Unit III Price Ceilings and Floors (Chapter 5)

In this chapter, look for the answers to these questions:

What are price ceilings and price floors? What are some examples of each?

How do price ceilings and price floors affect market outcomes?

How do taxes affect market outcomes? How does the outcome depend on whether the tax is imposed on buyers or sellers?

What is the incidence of a tax? What determines the incidence?

Market Disruptions

• How do we ration goods and services?– Prices– Queues– Lotteries

• Prices ration available resources most efficiently

Market Disruptions• When a

drought occurs in the United States, what is the best means of rationing water?–California vs. Puerto Rico

Market Disruptions• When a

drought occurs in the United States, what is the best means of rationing water?– California vs.

Puerto Rico

Government Policies That Alter the Private Market Outcome

• Price controls– Price ceiling: a legal maximum on the price

of a good or service. Example: rent control. – Price floor: a legal minimum on the price of

a good or service. Example: minimum wage.

We will use the supply/demand model to see how each policy affects the market outcome

(the price buyers pay, the price sellers receive, and eq’m quantity).

Black Markets• Market for illegal

g/s

• Market in which g/s trade at prices above their legal maximum prices– Tickets to

sporting events

– Rent in some cities• Stacia

Bekemeyer

• What do you think the housing market might look like in Amsterdam?

Questions

1. Why do we call a price that is lower than the equilibrium a price ceiling?

2. What would be the long-run effects of aprice ceiling policy?

3. Isn’t it true that lower prices are a good

thing for consumers?

Rent Control

• placement of price ceilings on rents in particular cities – Over 200 American cities operate under some

kind of rent control

• Example:– New York City, Santa Monica, CA, Berkeley, CA

Two Functions of Rental Prices1) promote efficient maintenance of existing housing /

stimulate construction of new housing– Rent controls discourage the construction of new

rental units. Why?– Rent -- most important long-term determinant of

profitability / rent controls artificially depress them• Examples:

– Dallas, Texas (16% vacancy) no rent control built 11,000 new rental units.

– San Francisco (1.6 % vacancy) with rent control built 2000 new rental units

Two Functions of Rental Prices2) allocate existing scarce housing among competing

claimants• What happens to the current supply of housing?

– When rental rates are held below the market equilibrium levels, property owners cannot recover the cost of maintenance, repairs, and capital improvements through higher rents.

– In extreme situations, fixed costs exceed the rental returns. The result is abandoned buildings

• Example: New York City and its numerous abandoned buildings.

Rent Control• Who loses in rent control?

– landlords– low income individuals looking for first apartment

• Who gains in rent control?– Upper-income professionals

• Important: Effective rent controls discourage new rental unit construction,

decrease spending on existing rental units and leads to a “Housing gridlock”

EXAMPLE 1: The Market for Apartments

Eq’m w/o price

controls

P

QD

SRental price of

apts

$800

300

Quantity of apartments

How Price Ceilings Affect Market Outcomes

A price ceiling

above the eq’m price is not binding –

it has no effect on the market outcome.

P

QD

S

$800

300

Price ceiling

$1000

How Price Ceilings Affect Market Outcomes

The eq’m price ($800) is above the ceiling and therefore illegal.The ceiling is a binding constraint on the price, and causes a shortage.

P

QD

S

$800

Price ceiling

$500

250 400

shortage

How Price Ceilings Affect Market Outcomes

In the long run, supply and demand

are more price-elastic. So, the shortage is larger.

P

QD

S

$800

150

Price ceiling

$500

450

shortage

Alternative Market Outcomes

Alternative:Section 8 Grants

P

QD

S

$800

150

Price ceiling

$500

450

shortage

Shortages and Rationing• With a shortage, sellers must ration the goods

among buyers.

• Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases

• These mechanisms are often unfair, and inefficient: the goods don’t necessarily go to the buyers who value them most highly.

• In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair???).

Price Floors in the Labor Market• Minimum Wage

– wage floor, legislated by the government, setting the lowest hourly wage rate that firms may legally pay workers

• Proponents:– ensure low-income workers a “decent” standard of

living• Opponents:

– causes increased unemployment• Note:

Economists estimate that a 10% increase in the real minimum wage decreases total employment of those affected by 1 to 2%.

EXAMPLE 2: The Market for Unskilled Labor

Eq’m w/o price

controls

W

LD

SWage paid to

unskilled workers

$4

500

Quantity of unskilled workers

How Price Floors Affect Market Outcomes

W

LD

S

$4

500

Price floor

$3

A price floor below the eq’m price is not binding –

it has no effect on the market outcome.

How Price Floors Affect Market Outcomes

W

LD

S

$4

Price floor

$5

The eq’m wage ($4) is below the floor and therefore illegal.The floor is a binding constraint on the wage, and causes a surplus (i.e.,unemployment).

400 550

labor surplus

Min wage laws do not affect highly skilled workers.

They do affect teen workers.

The Minimum Wage

W

LD

S

$4

Min. wage

$5

400 550

unemp-loyment

Earned Income Tax Credit

• refundable tax credit primarily for individuals and couples with qualifying children

• Theory -- Minimum wage laws are a undue burden on small business

Price Floors in AgricultureHistorical note: 1933 Federal government placed price

floors on agriculture • How it works:

1. Government sets a support price for ag product / acts to ensure that price never falls below support price2. excess quantity supplied or surplus is purchased

by government• 3. program run on a per bushel basis / larger farms

better off • Note: 1996 these supports were supposed to be

eliminated except for tobacco and peanuts

Ag. Price supports create surplus Ag product in the market.

Ag Price Floor

P

QD

S

$4

Ag. Surplus

$5

400 550

surplus

A C T I V E L E A R N I N G 1: Price floors & ceilings

30

Q

PS

0

The market for hotel rooms

D

Determine effects of:A. $90 price

ceiling

B. $90 price floor

C. $120 price floor

Q

PS

0

The market for hotel rooms

D

A C T I V E L E A R N I N G 1: A. $90 price ceiling

31

The price falls to $90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage.

shortage = 30

Price ceiling

Q

PS

0

The market for hotel rooms

D

A C T I V E L E A R N I N G 1: B. $90 price floor

32

Eq’m price is above the floor, so floor is not binding. P = $100, Q = 100 rooms.

Price floor

Q

PS

0

The market for hotel rooms

D

A C T I V E L E A R N I N G 1: C. $120 price floor

33

The price rises to $120. Buyers demand 60 rooms, sellers supply 120, causing a surplus.

surplus = 60

Price floor

Evaluating Price Controls

• Markets are usually a good way to organize economic activity.

Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices.

Price controls are often intended to help the poor, but they often hurt more than help them:

The min. wage can cause job losses.Rent control can reduce the quantity and quality of affordable housing.

CHAPTER SUMMARY A price ceiling is a legal maximum on

the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage.

A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment.