Economics Chapter 5 Interactive Activity Price Controls And Quotas Meddling With Markets Order Ingratiate

Unlock access to all the studying documents.

View Full Document

interactive activity

Chapter 5

Price Controls and

Quotas: Meddling with Markets

1. In order to ingratiate himself with voters, the mayor of Gotham City decides to

lower the price of taxi rides. Assume, for simplicity, that all taxi rides are the

same distance and therefore cost the same. The accompanying table shows the

demand and supply schedules for taxi rides.

Fare

(per ride)

Quantity of rides

(millions per year)

Quantity demanded Quantity supplied

$7.00 10 12

6.00 12 10

5.00 14 8

4.50 15 7

a. Assume that there are no restrictions on the number of taxi rides that can

be supplied (there is no medallion system). Find the equilibrium price and

quantity.

b. Suppose that the mayor sets a price ceiling at $5.50. How large is the short-

age of rides? Illustrate with a diagram. Who loses and who benefits from this

policy?

c. Suppose that the stock market crashes and, as a result, people in Gotham City

are poorer. This reduces the quantity of taxi rides demanded by 6 million rides

per year at any given price. What effect will the mayor’s new policy have now?

S-70 Chapter 5 Price controls and Quotas: Meddling with Markets

1. a. The equilibrium in the market for taxi rides is shown by E1 in the accom-

panying diagram. The equilibrium price is $6.50; at that price, the quantity

demanded equals the quantity supplied—11 million taxi rides per year. The

demand and supply curves (D1 and S) illustrate this initial situation.

6.50

5.50

4.50

Fare

(per ride)

Quantity of rides

(millions per year)

57911 13 15

b. With a price ceiling of $5.50, the quantity supplied is 9 million taxi rides and

the quantity demanded is 13 million. So the shortage is 13 million – 9 million =

$7.00

6.00

5.00

4.50

Fare

(per ride)

Quantity of rides

(millions per year)

57911131

517

Shortage

ceiling

c. The new demand curve is D2. Now the price ceiling has no effect: the equilib–

rium is point E2 and the market price settles at $5, which is below the man-

dated price ceiling of $5.50. There will be 8 million taxi rides demanded and

supplied, at a price of $5 each.

6.50

5.50

4.50

Fare

(per ride)

5789 11 13 15 17

Price

Solution

Chapter 5 Price controls and Quotas: Meddling with Markets S-71

d. The accompanying diagram illustrates the effect of the quota of 10 million

taxi rides. The quantity of taxi rides is now 10 million, at a price of $7. The

quota rent per ride is $1.

$7.00

6.00

5.00

4.50

Fare

(per ride)

Quantity of rides

(millions per year)

Quota

2. In the late eighteenth century, the price of bread in New York City was con-

trolled, set at a predetermined price above the market price.

a. Draw a diagram showing the effect of the policy. Did the policy act as a price

ceiling or a price floor?

b. What kinds of inefficiencies were likely to have arisen when the controlled

price of bread was above the market price? Explain in detail.

One year during this period, a poor wheat harvest caused a leftward shift in the

supply of bread and therefore an increase in its market price. New York bakers

found that the controlled price of bread in New York was below the market price.

c. Draw a diagram showing the effect of the price control on the market for

bread during this one–year period. Did the policy act as a price ceiling or a

price floor?

d. What kinds of inefficiencies do you think occurred during this period?

2. a. Panel (a) of the accompanying diagram illustrates the effect of this policy.

Since the price is set above the market equilibrium price, this policy acts as

a price floor: it raises the price artificially above the equilibrium. As a result,

too much bread is produced: there is a surplus.

Price

Quantity of bread

Price

Quantity of bread

Price

floor Shortage

Panel (a) Panel (b)

Solution

S-72 Chapter 5 Price controls and Quotas: Meddling with Markets

b. As with all price floors above the equilibrium price, there are several associ-

ated inefficiencies. First, there is deadweight loss from inefficiently low quan-

tity. Some transactions that would have occurred at the unregulated market

c. Panel (b) illustrates the effect of the fixed price if the market equilibrium is

above that price. The set price now acts like a price ceiling, preventing the

price from rising to the equilibrium. There is a shortage, as occurs with every

price ceiling below the equilibrium price.

d. As with all price ceilings below the equilibrium price, there are several associ-

ated inefficiencies. First, there is deadweight loss from inefficiently low quan-

tity. There is a persistent shortage of bread, and some transactions that would

3. In 2014, the U.S. House of Representatives approved a new farm bill establish-

ing the Margin Protection Program (MPP) for dairy producers. The MPP sup–

ports dairy farmers when the margin between feed costs and milk prices falls

Price of milk

(per pound)

0.18

0.05

240200140

Quantity of

milk

(billions of pounds)

a. In the absence of a price floor, how much consumer surplus is created? How

much producer surplus? What is the total surplus (producer surplus plus con–

sumer surplus)?

b. With the price floor at $0.18 per pound of milk, consumers buy 140 billion

pounds of milk. How much consumer surplus is created now?

c. With the price floor at $0.18 per pound of milk, producers sell 240 billion

pounds of milk (some to consumers and some to the USDA). How much pro–

ducer surplus is created now?

d. How much money does the USDA spend to buy surplus milk?

3. a. In the absence of a price floor, consumer surplus is the area below the demand

curve but above the equilibrium price of $0.15: it is (($0.25 – $0.15) ×

b. With the price floor at $0.18 per pound, consumer surplus is the area below

the demand curve but above the price of $0.18: it is (($0.25 – $0.18) ×

140 billion)/2 = $4.9 billion.

d. The USDA buys 100 billion pounds of milk at a price of $0.18 per pound, for a

total of $0.18 × 100 billion = $18 billion.

4. The accompanying table shows hypothetical demand and supply schedules for

milk per year. The U.S. government decides that the incomes of dairy farmers

should be maintained at a level that allows the traditional family dairy farm

to survive. So it implements a price floor of $1 per pint by buying surplus milk

until the market price is $1 per pint.

Price of milk

(per pint)

Quantity of milk

(millions of pints per year)

Quantity demanded Quantity supplied

$1.20 550 850

1.00 650 750

0.80 750 650

a. In a diagram, show the deadweight loss from the inefficiently low quantity

bought and sold.

b. How much surplus milk will be produced as a result of this policy?

c. What will be the cost to the government of this policy?

d. Since milk is an important source of protein and calcium, the government

at any price by 50 million pints per year because they know their children

are getting milk at school. How much will the dairy program now cost the

government?

Solution

S-74 Chapter 5 Price controls and Quotas: Meddling with Markets

4. a. The deadweight loss is shown in the accompanying diagram by the shaded

triangle.

b. With demand of D1 and supply of S, the equilibrium would be at point E1 in

the accompanying diagram. However, with a price floor at $1, the quantity

supplied is 750 million pints and the quantity demanded is 650 million pints.

So the policy causes a surplus of milk of 100 million pints per year.

1.10

0.90

Price of milk

(per pint)

Quantity of milk

(millions of pints per year)

500 550 600 650 700 750 850800

E1Price

100 million pints

Deadweight

c. In order to sustain this price floor (to prevent black market sales of surplus

milk below the price floor), the government has to buy up the surplus of milk.

Buying 100 million pints of milk at a price of $1 each costs the government

$100 million.

d. As a result of sales of cheap milk to schools, the quantity demanded falls by

50 million pints per year at any price: the demand curve shifts leftward to the

new demand curve D2. Without the price floor, the equilibrium would now

$1.20

1.00

0.80

Price of milk

(per pint)

Quantity of milk (millions of pints per year)

500 600 700 750675 800 850

Surplus of

150 million pints

e. Some milk producers are inefficient: if the price was allowed to reach equi-

librium, they would find it too costly to produce. In their absence, milk would

be produced only by the most efficient producers. Furthermore, resources

Solution

5. European governments tend to make greater use of price controls than does

the U.S. government. For example, the French government sets minimum start-

ing yearly wages for new hires who have completed le bac, certification roughly

equivalent to a high school diploma. The demand schedule for new hires with

le bac and the supply schedule for similarly credentialed new job seekers are

given in the accompanying table. The price here—given in euros, the currency

used in France—is the same as the yearly wage.

Wage

(per year)

Quantity demanded

(new job offers

per year)

Quantity supplied

(new job seekers

per year)

€45,000 200,000 325,000

30,000 290,000 290,000

25,000 370,000 200,000

a. In the absence of government interference, what are the equilibrium wage and

number of graduates hired per year? Illustrate with a diagram. Will there be

anyone seeking a job at the equilibrium wage who is unable to find one—that

is, will there be anyone who is involuntarily unemployed?

b. Suppose the French government sets a minimum yearly wage of €35,000. Is

there any involuntary unemployment at this wage? If so, how much? Illustrate

with a diagram. What if the minimum wage is set at €40,000? Also illustrate

5. a. The equilibrium wage is €30,000, and 290,000 workers are hired. There is full

employment: nobody is involuntarily unemployed. The equilibrium is at point E.

Wage

(thousands

per year)

Quantity of workers

(thousands per year)

200 220 250 290 310

320 325

370

Surplus

b. With a minimum wage of €35,000, there is a surplus of workers of 60,000 (the

quantity supplied is 310,000 and the quantity demanded is 250,000). That is,

Solution

S-76 Chapter 5 Price controls and Quotas: Meddling with Markets

c. The higher the minimum wage, the larger the amount of involuntary unem-

ployment. The people who benefit from this policy are those workers who

6. In many European countries high minimum wages have led to high levels of

unemployment and underemployment, and to a two-tier labor system. In the

formal labor market, workers have good jobs that pay at least the minimum

wage. In the informal, or black market for labor, workers have poor jobs and

receive less than the minimum wage.

a. Draw a demand and supply diagram showing the effect of the imposition of a

minimum wage on the overall market for labor, with wage on the vertical axis

and hours of labor on the horizontal axis. Your supply curve should represent

the hours of labor offered by workers according to the wage, and the demand

b. Assume that the imposition of the high minimum wage causes a contraction

in the economy so that employers in the formal sector cut their production

and their demand for workers. Illustrate the effect of this on the overall mar-

ket for labor. What happens to the size of the deadweight loss? The shortage?

Illustrate with a diagram.

c. Assume that the workers who cannot get a job paying at least the minimum

wage move into the informal labor market where there is no minimum wage.

What happens to the size of the informal market for labor as a result of the

economic contraction? What happens to the equilibrium wage in the informal

labor market? Illustrate with a supply and demand diagram for the informal

market.

6. a. The shortage created is a shortage of jobs: at the minimum wage there are

more job–seekers than there are jobs available.

(Overall labor mark

et)

Shortage

Hours work

Wage

Minimum

(Overall labor mark

et)

Solution

Chapter 5 Price controls and Quotas: Meddling with Markets S-77

b. The contraction in the economy causes the demand for labor to fall, shifting

the demand curve leftwards from D to its new position at D′. Both the dead-

weight loss and the shortage of jobs caused by the minimum wage increase as

a result of the fall in the demand for labor.

D’

(Overall labor

market)

New shortage

Old shortage

Hours worked

Wage

Minimum

wage

loss

(Overall labor mark

et)

c. As a result of the economic contraction, which reduces the demand for work–

ers in the overall market, workers move to the informal labor market. This

increases the supply of labor in the informal labor market. The supply curve

Wage

S (Informal

labor market)

S’

7. For the last 80 years the U.S. government has used price supports to provide

income assistance to American farmers. To implement these price supports, at

times the government has used price floors, which it maintains by buying up

1,2001,000800

Price of corn

(per bushel)

Quantity of corn (bushels)

a. If the government sets a price floor of $5 per bushel, how many bushels of

corn are produced? How many are purchased by consumers? By the govern-

ment? How much does the program cost the government? How much revenue

do corn farmers receive?

7. a. With a price floor of $5, the quantity of corn supplied is 1,200 bushels. The

quantity demanded is only 800 bushels: there is a surplus of 400 bushels. The

b. If the government sets a target price of $5, the market reaches equilibrium at

a price of $3 and a quantity of 1,000 bushels. There is no surplus (or short-

age). The government does not buy any corn under this policy. For each bushel

c. The price–floor policy is more expensive for consumers: they pay $5 per bushel

(compared to the $3 under the target-price policy). Both policies are equally

expensive for the government.

Solution

8. The waters off the North Atlantic coast were once teeming with fish. But due

to overfishing by the commercial fishing industry, the stocks of fish became

seriously depleted. In 1991, the National Marine Fishery Service of the U.S. gov-

Price of swordfish

(per pound)

Quantity of swordfish

(millions of pounds per year)

Quantity demanded Quantity supplied

$20 6 15

18 7 13

a. Use a diagram to show the effect of the quota on the market for swordfish in

1991. In your diagram, illustrate the deadweight loss from inefficiently low

quantity.

b. How do you think fishermen will change how they fish in response to this

policy?

8. a. The quantity sold is 7 million pounds, at a price of $18 per pound. On each

pound of fish caught, each fisherman earns quota rent of $6, as shown in the

accompanying diagram. The shaded triangle shows the deadweight loss.

$20

Price of swordfish

(per pound)

Quantity of swordfish

(million pounds per year)

678910 11 15141312

Quota

b. Because each pound of swordfish gives a fisherman $6 quota rent, each fisher-

Solution

S-80 Chapter 5 Price controls and Quotas: Meddling with Markets

9. In Maine, you must have a license to harvest lobster commercially; these licenses

are issued yearly. The state of Maine is concerned about the dwindling supplies

of lobsters found off its coast. The state fishery department has decided to place

a yearly quota of 80,000 pounds of lobsters harvested in all Maine waters. It has

also decided to give licenses this year only to those fishermen who had licenses

last year. The accompanying diagram shows the demand and supply curves for

Maine lobsters.

120804020 60 100 1400

Price of

lobster

(per pound)

Quantity of lobsters (thousands of pounds)

a. In the absence of government restrictions, what are the equilibrium price and

quantity?

b. What is the demand price at which consumers wish to purchase 80,000 pounds

of lobsters?

c. What is the supply price at which suppliers are willing to supply 80,000 pounds

of lobsters?

d. What is the quota rent per pound of lobster when 80,000 pounds are sold?

9. a. Without government restrictions, the equilibrium in the market for lobsters is

at point E. The equilibrium price for lobsters is $10 per pound. At that price,

the quantity demanded and the quantity supplied are 120,000 pounds of

lobsters.

$22

Price of lobster

(per pound)

Quantity of lobsters

(thousands of pounds)

20 40 60 100

140

12080

Quota

b. The demand price of 80,000 pounds of lobsters is $14.

c. The supply price of 80,000 pounds of lobsters is $8.

Solution

10. The Venezuelan government has imposed a price ceiling on the retail price of

roasted coffee beans. The accompanying diagram shows the market for coffee

beans. In the absence of price controls, the equilibrium is at point E, with an

equilibrium price of PE and an equilibrium quantity bought and sold of QE.

Quantity of coffee beans

Price of

ffee beans

QCQE

a. Show the consumer and producer surplus before the introduction of the price

ceiling.

After the introduction of the price ceiling, the price falls to PC and the quantity

bought and sold falls to QC.

b. Show the consumer surplus after the introduction of the price ceiling (assum–

c. Show the producer surplus after the introduction of the price ceiling (assum–

ing that the producers with the lowest cost get to sell their coffee beans; that

is, assuming that there is no inefficient allocation of sales among producers).

e. Using the diagram, show how much of what was total surplus before the

introduction of the price ceiling has been lost. That is, how great is the

deadweight loss?

10. a. Consumer surplus is the area labeled CS1 and producer surplus is the area

labeled PS1 in panel (a) of the accompanying diagram.

b. Consumer surplus after the introduction of the price ceiling is made up of the

Solution

S-82 Chapter 5 Price controls and Quotas: Meddling with Markets

e. The amount of total surplus lost as a result of the introduction of the price

ceiling, the deadweight loss, is the area labeled deadweight loss in panel (b).

Quantity of coffee beans

Price of

coffee

Quantity of coffee beans

Price

coffee

(a) Before the Introduction

of the Price Ceiling

(b) After the Introduction

of the Price Ceiling

Deadweight

11. The accompanying diagram shows data from the U.S. Bureau of Labor Statis-

tics on the average price of an airline ticket in the United States from 1975 until

1985, adjusted to eliminate the effect of inflation (the general increase in the

11. a. When a binding price floor—one that is set above the equilibrium price—is

removed, you should expect the price of the good to fall. From looking at the

data in the figure, you should think that the pre–1978 price floor was inef-

fective, since the price of an airline ticket actually rose after 1978. In the

accompanying diagram, the price floor, PF, is nonbinding: it is set below the

equilibrium price, PE. In that case, removing the price floor would not lead to

a decrease in price.

Quantity of airline tickets

Price of

airline tick

b. Many things that determine the price of an average airline ticket changed in

1978; the removal of the price floor on airline tickets was just one of them.

What also changed was that airlines now could—and did—offer longer–range

flights. So although the average ticket price increased, so did the distance of

12. Many college students attempt to land internships before graduation to burnish

their resumes, gain experience in a chosen field, or try out possible careers.

The hope shared by all of these prospective interns is that they will find intern-

ships that pay more than typical summer jobs, such as waiting tables or flipping

burgers.

a. With wage measured on the vertical axis and number of hours of work on the

Solution

12. a. Here the market-clearing wage, W1, is nonbinding because it is above the

minimum wage. In this case the minimum wage has no effect on the market

for interns: the number of hours transacted in the market equilibrium, X1, is

the same as if there had been no minimum wage.

Wage

Solution

Chapter 5 Price controls and Quotas: Meddling with Markets S-85

WORK IT OUT Interactive step-by-step help with solving this

problem can be found online.

13. Suppose it is decided that rent control in New York City will be abolished

and that market rents will now prevail. Assume that all rental units are iden-

tical and so are offered at the same rent. To address the plight of residents

a. Use a diagram to show the effect on the rental market of the elimination

of rent control. What will happen to the quality and quantity of rental

housing supplied?

b. Use a second diagram to show the additional effect of the income–supple–

ment policy on the market. What effect does it have on the market rent

and quantity of rental housing supplied in comparison to your answers to

part a?

c. Are tenants better or worse off as a result of these policies? Are landlords

better or worse off? Is society as a whole better or worse off?

13. a. With a price ceiling at PC, the quantity bought and sold is QC, indicated by

point A. The ceiling at PC is eliminated and the rent returns to the market

equilibrium E1, with an equilibrium rent of P1. The quantity supplied increases

from QC to the equilibrium quantity Q1. At the same time, you should expect

the quality of rental housing to improve. As you learned in this chapter, one

of the inefficiencies caused by price ceilings is inefficiently low quality. As

the rent returns to the equilibrium rent, landlords again have the incentive to

invest in the quality of their apartments in order to attract renters.

QCQuantity of apartments

Monthly

rent

Solution

S-86 Chapter 5 Price controls and Quotas: Meddling with Markets

b. The income–supplement policy causes a rightward shift of the demand curve

from D1 to D2. This results in an increase in the equilibrium rent, from P1 to

P2, and an increase in the equilibrium quantity, from Q1 to Q2, as the equilib-

rium changes from E1 to E2.

Q1Quantity of apartments

Monthly

rent

c. Landlords are clearly better off as a result of these two policies: more land-

lords rent out apartments, and at a higher monthly rent. It is not clear whether

tenants are better or worse off. Some tenants who previously could not get

apartments can now do so, but at a higher rent. In particular, those tenants

d. It is likely that tenants who currently live in rent–controlled housing are better

organized than people who cannot currently find rental housing. And more

organized groups can generally exert greater influence over city policy.