Market Efficiency and Market Failure

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CHAPTER 4
Market Efficiency and Market Failure

1. Chapter Summary
Governments of over 200 cities in the United States have placed ceilings on the maximum rent some landlords can charge for their apartments. Some firms have coaxed governments into imposing price floors, which are legally determined minimum prices that sellers may receive. To understand the economic impact of government interventions in markets, it is necessary to understand consumer surplus and producer surplus.

Consumer surplus is the dollar net benefit consumers receive from buying goods and services at market prices less than the maximum prices they would be willing to pay. In a demand and supply graph, consumer surplus equals the area below the demand curve and above a horizontal line drawn from the price axis to the point on the demand curve that represents the market price. Producer surplus is the dollar net benefit producers receive from selling goods and services at prices greater than the minimum prices they would be willing to accept. In a demand and supply graph, producer surplus is equal to the area above the supply curve and below a horizontal line drawn from the price axis to the point on the supply curve that represents the market price. In a competitive market, the equilibrium price for a good or service occurs at the quantity of product where the marginal cost of the last unit produced and sold is equal to the marginal benefit consumers receive from the last unit bought. Therefore, equilibrium in a competitive market results in an economically efficient level of output. At this same level of output economic surplus, the sum of consumer and producer surplus in this market is maximized.

Some producers who believe an equilibrium price is too low will lobby for government action to set a higher legal price (a “floor price”). Some consumers who believe that an equilibrium price is too high will lobby government to legally require that a lower price (a “ceiling price”) be charged. Although price ceilings and price floors are not common, they have been established in some markets. Price floors were established in agricultural markets in the United States during the Great Depression. Government intervention in agriculture has continued ever since. Although the administration of price floors can be complex, the basic operation of this price control involves a government commitment to maintain a price (for example, $3.50 per bushel of wheat) that exceeds the equilibrium price (for example, $3.00). The price floor reduces the quantity demanded of the product while it encourages producers to increase the quantity supplied. The difference between these two quantities, a surplus, is typically bought by government at the floor price. The result of the price floor is to (a) transfer some consumer surplus that would exist at the equilibrium price to producer surplus and (b) create a “deadweight loss” or a net loss of consumer and producer surplus. The deadweight loss is also the efficiency loss that results from the price floor. Another example of a price floor is the “minimum wage,” which is a legal wage imposed above the equilibrium wage offered in the United States for most occupations. Since most workers earn wages above the minimum wage, this price (wage) floor affects low-skilled and inexperienced workers. Although the economic impact of the minimum wage is similar to that of price floors imposed in other markets (deadweight losses result), economists have disagreed about the extent to which the minimum wage reduces employment.

Price ceilings are found most often in the markets for apartments in various cities; local governments will usually impose this type of price ceiling. In New York City, about 1 million apartments are subject to rent control. A simple description of the impact of a price ceiling on rent (administration of the ceiling will vary by city and over time) is that the quantity demanded at the ceiling...
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