Chapter
6
Supply, Demand, and
Government Policies
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
2
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 $75,000 ... So 5,000 paying bottles at the
new price is $375,000,000
• Market power – patent -> monopoly
3
Figure 2
The market for gasoline with a price ceiling
(a) The price ceiling on gasoline
is not binding
Price of
(b) The price ceiling on gasoline
Price of
is binding
Gasoline
Gasoline
S2
1. Initially, the
price ceiling is
not binding …
Supply, S1
S1
P2
Price ceiling
Price ceiling
3…the price
ceiling becomes
binding…
P1
P1
4. …resulting
in a shortage
Demand
Demand
0
Q1
Quantity of Gasoline
2…but when
supply falls…
0
QS
QD
Q1
Quantity of Gasoline
4
Lines at the gas pump
Price Ceiling – Not Binding then Binding
• 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
5
Figure 4
A market with a price floor
Price of
Ice
Cream
Cone
(a) A price floor that is not binding
Supply
Price of
Ice
Cream
Cone
$4
(b) A price floor that is binding
Surplus
Supply
Price floor
3
$3
Equilibrium
price
2
Equilibrium
price
Price floor
Demand
Demand
Quantity
demanded
Equilibrium
quantity
0
100
Quantity of Ice-Cream Cones
0
Quantity
supplied
120
80
Quantity of Ice-Cream Cones
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
6
only 80 are demanded, there is a surplus of 40 cones.
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)
8
Impacts of a Price Support
Inefficient Production
MC(C) > MV(D)
Transfer CS-PS
Transfer
Due to
Increased
Production
Increased PS
9
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 inefficiently
– 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
10
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 3rd World countries
• Powdered Milk
• Disrupts their dairy industry
11
What Could Go Wrong?
The Complete Stupidity Of The Looming Dairy Cliff: Milk To ...
www.forbes.com/.../the-complete-stupidity-of-the-looming-dairy-...
Forbes
Dec 31, 2012 - 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
www.cato.org/.../dairy-price-supports-still-milking-public
Cato Institute
Why $7-Per-Gallon Milk Looms Once Again : The Salt : NPR
www.npr.org/sections/.../why-7-per-gallon-milk-looms-once-againNPR
12
An Economist’s Perspective
• Cato Institute
– http://www.cato.org/pubs/tbb/tbb_0707_47.pdf
• The federal government has subsidized and regulated the dairy
industry since the 1930s. A system of “marketing order”
regulations was enacted in 1937. A dairy price support program
was added in 1949. An income support program for dairy
farmers was added in 2002.
• As part of this year’s farm bill, Congress may reauthorize dairy
programs, but they are among the most illogical of all farm
programs. 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
14
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.
15
Agricultural Price Supports in the 3rd World
Agricultural price supports often stimulate larger production, tax consumers, and
impede international trade. They often transfer income from lower-income
consumers to wealthier owners of farmland. Price supports do little to help
farmers with below-average incomes because benefits are distributed in
proportion to sales. A more efficient and equitable way to help low-income
farmers would be to transfer income to them directly.
Agricultural Price Supports
by Robert L. Thompson
16
Agricultural Price Support Programs in the US
The Economist labeled the recently enacted 2008 farm bill “A
Harvest of Disgrace” (May 24, 2008). The five-year $307 billion bill,
through a complicated system of government programs, lavishes
cash on upper-income farm households.
The major beneficiaries of U.S. agricultural programs, commercial
farmers, will have an average income of some $230,000 in 2008,
according to the U.S. Department of Agriculture (USDA). The main
restriction on these subsidies is a means test that applies to couples
making more than $1.5 million per year.
A host of “emergency programs” was enacted as part of President
Franklin Roosevelt’s New Deal during the Great Depression of the
1930s. Despite huge changes over time in the particulars, the
programs affecting the growing and marketing of farm crops remain
largely intact.
17
Agricultural Price Supports – An Economic Analysis
https://en.wikipedia.org/wiki/Price_support
•Price = $5
•Quantity = 500
•Consumer Surplus = $1,250
•Producer Surplus = $1,250
•The government agrees to pay $6 per
unit, setting market price at $6
•At this price:
• consumers buy 400 units
• producers supply 600 units
•To maintain a price of $6 per unit, the
government buys the surplus of 200
units
•Consumer Surplus decreases to $800
•Producer Surplus increases to $1,800
18
5
How the minimum wage affects the labor market
(a) A free labor market
(b) A Labor Market with a
Binding Minimum Wage
Wage
Wage
Labor
supply
Labor surplus
(unemployment)
Minimum
wage
Equilibrium
wage
Labor
demand
Labor
demand
0
Labor
supply
Equilibrium
employment
Quantity
of Labor
0
Quantity
demanded
Quantity Quantity
supplied of Labor
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.
19
The result is unemployment.
The minimum wage
• 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
20