PRICE CEILINGS &
PRICE FLOORS
(Consumer Surplus &
Producer Surplus)
Krugman Section 2, Module 8
What you will learn
in this Module:
• The meaning of price controls, one way
government intervenes in markets
• How price controls can create problems and
make a market inefficient
• Why economists are often deeply skeptical
of attempts to intervene in markets
• Who benefits and who loses from price
controls, and why they are used despite
their well-known problems
Module 8
What you will learn
in this Module:
• The meaning of quantity controls, another
way government intervenes in markets
• How quantity controls create problems and
can make a market inefficient
• Who benefits and who loses from quantity
controls, and why they are used despite
their well-known problems
Module 9
Why Governments Control
Prices
• Unpopular market
prices
• Political pressure
Module 8
What happens when
prices are “fixed” by the
government?
Let’s look at a graph which shows
the average consumption of beer in
the United States.
Module 8
In this example,
the average
beers consumed
per week is 6
S
$4
$3
at an average
price of $2.50.
E
$2
$1
D
0 1 2 3 4 5 6 7
Ge
Beers per week
This chart illustrates the effects upon people
if they were forced to go from Ge to zero.
You might be
willing to pay $4
for your first beer,
but price is $2.50
…..now you are
$1.50 better off.
This is called
CONSUMER
SURPLUS.
S
$4
$3
E
$2
$1
D
0 1 2 3 4 5 6 7
Ge
Beers per week
The 9th beer is
worth to people
what it is worth to
people.
It is different for
everybody.
S
From the
suppliers’
standpoint, they
could supply at a
lower price but
they CAN get
more. This is
called PRODUCER
SURPLUS.
$4
$3
E
$2
$1
D
0 1 2 3 4 5 6 7
Ge
Beers per week
The colored
area is the
$4
total value
to society of $3
the cost of 6
$2
beers.
$1
S
Consumer
Surplus
E
Producer
Surplus
D
0 1 2 3 4 5 6 7
Ge
Beers per week
What if government mandate limited the maximum
number of beers one could drink to 4 per week?
Government
Mandated Supply
Four beers is
not enough
(too little,
inefficient)
….This is called
DEADWEIGHT
loss.
Module 9
S
$4
$3
E
$2
$1
D
0 1 2 3 4 5 6 7
http://www.yadayadayadaecon.com/clip/16/
Deadweight loss of gift giving
Ge
Beers per week
Controlling Quantities
• Quantity Control - Quota
• Licenses
Module 9
The Anatomy of Quantity Controls
Module 9
The Anatomy of Quantity Controls
• Demand Price
• Supply Price
• Wedge - Quota Rent
Module 9
The Cost of Quantity Controls
• Deadweight Loss
Module 9
What if government mandate limited the
maximum price of a beer to $1.00?
$4
$3
However,
suppliers would
not want to
produce as much
beer.
E
$2
S
Consumers would
want to buy more
beer.
$1
D
0 1 2 3 4 5 6 7
Ge
10
Beers per week
Producers will not want to produce
for low prices.
If government
limited the
maximum price
of a beer to
$1.00, it would
create a
shortage.
S
$4
$3
E
$2
shortage
$1
D
0 1 2 3 4 5 6 7
Ge
Beers per week
The legal maximum price that can be
charged is called a PRICE CEILING. A
legal minimum price that can be
charged is called a PRICE FLOOR. Price
ceilings and floors keep markets from
reaching equilibrium.
Price Ceilings
• Legal maximum price
• Examples
– Resource prices during
WWII
– Oil Prices in1970s
– California electricity
– New York City apartments
Modeling a Price Ceiling
Module 8
How a Price Ceiling Causes
Inefficiency
• Inefficient Allocation to
Consumers
• Wasted Resources
• Inefficiently Low Quality
• Black Markets
Module 8
So Why Are There Price Ceilings?
• Benefit some
• Uncertainty
• Lack of understanding
Module 8
Politically popular ideas include:
--$ minimums on inputs (wages).
--$ maximums on outputs (prices).
When POLITICS vs. ECONOMICS =>
Politics always wins
A price ceiling keeps the market from reaching
equilibrium.
The
S
government
$4
mandating
the maximum
price of a beer $3
E
is called a
$2
PRICE
shortage
CEILING.
$1
D
0 1 2 3 4 5 6 7
Ge Beers per week
The shortage created from the price ceiling will
result in increased demand.
S
$4
$3
E
$2
$1
shortage
D
0 1 2 3 4 5 6 7
X
Ge Beers per week
The increased demand and a
willingness to pay higher
prices will result in a BLACK
MARKET for beer.
http://www.yadayadayadaecon.com/clip/31/
http://www.yadayadayadaecon.com/clip/33/
http://www.yadayadayadaecon.com/clip/72/
http://www.yadayadayadaecon.com/clip/6/
http://www.yadayadayadaecon.com/clip/12/
When the government mandates a the
minimum price of something, it is called a PRICE
FLOOR.
S
The
minimum
wage is an
example of a
price floor.
$5
$4
E
$3
$2
$1
D
0 1 2 3 4 5 6 7
Ge
Labor
The minimum wage increases the number of people
who want to work (supply of labor). . .
. . . And
decreases the
number of
$5
businesses who
want to hire
$4
(demand for
$3
labor)
$2
Creating a
SURPLUS of
labor.
S
SURPLUS
E
$1
D
0 1 2 3 4 5 6 7
Ge
Labor
CONCLUSION:
A price floor stops the market from
reaching equilibrium and creates a
surplus.
A price ceiling stops the market from
reaching equilibrium and creates a
shortage.
Typically, the
government jumps in
during a surplus, buys
the surplus….
and the surplus rots.
Price Floors
• Legal minimum price
• Examples
– Agricultural products
– Minimum wage
– Trucking
– Air travel
Module 8
Modeling a Price Floor
Module 8
How a Price Floor Causes
Inefficiency
• Inefficiently Low Quantity
• Inefficient Allocation of Sales
Among Sellers
• Wasted Resources
• Inefficiently High Quality
• Illegal Activity
Module 8
So Why Are There Price Floors?
• Benefit some
• Disregard
• Lack of understanding
Module 8
http://www.yadayadayadaecon.com/clip/12/
http://www.yadayadayadaecon.com/clip/6/
PROBLEM SOLVING
ANSWER: The 18th Amendment created a
shortage of alcohol for consumption
When the price of
alcohol increased
under black market
conditions, this
initiated the
development of
the syndicate and
the notoriety of
such underworld
figures as Al
Capone.
S
$5
$4
E
$3
$2
$1
D
0 1 2 3 4 5 6 7
Ge
Beers per week
QUESTION 1:
Using economic principles and the
impact of government mandate,
why was the 18th Amendment to
the U.S. Constitution considered
“the great experiment that failed?”
QUESTION 2:
Using economic principles, explain the
impact of government mandates on the
supply and demand of the illegal
marijuana market.
ANSWER: In 1937, the government reduced the availability of
marijuana to zero by making it illegal.
This created a shortage in the market.
Because people
have been willing
to pay a high
price for the
product, black
market
conditions have
existed since the
shortage was
created.
S
$300
$250
$200
E
$150
$100
D
$ 50
0 1 2 3 4 5 6 7
Ge
Marijuana use
QUESTION 3:
In 1973, President Nixon froze
gasoline prices after the OPEC
cartel created a shortage in the
United States. What impact did
this have on the market economy
at that time?
ANSWER:
President Nixon
initiated a price
ceiling of $1.60.
Consequently, a
shortage existed
because gas
companies were
taking a loss. This
resulted in long lines
and gas stations
running out of fuel.
REMEMBER: Producers will not want to
produce for low prices.
S
$4
$3
E
$2
$1
shortage
D
0 1 2 3 4 5 6 7
Ge
Gallons of Gas
QUESTION 4:
Using economic principles and the
impact of government mandate,
explain what would happen if
cigarette smoking were made
illegal.
What would be the opportunity
cost of making cigarettes illegal?
ANSWER: The government would reduce the supply of cigarettes
to zero by making it illegal.
This will create a shortage in the market.
Because some
people will be
willing to pay a
high price for the
product, black
market
conditions will
exist and the
price of
cigarettes will
increase.
S
$10
$8
E
$6
$4
$2
D
0 1 2 3 4 5 6 7
Ge
Cigarette use
ANSWER:
The opportunity costs would include:
•Lower environmental costs
•Cleaner air
•Lower costs for health care
•Healthier population
•Higher unemployment for lost jobs
Question 5:
Many experts contend that the Food and Drug
Administration (FDA) directly creates the high
price of prescription drugs. Do you agree? Why
or why not? Explain your answer.
ANSWER: The FDA, a government regulatory agency, reduces the supply of
certain drugs by making them unavailable to certain people through the use of
prescriptions.
This results in a
limited market.
Because doctors
prescribe drugs for
illness and the
patient requests
good health, they
pay the higher
price created by
the government.
S
$100
$80
E
$60
$40
$20
D
0 1 2 3 4 5 6 7
Ge
Drug use
Question 6:
In May 2001, President Bush visited with Governor
Gray of California to discuss the energy crisis in that
state. It will take 10 years to build the power plants
necessary to provide the electricity needed to support
the population and costs will skyrocket as demand
exceeds supply. Governor Gray is requesting that
President Bush place a federal price ceiling on the cost
of energy. Why did President Bush refuse?
ANSWER:
President Bush
realizes that a price
ceiling will result in a
shortage of
electricity.
Limiting the price that
power companies can
charge for electricity
will cause them to lose
money, not produce
efficiently, and result in
a shortage of power.
REMEMBER: Producers will not want
to produce for low prices.
S
$D
$C
E
shortage
$B
$A
D
0 a b c d e f g
Ge
Kilowatts
THE END
Sources:
Economics for AP, by Krugman, Wells.
Economics, by McConnell, Brue
Economics, by Mankiw
Compiled by Virginia Meachum Economics
Teacher, Coral Springs High School, Florida