Exam Focus

This review examines how market equilibrium is affected by price ceilings, minimum wages, taxes, subsidies, quotas, and trade in illegal goods. For each of these you should know how supply, demand, and the resulting market equilibrium price and quantity are affected. It is important to understand why economists believe that, in general, interference with market forces causes economic inefficiency (an inefficient allocation of resources).

LOS 15.a: Explain market equilibrium, distinguish between long-term and short-term impacts of outside shocks, and describe the effects of rent ceilings on the existence of black markets in the housing sector and on the market s efficiency.

Market equilibrium, as we saw in the previous topic review, occurs at the price where the quantity supplied is equal to the quantity demanded.

Outside shocks, such as natural disasters, can temporarily interrupt the supply of goods or services. In panel (a) of Figure 1 this is shown as a shift to the left in the short-run supply curve. The short run is the period in which producers cannot adjust their capacity. Assuming the outside shock does not affect demand, the reduction in supply results in a higher equilibrium price and lower equilibrium output in the short run.

In the long term, when producers can adjust capacity, they find that the higher price is an opportunity to profit bv increasing their output. The resulting higher output quantity drives the equilibrium price lower again. Other things equal, in the long run both price and quantity can return to their equilibrium levels prior to the outside shock as shown in panel (b) of Figure 1.

Figure 1: Impact of an Outside Shock

(a) Short-term impact

Figure 1: Impact of an Outside Shock

(a) Short-term impact

(b) Long-term impact

An example of a supply shock from a disaster is an earthquake that destroys a significant portion of the housing stock in an area. Initially, rents rise because of the decrease in supply. Over time, spare rooms and garages are converted to rentable housing and new units of housing are constructed in response to the price increase. This accounts for the increase in supply over time; prices eventually fall to prior levels as more supply is created. However, increasing rents often bring calls for authorities to intervene in the market by imposing price controls. Limiting how high rents can go decreases the incentive to create more housing units in the short run.

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A price ceiling is an upper limit on the price which a seller can charge. If the ceiling is above the equilibrium price, it will have no effect. As illustrated in Figure 2, if the ceiling is below the equilibrium price, the result will be a shortage (excess demand) at the ceiling price. The quantity demanded, Q^, exceeds the quantity supplied, Q^. Consumers are willing to pay Pws (price with search costs) for the Q^ quantity suppliers are willing to sell at the ceiling price, P . Consumers are willing to expend effort with a value of P - Pc in search activity to find the scarce good. The reduction in quantity exchanged due to the price ceiling leads to a deadweight loss in efficiency as noted in Figure 2.

Figure 2: Price Ceiling

Price demand demand

ceiling price (maximum)

supply / Deadweight loss ceiling price (maximum)

With an effective price ceiling, price is no longer an effective means of rationing the good or service. In the long run, price ceilings lead to the following:

• Consumers may have to wait in long lines to make purchases. They pa}' a price (an opportunity cost) in terms of the time they spend in line.

• Suppliers may engage in discrimination, such as selling to friends and relatives first.

• Suppliers "officially" sell at the ceiling price, but take bribes to do so.

• Suppliers may also reduce the quality of the goods produced to a level commensurate with the ceiling price.

In the housing market, price ceilings are appropriately called rent ceilings or rent control. Rent ceilings are a good example of how a price ceiling can distort a market. Renters must wait for units to become available. Renters may have to bribe landlords to rent at the ceiling price. The quality of the apartments will fall. Other inefficiencies can develop. For instance, a renter might be reluctant to take a new job across town because it means giving up a rent-controlled apartment and risking not finding another (rent-controlled) apartment near the new place of work.

A black market refers to economic activity that takes place illegally. This includes selling goods at prices that exceed legally imposed price ceilings. Bribing a landlord to get a rent-controlled apartment is an example of black market activity. Another way for a landlord to charge rent that exceeds the rent ceiling is to "officially" rent at the ceiling, then charge excessive fees for items such as mailboxes, keys and locks, or window treatments.

A black market is generally inefficient because:

• Contracts are not as enforceable.

• The risk of prosecution increases the prices required by suppliers.

• Quality control deteriorates, which leads to more defective products.

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