Macroeconomics

Paul Krugman, Robin Wells

ISBN #9781464110375

4th Edition

265 Questions

16,351 Students Helped

Homework Questions

Summary

Learning Objectives

Key Concepts

Example Problems

Explanations

Common Mistakes

Summary

This chapter examines how well-intentioned government interventions, including price ceilings, price floors, and quotas, aim to protect specific groups but often introduce market inefficiencies. Such interventions can lead to shortages, surpluses, misallocation of resources, quota rents, and unintended consequences like black markets and illegal activities. The key lesson is that while these policies may address immediate concerns, they often shift problems rather than solving them, and the benefits are usually skewed towards organized interest groups at the expense of overall market efficiency.

Learning Objectives

Explain how government interventions such as price controls and quotas are intended to protect certain groups but can lead to market inefficiencies.

Analyze the effects of price ceilings and price floors on supply and demand, including shortages and surpluses.

Describe the concept of quota rent and how quantity controls create disparities between consumer payments and seller receipts.

Evaluate the unintended consequences of these policies, such as misallocation of resources, reduced quality, black markets, and illegal activities.

Key Concepts

CONCEPT

DEFINITION

Price Control

Government-imposed limits on the prices that can be charged in the market, including both ceilings and floors.

Price Ceiling

A maximum allowable price set by the government, which if below the equilibrium price, leads to shortages and reduced product quality.

Price Floor

A minimum allowable price set by the government, which if above the equilibrium price, results in surpluses and unwanted resource expenditure.

Quota

A limit on the quantity of a good that can be produced or sold, creating a gap between what consumers pay and what sellers receive.

Quota Rent

The extra earnings that sellers receive due to the limitation imposed by a quota, representing the difference between the consumer's willingness to pay and the actual price received by sellers.

Market Inefficiencies

Outcomes where resources are not allocated in the most economically efficient way due to interventions such as price controls and quotas.

Example Problems

Example 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. 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 shortage 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? Illustrate with a diagram. A. Suppose that the stock market rises and the demand for taxi rides returns to normal (that is, returns to the demand schedule given in the table). The mayor now decides to ingratiate himself with taxi drivers. He announces a policy in which operating licenses are given to existing taxi drivers; the number of licenses is restricted such that only 10 million rides per year can be given. Illustrate the effect of this policy on the market, and indicate the resulting price and quantity transacted. What is the quota rent per ride?

Example 2

In the late eighteenth century, the price of bread in New York City was controlled, 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? 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? Explain in detail.

Example 3

The U.S. Department of Agriculture (USDA) administers the price floor for butter, which the 2008 Farm Bill set at $$\$ 1.05$$ per pound. At that price, according to data from the USDA, the quantity of butter supplied in 2010 was $1.7$ billion pounds, and the quantity demanded was $1.6$ billion pounds. To support the price of butter at the price floor, the USDA therefore had to buy up 100 million pounds of butter. The accompanying diagram shows supply and demand curves illustrating the market for butter. a. In the absence of a price floor, how much consumer surplus is created? How much producer surplus? What is the total surplus? b. With the price floor at $$\$ 1.05$$ per pound of butter, consumers buy $1.6$ billion pounds of butter. How much consumer surplus is created now? c. With the price floor at $$\$ 1.05$$ per pound of butter, producers sell $1.7$ billion pounds of butter (some to consumers and some to the USDA). How much producer surplus is created now? d. How much money does the USDA spend on buying up surplus butter? e. Taxes must be collected to pay for the purchases of surplus butter by the USDA. As a result, total surplus (producer plus consumer) is reduced by the amount the USDA spent on buying surplus butter. Using your answers for parts $\mathrm{b}-\mathrm{d}$, what is the total surplus when there is a price floor? How does this compare to the total surplus without a price floor from part a?

Example 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. a. How much surplus milk will be produced as a result of this policy? b. What will be the cost to the government of this policy? c. since milk is an important source of protein and calcium, the government decides to provide the surplus milk it purchases to elementary schools at a price of only $\$ 0.60$ per pint. Assume that schools will buy any amount of milk available at this low price. But parents now reduce their purchases of milk 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? d. Explain how inefficiencies in the form of inefficient allocation to sellers and wasted resources arise from this policy.

Example 5

European governments tend to make greater use of price controls than does the U.S. government. For example, the French government sets minimum starting 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. 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 $\in 35,000 .$ Is there any involuntary unemployment at this wage? If so, how much? Illustrate with a diagram. What if the minimum wage is set at $\in 40,000 ?$ Also illustrate with a diagram. c. Given your answer to part b and the information in the table, what do you think is the relationship between the level of involuntary unemployment and the level of the minimum wage? Who benefits from such a policy? Who loses? What is the missed opportunity here?

Step-by-Step Explanations

QUESTION

How does a price ceiling lead to a shortage in the market?

STEP-BY-STEP ANSWER:

Step 1: Identify the equilibrium price where the quantity supplied equals the quantity demanded without intervention.
Step 2: Impose a price ceiling that is set below this equilibrium price.
Step 3: Recognize that at the lower price, consumers demand more of the product than producers are willing to supply.
Step 4: Conclude that the excess demand results in a shortage, as the reduced price signals consumers to purchase more while discouraging producers from supplying enough.
Final Answer:

Price Ceiling

QUESTION

How does a price floor cause a surplus in the market?

STEP-BY-STEP ANSWER:

Step 1: Determine the market's equilibrium price where supply equals demand.
Step 2: Set a price floor that is above this equilibrium price.
Step 3: Observe that at the higher price, producers are willing to supply more while consumers demand less due to the increased cost.
Step 4: Recognize that this imbalance where supply exceeds demand results in a surplus of goods.
Final Answer:

Price Floor

QUESTION

What is the effect of a quota on market transactions and how is quota rent generated?

STEP-BY-STEP ANSWER:

Step 1: Understand that a quota limits the quantity of a good available for sale, regardless of demand.
Step 2: Realize that this limitation restricts supply which can drive the market price higher than what sellers actually receive.
Step 3: Recognize that consumers may be willing to pay a higher price than the price sellers receive, leading to a difference known as quota rent.
Step 4: Conclude that this rent is effectively captured by those who have the legal access to the quota, representing an inefficient transfer of wealth.
Final Answer:

Quota

Common Mistakes

Confusing the effects of price ceilings with those of price floors, instead of recognizing that each creates different issues (shortages vs. surpluses).
Assuming that any government intervention automatically results in positive outcomes, without accounting for the unintended market inefficiencies and black market creations.
Overlooking the concept of quota rent and its implication on the distribution of hidden gains from market restrictions.
Believing that the objectives of protecting certain economic groups justify all side effects, without understanding the overall cost to market efficiency.