Model: Price Ceilings
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- Teresa Griffin
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1 Model: Price Ceilings Today, we will examine a model of price ceilings, one type of market distortion. This model reflects a pattern of policy used in response to unpopular fluctuations in the prices of resources and goods such as food, gasoline, and other energy sources. Assumptions An economic model is basically a set of equations and rules that we use to describe a situation. Some of the most important rules (or assumptions) are those that describe how people perceive those situations and act in response. The price ceiling model is a variation of the basic model (short-term equilibrium in a perfectly competitive market). The key assumptions of the models are listed below. Note that the assumptions in bold differ between the two models. Standard (neoclassical) economics assumptions Rational consumers who maximize utility Rational producers who maximize profits Perfect competition Consumers are price-takers Producers are price-takers Short-term equilibrium Some factors of production are fixed No entry or exit Other No market failure No government intervention (basic model) Government regulation of pricing (price ceiling) Any model is effective only as far as its assumptions describe the situation of interest. You should view an economic model as only a rough approximation of reality, rather than an attempt to capture it precisely and completely. Even as a rough approximation, using a particular model makes sense only if you think that the assumptions are reasonable for describing the situation.
2 Problem Setup Consider the following market for widgets: The aggregate marginal benefit curve for widget consumers is P = 200 2Q, where Q is quantity demanded. The aggregate marginal cost curve for widget producers is P = Q, where Q is quantity supplied. Questions to Discuss Efficient Outcome Use the marginal benefit and marginal cost equations given above to determine the efficient outcome. Answer the following questions: What is the efficient quantity (Q*)? What is the joint surplus (JS*) based on that quantity? Scenario A Basic Model Suppose that all the assumptions of the basic model apply. Answer the following questions: Find the market equilibrium quantity (Q) and price (P). Draw a graph showing the demand and supply equations and the market equilibrium. (Blank figure below) Find the consumer surplus (CS) and producer surplus (PS) for this equilibrium outcome. Find the joint surplus (JS) and deadweight loss (DWL) associated with this outcome. Is this outcome efficient? Why or why not? Note: This scenario is sometimes called the unregulated (or free or laissez-faire) market, since there is no government intervention. Scenario B Price Ceiling Suppose that the government does not like the equilibrium outcome of the unregulated market above. Specifically, the price seems too high. Thus, the government imposes a form of price controls: a price ceiling. A newly enacted law states that no one may charge a price higher than P = 50 for widgets.
3 Answer the following questions: What quantity is demanded (QD) at the ceiling price? What quantity is supplied (QS) at the ceiling price? What is the consumers marginal benefit at the quantity supplied [MB(QS)]? You do not need to record this answer in the table, but it will help you calculate consumer surplus later. What is the market outcome? What market quantity (Q) will be produced and consumed? What is the market price (P)? Note: This market outcome is not an equilibrium, since QD QS. Draw a graph showing the relevant equations and market outcome. (Blank figure below) Find the consumer surplus (CS) and producer surplus (PS) for this market outcome. Find the joint surplus (JS) and deadweight loss (DWL) associated with this outcome. Is this outcome efficient? Why or why not? You can draw your figures here: Scenario A Basic Model
4 Scenario B Price Ceiling
5 You can record your answers to the mathematical questions here: Efficient Outcome Unregulated Equil. Scenario A Price Ceiling Scenario B Efficient quantity (Q*) Quantity demanded (Q D ) Quantity supplied (Q S ) Market quantity (Q) Market price (P) Consumer surplus (CS) Producer surplus (PS) Joint surplus (JS* or JS) Deadweight loss (DWL)
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