Microeconomic Theory - Eiu

Chapter 15 APPLIED COMPETITIVE ANALYSIS MICROECONOMIC THEORY BASIC PRINCIPLES AND EXTENSIONS EIGHTH EDITION WALTER NICHOLSON Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved. Price Controls Sometimes the government may seek to control prices at below equilibrium levels will lead to a shortage We can look at the changes in producer and consumer surplus from this policy to analyze its impact on welfare Price Controls Price

Initially, the market is in long-run equilibrium at P1, Q1 SS LS P1 Demand increases to D D D Q1 Quantity Price Controls Price In the short run, price rises to P2 SS

P2 LS P3 P1 D Firms would begin to enter the industry The price would end up at P3 D Q1 Quantity Price Controls Price

Suppose that the government imposes a price ceiling at P1 SS LS P3 P1 D There will be a shortage equal to Q2 - Q1 D Q1 Q2 Quantity

Price Controls Price Some buyers will gain because they can purchase the good for a lower price SS LS P3 P1 D This gain in consumer surplus is the shaded rectangle D

Q1 Q2 Quantity Price Controls Price The gain to consumers is also a loss to producers who now receive a lower price SS LS P3 P1 D D

Q1 Q2 The shaded rectangle therefore represents a pure transfer from producers to consumers No welfare loss there Quantity Price Controls Price SS LS P3 P1 This shaded triangle

represents the value of additional consumer surplus that would have been attained without the price control D D Q1 Q2 Quantity Price Controls Price SS LS

P3 P1 This shaded triangle represents the value of additional producer surplus that would have been attained without the price control D D Q1 Q2 Quantity Price Controls Price SS

LS P3 This shaded area represents the total value of mutually beneficial transactions that are prevented by the government P1 D This is a measure of the pure welfare costs of this policy D Q1

Q2 Quantity Disequilibrium Behavior Assuming that observed market outcomes are generated by Q(P1) = min [QD(P1),QS(P1)] suppliers will be content with the outcome but demanders will not This could lead to black markets