Chapter 09 _Government in the Market_

Chapter 09 _Government in the Market_ - Chapter 9...

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1 Chapter 9 Government in the Marketplace Introduction and Review The last chapter showed that, in the absence of any market failure , the outcome of a perfectly competitive market would be allocatively efficient. In this chapter we will consider a perfectly competitive market system in the short run in the absence of any market failure. We will then analyze the effects of several types of government intervention in the market. All these policy measures will be shown to produce economic inefficiencies. The reason for this result should be intuitively clear from the discussion in the last chapter. If the unfettered free market system results in the best possible outcome, any interference in the system would change the situation for the worse. As they say, ―If it ain’t broke, don’t fix it.‖ We focus on the short run equilibrium since any conclusions that we draw would apply equally or more strongly to the long run situations. We will study four types of government intervention in the market: price ceilings, price floors, taxes, and subsidies. Price Ceilings Sometimes governments impose a price ceiling or cap on a product, meaning that no producer would be allowed to charge a higher price. Examples of price ceilings are rent control, proposals to set a cap on credit card interest rates, price caps on electricity transacted in California, or price ceilings on necessities after wars or revolutions. Consider Figure 1, which shows a hypothetical market for rental apartments in a city. In the absence of any rent control , the equilibrium rent would be $1,000 and 10,000 units would be rented. Perhaps to help low-income families, the city government imposes a ceiling of $500 on the rent. First of all, note that to be effective the price ceiling should be lower than the equilibrium price. If the government imposes a ceiling of $1,500, the rent will just equal $1,000, the equilibrium rent. An effective price ceiling is the one that is lower than the equilibrium price. This is because without government intervention the market price will go above that price. The following will be the results of this rent control. They also apply to any other good that is under an effective price ceiling. A shortage will develop. The rent of $500 is so low that many people who were contemplating buying a house now decide to rent. The quantity demanded increases to 15,000 units due to this substitution effect. On the other hand, many home owners might think it is not worth renting their room at such a low rent. They will withdraw their units from the market and the quantity supplied will drop to 5,000 units. The shortage will equal 10,000 (=15,000 – 5,000) apartments. The quantity transacted in the market will be equal to the ― short side of the market .‖ At the rent of $500, the short side of the market is determined by the supply function.
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2 Figure 1 A Price Ceiling Generally a price control might necessitate a quantity control . The government needs to decide how to allocate the 5,000 apartment units among 15,000 households. The
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This note was uploaded on 11/08/2010 for the course PSC PSC 001 taught by Professor Paoli during the Spring '09 term at UC Davis.

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Chapter 09 _Government in the Market_ - Chapter 9...

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