Price Controls Pp 70- 74 of text book

Price Controls Price Controls: the setting/controlling of the prices of goods by the government  prices are unable to adjust to the equilibrium determined by free markets i.e disequilibrium with either excess demand or excess supply Two types : 1. Price floor – setting a legal minimum price 2. Price ceiling – setting a legal maximum price

1. Price Floors A price floor is a minimum price set by the government or organisation for a good. It means that the price must not be lower than the minimum price. To be EFFECTIVE, it is ABOVE the equilibrium price

Price Floors Seems to be a contradiction … But when the price (Pf) is set by the government at a level above the equilibrium price, it leads to excess supply (what the consumer are willing and able to buy –Qd- is less than what producers are willing and able to sell-Qs) If the market were free and left alone, the forces of D and S would force price down to Pe By blocking the downward forces, there is essentially a “floor” on the price.

Why would governments impose a Price Floor? 1) To protect and support certain groups of people e.g.a) income support and stabilization for primary goods producers (e.g. farmers) See graphs on H/O Prices are VOLATILE (due to shifts in supply) and incomes are UNSTABLE , because demand is not very sensitive (inelastic) to price changes b) or minimum wage law for low skilled, low wage workers 2) To discourage consumption of certain demerit goods (eg………………………….}

Impact on Market Outcomes (P and Q) With Pf set above Pe, a price floor results in larger quantity supplied of Qs and smaller quantity demanded by consumers to Qd As the market does not clear, it results in disequilibrium with excess supply If the purpose is 1) (protection of producers) governments often maintain the price floor by buying the excess supply,  demand curve shifts right OR Supply shifts left The cabbage article

What does the government do with the surplus? Several options : a. Store it, giving rise to additional cost for storage above the purchase b. Export it to other countries, which often requires granting a subsidy to lower the price to make it competitive in world markets = DUMPING c. Use it as aid to help developing countries (ODA, overseas development assistance) which often poses problems for the receiving countries d. repurpose the food to another type (winevinegar) e. destroy it OR pay farmers NOT to grow it But if purpose is 2) (ie to deter consumption of demerit goods), then the excess supply MIGHT be sold with .secret discounts OR just might not produce the extra supply

Analysis of Price Floors on Market Outcomes See H/O

Welfare Impacts and Stakeholder Analysis Consumers are worse off Smaller quantity (Qd) is purchased at higher price (Wm) Consumer surplus is now area “a” as it loses area “b” to producers and also lose area “c” Producers can be better off Less quantity of good is sold at a higher price (Wm)  possible increase in total revenue (PxQ) Producer surplus gains area “b” (from consumers) but loses “e” HOWEVER if govt buys the excess supply………….

(continued) Government There will be no gains or losses for the government in terms of budget and spending HOWEVER if govt buys the excess supply…- Society as a whole… There are too few resources allocated to the production of the good, resulting in underproduction relative to the social optimum (Qe) Society is worse off due to allocative inefficiency Marginal Benefit ? Marginal Cost for the last unit WELFARE LOSS of ………….. (decrease in social/community surplus) (but….if it is a DEMERIT good…..)

2. Price Ceilings A Price ceiling is a maximum price set by the government for a particular good or service. To be EFFECTIVE, it is below the equilibrium

Price Ceilings Seems to be a contradiction again ………………… It is because, when the price (Pc) is set by the government at a level below the equilibrium price, it leads to excess demand if the market were free , the forces of D and S would force price up to Pe. But now, this cannot happen because the price is set at Pc  by blocking the upward forces of the price, we are essentially putting a “ceiling” on the price.

Why would governments impose a Price Ceiling? 1) Price ceilings are usually set to make certain goods/services considered to be necessities more affordable to low income earners  for the “people and society” and “equity”, to change the answer to “for whom” question e.g. Rent controls and Food price controls Especially during……………………………….. 2) To encourage consumption of certain goods (merit goods)

Analysis of Price Ceiling on Market Outcomes (P, Q) By imposing a lower price of Pc  lower quantity is supplied, while larger quantity is demanded (by definition of D and S) than the market equilibrium Qe As price does not allow markets to clear, this creates a disequilibrium where there is a excess demand (Qd > Qs)

EXAMPLE: Rent Controls What is rent ? Factor of payment to the resource Land. Price you pay for borrowing a house, apartment, office space, land, etc. Rent controls consist of a maximum legal rent on housing, which is below the market determined level of rent It is undertaken in various cities or parts of cities around the world to make housing more affordable to low income earners Department of Housing and Urban Planning in US e.g. apartments in university districts  to assist students to find affordable places to live e.g. social housing in UK

Welfare Impacts and Stakeholder Analysis for a price ceiling Consumers-Partly better off and partly worse off Consumer surplus gains area “c” from producers and loses area “b” Some consumers who are able to buy and access the good at lower price are better off while some remain unsatisfied as there are not enough goods for all Producers Producers are worse off Smaller quantity of good is sold at a lower price  less total revenue (PxQ) Producer surplus lose “c” (to consumers) and “d”

(continued) Government Society as a whole… There will be no gains or losses for the government in terms of budget and spending Could gain more political popularity by supporting the consumers who are better off with the price ceiling Society as a whole…

Consequences for the Society as a Whole The lower than equilibrium price results in smaller quantity supplied than the amount determined by the free market (Qe) There are too few resources allocated (and wasted) to the production of the good, resulting in underproduction relative the social optimum (Qe) Society is worse off due to allocative inefficiency This is indicated with a decrease in social/community surplus of the area “c + d” which represent the “welfare” loss

Other Consequences of a Max. Price (Group VI Mon) Non-price rationing Before, the price mechanism determined the rationing (what, how and for whom) the good is produced and distributed Now, with the shortage, the question is how will the Qs be distributed among the buyers? Non-price rationing which can be… Waiting in line and the first come first served …. QUEUES Distribution of coupons Favoritism where sellers sell it to their preferred customers raffling The case of Venezuela BUT consider what happened after the 2011 earthquake……..would this have worked in the Long Run? Introduction to informal or PARALLEL (underground or black) markets

Parallel /Informal Markets Parallel or INFORMAL ( or underground or black )markets= buying and selling of goods where transactions are unrecorded and usually illegal. Appear for various reasons and for various products In case of price ceiling, it involves reselling the product (by those who were able to access it) at a price above the ceiling price Case of Venezuala – rise of parallel market Others: medication, possibly guns and weapons…

Price Stabilization Schemes Food tends to have high price volatility (e.g. due to a typhoon, supply decreases) To make food more affordable to low income earners , while protecting farmers, government imposes food price controls (both a ceiling and a floor) more stable and predictable prices (price stabilization) Also used to stabilize exchange rates (H/O page 2) Have been used to control inflation (rise in cost of goods and services and cost of living) in developing countries such as Vietnam and Venezuala

Review: WELFARE LOSS for all price controls The welfare or deadweight loss represents allocative inefficiency caused by overallocation or underallocation of resources to the production of the good FOR EXAMPLE for a price floor  Qs > Qe (if government buys up the excess supply) At the point of production Qs and Pf, MB < MC and the society would be better off if less of the good were produced Moreover, the WL (with the above equilibrium P and Q) signifies the protection of inefficient firms in the industry Firms with high cost of production do not face the competition from other low cost efficient producers They do not have strong incentives to become more efficient

Evaluation of a minimum wage - In reality… very contentious and ambiguous results.. In reality, it is uncertain whether minimum wage leads to the increase in unemployment as the theory/concepts predict Some empirical (data based) studies have found conflicting results some firms respond by cutting back other benefits such as paid holiday and sick leaves to maintain the same employment of unskilled workers with the insurance of minimum wage, labor productivity also may increase (workers more motivated) leading to more output and therefore more employment With higher wages, consumption overall increases  local economy benefits and overall employment rises Economics is a social, human behavior science! Must test the theories and predictions using data and evidence!

Summary on Price Controls Page 1 of hand-out: AIMS to (i)benefit or protect certain groups (eg consumers) (ii) stabilise volatile prices (or exchange rates) (iii) to change demand for merit or demerit goods OUTCOMES: excess D or S welfare losses (inefficiency) but may be justified by other considerations Usually need supporting measures (eg rationing schemes or govt buying up excess supply) , especially if to continue in the LONG-RUN EXAMPLES in many markets (goods, foreign exchange, labor) THE END