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DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL

Price Ceilings and Price Ceilings and FloorsFloors

CHAPTER OUTLINEPrice Ceilings

Rent Control (Optional Section)

Arguments for Price Controls

Universal Price Controls

Price Floors

For applications, click here

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Some good blogs and other sites to get the juices flowing:

Food for Food for Thought….Thought….

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

Iraq 2003: Gas prices are frozen at $.05 per gallon.

A good idea?

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

Getting in the way of the invisible hand? Distorted price signals cause resources to be

misallocated.

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Price Ceilings

Policy makers may respond to buyers’ complaints that prices are “too high” by enacting price controls.A Price Ceiling A Price Ceiling is a maximum price allowed by law.

Price ceilings limit the price sellers can charge for their goods to the maximum price.Prices cannot legally go higher than the ceiling.

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Price Ceilings

Price ceilings that involve a maximum price below the market price create five important effects.

1. Shortages2. Reduction in Product Quality3. Wasteful Lines and Other Costs of

Search4. Loss of Gains from Trade5. Misallocation of Resources

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Shortages

1. When prices are held below the market price shortages are created.

The shortage The shortage = difference between the Qd and the Qs at the controlled price.

The lower the controlled price relative to the market equilibrium price, the larger the shortage.

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Shortages

Price Ceilings Create Shortages

Quantity

PriceSupply

Demand

Market Equilibrium

ShortageControlled Price (Ceiling)

Qsupplied at the Controlled Price

Qdemanded at the Controlled Price

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

A shortage of vinyl in 1973 forced Capitol

Records to melt down slow sellers so they

could keep pressing Beatles’ albums.

Take a look…..Take a look…..

Does it matter that chicken prices were subject to a price ceiling but their feed was not? Click on the picture for a short video (first 1:40 min of the clip)

Why do you think farmers killed a million baby chickens in 1973?

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http://www.youtube.com/watch?v=IFbAwzU6G7s&NR=1

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Reduction of Product Quality

2. At the controlled price, sellers have more customers than goods.In a free market, this would be an opportunity to profit by raising prices.But when prices are controlled, sellers cannot.Sellers respond to this problem in two ways:

Reduce qualityReduce service

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Wasteful Lines and Other Costs of Search

3. Price controls that create shortages lead to bribery and wasteful lines.Shortages: not all buyers will be able to purchase the good.Normally, buyers would compete with each other by offering a higher price.If price is not allowed to rise, buyers must compete in other ways.

Take a look…..Take a look…..

How do rent-controlled apartments get distributed? Click on the picture below to find out in this clip from the “Economics of Seinfeld”. (1:20 minutes)

http://yadayadayadaecon.com/clip/6/

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Wasteful Lines and Other Costs of Search

Some buyers may be willing to bribe sellers in order to obtain the good.

The highest bribe a buyer would pay is the difference between his max price and the price ceiling.If bribes are common, then the total price of the good is the legal price plus the bribe.

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Wasteful Lines and Other Costs of Search

Buyers can also compete with each other through their willingness to wait in line.

The maximum wait time (translated into monetary terms) for a buyer is the difference between the max price and the price ceiling.So the total price of the good is the legal price plus the time costs.

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Wasteful Lines and Other Costs of Search

Bribes and waits both lead to a total price that is greater than the controlled price, (but they are different.)

Bribes involve a simple transfer from buyers to sellers.The time spent waiting in line, however, is simply lost – paying in time is much more wasteful.

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Wasteful Lines and Other Costs of Search

Price Ceilings Create Wasteful Lines

Quantity

Price

Supply

Demand

Market Equilibrium

Controlled Price (Ceiling)

Qsupplied at the Controlled Price

Qdemanded at the Controlled Price

Total Value of Wasted Time

Shortage

Willingness to Pay

Tim

e C

ost

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Lost Gains from Trade

4. Price controls reduce the gains from trade.Price ceilings set below the market price cause Qs to be less than the market Q.

When Q is below the equilibrium market Q, consumers value the good more than the cost of its production.This represents a gain from trade that would be exploited (if the market were free).

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Lost Gains from Trade

Dead-weight LossDead-weight Loss is the total of lost consumer and producer surplus when all mutually profitable gains from trade are not exploited.Price ceilings create a dead-weight loss by forcing Qs below the market Q.

Buyers and sellers would both benefit from trade at a higher price, but cannot since it is illegal for price to rise.

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Qmarket

Market Price

Lost Gains from Trade

Controlled Price (Ceiling)

Qsupplied Qdemanded

Willingness to Pay

Consumer Surplus Shrinks to this

Shortage

Consumer surplus in market equilibrium

Price Ceilings Reduce the Gains from Trade

Quantity

Price

Supply

Demand

Market Equilibrium

Producer Surplus Shrinks to this

Producer Surplus in equilibrium

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Qmarket

Market Price

Lost Gains from Trade

Controlled Price (Ceiling)

Qsupplied Qdemanded

Willingness to Pay

Deadweight Loss (lost gains from trade)= Lost Consumer Surplus+ Lost Producer Surplus

Shortage

Lost Consumer Surplus

Lost Producer Surplus

Price Ceilings Reduce the Gains from Trade

Quantity

Price

Supply

Demand

Market Equilibrium

Total Value of Wasted Time

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Misallocation of Resources

5. Price controls distort signals and eliminate incentives-- leading to a misallocation of resources.Consumers who value a good most are prevented from signaling their preference (by offering sellers a higher price.)So producers have no incentive to supply the good to the “right” people first.As a result, goods are misallocated.

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Misallocation of Resources

Price Controls Prevent Resources from flowing to their Highest-Valued Uses

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Rent Controls

Rent ControlRent Control: a regulation that : a regulation that prevents rents from rising to prevents rents from rising to equilibrium levels.equilibrium levels.

Rent control is a price ceiling whose effects worsen over time

No one wants to build new apartments if the rents will be artificially low…

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Short Run Supply

Demand

Market Equilibrium

Controlled Rent

Qsupplied

(Short Run)Qdemanded

Rent Controls

Quantity (rental apartments)

Price(rent)

Long Run Supply

Qsupplied

(Long Run)

…..than in the Long RunThe shortage is smaller in the Short Run…

Short Run Shortage

Long Run Shortage

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Arguments for Price Controls

So why do price controls ever get passed?The general public may not understand the nasty side-effects of price controlsShortages may benefit the ruling elite…

In the former USSR, the communist party elite used Blat to obtain goods. Blat= having connections that can be used to

get favors.The party elite can use their connections and

power to obtain goods for themselves or others.Without such leverage their power

dissipates.

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Universal Price Controls

Just Another Day in a USSR Bread LineUniversal price controls caused widespread and persistent shortages in the USSR.Average time in line for a Soviet woman? 2 hours every day, 7 days/week.

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Are you better or worse off when the food is included in your airfare?

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Price Floors

Price floorPrice floor: : a minimum price allowed by law.

not as common as price ceilings (but still important)

Price floors have four common effects:1. Surpluses2. Lost gains from trade (deadweight loss)3. Wasteful increases in quality4. A misallocation of resources

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If the government of the European Union sets a price floor for butter above the equilibrium market price, what will be the effect?a)Farmers will produce less butter and consumers will purchase more, resulting in a shortage of butter.b)The supply of butter will increase and the demand will decrease.c)Farmers will produce more butter and consumers will purchase less, resulting in a surplus of butter.d)The equilibrium price will rise to the price floor.

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When prices are held above the market price (price floor) quantity supplied exceeds the quantity demanded.

Surplus

Quantity

Price

Qsupplied at the Controlled Price

Qdemanded at the Controlled Price

SurplusControlled Price (Ceiling)

Supply

Demand

Market Price

Qmarket

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Price controls reduce the gains from trade (create deadweight losses)

Willingness to Sell

Lost Producer Surplus

Deadweight Loss= Lost Consumer Surplus+ Lost Producer Surplus

Lost Consumer Surplus

Lost Gains from Trade

Quantity

Price

Supply

Demand

Qmarket

Market Price

Qdemanded Qsupplied

Controlled Price(Floor)

Surplus

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Price controls that create surpluses lead to wasteful increases in quality.

Wasteful Increases in Quality

If they can’t lower price, sellers will find other ways to compete!

Willingness to Sell

Controlled Price (Floor)

Qdemanded at the Controlled Price

Quantity

Price Supply

Demand

Deadweight Loss

Market Equilibrium“Quality” Waste

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Wasteful Increases in Quality

Higher quality raises costs and reduces seller profit.Buyers get higher quality, but would prefer a lower price.Price floors encourage sellers to waste resources:

higher quality than buyers are willing to pay for

Most flyers prefer a lower price

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Misallocation of Resources

Price controls misallocate resources by: Allowing high-cost firms to operate. Preventing low-cost firms from entering the industry.

Regulation prevented Southwest (and 79 other firms) from entering the national market

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDPresident Jimmy Carter deregulated

the price floors in much of the trucking industry. Trucks carry almost all of the consumer goods that you purchase, so almost every time you purchase something, you're paying money to a trucking company. What do you think happened in the trucking industry after deregulation?a)The price of trucking services fell.b)Truckers earned less money.c)Consumers saved a lot of money.d)All of the above are correct.

Try it!Try it!If the U.S. government sets a price floor on milk, it will not always lead to a surplus. Why not?

a)The price floor would be rarely enforced.b)Because price floors most commonly lead to shortages, not surpluses.c)The market price of milk will sometimes rise above the price floor, rendering the price floor irrelevant.d)Price floors cause supply and demand to change, which leads to changes in equilibrium price.

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During research for a class you find out that in the year 301, the Roman Emperor Diocletian issued an “Edict on Prices” for shoes and you want to find out if it was a price ceiling or a price floor. Further research tells you that the number of shoes sold dropped dramatically and that both sellers and buyers were very upset. Was it a:a)Price ceilingb)Price floorc)Not enough information BACK TO