3. The equilibrium
quantity is 6,000
servers.
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7.2 PRICE FLOORS
The Minimum Wage
A minimum wage law is a government regulation that
makes hiring labor for less than a specified wage illegal.
Firms can pay a wage rate above the minimum wage but
they may not pay a wage rate below the minimum wage.
The effect of a minimum wage depends on whether it is
set above or below the market equilibrium wage rate.
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7.2 PRICE FLOORS
Figure 7.6 shows how a
minimum wage creates
unemployment.
A minimum wage is set
above the equilibrium
wage.
1. The quantity
demanded decreases
to 3,000 workers.
2. The quantity supplied
increases to 8,000 people.
3. 5,000 people are unemployed.
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7.2 PRICE FLOORS
Of the 5,000 people unemployed, 3,000 have been fired
and another 2,000 would like to work at $10 an hour.
The 3,000 jobs must somehow be allocated to the
8,000 people who would like to work.
This allocation is achieved by
• Increased search activity
• Illegal hiring
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7.2 PRICE FLOORS
Figure 7.7 shows how a
minimum wage increases
job search.
1. At the minimum wage
rate of $10 an hour,
3,000 jobs are
available.
2. Someone is willing to
take the 3,000th job
for $5 an hour.
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7.2 PRICE FLOORS
People are willing to
spend time on job search
that is worth the
equivalent of lowering
their wage rate by $5 an
hour.
3. Illegal wage rates
might range from just
below $10 an hour to
$5 an hour.
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7.2 PRICE FLOORS
Is the Minimum Wage Efficient?
The firms’ surplus and workers’ surplus shrink, and a
deadweight loss arises.
Firms that cut back employment and people who can’t
find jobs at the higher wage rate lose.
The total loss exceeds the deadweight loss because
resources get used in costly job-search activity.
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7.2 PRICE FLOORS
Figure 7.8(a) shows an
efficient labor market.
1. At the market
equilibrium, the
marginal benefit of
labor to firms equals
the marginal cost of
working.
2. The sum of the firms’
surplus and
3. the workers’ surplus is
as large as possible.
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7.2 PRICE FLOORS
Figure 7.8(b) shows an
inefficient labor market
with a minimum wage.
The minimum wage
restricts the quantity
demanded.
1. The firms’ surplus
shrinks.
2. The workers’ surplus
shrinks.
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7.2 PRICE FLOORS
3. A deadweight loss
arises.
4. Other resources are
used up in job-search
activity.
The outcome is inefficient.
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7.2 PRICE FLOORS
Is the Minimum Wage Fair?
Is the rule fair?
Is the result fair?
If the wage rate doesn’t allocate labor, what does?
Are non-wage allocation mechanisms fair?
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7.2 PRICE FLOORS
If the Minimum Wage Is So Bad, Why Do We
Have It?
The effects of minimum wage on employment might be
small.
What would make the effects on employment small?
Labor unions might lobby for a minimum wage: why?
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7.3 PRODUCTION QUOTAS
Governments often intervene in agriculture markets with
the aims of blocking the quantity supplied from moving
toward the equilibrium quantity.
The tool used for this purpose is a production quota.
A production quota is a government regulation in a
market that places an upper limit on the quantity that
may be supplied.
To regulate the quantity supplied, the government must
isolate the domestic market from global competition.
For this reason, the government restricts the quantity
that can be imported from other countries.
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7.3 PRODUCTION QUOTAS
To make a production quota effective, quotas must be
allocated to each producer that sum to the market quota.
Also, individual producers must be prevented from
exceeding their quotas.
Production Quota: An Example
The market for dairy products in California is regulated by
the California Department of Food and Agriculture.
A production quota for the market is set and allocations
are made to each producer that sum to the market quota.
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7.3 PRODUCTION QUOTAS
Free Market Reference
Point
In Figure 7.9(a), with no
production quota,
1. The market equilibrium
is efficient.
2. Consumer surplus
plus
3. Producer surplus is
maximized.
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7.3 PRODUCTION QUOTAS
Effective Production
Quota
In Figure 7.9(b),
4. The production quota
is 40 billion pounds a
year.
5. Consumer surplus
shrinks.
6. Producer surplus
grows.
7. Deadweight loss
arises.
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7.3 PRODUCTION QUOTAS
Production Quota Is Inefficient
The production quota is inefficient because it creates
deadweight loss—farmers gain and buyers lose, but
buyers lose more than farmers gain.
Production Quota is Unfair
A production quota is unfair on both views of fairness:
The result-view: With the quota, well-off farmers benefit
and consumers lose.
The rule-view: The quota blocks voluntary exchange.
Farmers want to produce more and consumers want to
buy more, but they are not permitted by the quota.
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When Congress enacts a new law and the President signs it,
the outcome is not always what was intended.
A mismatch between intention and outcome is almost
inevitable when a law or regulation seeks to block the law of
market forces.
You’ve seen that the federal minimum wage law leaves some
teenagers without jobs.
Problems would also arise if a law tried to cap executive pay.
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Placing a cap on executive pay would work like putting a
ceiling on home rents.
The quantity of executive services supplied would
decrease and the most talented executives would seek
jobs with the unregulated employers.
The firms in the most difficulty would face the added
challenge of recruiting and keeping competent executives
and directors.
The deadweight loss from this action would be large.
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