Economics Year 1

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Economics coursework
Question A
After World War II local authorities in some European cities (Berlin and Frankfurt, for instance) prescribed ceilings on rental prices for city flats. The idea was to make access to appropriate dwelling space largely independent of income. Although the measures served the purpose for a while, very soon negative side-effects did appear; in particular, black markets for flats developed, and, in the longer run, inner cities’ residential houses got dilapidated. Use economic theory to explain the situation and the consequences that arose. Hint: Consider the incentives of landlords, rental agencies and flat-hunters. Post WW2 times in Germany were really hard for a nation which just came out of a losing war. The country was full of debts with other countries and the economy was low because a lot of money had been spent on weapons and on the army. Many men died at war, so there was a gap in a generation of men. The country was divided into various parts and in particular Berlin was divided by a wall between East and West Germany. Many people suffered from financial struggles and so the government imposed a price ceiling on the rental prices of city flats so that the flats available for rent were spread equally across the people, independently of income. As stated on the fundamental economics finance website (http://economics.fundamentalfinance.com/price-ceiling.php) “a price ceiling occurs when the government puts a legal limit on how high the price of product can be. In order for a product to be effective, it must be set below the natural market equilibrium.” Using economic theory we assume that before the price ceiling was imposed, the city flats trade was found to be a in a free and competitive market. The main players in this market are landlords, rental agencies and flat hunters who each have their own motives and different needs. Landlords want to make the highest possible profit for renting their flats out; rental agencies which act as middle men between landlords and flat hunters, want to make the highest possible commission; and finally flat hunters want to pay the lowest possible price for the flats they rent. However as the government steps in to implement a rent control, a free and competitive market is no longer assumed as there is a limit to the profits landlords and rental agencies can make. So before the price ceiling was imposed, the flat rental market was assumed to be a free and competitive market as shown in diagram 1.

DIAGRAM 1 A free and competitive market
P DS

P1 E

S D
0Q1Q
D= Demand; S= Supply; Q= Quantity; P=Price; E= Equilibrium.
In diagram 1 it is possible to see the conditions of a free market before the introduction of price ceiling; the equilibrium is found at E. The equilibrium shows that the number of flats for rent is equal to the price tenants are prepared to pay for them.

DIAGRAM 2 Price ceiling
P DS

P1 E
PC
S D 0 Q3 Q1 Q2 Q

In diagram 2 it can be seen that as price of flats goes down, because of price ceilings, the demand for flats goes higher, as it can be seen by Q2. However as landlords suffer from lower profits, some of them withdraw their flats for rent in the market, making the quantity for flat available go to Q3. Price ceiling, PC, is set below the market equilibrium, thus making this no longer a free and competitive market. The space between Q3 and Q2 represents excess demand, which is shown by the arrow.

DIAGRAM 3 Short term and long term effects of price ceiling
P D Short term supply curve
Long term supply curve
P1 E
PC
D 0 Q4 Q3 Q1...
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