Unit III
Price Ceilings and Floors
(Chapter 5)
In this chapter, look for the
answers to these questions:
e What are price ceilings and price floors?
What are some examples of each?
e How do price ceilings and price floors
affect market outcomes?
e How do taxes affect market outcomes?
How does the outcome depend on
whether
the tax is imposed on buyers or sellers?
e What is the incidence of a tax?
What determines the incidence?
Market Disruptions
• How do we ration goods and services?
– Prices
– Queues
– Lotteries
• Prices ration available resources most
efficiently
Market Disruptions
• When a
drought
occurs in
the United
States,
what is the
best means
of rationing
water?
– California vs. Puerto Rico
Market Disruptions
• When a
drought
occurs in
the United
States,
what is the
best means
of rationing
water?
– California vs.
Puerto Rico
Government Policies That Alter
the Private Market Outcome
• Price controls
– Price ceiling: a legal maximum on the price
of a good or service. Example: rent control.
– Price floor: a legal minimum on the price of
a good or service. Example: minimum wage.
We will use the supply/demand model to see
how each policy affects the market outcome
(the price buyers pay, the price sellers receive,
and eq’m quantity).
• Market for illegal
g/s
• Market in which
g/s trade at
prices above
their legal
maximum prices
– Tickets to
sporting
events
– Rent in some
cities
• Stacia
Bekemeyer
Black Markets
• What do you think the housing market
might look like in Amsterdam?
Questions
1.
Why do we call a price that is lower than
the equilibrium a price ceiling?
2.
What would be the long-run effects of a
price ceiling policy?
3.
Isn’t it true that lower prices are a good
thing for consumers?
Rent Control
• placement of price ceilings on rents in
particular cities
– Over 200 American cities operate under some
kind of rent control
• Example:
– New York City, Santa Monica, CA, Berkeley, CA
Two Functions of Rental Prices
1) promote efficient maintenance of existing housing /
stimulate construction of new housing
– Rent controls discourage the construction of new
rental units. Why?
– Rent -- most important long-term determinant of
profitability / rent controls artificially depress them
• Examples:
– Dallas, Texas (16% vacancy) no rent control built
11,000 new rental units.
– San Francisco (1.6 % vacancy) with rent control built
2000 new rental units
Two Functions of Rental Prices
2) allocate existing scarce housing among competing
claimants
• What happens to the current supply of housing?
–
–
•
When rental rates are held below the market
equilibrium levels, property owners cannot
recover the cost of maintenance, repairs, and capital
improvements through higher rents.
In extreme situations, fixed costs exceed the
rental returns. The result is abandoned buildings
Example: New York City and its numerous
abandoned buildings.
Rent Control
•
Who loses in rent control?
–
–
•
Who gains in rent control?
–
•
landlords
low income individuals looking for first apartment
Upper-income professionals
Important: Effective rent controls discourage
new rental unit construction, decrease
spending on existing rental units and
leads to a “Housing gridlock”
EXAMPLE 1: The Market for Apartments
P
Rental
price of
apts
S
$800
Eq’m w/o
price
controls
D
300
Q
Quantity of
apartments
How Price Ceilings Affect Market
Outcomes
A price ceiling
above the
eq’m price is
not binding –
it has no
effect on the
market
outcome.
P
S
Price
ceiling
$1000
$800
D
300
Q
How Price Ceilings Affect Market
Outcomes
The eq’m
price ($800)
is above the
ceiling and
therefore
illegal.
The ceiling
is a binding
constraint
on the price,
and causes
a shortage.
P
S
$800
Price
ceiling
$500
shortage
D
250
400
Q
How Price Ceilings Affect Market
Outcomes
P
In the long
run, supply
and demand
are more
price-elastic.
So, the
shortage
is larger.
S
$800
Price
ceiling
$500
shortage
150
450
D
Q
Alternative Market Outcomes
Alternative:
Section 8 Grants
P
S
$800
Price
ceiling
$500
shortage
150
450
D
Q
Shortages and Rationing
• With a shortage, sellers must ration the goods
among buyers.
• Some rationing mechanisms: (1) long lines
(2) discrimination according to sellers’ biases
• These mechanisms are often unfair, and inefficient:
the goods don’t necessarily go to the buyers who
value them most highly.
• In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair???).
Price Floors in the Labor Market
• Minimum Wage
– wage floor, legislated by the government, setting the
lowest hourly wage rate that firms may legally pay
workers
• Proponents:
– ensure low-income workers a “decent” standard of
living
• Opponents:
– causes increased unemployment
• Note:
Economists estimate that a 10% increase in the real
minimum wage decreases total employment of those
affected by 1 to 2%.
EXAMPLE 2: The Market for
Unskilled Labor
Wage
paid to
unskilled
workers
W
S
$4
Eq’m w/o
price
controls
D
500
L
Quantity of
unskilled workers
How Price Floors Affect Market
Outcomes
A price floor
below the
eq’m price is
not binding –
it has no
effect on the
market
outcome.
W
S
$4
Price
floor
$3
D
500
L
How Price Floors Affect Market
Outcomeslabor
The eq’m wage ($4) W
is below the floor
$5
and therefore
illegal.
$4
The floor
is a binding
constraint
on the wage,
and causes
a surplus
(i.e.,unemployment).
surplus S
Price
floor
D
400
550
L
The Minimum Wage
Min wage laws
do not affect
highly skilled
workers.
W
unemployment S
Min.
wage
$5
$4
They do affect
teen workers.
D
400
550
L
Earned Income Tax Credit
• refundable tax credit primarily for
individuals and couples with qualifying
children
• Theory -- Minimum wage laws are a
undue burden on small business
Price Floors in Agriculture
Historical note:
1933 Federal government placed price
floors on agriculture
• How it works:
1. Government sets a support price for ag product / acts to
ensure that price never falls below support price
2. excess quantity supplied or surplus is purchased
by government
• 3. program run on a per bushel basis / larger farms better
off
• Note: 1996 these supports were supposed to be
eliminated except for tobacco and peanuts
Ag Price Floor
Ag. Price
supports
create surplus
Ag product in
the market.
surplus
P
S
Ag.
Surplus
$5
$4
D
400
550
Q
A C T I V E L E A R N I N G 1:
Price floors
& ceilings
P
140
130
The market for
hotel rooms
S
120
Determine
effects of:
110
100
90
A. $90 price
ceiling
80
B. $90 price
floor
60
C. $120 price
floor
D
70
50
40
0
Q
50 60 70 80 90 100 110 120 130
29
A C T I V E L E A R N I N G 1:
A. $90 price ceiling
P
140
The price
falls to $90.
Buyers
demand
120 rooms,
sellers supply
90, leaving a
shortage.
The market for
hotel rooms
S
130
120
110
100
90
80
70
Price ceiling
D
shortage = 30
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
30
A C T I V E L E A R N I N G 1:
B. $90 price floor
P
140
The market for
hotel rooms
130
S
120
Eq’m price is
above the
floor, so floor
is not binding.
P = $100,
Q = 100
rooms.
110
100
90
80
Price floor
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
31
A C T I V E L E A R N I N G 1:
C. $120 price 140
floor
P
130
120
The price
rises to $120.
Buyers
demand
60 rooms,
sellers supply
120, causing
a surplus.
110
The market for
hotel rooms
surplus = 60
S
Price floor
100
90
80
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
32
Evaluating Price Controls
• Markets are usually a good way
to organize economic activity.
Prices are the signals that guide the allocation of
society’s resources. This allocation is altered when
policymakers restrict prices.
Price controls are often intended to help the poor,
but they often hurt more than help them:
The min. wage can cause job losses.
Rent control can reduce the quantity and quality of
affordable housing.
CHAPTER SUMMARY
e A price ceiling is a legal maximum on
the price of a good. An example is rent
control. If the price ceiling is below the
eq’m price, it is binding and causes a
shortage.
e A price floor is a legal minimum on the
price of a good. An example is the
minimum wage. If the price floor is
above the eq’m price, it is binding
and causes a surplus. The labor surplus
caused by the minimum wage is
unemployment.