Price Controls

Copyright © 2004 South-Western

Supply, Demand, and Government Policies

Copyright © 2004 South-Western/Thomson Learning

Supply, Demand, and Government Policies

• In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.

• While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.

• One of the roles of economists is to use their theories to assist in the development of policies.


CONTROLS ON PRICES

• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.

• Result in government-created price ceilings and floors.

• Price Ceiling • A legal maximum on the price at which a good can

be sold.

• Price Floor• A legal minimum on the price at which a good can

be sold.


How Price Ceilings Affect Market Outcomes

• Two outcomes are possible when the government imposes a price ceiling:• The price ceiling is not binding if set above the

equilibrium price. • The price ceiling is binding if set below the

equilibrium price, leading to a shortage.

Figure 1 A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

Equilibriumquantity

$4 Priceceiling

Equilibriumprice

Demand

Supply

3

100

Figure 1 A Market with a Price Ceiling

Copyright©2003 Southwestern/Thomson Learning

(b) A Price Ceiling That Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

Supply

2 PriceceilingShortage

75

Quantitysupplied

125

Quantitydemanded

Equilibriumprice

$3


How Price Ceilings Affect Market Outcomes

• Effects of Price Ceilings

• A binding price ceiling creates• shortages because QD > QS.

• Example: Gasoline shortage of the 1970s

• nonprice rationing• Examples: Long lines, discrimination by sellers


• In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.

• What was responsible for the long gas lines?

CASE STUDY: Lines at the Gas Pump

• Economists blame government regulations that limited the price, oil companies could charge for gasoline.

Figure 2 The Market for Gasoline with a Price Ceiling


(a) The Price Ceiling on Gasoline Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

1. Initially,the priceceilingis notbinding . . . Price ceiling

Demand

Supply, S1

P1

Q1

Figure 2 The Market for Gasoline with a Price Ceiling


(b) The Price Ceiling on Gasoline Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

S1

S2

Price ceiling

QS

4. . . . resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1


CASE STUDY: Rent Control in the Short Run and Long Run

• Rent controls are ceilings placed on the rents that landlords may charge their tenants.

• The goal of rent control policy is to help the poor by making housing more affordable.

• One economist called rent control “the best way to destroy a city, other than bombing.”

Figure 3 Rent Control in the Short Run and in the Long Run


(a) Rent Control in the Short Run(supply and demand are inelastic)

Quantity ofApartments

0

Supply

Controlled rent

RentalPrice of

Apartment

Demand

Shortage

Figure 3 Rent Control in the Short Run and in the Long Run


(b) Rent Control in the Long Run(supply and demand are elastic)

0

RentalPrice of

Apartment

Quantity ofApartments

Demand

Supply

Controlled rent

Shortage


How Price Floors Affect Market Outcomes

• When the government imposes a price floor, two outcomes are possible.

• The price floor is not binding if set below the equilibrium price.

• The price floor is binding if set above the equilibrium price, leading to a surplus.

Figure 4 A Market with a Price Floor


(a) A Price Floor That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

Figure 4 A Market with a Price Floor


(b) A Price Floor That Is Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3


The Minimum Wage

• An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

Figure 5 How the Minimum Wage Affects the Labor Market


Quantity ofLabor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage

Figure 5 How the Minimum Wage Affects the Labor Market


Quantity ofLabor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied


Other Measures of Interventions

Evaluate price controls Other Measures:• Subsidies: rent or wage

• Don’t reduce quantity and quality• But need taxes to finance the subsidies• Taxation issues

• Rationing: Quota, license, permit• Often used in centrally planned economies


The Market forThe Market for Taxi Rides in the Taxi Rides in the

Absence of Government ControlsAbsence of Government Controls

Without government intervention, the market reaches equilibrium with 10 million rides taken per year at a fare of $5 per ride.


Excise taxes are taxes on the purchase or sale of a good.They have effects similar to quotas:

raise the price paid by buyers and reduce the price received by sellers,

and drive a wedge between the two.

Examples: Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides

Excise Taxes


Effect of an Excise Tax Levied on the Sales of Taxi Rides


Effect of anEffect of an Excise Tax Levied on Excise Tax Levied on the Purchases of Taxi Ridesthe Purchases of Taxi Rides


The incidence of a tax is a measure of who really pays it.Who really bears the tax burden (higher prices to consumers and lower prices to sellers) does not depend on who officially pays the tax. Depending on the shapes of supply and demand curves, the incidence of an excise tax may be divided differently.

The wedge between the demand price and supply price becomes the government’s tax revenue.


The Revenue from an Excise Tax

Area of the shaded rectangle: $2 per ride × 8 million rides = $16 million.


Excise taxes also cause inefficiency: excess burden or deadweight loss.

This excess burden, or deadweight loss, meansthat the true cost is always larger than the amount paid in taxes.

Excise taxes prevent some mutually beneficial transactions.

They also encourage illegal activity in attempts to avoid the tax.

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Price Controls

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