CHAPTER
5
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Price Ceilings and Floors
CHAPTER OUTLINE
Price Ceilings
Rent Control (Optional Section)
Arguments for Price Controls
Universal Price Controls
Price Floors
For applications, click here
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questions
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Video
Food for Thought….
Some good blogs and other sites to get the juices flowing:
SEE THE INVISIBLE HAND
Iraq 2003: Gas prices are frozen at $.05 per gallon.
A good idea?
SEE THE INVISIBLE HAND
Getting in the way of the invisible hand?
Distorted price signals cause resources to be misallocated.
Price Ceilings
Policy makers may respond to buyers’
complaints that prices are “too high”
by enacting price controls.
A Price Ceiling is a maximum price allowed
by law.
Price ceilings limit the price sellers can charge
for their goods to the maximum price.
Prices cannot legally go higher than the
ceiling.
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Price Ceilings
Price ceilings that involve a
maximum price below the market
price create five important effects.
1. Shortages
2. Reduction in Product Quality
3. Wasteful Lines and Other Costs of
Search
4. Loss of Gains from Trade
5. Misallocation of Resources
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Shortages
1. When prices are held below the market price
shortages are created.
The shortage = difference between the Qd and
the Qs at the controlled price.
The lower the controlled price relative to the
market equilibrium price, the larger the shortage.
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Shortages
Price Ceilings Create Shortages
Price
Supply
Market Equilibrium
Shortage
Controlled
Price
(Ceiling)
Demand
Quantity
Qsupplied at the
Controlled
Price
Qdemanded at the
Controlled Price
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SEE THE INVISIBLE HAND
A shortage of vinyl in 1973 forced Capitol
Records to melt down slow sellers so they
could keep pressing Beatles’ albums.
Take a look…..
Why do you think farmers killed a million baby chickens in 1973?
Does it matter that chicken prices were subject to a price ceiling but
their feed was not? Click on the picture for a short video (first 1:40 min of
the clip)
http://www.youtube.com/watch?v=IFbAwzU6G7s&NR=1
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Video
Reduction of Product Quality
2. At the controlled price, sellers have
more customers than goods.
In a free market, this would be an opportunity
to profit by raising prices.
But when prices are controlled, sellers cannot.
Sellers respond to this problem in two ways:
Reduce quality
Reduce service
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Wasteful Lines and Other
Costs of Search
3. Price controls that create
shortages lead to bribery and
wasteful lines.
Shortages: not all buyers will be able
to purchase the good.
Normally, buyers would compete
with each other by offering a higher
price.
If price is not allowed to rise, buyers
must compete in other ways.
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Take a look…..
How do rent-controlled apartments get distributed?
Click on the picture below to find out in this clip from
the “Economics of Seinfeld”. (1:20 minutes)
http://yadayadayadaecon.com/clip/6/
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Wasteful Lines and Other
Costs of Search
Some buyers may be willing to bribe
sellers in order to obtain the good.
The highest bribe a buyer would pay is the
difference between his max price and the
price ceiling.
If bribes are common, then the total price of
the good is the legal price plus the bribe.
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Wasteful Lines and Other
Costs of Search
Buyers can also compete with each other
through their willingness to wait in line.
The maximum wait time (translated into
monetary terms) for a buyer is the difference
between the max price and the price ceiling.
So the total price of the good is the legal price
plus the time costs.
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Wasteful Lines and Other
Costs of Search
Bribes and waits both lead to a total price
that is greater than the controlled price,
(but they are different.)
Bribes involve a simple transfer from buyers to
sellers.
The time spent waiting in line, however, is
simply lost – paying in time is much more
wasteful.
BACK TO
Wasteful Lines and Other
Costs of Search
Price Ceilings Create Wasteful Lines
Price
Supply
Total Value
of Wasted
Time
Time Cost
Willingness to
Pay
Market Equilibrium
Shortage
Controlled
Price (Ceiling)
Demand
Quantity
Qsupplied at the
Controlled Price
Qdemanded at the
Controlled Price
BACK TO
Lost Gains from Trade
4. Price controls reduce the gains from
trade.
Price ceilings set below the market price
cause Qs to be less than the market Q.
When Q is below the equilibrium market Q,
consumers value the good more than
the cost of its production.
This represents a gain from trade that would
be exploited (if the market were free).
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Lost Gains from Trade
Dead-weight Loss is the total of lost
consumer and producer surplus when
all mutually profitable gains from
trade are not exploited.
Price ceilings create a dead-weight loss
by forcing Qs below the market Q.
Buyers and sellers would both benefit from
trade at a higher price, but cannot since it is
illegal for price to rise.
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Lost Gains from Trade
Price Ceilings Reduce the Gains from Trade
Consumer Surplus Shrinks to this
Price
Producer Surplus Shrinks to this
Willingness to
Pay
Market
Price
Supply
Consumer
surplus in
market
equilibrium
Market Equilibrium
Producer Surplus in
equilibrium
Controlled
Price
(Ceiling)
Shortage
Demand
Quantity
Qsupplied
Qmarket
Qdemanded
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Lost Gains from Trade
Price Ceilings Reduce the Gains from Trade
Deadweight Loss (lost gains
Price
from trade)
= Lost Consumer Surplus
+ Lost Producer Surplus
Supply
Willingness to
Pay
Market
Price
Controlled
Price
(Ceiling)
Total
Value of
Wasted
Time
Lost
Consumer
Surplus
Market Equilibrium
Lost
Producer
Surplus
Shortage
Demand
Quantity
Qsupplied
Qmarket
Qdemanded
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Misallocation of Resources
5. Price controls distort signals and
eliminate incentives-- leading to a
misallocation of resources.
Consumers who value a good most are
prevented from signaling their preference (by
offering sellers a higher price.)
So producers have no incentive to supply the
good to the “right” people first.
As a result, goods are misallocated.
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Misallocation of Resources
Price Controls Prevent Resources from flowing to their Highest-Valued Uses
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Rent Controls
Rent Control: a regulation that prevents
rents from rising to equilibrium levels.
Rent control is a price ceiling whose
effects worsen over time No one wants to build new
apartments if the rents will be
artificially low…
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Rent Controls
The shortage is smaller in the Short Run…
Price
(rent)
…..than in the Long Run
Short Run Supply
Long Run Supply
Market Equilibrium
Controlled
Rent
Long Run Shortage
Short Run Shortage
Qsupplied
(Long Run)
Qsupplied
(Short Run)
Demand
Qdemanded
Quantity
(rental apartments)
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Arguments for Price Controls
So why do price controls ever get passed?
The general public may not understand the nasty
side-effects of price controls
Shortages may benefit the ruling elite…
In the former USSR, the communist party elite used Blat
to obtain goods.
Blat= having connections that can be used to get
favors.
The party elite can use their connections and power to
obtain goods for themselves or others.
Without such leverage their power dissipates.
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Universal Price Controls
Just Another Day in a USSR Bread Line
Universal price controls caused widespread
and persistent shortages in the USSR.
Average time in line for a Soviet woman?
2 hours every day, 7 days/week.
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SEE THE INVISIBLE HAND
Are you better or worse off when the food is included in your airfare?
Price Floors
Price floor: a minimum price allowed by
law.
not as common as price ceilings (but still
important)
Price floors have four common effects:
1. Surpluses
2. Lost gains from trade (deadweight loss)
3. Wasteful increases in quality
4. A misallocation of resources
BACK TO
Try it!
If the government of the European Union sets a price
floor for butter above the equilibrium market price,
what will be the effect?
a) Farmers will produce less butter and consumers will
purchase more, resulting in a shortage of butter.
b) The supply of butter will increase and the demand
will decrease.
c) Farmers will produce more butter and consumers
will purchase less, resulting in a surplus of butter.
d) The equilibrium price will rise to the price floor.
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Try it!
Surplus
When prices are held above the market price (price floor) quantity
supplied exceeds the quantity demanded.
Price
Supply
Controlled
Price
(Ceiling)
Surplus
Market
Price
Demand
Quantity
Qdemanded at the
Controlled Price
Qmarket Qsupplied at the
Controlled Price
BACK TO
Lost Gains from Trade
Price controls reduce the gains from trade (create deadweight
losses) Price
Deadweight Loss
= Lost Consumer Surplus
+ Lost Producer Surplus
Controlled
Price
(Floor)
Market Price
Supply
Surplus
Lost
Consumer
Surplus
Lost
Producer
Surplus
Willingness to
Sell
Demand
Qdemanded
Qmarket
Qsupplied
Quantity
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Wasteful Increases in Quality
Price controls that create surpluses lead to wasteful increases in quality.
Supply
Price
Deadweight
Loss
Controlled
Price (Floor)
“Quality”
Waste
Market Equilibrium
Willingness
to Sell
Demand
Quantity
Qdemanded at the
Controlled Price
If they can’t lower price, sellers will find other ways to compete!
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Wasteful Increases in Quality
Higher quality raises costs and reduces seller profit.
Buyers get higher quality, but would prefer a lower price.
Price floors encourage sellers to waste resources:
higher quality than buyers are willing to pay for
Most flyers prefer a lower price
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Misallocation of Resources
Price controls misallocate resources by:
Allowing high-cost firms to operate.
Preventing low-cost firms from entering the industry.
Regulation prevented Southwest (and 79 other firms) from
entering the national market
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SEE THE INVISIBLE HAND
President Jimmy Carter deregulated the
price floors in much of the trucking industry.
Trucks carry almost all of the consumer
goods that you purchase, so almost every
time you purchase something, you're paying
money to a trucking company. What do you
think happened in the trucking industry after
deregulation?
a) The price of trucking services fell.
b) Truckers earned less money.
c) Consumers saved a lot of money.
d) All of the above are correct.
Try it!
If the U.S. government sets a price floor on milk,
it will not always lead to a surplus. Why not?
a)
b)
c)
d)
The price floor would be rarely enforced.
Because price floors most commonly lead
to shortages, not surpluses.
The market price of milk will sometimes rise
above the price floor, rendering the price
floor irrelevant.
Price floors cause supply and demand to
change, which leads to changes in
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Try it!
equilibrium price.
Try it!
During research for a class you find out that
in the year 301, the Roman Emperor
Diocletian issued an “Edict on Prices” for
shoes and you want to find out if it was a
price ceiling or a price floor. Further
research tells you that the number of shoes
sold dropped dramatically and that both
sellers and buyers were very upset. Was it a:
a) Price ceiling
b) Price floor
c) Not enough information
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