Chapter 4: Demand and Supply Applications – Rationing, Market Efficiency, and Deadweight Loss

4.1 The Price System: Rationing and Allocating Resources

Introduction

The market price system plays a crucial role in allocating scarce resources and rationing goods and services among consumers. It operates through price signals, which reflect the interaction of supply and demand.

• Price rationing device: Allocates goods/services to consumers when quantity demanded exceeds quantity supplied.

• Allocation of resources: Distributes resources among producers and determines the final mix of outputs.

Price Rationing

• Shortages in free markets cause prices to rise until $Q_s = Q_d$ (market clears).

• Scarce supply leads to price being determined by demand; highest bidder sets the price.

• Price rationing ensures that those willing to pay more get the limited supply.

• Adjustment of price is the rationing mechanism in free markets.

Nonprice Rationing Devices

• Queuing: Waiting in line, time/aggravation costs.

• Favored customers: Friends/family may receive priority.

• Ration coupons: Fixed amounts per family, regardless of income.

• If trading coupons is allowed, it mimics price rationing (people buy/sell coupons, price rises).

Price Ceilings

• Price ceiling: Maximum legal price set by government.

• If set below equilibrium, $Q_d > Q_s$ → shortage (excess demand).

Ticket Example

• High sport/concert ticket prices (scalpers).

• Firms may avoid charging max price due to public backlash.

• Even devoted fans often resell tickets at higher prices.

• Alternatives to price rationing often fail; price system dominates.

• Favored customers & black markets often less fair than simple price rationing.

Price Floors

• Price floor: Minimum legal price.

• If set above equilibrium, results in excess supply.

• Minimum wage: Price floor for labor.

Tariffs

• Tariff: Tax on goods produced outside the country.

• Benefits domestic producers, reduces foreign dependence.

• Effects:

  • Higher prices

  • Lower $Q_d$ (along demand curve)

  • Higher $Q_s$ (along supply curve)

  • Reduced imports

• Importers may pay increased price, but domestic producers benefit by charging more.

• Tariffs also raise government revenue.

4.3 Supply and Demand and Market Efficiency

Introduction

Market efficiency is achieved when resources are allocated in a way that maximizes total surplus, with no government interference in perfectly competitive markets.

• Positive economics: Describes how the system works.

• Normative economics: Judgments about fairness.

• Consumers reveal preferences through choices.

Consumer and Producer Surplus

• Consumer surplus: Difference between willingness to pay and market price.

• Producer surplus: Difference between market price and cost of production (profit).

• Competitive markets maximize total surplus (consumer + producer surplus).

• Graphically:

  • Consumer surplus is the triangle above equilibrium price.

  • Producer surplus is the triangle below equilibrium price.

Surplus and Equilibrium

• Consumers benefit from paying less than what they're willing to pay.

• Producers benefit by selling above their minimum acceptable cost.

• Occurs in perfectly competitive markets (no government interference).

Deadweight Loss

Introduction

Deadweight loss (DWL) refers to the loss of total surplus that occurs when market equilibrium is not achieved, often due to underproduction or overproduction.

• Reduction in $Q$ causes loss of consumer & producer surplus.

• Deadweight loss (DWL): Loss from underproduction or overproduction.

• Underproduction: Triangle inside curve.

• Overproduction: Triangle outside curve.

• Overproduction DWL occurs when resource costs > consumer benefits.

Causes of Deadweight Loss

• Underproduction

• Overproduction

• Taxes & subsidies

• External costs (e.g., pollution)

• Price floors & ceilings can both create DWL.

Summary Table: Price Controls and Market Outcomes

Control Type	Definition	Effect on Market	Deadweight Loss?
Price Ceiling	Maximum legal price	Shortage (Qd > Qs)	Yes
Price Floor	Minimum legal price	Surplus (Qs > Qd)	Yes
Tariff	Tax on imports	Higher prices, reduced imports	Yes (if market is distorted)
Ration Coupons	Fixed quantity per family	Nonprice rationing, possible black market	Possible

Key Formulas

• Market Equilibrium: $Q_s = Q_d$

• Consumer Surplus: $CS = \int_{0}^{Q^*} [D(Q) - P^*] dQ$

• Producer Surplus: $PS = \int_{0}^{Q^*} [P^* - S(Q)] dQ$

• Total Surplus: $TS = CS + PS$

• Deadweight Loss: $DWL = \text{Loss in total surplus due to market distortion}$

Additional info: Academic context and definitions have been expanded for clarity and completeness. Examples and formulas have been added to support exam preparation.