Competitive markets
[Michael] In this set of lecture videos, we’ll discuss the impact of two government policies, price controls, and taxation on competitive markets. The purpose of this set of videos is to illustrate select instances of government or political failure. Government failure arises when government intervention in a market leads to a misallocation of resources. Later this semester, we’ll talk about market failure. This is when the markets themselves misallocate resources. Okay, let’s talk about how government policies can alter market outcomes. Price controls consist of price ceilings and price floors. A price ceiling is a legally determined, maximum price that can be charged for a good or service. An example of a price ceiling is rent control. A price floor, on the other hand, is a legally determined minimum price that can be charged for a good or service. An example of a price floor is a minimum wage in a labor market.
Taxation, of course, can take many different forms. We’ll simplify the world and just consider the impact of a unit tax on consumers and firms in some competitive market. But we won’t get to that for a bit. For the time being, let’s focus exclusively on price controls. Price controls are either binding or non-binding in nature. They are binding when they prohibit the market from clearing. In other words, a binding price control exists when it prevents the market-clearing price from being achieved. Since the market can’t clear, a binding price control will result in either a surplus or a shortage. You probably recall how we already talked about these concepts earlier in the semester. We discussed how a surplus exists when the quantity supplied exceeds the quantity demanded. While a shortage exists. When the quantity demanded exceeds the quantity supplied. And we concluded that in competitive markets, surpluses and shortages were just temporary phenomenon.
The market price would adjust to clear the market and eliminate the surplus or the shortage. But that is not the case here. It’s not the case here because, again, a binding price control by definition prohibits the market from clearing. Non-binding price controls, on the other hand, have no impact on the market. This is because price can adjust to clear the market. An example of a non-binding price control would be a 1 cent per hour minimum wage, that wouldn’t impact the labor market at all. Consider the following example of a binding price ceiling. In the case of rent control, which impacts the market for apartments, the legislated price is below the market-clearing price. But before we analyze the impact of rent control specifically, let’s take a look at what would happen otherwise in a competitive market. Suppose the figure you see here captures the market for apartments.
Notice that in competitive equilibrium, the price of an apartment is $800 per month, and 300 apartments are rented per month. Now suppose the legislature enacts a $500 per month rent control measure. This is binding because the equilibrium price of $800 per month can’t be achieved. The quantity of apartments supplied at a monthly price of $500 is only 250 per month. While the quantity demanded at this rent-controlled price is 400 apartments per month. As a result, there is a shortage of 400. The quantity demanded minus 250, the quantity supplied, which equals a shortage of 150 apartments in a given month. Since there is a shortage, some mechanism other than price will be used to allocate apartments. Landlords must ration the few apartments among the many possible renters. And there are multiple socially undesirable ways for this rationing to occur. Generally speaking, in the presence of a shortage, sellers can ration goods and services via a first-in-time mechanism or via discrimination.
First-in-time implies that buyers will wait in lines to acquire the good or service in question. Earlier this semester, we recognized how this arose back in the day when Apple would release its newest product. And we still see it today in other areas like when you want to purchase tickets to a popular concert or sporting event. It is clear why this method of allocating resources is socially undesirable. Buyers incur costs by waiting in line. Indeed, they could be doing something else. And with discrimination, sellers’ biases dictate which buyers receive the good or service. It is clear why this method two is socially undesirable. We don’t want sellers’ tastes and preferences for discrimination to govern the allocation of resources. Goods and services do not find their way into the hands of the highest-valuing users. And that’s something we would otherwise get in a competitive market. In competitive equilibrium, the market has rationed goods and services to the highest-valuing users via the price signal, which is efficient, and it is unbiased.
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