Week II: Applying the Basic Model
KW. Ch. 4&5
Chapter 4: Price Controls and Quotas: Meddling with Markets
In principle, the market always moves towards an equilibrium, sometimes governments try to
meddle with the market and the market can strike back in unpredictable ways
Supply and demand analysis can be a useful tool to determine what the outcome could be
The total consumer surplus generated by purchases of a good at a given price is equal to the area
below the demand curve but above that price
The total producer surplus from sales of a good at a given price is the area above the supply
curve but below that price
Willingness to pay The maximum price that an individual consumer is willing to pay for a
good; also defines the demand schedule
-> price is lower: eager to purchase
-> price is higher: won’t purchase
-> price is equal: indifferent to purchase
Individual consumer surplus The net gain that an individual buyer achieves from the purchase of a
good
Total consumer surplus The sum of all individual consumer surpluses of one good
-> often consumer surplus is used as a term for both
In the graph: the total consumer surplus is equal to the area below the
demand curve but above the price
Seller's cost The lowest price at which a potential seller is willing to sell a good
Opportunity cost The true measure of the cost of doing something is opportunity cost
(the loss of alternatives if one alternative is chosen)
Individual producer surplus The net gain that describes the difference between what the seller
actually achieves and what their cost was
Total producer surplus The sum of all individual producer surpluses of a good in a market
-> often producer surplus is used as a term for both
Total surplus The total surplus describes the sum of consumer and producer surplus
Why Governments control prices
Markets strive for the equilibrium, but that point does not always serve the
consumers/producers
There is often a strong demand for governments to intervene in markets (examples: housing
markets, minimum wages)
They can impose price controls: usually price ceiling and a price floor
-> markets are actually very difficult to control; so there are always unpredictable side effects of
price controls
Price ceilings
Price ceilings are not that common today, but are usually imposed in times of crises, because
there can be a sudden price increase
Example of the NYC housing market: the equilibrium is $1000 per month, they change it to $800
a month -> new price is below equilibrium (above it, it would have no effect)-> now there is a
shortage of rental housing (Inefficient!)
Price controls can be seriously harmful as it leads to inefficiency
1. Reduces quantity of apartments rented below the efficient level
2. It typically leads to inefficient allocation of apartments among would-be renters
1
, 3. It leads to wasted time and effort as people search for apartments
4. It leads landlords to maintain apartments in inefficiently low quality or condition
Additionally: gives rise to illegal behaviour as people try to circumvent them
Price controls Legal restrictions on how high or low a market price may go
Price ceiling A maximum price that sellers are allowed to charge for a good
Price floor A minimum price that buyers are required to pay for a good
Deadweight loss Loss of total surplus that occurs whenever an action or policy reduces
(Inefficiently low quantity transacted below the efficient market equilibrium quantity
Quantity) -> key concept in economics that describes loss to society
Inefficient allocation to Some people who want the good badly and are willing to pay a high price
consumers don’t get it, and some who care relatively little about the good and are only
willing to pay a low price do get it
Wasted resources People expend money, time and effort to cope with the shortages caused
by price ceilings
Inefficient low quality Sellers offer low-quality goods at a low price even though buyers would
prefer a higher quality at a higher price
Price Floors
Governments use price floors to intervene in the market to push prices up (example: minimum
wage)
There are also predictable and unwanted side effects; example of butter -> the price floor is
above the equilibrium price, which leads to an unwanted surplus of the good
Countries deal differently with those surpluses – the government often buys them (European
Commission pays exporters to sell products at a loss overseas)
Emerging illegal activity: example of minimum wage -> if the price floor of minimum wage is far
lower than the equilibrium price, there emerges the chance for a ‘black labour market’ (work off
the book, leading to official corruption)
Deadweight loss Similar effect as with the price ceiling: since the equilibrium maximizes the
(surplus of the good) sum of consumer and producer surplus, a price floor below the equilibrium
reduces the total surplus
Inefficient allocation of Sellers who are willing to sell at the lowest price are unable to make sales
sales among sellers while sales go to sellers who are only willing to sell at a higher price
Wasted resources Price floors lead to wasted time and effort, often unwanted surpluses have
to be thrown away
Inefficiently high quality Sellers offer high quality goods at a high price, even though buyers would
prefer a lower quality at a lower price
Controlling Quantities
Quantity control (quota) is an upper limit on the quantity of some good than can be bought or
sold on a market
They are controlled by governments by giving out licenses (which gives owners the right to
supply a good)
The total amount of the good than can be transacted under the quantity control is called the
quota limit
Often quantity controls are put into place to address a temporary problem, but become
complicated to abolish again
Demand price: describes at which price consumers want to buy a given quantity
Supply price: of a given quantity is the price at which producers will supply that quantity
2
, Example of taxi medallions
The quota restricts the quantity supplied, which leads to a deadweight loss
The restriction also opens up a second market: besides the market for taxi rides, there is a
market for medallions (in case a taxi driver would rent his medallion to someone else)
The price for which Taxi driver A would rent to taxi driver B depends on the wedge between
demand price and supply price
Wedge: difference between the demand price and the supply price of a good; that is the price
paid by buyers ends up being higher than that received by the sellers (in example that’s $2)
Quotas don’t always have an effect on the market (if it is above the equilibrium quantity, it
would have no effect)
Negative side effects of quotas:
1. Deadweight loss by preventing mutually beneficial transactions from occurring (only if the
market reached the unregulated market equilibrium quantity, there would be no missed
opportunities)
2. More reason to break the law (because people want to avoid the restrictions around the
quota)
Week II: Applying the basic model
Notes on the Reading chapter 5
Part I: Elasticity
Price elasticity measures how the quantity demanded responds to changes in price
The price elasticity is important for investors to know (whether they can earn significant profit
from a business)
With the information of price elasticity, the investors can predict if rises in pricing results in an
increase of revenue
To describe the elasticity, percentages are used because those don’t depend on the unit in which
a good is measured in
The price elasticity of demand is equal to the percent change in the quantity demanded divided
by the percent change in the prices as you move along the demand curve, and dropping any
minus sign
How to calculate
% change in quantity demanded = change in quantity demanded/ Initial quantity demanded x 100
% change in price = change in price/ Initial price x 100
% price elasticity of demand = % change in quantity demanded/ % change in price
Importance of the minus sign: in example calculation, the minus has been dropped; law of
demand says that demand curves are always downward sloping, therefore the price and quantity
demanded move in different directions
-> a positive percent change in price leads to a negative percent change in quantity demanded
-> a negative percent change in price leads to a positive percent change in quantity demanded
The price elasticity is always a negative number; in practice the minus is not mentioned (but
taken for granted)
3
KW. Ch. 4&5
Chapter 4: Price Controls and Quotas: Meddling with Markets
In principle, the market always moves towards an equilibrium, sometimes governments try to
meddle with the market and the market can strike back in unpredictable ways
Supply and demand analysis can be a useful tool to determine what the outcome could be
The total consumer surplus generated by purchases of a good at a given price is equal to the area
below the demand curve but above that price
The total producer surplus from sales of a good at a given price is the area above the supply
curve but below that price
Willingness to pay The maximum price that an individual consumer is willing to pay for a
good; also defines the demand schedule
-> price is lower: eager to purchase
-> price is higher: won’t purchase
-> price is equal: indifferent to purchase
Individual consumer surplus The net gain that an individual buyer achieves from the purchase of a
good
Total consumer surplus The sum of all individual consumer surpluses of one good
-> often consumer surplus is used as a term for both
In the graph: the total consumer surplus is equal to the area below the
demand curve but above the price
Seller's cost The lowest price at which a potential seller is willing to sell a good
Opportunity cost The true measure of the cost of doing something is opportunity cost
(the loss of alternatives if one alternative is chosen)
Individual producer surplus The net gain that describes the difference between what the seller
actually achieves and what their cost was
Total producer surplus The sum of all individual producer surpluses of a good in a market
-> often producer surplus is used as a term for both
Total surplus The total surplus describes the sum of consumer and producer surplus
Why Governments control prices
Markets strive for the equilibrium, but that point does not always serve the
consumers/producers
There is often a strong demand for governments to intervene in markets (examples: housing
markets, minimum wages)
They can impose price controls: usually price ceiling and a price floor
-> markets are actually very difficult to control; so there are always unpredictable side effects of
price controls
Price ceilings
Price ceilings are not that common today, but are usually imposed in times of crises, because
there can be a sudden price increase
Example of the NYC housing market: the equilibrium is $1000 per month, they change it to $800
a month -> new price is below equilibrium (above it, it would have no effect)-> now there is a
shortage of rental housing (Inefficient!)
Price controls can be seriously harmful as it leads to inefficiency
1. Reduces quantity of apartments rented below the efficient level
2. It typically leads to inefficient allocation of apartments among would-be renters
1
, 3. It leads to wasted time and effort as people search for apartments
4. It leads landlords to maintain apartments in inefficiently low quality or condition
Additionally: gives rise to illegal behaviour as people try to circumvent them
Price controls Legal restrictions on how high or low a market price may go
Price ceiling A maximum price that sellers are allowed to charge for a good
Price floor A minimum price that buyers are required to pay for a good
Deadweight loss Loss of total surplus that occurs whenever an action or policy reduces
(Inefficiently low quantity transacted below the efficient market equilibrium quantity
Quantity) -> key concept in economics that describes loss to society
Inefficient allocation to Some people who want the good badly and are willing to pay a high price
consumers don’t get it, and some who care relatively little about the good and are only
willing to pay a low price do get it
Wasted resources People expend money, time and effort to cope with the shortages caused
by price ceilings
Inefficient low quality Sellers offer low-quality goods at a low price even though buyers would
prefer a higher quality at a higher price
Price Floors
Governments use price floors to intervene in the market to push prices up (example: minimum
wage)
There are also predictable and unwanted side effects; example of butter -> the price floor is
above the equilibrium price, which leads to an unwanted surplus of the good
Countries deal differently with those surpluses – the government often buys them (European
Commission pays exporters to sell products at a loss overseas)
Emerging illegal activity: example of minimum wage -> if the price floor of minimum wage is far
lower than the equilibrium price, there emerges the chance for a ‘black labour market’ (work off
the book, leading to official corruption)
Deadweight loss Similar effect as with the price ceiling: since the equilibrium maximizes the
(surplus of the good) sum of consumer and producer surplus, a price floor below the equilibrium
reduces the total surplus
Inefficient allocation of Sellers who are willing to sell at the lowest price are unable to make sales
sales among sellers while sales go to sellers who are only willing to sell at a higher price
Wasted resources Price floors lead to wasted time and effort, often unwanted surpluses have
to be thrown away
Inefficiently high quality Sellers offer high quality goods at a high price, even though buyers would
prefer a lower quality at a lower price
Controlling Quantities
Quantity control (quota) is an upper limit on the quantity of some good than can be bought or
sold on a market
They are controlled by governments by giving out licenses (which gives owners the right to
supply a good)
The total amount of the good than can be transacted under the quantity control is called the
quota limit
Often quantity controls are put into place to address a temporary problem, but become
complicated to abolish again
Demand price: describes at which price consumers want to buy a given quantity
Supply price: of a given quantity is the price at which producers will supply that quantity
2
, Example of taxi medallions
The quota restricts the quantity supplied, which leads to a deadweight loss
The restriction also opens up a second market: besides the market for taxi rides, there is a
market for medallions (in case a taxi driver would rent his medallion to someone else)
The price for which Taxi driver A would rent to taxi driver B depends on the wedge between
demand price and supply price
Wedge: difference between the demand price and the supply price of a good; that is the price
paid by buyers ends up being higher than that received by the sellers (in example that’s $2)
Quotas don’t always have an effect on the market (if it is above the equilibrium quantity, it
would have no effect)
Negative side effects of quotas:
1. Deadweight loss by preventing mutually beneficial transactions from occurring (only if the
market reached the unregulated market equilibrium quantity, there would be no missed
opportunities)
2. More reason to break the law (because people want to avoid the restrictions around the
quota)
Week II: Applying the basic model
Notes on the Reading chapter 5
Part I: Elasticity
Price elasticity measures how the quantity demanded responds to changes in price
The price elasticity is important for investors to know (whether they can earn significant profit
from a business)
With the information of price elasticity, the investors can predict if rises in pricing results in an
increase of revenue
To describe the elasticity, percentages are used because those don’t depend on the unit in which
a good is measured in
The price elasticity of demand is equal to the percent change in the quantity demanded divided
by the percent change in the prices as you move along the demand curve, and dropping any
minus sign
How to calculate
% change in quantity demanded = change in quantity demanded/ Initial quantity demanded x 100
% change in price = change in price/ Initial price x 100
% price elasticity of demand = % change in quantity demanded/ % change in price
Importance of the minus sign: in example calculation, the minus has been dropped; law of
demand says that demand curves are always downward sloping, therefore the price and quantity
demanded move in different directions
-> a positive percent change in price leads to a negative percent change in quantity demanded
-> a negative percent change in price leads to a positive percent change in quantity demanded
The price elasticity is always a negative number; in practice the minus is not mentioned (but
taken for granted)
3
