AP Microeconomics

2.8B Government Intervention: Price and Quantity Controls

 Learning Objectives
Define forms of government price and quantity intervention.
Explain (using graphs where appropriate) how government policies
alter consumer and producer behaviors that influence incentives and
therefore affect outcomes.
Calculate (using data from a graph or table where appropriate)
changes in market outcomes resulting from government policies.
 Why Governments Control Prices
• Reminder:
The equilibrium price creates the largest possible total surplus, which is
the sum of consumer surplus and producer surplus. Even so, the
equilibrium price is actually not the preferred price of either buyers or
sellers. After all buyers would always like to pay less, and sometimes
they can make strong argument for lower prices.

For example:
Citizens might ask the government to impose limits on rents landlords
can charge.
Workers(sellers) might ask the government to require employers to pay
a rate no lower than some specified minimum wage.
• Deadweight loss (total surplus is not maximized) typically occurs
due to market inefficiencies, often created by external
interventions such as:
• Price ceilings or floors Deadweight loss
• Taxes or subsidies
Why Governments Control Prices

• Price controls: are legal restrictions on how high or low a market

price may go.

• They can take two forms:

Price ceiling: the maximum price sellers are allowed to charge for
a good or service.(upper limit)

Price floor: the minimum price buyers are required to pay for a
good or service. (lower limit)
 Price Ceilings
• How Price Ceilings Cause Inefficiencies

The figure shows a simplified model of the market for apartments in New York.

The equilibrium would be at point E: 2 million apartments would be rented for

$1400 each per month.
Inefficiently Low Quantity

Suppose the government imposes a price ceiling on rent of $1200. The figure shows the effect of the
price ceiling, represented by the line at $1200. For $1200, landlords have less incentives to offer
apartments, so they won’t be willing to supply as many as they would at the equilibrium rate of $1400.
They will choose point A on the supply curve, offering only 1.8 million apartments for rent.
 Inefficiently Low Quantity

At the same time, more people will want to rent apartments for $1200 than for the equilibrium price of
$1400; as shown at point B on the demand curve (2.2 million )

So, there is a shortage of 400000 apartments.

The reduction in quantity leads to deadweight loss because there are lost opportunities for mutually
beneficial trade.
Note
• If price ceiling is set above the equilibrium price, it won’t
have any effect.

• Suppose that the equilibrium rental rate on apartments is $1400

per month and the city government sets a ceiling of $1600. Who
cares? In this case it won’t have any effect because that the
market price is already lower than the ceiling, so the ceiling is
not restrictive.
Inefficient Allocation to Consumers
• Rent control doesn’t just lead to shortage. It also can lead to
misallocation of resources.
• For example: 2.2 million people would like to rent an apartment
at $1200 per month but only 1.8 million apartments are
available. If those 2.2 million who are seeking an apartment
some want an apartment badly and are willing to pay a high
price to get one, others have a less urgent need and are willing
only to pay a low price.

• Apartments are distributed inefficiently, if some people who are

not especially eager to find an apartment get one and others
who are very eager to find an apartment can’t.
Wasted Resources
• Sometimes a price ceiling leads to a wasted resources: people
expend money, effort, and time to cope with the shortages
caused by the price ceilings.

• The opportunity cost of the time spent waiting in lines because

of shortage would be the wages not earned, the time not
enjoyed (waste).
Inefficiently Low Quality
• Landlords will have no incentive to provide better conditions because
they cannot raise rents to cover their repair cost, and they can easily
find tenants to rent their apartments.

In many cases, tenants would be willing to pay much more for

improved conditions than it would cost for the landlord to provide them.

Black Market: is a market in which goods or services are bought and

sold illegally either because it is illegal to sell them at all or because
the prices charged are legally prohibited by a price ceilings.
Black markets may help those who are willing to pay the most for
apartments to get them by also it encourages disrespect for the law
and bias the opportunities against those who are honest.
So Why are there price ceilings?
Given that price ceilings cause shortages, inefficiency, and black
markets, why do governments still sometimes impose them?

1- Although price ceilings have adverse effects, they do benefit a small

group of people. And those who benefit from the controls mabe better
organized and more vocal than those who are harmed by them.

2- When price ceilings have been in effect for a long time, buyers may
not have a realistic idea of what would happen without them.They don't
realise that black market prices are much higher than the price that
would prevail in the absence of price controls.

3- The government officials often do not understand what you just

learned about supply and demand.
Let's assume that the
equilibrium price for chicken
is $20 and the equilibrium
quantity is 30.

That’s the socially optimal

quantity where there is no
deadweight loss. We
maximized consumer surplus
and producer surplus.
If the government says you cannot
raise the price of chicken above
$10.

The result will be a shortage.

At a $10 price consumers want to
buy 50 million chickens but
producers has no incentive to
produce some so they will produce
only 10 million chicken.
 Now the producer surplus
is smaller.

Consumer
surplus

Producer
surplus
Deadweight
loss
Practice
Before price ceiling:
Producer surplus=
0.5*2*20=20
Consumer surplus=
0.5*2*20=20
Total surplus=40

After price ceiling:

Producer surplus=
0.5*1*10=5
Consumer surplus=25
Triangle= 0.5*1*10=5
rectangle= 2*10= 20
Total surplus= 30
DWL=0.5*10*2= 10
Price Floors
The government intervene to push market prices up instead of
down.

Example: -
-Price floors on agricultural products like wheat and milk.
-Price floor on the price of labor ‘minimum wage’.

Minimum wage: is a legal floor on the

hourly wage rate paid for a worker’s
labor.
Price Floors

The figure shows hypothetical supply and demand curves for butter. The
market would move to equilibrium at point E, with 10 million pounds of
butter bought and sold at a price of $1 per pound.
Price Floors
Suppose that to help dairy farmers, the
government imposes a price floor on butter of
$1.20.

At that price:
- producers want to supply 12 million
pounds(point B on the supply curve).
-consumers want to buy only 9 million
pounds(point A on the demand curve).

The price floor leads to a surplus of 3 million

pounds of butter.
The yellow rectangle represents deadweight
loss from the 1 million pounds of butter

Note: if the equilibrium price of butter is $1

per pound but the floor is set at only 0.80,
the floor has no effect.(not
binding/irrelevant)
Notes:
When it comes to price
If the price floor is binding what controls, the ceiling is down
happens to the unwanted surplus?
It depends on the government policy, low and the floor is up high.
governments may buy up the
unwanted surplus and then give the
surplus food to schools or some To have any effect a price
countries pay exporters to sell ceiling must be below the
products at a loss.
The U.S government pays farmers equilibrium price, and a
not to produce the products at all price floor must be above
the equilibrium price.
Minimum wage surplus
When the government is not prepared to purchase the unwanted
surplus, a price floor means that would be sellers cannot find
buyers.

This is what happens when there is a price floor on the wage rate
paid for an hour of labor, the minimum wage: when the minimum
wage is above the equilibrium wage rate, some people who are
willing to work-sell labor- cannot find employers who want to hire
them- that is buy labor. The result is unemployment-a surplus of
workers in the market
Example

Assume that the

government set a
minimum price at $30.

Producers want to
producer 50 million
chickens.
Consumers want to
buy only 10 million
chickens.
We have a surplus
 Consumer
surplus

Producer
surplus
Deadweight loss
Note

Both price ceiling a floor have the effect

of reducing the quantity of a good bought
and sold
How a price floor causes inefficiency
The surplus that results from a price floor creates missed opportunities-
inefficiencies-.

1- Inefficiently low quantity: by raising the price of a good, a price floor

reduces the quantity of that good demanded, which reduces the quantity
bought and sold below the market equilibrium quantity.

2- Inefficient allocation of sales among sellers: suppose you would

be willing to sell your English tutoring services for $5 per hour, but the
minimum wage is $9 per hour. Because you are forced to compete with
someone who would tutor for no less than $9 per hour, you risk losing
the job to this competitor. In this case the price floor on wages prevents
the worker who would sell tutoring services for the lowest amount from
being able to do so.
How a price floor causes inefficiency

3- Wasted resources:
a. The government purchases of unwanted surpluses of
agricultural products caused by price floors/ when the surplus
production is destroyed it is a pure waste.

b. Wasted time and effect: in case of minimum wage, would be

workers spend excessive amounts of time searching for job
due to the surplus of workers.

c. Inefficiently high quality: consumers would rather have

producers spend less on quality and offer lower price.
How a price floor causes inefficiency

4- Illegal activity: workers desperate for jobs sometimes agree to

work off the books for employers who conceal their employment
from the government or who bribe the government inspectors.

Why are there price floors?

Price floors are often imposed because they benefit some
influential sellers
Controlling Quantities/Quota
New York city instituted a system of licensing
for taxi cabs: only taxi with a ‘medallion’ were
allowed to pick up passengers.

A taxi medallion system is a form of quantity

control, or quota.

• The government regulates the quantity

of a good that can be bought or sold
rather than regulating the price.
License: gives the owner the right
• The government limits quantity in a to supply a good or service.
market by issuing licenses, only people
with license can legally supply the
good.
 The Anatomy of Quantity controls Note:
we will assume that:
- the medallion
system limits the
number of taxi rides
that can legally be
given.

The figure shows a simplified version of the market for

taxi rides. The table shows the supply and demand
schedules. The equilibrium indicated by point E is a
fare of $5 per ride with 10 million rides rides takes per
year.
 The Anatomy of Quantity controls
-the demand curve represents
-> how many taxi rides will
passengers want to take if the
price is $5 per ride?
OR at what price will consumers
want to buy a given quantity.

- the supply curve represents

-> how many taxi rides would
taxi drivers supply at a price of
$5 each? OR at what price will
producers be willing to supply 10
million rides per year?

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 price at which producers will
supply that quantity
The Anatomy of Quantity controls

The supply price of 6 million rides is $3 per ride.

The supply price of 7 million rides is $3.50 per ride.
 Quota
Assume that the city
government limits the
number of taxi rides that
can legally be given to 8
million per year.

We draw the black

vertical line to
represent the quota.

The demand price is $6

The supply price is $4

Note
Quantity controls and price controls are graphed differently.

Graph a quota as a vertical line at the quantity limit.

Graph a price ceiling or floor as a horizontal line at a price limit.

Quota Rent
In every case in which the supply of a
good or service is legally restricted, there
is a wedge between the demand price
and the supply price.

The wedge is the quota rent.

The quota rent: the earnings that accrue

to the license-holder from ownership of
the right to sell the good or service. It is
equal to the market price of the license
when the licenses are traded.

The quota rent is the opportunity cost of

using the medallion instead of allowing
another driver to use it. If the medallion owner were to sell or rent out
the medallion, its value would be equivalent to
the quota rent * the number of rides for which
the ownership was transferred. (width*height)
Note:
If quota were to set at above the equilibrium
quantity is an unregulated market- it would
have no effect because it would not be binding
because it does not restrict the quantity that
would naturally be produced or sold.
The Cost of Quantity Controls
Deadweight loss: missed opportunities, preventing transactions
that would benefit both buyers and sellers.

The quantity control leads to innovation( ride sharing services) in

the market for taxi rides that diminishes the value of taxi
medallions.