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.