Government action in markets

Price Ceiling (Price cap)

Meaning:*Government sets a maximum
price for some essential goods &
services to benefit poor consumers. Eg.
Rent ceiling
• * An effective price ceiling is set below the
equilibrium price.
• * Main results:
• - housing shortage (excess demand occurs, Qd
for houses exceeds Qs of houses.)
• -increased search activity : time spent to find
someone to do business with.
• - black market (illegal trading) exists.
• Gr. Ill. The case of a price ceiling eg(rent
ceiling)

• Gr. Ill. The black market price.

 Price floor
• Meaning: Government sets a minimum price
for some goods & services to benefit poor
producers eg. Minimum labor wages.
• An effective price floor is set above the
equilibrium price.
• Main results:
• Excess supply of labor occurs (Qs of labor
exceeds Qd of labor). Unemployment exists
• Gr. Ill the case of a price floor (eg minimum
wages)
Possibilities, Preferences & Choices
• 1- Meaning of consumer`s equilibrium.
• 2-The Budget line BL.
• 3- The Indifference Curve IC & schedule.
• 4- Indifference map (Preference map).
• 5- Consumer`s equilibrium graphically.
1- Meaning of consumer`s equilibrium
• The consumer seeks to maximize
SATISFACTION given a certain INCOME &
PRICES OF GOODS.

• Thus, we need a tool of analysis that reflects

SATISFACTION (IC) & another tool of analysis
that reflects INCOME & PRICES ( BL).
 2- The Budget Line BL
• A- How is it drawn?
• B- What does a BL show?
• C- Characteristics of BL.
• D- Slope of BL
• E- Changes of BL
 A- How to draw a BL
• If income (I) is $100 (I= 100) & the consumer
fully spends his income. If unit price of X is
$10 (Px = 10) & unit price of Y is $20 ( Py=20).
Draw the BL.

• WE assume 2 extremes : spending all income

on X only, thus consumer buys 10 units of X
• (I / Px = 100 / 10 = 10 units of X
• Then we assume spending all income on Y
only, thus consumer buys 5 units of y . ( I / Py
= 100 / 20 = 5 units of Y.

• Then we join the 2 extremes.

• Gr. Ill the previous BL

• B- What does the BL show?

• It shows various combinations of 2 goods (X,Y)
that can be bought given consumer`s income &
prices of goods. BL shows consumer`s
possibilities.
 C- Characteristics of BL
• Any point BELOW the BL is attainable, but
income isn`t fully spent.
• Any point ABOVE the BL is unattainable.
• Any point on the BL is attainable & income is
fully spent. Accordingly, any point ON the BL
fulfills the following EQUATION:
• Px Qx + Py Qy = Income (I)
• From the following diagram if income = 100 &
Px = 10 & Py = 20, what is the budget
equation at point e ?

• Equation at point e : Px Qx + Py Qy = income

• (10) (5) + (20) (2.5) = 100
 E- Slope of BL
• The slope of the budget line is the RELATIVE
PRICES Px / Py
 F- Changes of the BL
• BL will change if INCOME changes, while
prices of goods are constant.

• OR
• BL will change if PRICE OF ONE GOOD
changes, while income & price of other good
remain constant.
• If Income = 100 Px = 10 Py = 20
• Draw the original BL, then show what happens
if Income = 200 Px = 10 Py = 20

• Graph shows if income rises, BL SHIFTS

PARALLEL TO ITSELF OUTWARDS.
• If income =100 Px = 10 Py = 20
• Draw the original BL, then show what happens
if income = 50 Px = 10 Py = 20

• Graph shows if income FALLS, BL SHIFTS

PARALLEL TO ITSELF INWARDS.
• If income = 100 Px = 10 Py = 20
• Draw the original BL, then show what happens
if income = 100 Px = 5 Py = 20

• Graph shows that if price of X falls, BL

ROTATES OUTWARDS
• If income = 100 Px = 10 Py = 20
• Draw the original BL,then show what happens
if income = 100 Px = 50 Py = 20

• Graph shows if price of X rises, BL ROTATES

INWARDS.
 3- Indifference curve (IC) & schedule
• Do you PREFER bundle A that contains:
• 5 units of Y & 1 unit of X
• OR bundle B that contains:
• 3.5 units of Y & 2 units of X
• Consumer might state that both bundles A & B
yield the same level of SATISFACTION, the
consumer is INDIFFERENT regarding these
bundles.
• Consumer is able to set an INDIFFERENCE
SCHEDULE that show various bundles of
products X & Y THAT YIELD THE SAME LEVEL
OF SATISFACTION.
 Indifference schedule
Bundle Qy Qx change in Y/change in X
A 5 1
B 3.5 2 1.5
C 2.5 3 1
D 1.7 4 0.8
• Graphically ill. An indifference curve (IC)

• Thus we focus on :a- What does an IC show?

• b- Characteristics of IC
• c- Slope of IC
• A- What does an IC show?
• IC shows the preferences of the consumer, it
shows various bundles of 2 goods THAT YIELD
THE SAME LEVEL OF SATISFACTION
• B- Characteristics of IC:
• * An IC is NEGATIVELY SLOPED so that all bundles
yield the same level of satisfaction.

• * An IC is CONVEX (bowed) toward the origin due

to DIMINISHING marginal rate of substitution
(MRS): there is a general tendency for a person to
be willing to give up LESS & LESS of good Y to get
an extra unit of X, while at the same time
remaining indifferent. (Check the previous
schedule)
• Check the column that shows:
• Change in Y / Change in X

• C- Slope of the IC is the MRS

 4- Indifference Map
• It consists of various ICs , the HIGHER the IC
the HIGHER THE LEVEL OF SATISFACTION.
• Gr. Ill an indifference map
5- Graphical illustration of consumer`s
equilibrium
• From the following diagram comment on the
different bundles:

• Point N is attainable but doesn`t maximize

satisfaction. Point M is unaffordable. Points L
& K are affordable but do not maximize
satisfaction . Point E (equilibrium) maximizes
satisfaction given income & prices.
• Gr. Ill consumer`s equilibrium

• It is where the BL is a TANGENT to the highest

possible IC.
• Thus slope of BL = slope of IC
• Thus relative prices = MRS