Microsoft Word - AEG114_Final Assessment_Reading.docx

Microsoft Word AEG114 Final Assessment Reading docx Read the passage Markets, Prices, and Price Controls ABSTRACT This essay describes the concepts of supply and demand and elaborates on their relatio[.]

Read the passage Markets, Prices, and Price Controls ABSTRACT This essay describes the concepts of supply and demand and elaborates on their relationship in a competitive market It details how the willingness of consumers to buy and of sellers to sell is dependent on price The equilibrium price is introduced , and it is shown to occupy a special point in market movement, the point at which supply matches demand The essay also examines attempts by governments to intervene in markets, usually to relieve the price pressure faced by lower-income consumers as they try to secure essentials like housing, food, and hygiene products The example is given of price controls imposed by the Venezuelan government on toilet paper The essay concludes with the contention that the Venezuelan government's price­ control attempts were unsuccessful, generating market dynamics that were harmful to both consumers and producers The author generalizes from this case and contend s that markets should be left alone to reach price points through the natural interplay of supply and demand Take a look around you at the kinds of products and services you usually consume Focus on the clothes you are wearing, the food you had for lunch, the phone you communicate with, and the computer you write assignments or play video games on Chances are that the vast majority of these goods and services were purchased in several markets What is a market? A market is a gathering of people This gathering allows producers of a good or service to find buyers who are interested in their good or service A market can be local, such as your neighborhood mall or town farmers' market, or much larger, such as global markets for different types of clothing, which involve sellers and buyers from all over the world A market can be physical, like a brick-and -mortar grocery store, or virtual, such as a website where you buy books or an online broker service through which you purchase stocks and bonds Markets have existed for thousands of years, ever since humans discovered the advantages of specialization and trade beyond their family unit or small tribe Specialization means someone spends much of his or her time producing a good or service that he or she is particularly proficient at creating The next step in specialization is trade-finding someone who wants that product or service As the number of such specialties becomes larger and societies become more complex, markets become more elaborate mechanisms for facilitating multi­ party trade among potential buyers and sellers This complexity is far from just a modem phenomenon, and there are notable examples in ancient civilizations of trade networks stretching thousands of miles and involving scores of middlemen Today's myriad markets both differ from and are remarkably similar to those of earlier exchanges, in scale and sophistication A lack of complete self-sufficiency may seem like a weakness, but in fact it's not Almost no one in a modern economy is even close to being self-sufficient To understand why, imagine what would happen if you had to create from scratch everything that you consume Imagine that you had to sew the fabric to get the shirt that you wear, and you also had to weave cotton to create that fabric, and furthermore you had to plant and harvest the cotton that would eventually be part of your shirt Imagine that you had to create your phone from scratch, from the plastic or metal casing to the delicate electronic components inside, and the smooth and delicate piece of glass that covers the screen No single human being can produce the variety of goods we enjoy today Under a regime of self-sufficiency, one's pursuits would be incredibly narrow and even the most basic subsistence would be difficult We have achieved our current level of consumption and economic well-being through specialization and trade 5 In this essay we will focus on how markets facilitate trade and let all of us-consumers and producers, society overall achieve better economic outcomes A market attracts producers and buyers of a certain good or service Within a market, each producer is trying to maximize revenue from selling a product while each buyer is trying to pay as little as possible for a product Out of all market transactions, two critical numbers emerge First, the number of units sold within a certain period of time, for example, the number of cars sold in your hometown in a month or the pounds of tomatoes sold in your local farmers' market in a day The second important number is the price at which these transactions occurred Prices may fluctuate across sellers and with time, but at each point in time, the price of a good tends to converge to a certain value The resulting price -when the quantity supplied equals the quantity demanded -is called the equilibrium price Modern markets are very complex institutions, sometimes with millions of consumers and tens of thousands of sellers in a single market, producing intricate behavioral patterns As all scientists normally do, economists take this complex, real-life situation and represent it with a model that captures the main features and allows us to understand what is going on and make useful predictions In this essay, we will focus on competitive markets ­ those with several sellers and buyers, all trading the same product Economists represent the behavior of consumers in a competitive market through the demand curve, which states that when the price of a product increases, consumers will buy fewer units (if nothing else changes simultaneously) For example, let us say we are studying the market for medium-quality bicycles, and ten million bicycles are purchased when the price is $250 If the price doubles to $500, then economists would expect to observe a decrease in the quantity demanded (e.g., to million) Graphically, the demand is a downward -sloping curve (Figure 1) Another way of interpreting the demand curve is that at each point, it shows how much the last consumer was willing to pay for the last unit purchased For example, the customer who bought the very fast bike that was sold at a price of $250 (bike number ten million) was also willing to pay exactly $250 Consumers higher on the demand curve have a higher willingness to pay (WTP) and thus would be willing to pay more than the market price of $250 Consumers lower on the demand curve have a willingness to pay less than the market price of $250, and as a result, not buy a bike In a competitive market, producers are willing to sell more units of the good when its price increases That behavior is summarized by an upward-sloping supply curve (Figure 2) In our bicycle-market example, with ten minion bicycles being sold at a price of $250, if the price of a bike doubles, then we would expect more bikes being offered in this market as more producers enter the market Just as consumers' willingness to pay is represented 011 the demand curve, the producers' willingness to sell (also called reservation price} is represented on the supply curve The producer's willingness to sell is based on the minimum value he or she will accept in order to sell a good 9 Given these representations of the fundamentals of the behavior of buyers (demand) and sellers (supply), economists analyze their impact on the market dynamics In essence, economists superimpose a supply curve on a demand curve to find the point where the two intersect If the price is high­ above the intersection of demand and supply (as represented in Figure 3)-sellers are offering more bicycles (Qs) than consumers are willing to buy (Qi), resulting in a surplus That surplus or excess supply of bicycles means that bicycles are piling up in stores, and to get rid of them, sellers are willing to lower the price to attract more consumers As the price falls, the quantity of bicycles demanded increases, but at the same time, sellers are willing to sell fewer units Prices will continue to fall only as long as the quantity supplied exceeds the quantity demanded This movement will stop when the price reaches the intersection of demand and supply, where the quantity demanded and the quantity supplied are equal 10 Similarly, if the price is low (below the intersection of demand and supply, as represented in Figure 4), consumers would to supply fewer bikes That creates a shortage of- or excess demand for - bicycles Some of those potential buyers who would like to have a bike but could not get one will be willing to bid up the price to buy a bike despite the shortage As the price of bicycles increases, producers will be wining to put more bikes on the market, and some consumers will decide not to buy any at the higher price, reducing the shortage The increase in prices will continue as long as there is a shortage, that is, until the price reaches the intersection of demand and supply 11 As you can see, whether the price is too high and there are too many bikes or the price is too low and there are not enough bikes to satisfy the demand, the combined behavior of consumers and producers will push the price of a bicycle toward the intersection of demand and supply At that point there is no further incentive to change the price, and we have reached the market equilibrium (Figure 5) The competitive market model predicts two specific numbers (the equilibrium price and the equilibrium quantity) that we can test against a real market to see whether the outcome of our simplified representation is close enough to real life 12 Note that for all but the last unit sold at the market equilibrium, the willingness to pay (represented by the demand curve) exceeds the market price For example, if I use a bicycle to go to work as well as to exercise and I am willing to pay $700 for the bike, but I only end up paying the market price of $250, then I gain $450 (WTP $700 - Price $250) in the transaction Consumer surplus is the difference between what a consumer is willing to pay and what he or she actually pays The aggregate gains for all consumers in this market are represented by the area between the demand curve and the market price, as shown in Figure Likewise, producers enjoy similar gains because the market price exceeds their willingness to sell for all but the last unit sold at the market equilibrium Producer surplus is the benefit that a producer receives by getting more for his or her product than the minimum he or she was willing to accept The aggregate difference between market price and willingness to sell is shown in Figure 13 A fascinating aspect of competitive markets is that consumers and producers individually need very little information to reach the market equilibrium In fact, a person may be completely ignorant about what others are doing as long as he or she has two pieces of information: his or her own willingness to pay (for consumers) or willingness to sell (for producers) and the market price The market price serves as a very accurate summary of the aggregate actions of all buyers and sellers in the market, and that information, coupled with the individual, self-interested behavior of buyers and sellers, yields three results that are good for society 14 First, consumer surplus and producer surplus are maximized at the market equilibrium How we prove that? Imagine a dictator who prevents market participants from selling- and therefore buying-as many u nits as in equilibrium Because of this, some buyers with willingness to pay above the market price will be prevented from buying the good (thus reducing consumer surplus), and some producers with willingness to sell below the market price will not be able to sell their product (thus reducing producer surplus) So reducing the quantity of goods to below the equilibrium quantity hurts both consumers and producers 15 Conversely, if the dictator forces consumers and producers to buy and sell more units, for each unit beyond the equilibrium quantity, some consumers will be forced to pay more than they are actually willing to pay (thus reducing consumer surplus), and some sellers will be forced to sell at a price below their willingness (thus reducing producer surplus) Taking those two scenarios together, if a forced decrease in quantity and a forced increase in quantity both result in producers as well off as they can be, and that no amount of tinkering with the total quantity or the price will improve this outcome 16 But is there any way to leave the market quantity untouched and just change the allocation among consumers or producers, and increase the consumer or producer surplus? Let's tackle that question for consumers first Each and every consumer has the incentive to continue buying as long as the market price is less than or equal to his or her willingness to pay, so the willingness to pay for the very last unit purchased by each consumer will be equal to or close to the market price Each consumer makes this decision independently, without knowing anyone else's willingness to pay; knowing just the market price and one's own willingness to pay is enough However, the combined result of these actions is that the willingness to pay of every consumer is equal to or close to the market price, which also means that without any conscious coordination, everyone has about the same willingness to pay for the last unit consumed That, in turn, means that if you were to take one unit from one consumer (thus hurting that person) to improve the welfare of another consumer (by adding one more unit to that person's consumption at a lower willingness to pay), then you will hurt the first consumer more than you benefit the second one, thus reducing consumer surplus For example, let's say Jane and Paul are each buying two cups of coffee a day for $2 per cup, in equilibrium So both of them have the same willingness to pay the same amount for that second cup-$2 If you now forcefully take one cup of coffee from Jane and give it to Paul for free, Jane loses her second cup (worth $2 to her) while Paul gains a third cup­ which will be worth less than his second cup of coffee, thus less than $2 The competitive market equilibrium automatically guarantees that there is no way to improve the welfare of any consumer without hurting others even more, a situation that economists describe as an efficient allocation of goods across consumers 17 Similarly, each and every producer has the incentive to continue selling as long as the market price is higher than or equal to the willingness to sell, so the willingness to sell the very last unit created by each producer will be equal to or close to the market price and therefore close to every other producer’s willingness to sell If you attempt to improve overall welfare by reallocating production across firms, you will hurt some firms who end up producing at a point where the market price is below their willingness to sell So, a competitive market also results in automatic efficient allocation of goods across producers Producers as well off as they can be, and that no amount of tinkering with the total quantity or the price will improve this outcome 18 Let's recap: If anyone messes with the total quantity transacted in a competitive market, or if anyone messes with the allocation of goods across consumers and producers in a competitive market, the result will be lower consumer and producer surplus No central planner can improve on the equilibrium outcome of a competitive market The one critical piece of information that allows this almost-magical result to happen over and over again across all competitive markets is the equilibrium price The price conveys to all consumers and producer’s essential information that allows them to reach maximum consumer and producer surplus without central coordination 19 Are all markets competitive? No For several reasons, in some markets you may observe just one or two sellers, or one or two buyers -for example, markets with goods that have relatively high fixed costs, like pharmaceutical products and electricity And the competitive markets' results may not apply to some special types of goods But by and large, competitive markets are efficient, resulting in the best allocation of goods and resources, maximizing consumer and producer surplus 20 Despite the critical role of prices in competitive markets, sometimes governments prevent the price of a good or a service from reaching its equilibrium, thus interfering with the information communicated across buyers and sellers There are two basic types of price controls: the maximum price or price ceiling, and the minimum price or price floor The minimum wage and the prices of raisins, milk, and some other agricultural products are all examples of price floors At this point in our discussion, we will focus our analysis on price ceilings, which include some notable examples, such as controlled rent and the prices of some goods deemed to be necessities in a given location at a given point in history 21 Price ceilings are meant to facilitate access to basic goods For example, at this point in history, rent control laws in New York City and San Francisco are politically important as city leaders try to make housing accessible to low-income households Similarly, the current government of Venezuela enforces price ceilings on coffee, bread, toilet paper, and other basic items in an attempt to keep these goods relatively cheap despite the rampant rate of price increases throughout the country 22 Inexpensive goods for everyone! What could be better? But price ceilings actually achieve their goal? Furthermore, how clod price ceilings affect consumer and producer surplus? Can price ceilings beat the market outcome without intervention? 23 Let's analyze price ceilings with our competitive market model Figure shows a competitive market reaching equilibrium at consumer surplus is ambiguous: some (Pe, Qi) Let's say this is the market for toilet paper in Venezuela, and the government imposes a price ceiling at Pmax At this lower price, the quantity demanded increases and more consumers would be happy to get toilet paper However, producers would only be willing to sell a limited quantity of toilet paper at this lower price What does our model predict? A shortage of toilet paper There will indeed be some lucky consumers who will be able to buy toilet paper at the low price But the limited supply will soon run out, and many consumers will be left without toilet paper In the absence of government intervention, the price of toilet paper would increase until the shortage disappears But raising the price of toilet paper is illegal in Venezuela, and anyone who attempts to get around this regulation risks imprisonment The net result is not at all what the government intended 24 So we are stuck with a price ceiling for toilet paper What are the consequences? First, since the quantity of toilet paper produced and consumed is lower than n in equilibrium, the total surplus for society (consumer plus producer surplus) is smallerthe Venezuelan society is worse off, a noticeable and unfortunate effect of the price ceiling When loss of economic efficiency occurs because equilibrium is not achieved, the result is deadweight loss The shaded triangle in Figure represents this loss 25 Note that producer surplus is certainly smaller On the other hand, the effect on consumer surplus is ambiguous: some consumers benefit from the lower price, though only those who are able to buy toilet paper But even for those consumers who got to purchase some toilet paper, is the artificially low price their only cost? Unfortunately, not Those consumers were able to buy toilet paper by waiting in line for hours, trying to be one of the first people to enter supermarkets as soon as they opened to be one of the few who could get their hands on a pack of toilet paper before the shelves were emptied Figure does not explicitly show the cost of lining up and the uncertainty of getting toilet paper, but it is undoubtedly another disadvantage of setting a price ceiling 26 Producers who see their ability to charge higher prices curtailed may resort to reducing their cost by lowering the quality of their product In the case of toilet paper, we should expect the high-quality toilet paper to be displaced by thin and rough toilet paper 27 Last but not least, who gets the toilet paper? In a competitive market, those buyers who value toilet paper the most would get iteveryone with a willingness to pay above the market price But the introduction of the price ceiling means that many people who would be willing to pay the price will not get toilet paper, and those who get it are not necessarily the consumers who value toilet paper the most The price ceiling has cost us not just our overall efficiency (the maximum total surplus for society) but also the efficiency in allocation across consumers The combined loss is much larger than the deadweight loss represented in Figure 28 Did the predictions of economists play out in Venezuela? They certainly did However, this phenomenon is not exclusive to the price ceiling of toilet paper in Venezuela It is observed in any competitive market with a price ceiling below the equilibrium price In some markets, like housing subject to rent control, beyond the short­ term shortage a misallocation of resources, the prospect of permanently lower future rents reduces investment in housing, resulting in poor maintenance and long-term shortages of good-quality housing in rent-controlled areas Governments may introduce additional regulation trying to lessen the negative impacts of price ceilings, but the only truly successful solution is the elimination of price controls 29 In a nutshell, the argument against price controls is that they result in fewer people getting the products or jobs they want So, are economists who dislike them saying that we should abandon the goal of access to basic goods to all people? Not at all If that is indeed the societal goal, there are better, less costly ways of achieving it Examples include a direct subsidy for lowincome people or better subsidized education that improves the opportunities of low-income people 30 Why then price controls exist at all? Because those who benefit, benefit in not insignificant ways and therefore tend to fight hard to keep them The few who can work at a higher wage, buy a good at a lower price, or sell a product at a higher price may, for example, actively lobby government to keep the status quo This occurs despite the harm caused to the many others who, in the absence of such price controls, would also be able to work or buy or sell goods In other words, price controls create very visible, empowered winners -those who earn the higher wage, pay the lower rent, sell the more expensive product-and this empowerment greases the gears of the political process that leads to price controls  ... rents reduces investment in housing, resulting in poor maintenance and long-term shortages of good-quality housing in rent-controlled areas Governments may introduce additional regulation trying... or sell goods In other words, price controls create very visible, empowered winners -those who earn the higher wage, pay the lower rent, sell the more expensive product-and this empowerment greases... represented in Figure 4), consumers would to supply fewer bikes That creates a shortage of- or excess demand for - bicycles Some of those potential buyers who would like to have a bike but could not