1SUPPLY, DEMAND, MARKETS AND APPLICATIONSUnderstanding How Markets Work1Markets I: Supply and DemandMarkets II: We Love Markets!Markets III: Sometimes We Don’t!Markets IV: Elasticity and ApplicationsMARKETS III:GOVERNMENT POLICY & MARKET FAILUREHow can government policies affect the market?When does the market do a bad job?2OVERVIEW / Questions of the DayWhat happens when we ‘interfere’ with markets?• Can the government control the price of a product/good/service?• How?• How do buyers and sellers respond?• What does that do to price, quantity and allocation?What happens if the market doesn’t do its job well?• What if the market doesn’t do what we as a society want?• What if the market fails to allocate resources the way we want?• Why does this occur?• Can we help to fix it?32I. PRICE CONTROLSWhat are price controls?Why do we have them?4I. Price FloorsPrice Floor: (also known as: price supports); a legal minimum price for a good or service• This makes it illegal to •Essentially, the government attempts to maintain a price higher than P* (called a • If the price floor is set lower than P*, it is “non-binding”•Who is the government trying to help?56I. Price Floors: Non-bindingSP*PQDPfloorA price floor essentially blocks off the market below itThis area of the market is no longer accessible to buyers or sellersSo what?37I. Price Floor: BindingSP*PQDPfloorThis price floor is effective…8SP*PDQPfloorI. Price Floor: General Outcome9I. Application: Agricultural Price SupportsS3P ($)DQ (bushels of corn)430 40Pf410I. Application: Minimum WageS (of labor)w*w (P of labor)D (of labor)L (Q of labor)WminI. Price CeilingsPrice Ceiling: a legal maximum price for a good or service• This makes it illegal to •Essentially, the government attempts to maintain a price lower than P* (called a• If the price ceiling is set higher than P*, it is “non-binding”•Who is the government trying to help?•1112I. Price Ceilings: Non-binding SP*PQDPceilingThe ceiling effectively shuts off this part of the marketSo what?513I. Price Ceilings: BindingSP*PQDPceiling14I. Price Ceiling: General OutcomeSP*PDQPc15I. Application: Rent CeilingsSrent*Rent DQ (apts)rent ceiling(P of Apts.)6BIG IDEA IN ECONOMICS•Economists, in general, are not in favor of price controls•Binding price floors• set the price • cause • In general, hurts •Binding price ceilings• set the price • cause • In general, hurts 16Below is the market for blue jeans. Suppose the government wanted to help blue jean sellers. Should they set a price floor or ceiling? At what price?17$80$70$90$100PBlue jeansQBlue jeans / day(thousands)20 28354555SDII. MARKET FAILURE!187II. Market Failure: What is it?For the majority of goods / services / inputs / resources / labor / etc., markets do a ‘good job’ for society• Markets allocate goods and services effectively and efficiently•However, sometimes they don’t…Market Failure: A situation where the market equilibrium results in Sometimes, government policies can19II. Market Failure: Some Causes•When might the market do a bad job?•What are the results?•How can government policy help improve the situation?1. Lack of Competition2. Externalities3. Public Goods4. Income Inequality2021Recall: Markets and Allocation8Q (do-dads/month)9Market SupplyMarket DemandAt P = $9, buyers wish to buy a total of 8 do-dads:K wants 3L wants 4M wants 1At P = $9, sellers wish to supply a total of 8 do-dads:Bud sells 4Coors sells 4P8II. Market Failure: A Perfect Example22What does a ‘Perfect Market’ look like?1. Demand is composed of lots of buyers• Buyers compete and 2. Supply is composed of lots of sellers• Sellers compete and can’t 3. The market finds the ‘correct’ price• P* accurately reflects the 4. The market finds the • We as a society actually want • We want to use resources to make only this muchP*Q*SDII. Market Failure: Lack of CompetitionThe Problem•Sometimes firms get greedy• Several competitors will• They reduce output and • This increases •Buyers end up paying more for product•Resources are The Solution•The government has passed several • It is illegal for firms to ‘restrict trade’ (fix the market)• Corporations can be • Individuals perpetrators can be 23II. Market Failure: Lack of Competition24P*Q*SDWhen firms collude, they generally agree to collectively reduce their outputThis works like9II. Market Failure: ExternalitiesSome goods have unique properties whereby people not represented in the market are affected by the decisions / actions of those in the marketExternality: A cost or benefit imposed on •Externalities can be negative or positive• Negative externalities: when market participants impose • Positive externalities: when market participants impose some25II. Market Failure: Negative Externalities26P1Q1SPrivateDProducers only take their private costs into accountThis results inThe optimal outcome would incorporate all costs of production (private and public)This would result in thee1II. Market Failure: Negative ExternalitiesThe Problem•Production of some goods creates special costs that aren’t taken into account• Therefore, the cost of production is • Thus, too much o• The price is too •Resources are The Solution•Two common methods to force firms to reduce production1. Tax goods that cause negative externalities2. Regulate the production of goods that cause negative externalities• Either method attempts to 2710II. Market Failure: Public Goods•Some goods have unique properties that make it difficult for normal firms to profitably providePublic Good: A good or service with the following properties: 1. Users collectively2. There is no way to bar Q.Why is this a problem?A.• Fireworks example28Private or Public Good?Private Good – markets typically do a pretty good job•• Ice Cream /• Houses / furniturePublic Goods – markets typically do NOT do a good job•••••29Free Markets and the Economic ‘Pie’30Size of the pie using the free market system The ‘Economic Pie’ represents the total value of what a country producesIt represent the goods & services produced that we all enjoyIt also represents income, as these are ultimately sold to buyersSize of the pie using a different economic system Most people more or less agree that the free market system results in a larger pie11Free Markets and the Economic ‘Pie’31Splitting the pie evenly(an equitable