Chapter Supply, Demand, and Government Policies 6

Figure The market for gasoline with a price ceiling 2 2 Price of Gasoline Quantity of Gasoline 0 Demand Q1Q1 (a)The price ceiling on gasoline is not binding (b) The price ceiling on gasoline is binding P1P1 Supply, S 1 Price ceiling 1. Initially, the price ceiling is not binding … Price of Gasoline Quantity of Gasoline 0 Demand Q1Q1 P1P1 S1S1 Price ceiling 2…but when supply falls… S2S2 P2P2 3…the price ceiling becomes binding… QSQS QDQD 4. …resulting in a shortage

1973, OPEC raised the price of crude oil – Reduced the supply of gasoline – Long lines at gas stations What was responsible for the long gas lines? – OPEC: created shortage of gasoline – U.S. government regulations: price ceiling on gasoline Before OPEC raised the price of crude oil – pre-1973 – Equilibrium price - below price ceiling: no effect When the price of crude oil rose – Reduced the supply of gasoline – Equilibrium price – above price ceiling: shortage Lines at the gas pump Price Ceiling – Not Binding then Binding 3

Figure A market with a price floor 4 4 Price of Ice Cream Cone Quantity of Ice-Cream Cones 0 Demand 100 (a) A price floor that is not binding In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones. (b) A price floor that is binding $3 Supply 2 Price floor Equilibrium price Equilibrium quantity Price of Ice Cream Cone Quantity of Ice-Cream Cones 0 Demand 3 Supply $4 Price floor Equilibrium price 80 Quantity supplied Quantity demanded 120 Surplus

Figure Examples of Price Floors Minimum wage – Can create a surplus of labor Agricultural price supports – Every year, farmers produce and sell a certain product at a certain price that is determined by the market. If the market price is lower than that price at which the farmers want to sell, the farmers are in a deficit. Therefore, in order to assist American farmers, our government gives price supports for some crops and dairy products. So in a case where the market price is lower that the target price for farmers, farmers receive a "deficiency payment", or price support, from the government in order to make up for the difference. – Has created a surplus of cheese and milk products Some released to low-income/poverty households Can exacerbate the effect by increasing supply

Figure How the minimum wage affects the labor market 5 6 Wage Quantity of Labor 0 Labor demand Equilibrium employment (a) A free labor market Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand. Panel (b) shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment. (b) A Labor Market with a Binding Minimum Wage Equilibrium wage Labor supply Wage Quantity of Labor 0 Minimum wage Quantity demanded Quantity supplied Labor surplus (unemployment) Labor demand Labor supply

Impact of the minimum wage – Workers with high skills and much experience Not affected: Equilibrium wages - above the minimum Minimum wage - not binding – Teenage labor – least skilled and least experienced Low equilibrium wages Willing to accept a lower wage in exchange for on-the-job training Minimum wage – binding The minimum wage 7

Controls on Prices Evaluating price controls Markets are usually a good way to organize economic activity – Economists usually oppose price ceilings and price floors Prices – coordinate economic activity 8

Market Failure Unregulated (“free”) markets are usually a good way to organize economic activity But not always – an example of market failure – As CEO of Turing, Shkreli hiked the price of the drug Daraprim from $13.50 a pill to $750 overnight. – "We raised the price from $1,700 per bottle to $75, So 5,000 paying bottles at the new price is $375,000,000 Market power – patent -> monopoly 9

Price Support - Milk Price ($16) set above market equilibrium price ($12) to “protect” small dairy farmers 10

Agricultural Price Supports Price Support – Market price is set by Government at > equilibrium price (binding) – Price is “supported” as Gov’t buys up the surplus Thus price will not drop due “normal” market forces (surplus) 11

Impacts of a Price Support 12 Transfer CS-PS Increased PS Due to Increased Production Transfer Inefficient Production MC(C) > MV(D)

Consequences of Binding Price Supports Compared to a “free” market (unregulated) Consumers buy less milk – Lost Consumer Surplus Producers – Gain lost consumer surplus (transfer to Producers) – Increased milk production (> old equilibirum) Get even more producer surplus Produced inefficientl y – Value (marginal benefits) of additional milk to consumers < increased (marginal) costs of resources used to produce it – And then there are the taxes to pay for it 13

What Do We Do With the Surplus Surplus milk bought by the Government – Give it to Low Income Decreases Private Sector Demand (Nbuyers) – Increases amount of surplus milk to be bought – Make cheese from it No effect on Milk market price – Strategic Cheese Reserve at Hanford – Transfer to 3 rd World countries Powdered Milk Disrupts their dairy industry 14

What Could Go Wrong? 15 The Complete Stupidity Of The Looming Dairy Cliff: Milk To... Forbes Dec 31, That will compel the Department of Agriculture to roughly double the price supports for dairy and other farm products thanks to a mystical Dairy Price Supports: Still Milking the Public Cato Institute Why $7-Per-Gallon Milk Looms Once Again : The Salt : NPR

An Economist’s Perspective Cato Institute – The federal government has subsidized and regulated the dairy industry since the 1930s. A system of “marketing order” regulations was enacted in A dairy price support program was added in An income support program for dairy farmers was added in As part of this year’s farm bill, Congress may reauthorize dairy programs, but they are among the most illogical of all farm programs.1 The government spends billions of dollars reducing food costs through programs such as food stamps, yet dairy programs increase milk prices.

Cost of Price Supports In 2013, the U.S. Department of Agriculture spent $107 million buying sugar to increase prices to producers Other Agricultural Price Support Programs – Wheat – Corn – Milk and milk products 17

Cost of Price Supports The U.S. government has been protecting farmers against unpredictable hardships such as bad weather since the 1930s, when drought and the Great Depression devastated the nation's agriculture industry. Today, agricultural subsidies and insurance cost the U.S. taxpayers about $20 billion annually, according to the U.S. 18