Price Controls: Ceilings and Floors Module 8 Price Controls: Ceilings and Floors

Main Ideas The meaning of price controls, one way government intervenes in markets. How price controls can create problems and make a market inefficient. Why economists are often deeply skeptical of attempts to intervene in markets. Who benefits and who loses from price controls, and why they are used despite their well-known problems. Duffka School of Economics

Key Economic Concept A price ceiling Pc is a legal maximum price that lies below equilibrium Pe. For it to be effective, the price ceiling Pc must be below Pe. After all, if Pc>Pe, the market will gravitate downward toward Pe. An effective price ceiling creates a shortage that can be seen in a graph like the one below. Duffka School of Economics

Key Economic Concept A price floor Pf is a legal minimum price that lies above equilibrium Pe. For it to be effective, the price floor Pf must be above Pe. After all, if Pf<Pe, the market will gravitate upward toward Pe. An effective price floor creates a surplus that can be seen in a graph like the one below Duffka School of Economics

I. Why Governments Control Prices Sometimes the efficient outcome in the market is judged as unfair to some groups, usually those that are disadvantaged (poor) and struggling to begin with. How will we deal with this? A price control is a legal restriction on how high or low a market price may go. Price controls are enacted by governments in response to political pressures from buyers and sellers. Duffka School of Economics

II. Price Ceilings A. Modeling a Price Ceiling A price ceiling is a maximum price sellers are allowed to charge for a good. Who would want such a thing? Consumers. What goods/services do you consider to be unfairly expensive. If Pe is considered “too high,” then a price ceiling must be set below the equilibrium price. A price ceiling set above the equilibrium price has no effect. Duffka School of Economics

II. Price Ceilings Equilibrium: Qe = 5, Pe=$5 Consumers are enraged at this high price and successfully lobby for a law that says you can’t sell tacos for more than $3. This is good, right? Duffka School of Economics

II. Price Ceilings B. The Effects of a Price Ceiling 1. Shortage 1. Shortage at Pc = Qd - Qs If the Pc=$3, Qd =7 and Qs= 3, so there is a shortage of 4 tacos. Is this so bad? Aren’t consumers helped by this lower price? Yes, if you are among the lucky 3 who get tacos! Duffka School of Economics

II. Price Ceilings B. The Effects of a Price Ceiling 2 II. Price Ceilings B. The Effects of a Price Ceiling 2. Inefficient allocation to consumers People who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. Suppose Stan was our sixth potential consumer. He would not have paid $5 for a taco before the price control, but maybe now he is one of the lucky ones that gets a taco at $3. Julia was our second potential customer who would have paid $8 for a taco, but can’t find one now. One way to define inefficiency: A market or an economy is inefficient if there are missed opportunities: Some people could be made better off without making other people worse off. This is inefficient, because Stan can sell a taco to Julia for $7 and both win. Duffka School of Economics

II. Price Ceilings B. The Effects of a Price Ceiling 3 II. Price Ceilings B. The Effects of a Price Ceiling 3. Wasted resources People spend money and expend effort in order to deal with the shortages caused by the price ceiling. Time spent looking for scarce tacos has an opportunity cost. You could be working, having some leisure, etc. These missed opportunities create more inefficiency to the price control. Duffka School of Economics

II. Price Ceilings B. The Effects of the Price Ceiling 4. Inefficiently low quality: Sellers offer low-quality goods at Pc, even though buyers would prefer a higher quality at a higher price. Taco suppliers may cut corners on food safety because that costs money. Maybe we get more tacos that make us sick. Duffka School of Economics

II. Price Ceilings B. The Effects of the Price Ceiling 5. Black Markets A black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling Duffka School of Economics

C. So Why Do We Have Price Ceilings? Summary Price ceilings are enacted because 1. They do benefit some consumers. Consumers may have the political clout to persuade government that the equilibrium price is taking advantage of them. This is a normative argument. 2. When they have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. 3. Government officials often do not understand supply and demand analysis. Duffka School of Economics

II. Price Ceilings The Effects of the Price Ceiling A free market will have no shortage and no surplus. Consumer and producer surplus is maximized and there is NO deadweight loss. A regulated market will have a surplus or shortage. A price ceiling will have a shortage. Decreasing both consumer and producer surplus. There is a deadweight loss. Duffka School of Economics

III. Price Floors A. Modeling a Price Floor A price floor is a legal minimum price buyers are required to pay for a good. The minimum wage is a legal floor on the wage rate, which is the market price of labor. If Pe is considered “too low,” a price floor is set above the equilibrium price. A price floor set below the equilibrium price has no effect. Duffka School of Economics

III. Price Floors A. Modeling a Price Floor Duffka School of Economics

III. Price Floor A. Modeling a Price Floor Equilibrium: Qe = 5, P× =$5 Producers are enraged at this low price and successfully lobby for a law that says you can’t sell tacos for less than $7. This is good for sellers, right? Duffka School of Economics

III. Price Floor B. The Effects of a Price Floor 1. Surplus at Pf Price floors lead to excess supply; the quantity supplied is greater than quantity demanded. At Pf=$7, Qs= 7, Qd = 3, so there is a surplus of 4 tacos. 2. Inefficiently low quantity Since a price floor raises the price of a good to consumers, quantity demanded falls, so the quantity bought and sold falls, creating a loss to society—deadweight loss. 3. Inefficient allocation of sales among sellers Those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it. Duffka School of Economics

III. Price Floor B. The Effects of a Price Floor 1. Surplus at Pf 2. Inefficiently low quantity 3. Inefficient allocation of sales among sellers 4. Wasted resources Government price floors set about the equilibrium price cause surpluses which the government may be required to buy and destroy. 5. Goods of inefficiently high quality Sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price. 6. Illegal activity Bribery of sellers or government officials. Working for less than minimum wage (off the books) because there is a surplus of labor willing to work. Duffka School of Economics

III. Price Floors C. So Why Do We Have Price Floors? Price floors are enacted because: 1. They do benefit some producers. Producers may have the political clout to persuade government that the equilibrium price is unfairly low. This is a normative argument. 2. Price floors create a persistent surplus of the good. 3. Inefficiencies arising from the persistent surplus come in the form of inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and an inefficiently high level of quality offered by suppliers. 4. There is also the temptation to engage in illegal activity, particularly bribery and corruption of government officials. Duffka School of Economics

APE U2 L3 A 16 9/20/2018 Figure 16.1: Effects of a new fertilizer Increases the number of potatoes can be harvested with no additional labor or machinery. Assume that this fertilizer DOES NOT affect wheat farming and that people are satisfied to eat potatoes or bread made from wheat flower. Potatoes Bread Wheat Machinery S S S S1 S D D D D1 D D1 D1 Demand: Supply: EQ Price EQ qty. Duffka School of Economics

APE U2 L3 A 16 9/20/2018 Figure 16.1: Effects of Increased Demand for Briefcases and Luggage Increase in the demand for…made from LEATHER. Shoelace Packaging Machinery Leather Shoes Shoelaces for Leather Shoes Leather S S1 S S S D1 D D D D D1 D1 Demand: Supply: EQ Price EQ qty. Duffka School of Economics

APE U2 L3 A 16 9/20/2018 Figure 16.3: Effects of a Loss of Coffee Crop Heavy frost destroys half the world’s coffee crop and that people use more cream in coffee than they do in tea. Coffee Makers Tea Cream Coffee S1 S S S S D1 D1 D D D D D1 D1 Demand: Supply: EQ Price EQ qty. Duffka School of Economics

APE U2 L3 A 16 9/20/2018 Figure 16.4: Effects of a Shirt to Sports Shirts Peoples tastes change in favor of colored sports shirts, which are worn without neckties, and against white dress shirts, which are worn with neckties and tie clasps. Sport Shirts Dress Shirts Neckties Tie Clasps S S S S D1 D D D D D1 D1 D1 Demand: Supply: EQ Price EQ qty. Duffka School of Economics

Relevant graphs for practice quiz #2 #4 & 5 Duffka School of Economics

Practice Question # 1 1. To be effective, a price ceiling must be set I. above the equilibrium price. II. in the housing market. III. to achieve the equilibrium market quantity. a. I b. II c. III d. I, II, and III e. None of the above Duffka School of Economics

Practice Question # 2 2. Refer to the graph provided. A price floor set at $5 will result in a. a shortage of 100 units. b. a surplus of 100 units. c. a shortage of 200 units. d. a surplus of 200 units. e. a surplus of 50 units. Duffka School of Economics

Practice Question # 3 3. Effective price ceilings are inefficient because they a. create shortages. b. lead to wasted resources. c. decrease quality. d. create black markets. e. do all of the above. Duffka School of Economics

Practice Question # 4 Refer to the graph provided. If the government establishes a minimum wage at $10, how many workers will benefit from the higher wage? A. 30 B. 50 C. 60 D. 80 E. 110 Duffka School of Economics

Practice Question # 5 5. Refer to the graph for question 4. With a minimum wage of $10, how many workers are unemployed (would like to work, but are unable to find a job)? a. 30 b. 50 c. 60 d. 80 e. 110 Duffka School of Economics

Duffka School of Economics

In Class Activity In-Class Activities and Demonstrations Think critically about the pros and cons of price controls. Many consumer advocacy groups have argued that the price of prescription drugs is too high. Find a newspaper article or editorial that makes this argument and distribute the article to the class. After you have read the article, summarize the pros and cons of this issue. Structure your responses along the predictable outcomes of a price ceiling and present their analysis to the class. Duffka School of Economics