Ragan: Economics

Sixteenth Canadian Edition

Chapter 5
Price Controls
and Market Efficiency

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Chapter Outline/Learning Objectives

Section Learning Objectives

Blank After studying this chapter, you will be able
to:
5.1 Government-Controlled 1. describe how legislated price ceilings and
Prices price floors affect equilibrium price and
quantity.
5.2 Rent Controls: A Case 2. compare the short-run and long-run
Study of Price Ceilings effects of legislated rent controls.
5.3 An Introduction to 3. describe the relationship between
Market Efficiency economic surplus and the efficiency of a
market.
4. explain why price controls and output
quotas tend to be inefficient for society as
a whole.

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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.

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The Determination of Quantity Exchanged in
Disequilibrium Figure 5-1

In disequilibrium, quantity exchanged is determined by the

lesser of quantity demanded and quantity supplied. At E, the
market is in equilibrium, with quantity demanded equal to
quantity supplied. For any price below p0, the quantity exchanged
will be determined by the supply curve. For any price above p0,
the quantity exchanged will be determined by the demand curve.
Thus, the solid portions of the S and D curves show the actual
quantities exchanged at different disequilibrium prices.

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Price Floors
A Binding Price Floor Figure 5-2

• 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.
A binding price floor leads to excess supply. The free-market equilibrium is
at E, with price p0 and quantity Q0. The government now establishes a binding
price floor at p1. Actual quantity exchanged is then Q1, and there is excess
supply equal to Q1Q2.
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Apply Economic Concepts 5-1 (1 of 2)
• Minimum Wages and Unemployment
– 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.
– 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.

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Apply Economic Concepts 5-1 (2 of 2)
• Minimum Wages and Unemployment
(continued)
– 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.

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Price Ceilings (1 of 2)
• Free markets with flexible prices eliminate excess
demand by allowing prices to rise.
• A price ceiling is a maximum price.
• With a binding price ceiling some other method of
allocation must be adopted.
• First-come, first-served allocation results in buyers
waiting in lines, disappointed to discover supplies
are exhausted.
• May lead to a black market.
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Black Markets
A Price Ceiling and Black-Market Pricing
Figure 5-3

• Black market ̶ 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.
A binding price ceiling causes excess demand and invites a black market. The
equilibrium point, E, is at a price of p0 and a quantity of Q0. If a price ceiling is set at
p1, the quantity demanded will rise to Q1 and the quantity supplied will fall to Q2.
Quantity actually exchanged will be Q2. But if all the available supply of Q2 were
sold on a black market, the price to consumers would rise to p2. If black marketeers
buy at the ceiling price of p1 and sell at the black-market price of p2, their profits are
represented by the shaded area.
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Price Ceilings (2 of 2)
• Goals of price ceilings are:
1. To restrict production

2. To keep specific prices down

3. To satisfy notions of equity in the consumption of a

product that is temporarily in short supply

• Black markets thwart government’s objectives

when imposing a price ceiling.

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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

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Figure 5-4 The Short-Run and Long-Run
Effects of Rent Controls

Rent control causes housing shortages that worsen as time passes. The free-
market equilibrium is at point E. The controlled rent of rc forces rents below their
free-market equilibrium value of r1. The short-run supply of housing is shown by the
perfectly inelastic curve SS. Thus, quantity supplied remains at Q1 in the short run,
and the housing shortage is Q1Q2. Over time, the quantity supplied shrinks, as shown
by the long-run supply curve SL. In the long run, there are only Q3 units of rental
accommodations supplied, fewer than when controls were instituted. The long-run
housing short-age of Q3Q2 is larger than the initial shortage of Q1Q2.
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Rent Controls in Ontario
• Instituted in 1975
• Permitted increases in rents only where these were
needed to pass on cost increases.
• 1990s ̶ shortage developed in the rental-housing
market (acute in Metro Toronto).
• Ontario government loosens rent controls by
exempting some units and permitting increases when
tenants vacated apartments.
• 2017 ̶ Ontario government expanded its rent controls
generating considerable opposition.

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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.

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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.

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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.

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Demand as “Value” and Supply as “Cost”
(1 of 2)

• The market demand curve for any product shows 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.

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Demand as “Value” and Supply as “Cost”
(2 of 2)

• 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.
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Reinterpreting the Demand and Supply
Curves for Pizza Figure 5-5 (1 of 2)
• For each pizza, the price on the demand curve
shows the value consumers receive from
consuming that pizza.
For each pizza, the price on the demand curve
shows the value consumers receive from consuming
that pizza; the price on the supply curve shows the
additional cost to firms of producing that pizza.
Each point on the demand curve shows the maximum
price consumers are willing to pay to consume that unit.
This maximum price reflects the value that consumers
get from that unit of the product. Each point on the
supply curve shows the minimum price firms are
willing to accept for producing and selling that unit.
This minimum price reflects the additional costs firms
incur by producing that unit.
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Reinterpreting the Demand and Supply
Curves for Pizza Figure 5-5 (2 of 2)
• For each pizza, the price on the supply curve
shows the additional cost to firms of producing
that pizza.
For each pizza, the price on the demand curve
shows the value consumers receive from consuming
that pizza; the price on the supply curve shows the
additional cost to firms of producing that pizza.
Each point on the demand curve shows the maximum
price consumers are willing to pay to consume that unit.
This maximum price reflects the value that consumers
get from that unit of the product. Each point on the
supply curve shows the minimum price firms are
willing to accept for producing and selling that unit.
This minimum price reflects the additional costs firms
incur by producing that unit.
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Economic Surplus in the Pizza Market
Efficiency Figure 5-6
• Economic surplus ̶ area
below the demand curve
and above the supply
curve ̶ is maximized at the
free-market equilibrium
quantity.
• Total economic surplus is
maximized.
For any quantity of pizzas, the area below the demand curve and above the supply curve shows the economic surplus
generated by the production and consumption of those pizzas. The demand curve shows the value consumers place on each
additional pizza; the supply curve shows the additional cost associated with producing each pizza. For example, consumers value the
100th pizza at $20, whereas the additional cost to firms of producing that 100th pizza is $5. The economic surplus generated by
producing and consuming this 100th pizza is therefore $15 ($20 ̶ $5). For any range of quantity, the shaded area between the curves
over that range shows the economic surplus generated by producing and consuming those pizzas. Economic surplus in the pizza
market is maximized—and thus market efficiency is achieved—at the free-market equilibrium quantity of 250 pizzas and price of
$12.50. At this point, total economic surplus is the sum of the three shaded areas.
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Market Inefficiency with Price Controls
Figure 5-7 (1 of 2)
• 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.
Binding price floors and price ceilings in competitive markets lead to a
reduction in overall economic surplus and thus to market inefficiency. In both
parts of the figure, the free-market equilibrium is at point E with price p0 and
quantity Q0. In part (i), the introduction of a price floor at p1 reduces quantity to Q1.
In part (ii), the introduction of a price ceiling at p2 reduces quantity to Q2. In both
parts, the shaded area shows the reduction in overall economic surplus—the
deadweight loss—created by the price floor or ceiling. Both outcomes display
market inefficiency.
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Market Inefficiency with Price Controls
Figure 5-7 (2 of 2)
• 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.

Binding price floors and price ceilings in competitive markets lead to a

reduction in overall economic surplus and thus to market inefficiency. In both
parts of the figure, the free-market equilibrium is at point E with price p0 and
quantity Q0. In part (i), the introduction of a price floor at p1 reduces quantity to Q1.
In part (ii), the introduction of a price ceiling at p2 reduces quantity to Q2. In both
parts, the shaded area shows the reduction in overall economic surplus—the
deadweight loss—created by the price floor or ceiling. Both outcomes display
market inefficiency.
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One Final Application:
The Inefficiency of Output Quotas Figure 5-8

• 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.

Binding output quotas lead to a reduction in output and a reduction in overall

economic surplus. The free-market equilibrium is at point E with price p0 and quantity
Q0. Suppose the government then restricts total quantity to Q1 by issuing output quotas
to firms. The market price rises to p1. The shaded area shows the reduction in overall
economic surplus—the dead-weight loss—created by the quota system.
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A Cautionary Word (1 of 2)
• 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.

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A Cautionary Word (2 of 2)
• 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.

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