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Binding and Non-Binding

Binding and Non-Binding

Author: Kate Eskra

This lesson covers the economics concepts of binding and non-binding.

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Source: Image of Apartment Market Graph with and without Price Ceiling created by Kate Eskra, Image of Labor Market Graph with and without Price Floor

Video Transcription

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Hi, welcome to macroeconomics. This is Kate. This tutorial is called Binding and Non-Binding. As always, my key terms are in red and my examples are in green.

In this tutorial, we'll look at how consumer and producer surplus are used to see the impact of different government policies. We'll compare consumer and producer surplus before and after a price ceiling and a price floor, which are called binding constraints. And we'll also see that non-binding constraints really have no market impact at all.

So in most cases, free markets function wonderfully with little or no government intervention. Producers have profit motive to provide consumers with what they want at prices that we are willing to pay.

So usually, unregulated free markets generally provide the best outcome. And that's the idea to keep in mind. And so when we talk about overall welfare being maximized, we mean that when the market reaches equilibrium, both consumers and producers are better off. And there's nothing called a dead weight loss, which I'll define for you in a little bit.

So when we're doing this welfare analysis with the consumer and producer surplus, that's what you're going to be able to see. That when the government doesn't intervene, the consumer and producer surplus will be maximized. But we know that sometimes it is necessary for the government to intervene and so often they do.

What we need to be able to do is be able to measure this impact on consumers, producers, and then society as a whole. And so what we'll be comparing, like I said, is consumer and producer surplus before and then after the government intervention. So let's start with consumer surplus.

Consumer surplus is something determined by the difference between the actual price paid for a good and the highest amount you'd be willing to pay for the good. So think about it this way.

If you were willing to pay $100 to go see a concert, but you bought a ticket from someone for $60, you enjoyed a consumer surplus of $40. Whereas, producer surplus is the difference between the actual payment for a good and the least amount that producer would have agreed to receive for the good.

So my husband's been selling baseball cards on eBay, and one night he said he was willing to accept as little as $25 for one. He woke up the next morning and someone had offered him $40. So he enjoyed a producer surplus of $15. So that's all we're talking about here with consumer and producer surplus.

How you can see this on a graph is, let's say we're talking about the market for apartments. And let's say it's kind of in an expensive city, like maybe in New York City. The equilibrium here.

If we allowed the market to achieve equilibrium, I'm suggesting that the equilibrium rent would be $2,000 and there would be 1,000 apartments supplied and demanded at that point. So the market's in equilibrium.

The idea is, though, that many people are unable to afford this high rent. And so often the government will step in and control rents, imposing a maximum price that landlords are allowed to charge. But notice before we make those changes, that the consumer surplus is this area here in green. It's everything-- all these people were willing to pay more than 2,000. And this is the producer surplus because all of these landlords were actually willing to rent for less.

Let's say the government set a maximum price. A maximum price meaning you cannot charge any higher than $2,500 per month. Well, if we did that, that would set a ceiling. And most people would think, oh, a ceiling should be above equilibrium because a ceiling is above our head. But if you think about it, would that have any market impact at all?

Really, landlords only want to charge $2,000 because that's what clears the market. So if they set a maximum price up here, that would actually have no market impact.

If you're told you can't charge more than 2,500, well, they don't want to. All they want to do is charge 2,000. So they'll do that anyway. That's what we call a non-binding constraint, a pricing constraint that does not preempt market equilibrium.

But a binding constraint is different. This is some type of regulatory constraint that does preempt market equilibrium by setting a different price level. And so it's what we call a price ceiling or a price floor.

So when the market cannot establish equilibrium, like let's say in this example, that the government would now step in and set a ceiling with the maximum rent allowed to be charged at $1,200.

Well now, if this is the maximum they're allowed to charge, notice the market cannot be in equilibrium anymore. The quantity demanded at this price is over here at 2,000, but the quantity supplied is lower now. Because at lower prices, landlords don't want to supply their apartments. So we have what's called a shortage of apartments, where the quantity demanded exceeds the quantity supplied.

So when you see what's going on with consumer and producer surplus, consumer surplus grows a little bit slightly, only for those people who can find apartments. But producer surplus definitely shrink. And now this red triangle that used to be enjoyed by both consumers and producers is just what we call a deadweight loss to society. I'll give you a definition for that in a few slides. But notice that that's what lost between consumer and producer surplus to society whenever the government imposed this binding price ceiling.

So rent control is a really good example of a price ceiling. Let's look at another example. Let's talk about the labor market.

Notice this is in equilibrium here. And in equilibrium, I'm suggesting-- I just made this up. I'm suggesting that the equilibrium wage rate would be $6 an hour. At $6 an hour, I'm suggesting that 3 million workers would want to supply their labor and 3 million workers would be demanded by employers.

But the government doesn't allow companies to pay workers $6 per hour. Minimum wage law prevents that from happening. Right here, if it were allowed to be in equilibrium, there would not be a deadweight loss to society. Consumer and producer surplus would be maximized as shown by the green and the blue triangles.

But they do set a price floor, which is another example of a binding constraint. A price floor is a minimum that must be paid for something. So with minimum wage, let's say at 7.25, that's above equilibrium. That is the lowest amount they can pay.

Now, as you raise up above equilibrium, the quantity supplied is greater. More workers are willing to supply their labor, but employers are less willing to hire. So the quantity demanded for labor falls and there's now a gap. The quantity supplied greater than the quantity demanded means we have a surplus of workers.

So consumer surplus, the green triangle, got much smaller. Producer surplus grows a little bit perhaps, but there's definitely, again, this red triangle here, which used to be consumer and producer surplus. And it's a deadweight loss to society because of this price floor being imposed. So minimum wage, like I said, is an example of a price floor-- a binding constraint.

That area, that red area there that I kept showing you, that deadweight loss, is really just the change in total surplus. It's the sum of producer and consumer surplus that we lost. It resulted from the imposition of a binding constraint, either a price ceiling or a price floor.

So in this tutorial, what we looked at was how consumer and producer surplus can be used to see the impact of different government policies, like ceilings and floors. And those things, those binding constraints, create a deadweight loss, reducing the overall sum of consumer surplus and producer surplus.

Remember, non-binding constraints have no market impact at all. It will just be at equilibrium.

Thanks so much for listening. Have a great day.

Terms to Know
Binding Constraint

Typically a regulatory constraint that preempts market equilibrium by setting different price level—price ceiling or price floor.

Consumer Surplus

Determined by the difference between actual price paid for a good and the highest amount a consumer would have paid for the good.

Deadweight Loss

The change in total surplus (sum of producer and consumer surplus) that results from the imposition of a binding constraint.

Non-Binding Constraint

A pricing constraint that does not preempt market equilibrium.

Producer Surplus

The difference between actual payment for a good and the least amount a producer would have agreed to receive for the good.