1. PRICE CEILINGS & PRICE FLOORS
(Consumer Surplus & Producer Surplus)
Krugman Section 2, Module 8

2. 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

3. 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

4. Why Governments Control Prices
Unpopular market prices
Political pressure
Sometimes the efficient outcome in the market is judged as unfair to some groups, usually those that are disadvantaged (poor) and struggling to begin with.
How will we deal with this?
A price control is a legal restriction on how high or low a market price may go.
Price controls are enacted by governments in response to political pressures from buyers and sellers.
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5. 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.
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6. $4 $3 $2 $1 Ge at an average price of $2.50. 0 1 2 3 4 5 6 7S
In this example, the average beers consumed per week is 6 $4 $3 $2 $1 E
at an average price of $2.50. D
Beers per week Ge

7. 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. $4 $3 $2 $1 E D
Beers per week Ge

8. The 9th beer is worth to people what it is worth to people.
It is different for everybody.

9. S $4 $3 $2 $1 E D Ge 0 1 2 3 4 5 6 7 Beers per week
From the suppliers’ standpoint, they could supply at a lower price but they CAN get more. This is called PRODUCER SURPLUS. $4 $3 $2 $1 E D
Beers per week Ge

10. The colored area is the total value to society of the cost of 6 beers. $4 $3 $2 $1
Consumer Surplus E
Producer Surplus D
Beers per week Ge

11. What if government mandate limited the maximum number of beers one could drink to 4 per week?
Government Mandated Supply S
Four beers is not enough (too little, inefficient) ….This is called DEADWEIGHT loss. $4 $3 $2 $1 E D
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Beers per week Ge
Deadweight loss of gift giving

12. Controlling Quantities
Quantity Control - Quota
Licenses
In addition to controlling prices, the government can also decide that the equilibrium quantity is, for some reason, too high.
So government determines a:
quantity control, or quota: an upper limit on the quantity of some good that can be bought or sold.
The total amount of the good that can be legally transacted is the quota limit.
Questions for the students:
Why would we want to limit the quantity of a good that can be bought or sold?
Can you think of any production that is limited?
Who would benefit from this?
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13. The Anatomy of Quantity Controls
A quota is set, a license is given (or auctioned) to producers.
A license gives its owner the right to supply the good.
Note: Excellent examples of quota limits are fishing limits. The instructor might provide the students with an article about depleted ocean fisheries or fishing seasons that have been completely closed to protect the stock of a species (i.e., salmon, swordfish, lobster,…).
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14. The Anatomy of Quantity Controls
Demand Price
Supply Price
Wedge - Quota Rent
The demand price Pd: the price at which consumers will demand that quantity.
The supply price Ps: the price at which producers will supply that quantity.
A quantity control, or quota, drives a wedge between the demand price and the supply price of a good.
Suppose at the quota of 40:
Demand Price = $80
Supply Price = $50
If buyers are willing to pay $80, but sellers can produce at cost $50, each owner of a license to fish salmon earns the difference of $30. And this is the amount that any salmon boat would pay to have a license.
quota rent: The difference between the demand and supply price
The earnings that accrue to the license-holder from ownership of the right to sell the good.
It is equal to the market price of the license when the licenses are traded.
We can also think of the quota rent as the opportunity cost the holder of the license bears for not renting out his license to another producer.
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15. The Cost of Quantity Controls
Deadweight Loss
1. Inefficiency: in the form of mutually beneficial transactions that don’t occur.
Anytime the demand price at a given quantity is not equal to the supply price at that quantity, there will be missed opportunities.
2. Incentives for illegal activities.
Suppliers know that additional units could be supplied and buyers could be found. This kind of overproduction would violate the quota.
In the salmon example, this is illegal fishing, or poaching.
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16. What if government mandate limited the maximum price of a beer to $1
However, suppliers would not want to produce as much beer. S $4 $3 $2 $1 E
Consumers would want to buy more beer. D 10
Beers per week Ge

17. 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. $4 $3 $2 $1 E
shortage D
Beers per week Ge

18. The legal maximum price that can be charged is called a PRICE CEILING
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.

19. Price Ceilings Legal maximum price Examples
Resource prices during WWII
Oil Prices in1970s
California electricity
New York City apartments
A price ceiling is a maximum price sellers are allowed to charge for a good.
Who would want such a thing? Consumers.
Note: Ask the students what goods/services they consider to be unfairly expensive.
You will often get responses like “gasoline” or “college tuition”.
You might use one of these examples to show students the impacts of a price ceiling on the market for this good.
If Pe is considered “too high”, then a price ceiling must be set below the equilibrium price. A price ceiling set above the equilibrium price has no effect.
Or you could go through an example of a common good that is very unlikely to be the target of a price control.

20. Modeling a Price Ceiling
Shortage at Pc = Qd - Qs
If the Pc=$2, Qd =5.75 and Qs = 4 so there is a shortage of almost 2 tacos.
Is this so bad? Aren’t consumers helped by this lower price? Yes, if you are among the lucky 4 who get tacos!
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21. How a Price Ceiling Causes Inefficiency
Inefficient Allocation to Consumers
Wasted Resources
Inefficiently Low Quality
Black Markets
People who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it.
Suppose Stan was our sixth potential consumer. He would not have paid $5 for a taco before the price control, but maybe now he is one of the lucky ones that gets a taco at $3.
Julia was our second potential customer who would have paid $8 for a taco, but can’t find one now.
One way to define inefficiency: A market or an economy is inefficient if there are missed opportunities: Some people could be made better off without making other people worse off.
This is inefficient, because Stan can sell a taco to Julia for $7 and both win.
This is exactly the reallocation that improves someone without harming another.
People spend money and expend effort in order to deal with the shortages caused by the price ceiling.
Time spent looking for scarce tacos has an opportunity cost. You could be working, having some leisure, etc. These missed opportunities create more inefficiency to the price control.
Sellers offer low-quality goods at Pc, even though buyers would prefer a higher quality at a higher price.
Taco suppliers may cut corners on food safety because that costs money. Maybe we get more tacos that make us sick
A black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling.
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22. So Why Are There Price Ceilings?
Benefit some
Uncertainty
Lack of understanding
Price ceilings are enacted because
1. They do benefit some consumers. Consumers may have the political clout to persuade government that the equilibrium price is taking advantage of them. This is a normative argument.
2. When they have been in effect for a long time, buyers may not have a realistic idea of what would happen without them.
3. Government officials often do not understand supply and demand analysis.
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23. When POLITICS vs. ECONOMICS => Politics always wins
Politically popular ideas include:
--$ minimums on inputs (wages).
--$ maximums on outputs (prices).
When POLITICS vs. ECONOMICS => Politics always wins

24. A price ceiling keeps the market from reaching equilibrium.
The government mandating the maximum price of a beer is called a PRICE CEILING. S $4 $3 $2 $1 E
shortage D
Beers per week Ge

25. The shortage created from the price ceiling will result in increased demand.$4 $3 $2 $1 E
shortage D X
Beers per week Ge

26. The increased demand and a willingness to pay higher prices will result in a BLACK MARKET for beer.

28. The minimum wage is an example of a price floor.
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 $3 $2 $1 E D
Labor Ge

29. Creating a SURPLUS of labor.
The minimum wage increases the number of people who want to work (supply of labor). . .
. . . And decreases the number of businesses who want to hire (demand for labor) S $5 $4 $3 $2 $1
SURPLUS E
Creating a SURPLUS of labor. D
Labor Ge

30. 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.

31. Typically, the government jumps in during a surplus, buys the surplus….
and the surplus rots.

32. Price Floors Legal minimum price Examples Agricultural products
Minimum wage
Trucking
Air travel
A price floor is a legal minimum price buyers are required to pay for a good.
The minimum wage is a legal floor on the wage rate, which is the market price of labor.
If Pe is considered “too low”, a price floor is set above the equilibrium price. A price floor set below the equilibrium price has no effect.
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33. Modeling a Price Floor Module 8 . Surplus at Pf
Price floors lead to excess supply; the quantity supplied is greater than quantity demanded.
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34. How a Price Floor Causes Inefficiency
Inefficiently Low Quantity
Inefficient Allocation of Sales Among Sellers
Wasted Resources
Inefficiently High Quality
Illegal Activity
1. Surplus at Pf
Price floors lead to excess supply; the quantity supplied is greater than quantity demanded.
2. Inefficiently low quantity:
Since a price floor raises the price of a good to consumers, quantity demanded falls, so the quantity bought and sold falls, creating a loss to society.
3. Inefficient allocation of sales among sellers:
Those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it.
Suppose Susan isn’t a very efficient taco vendor and couldn’t sell tacos at a price of $5, but can at $7. She is lucky enough to get one of the few buyers.
Juan is very efficient and could sell at $4, but is unlucky and doesn’t get a buyer at $7.
The price floor has just enabled a less efficient seller to make a sale, and might force an efficient seller out of the market.
4. Wasted resources.
Government price floors set about the equilibrium price cause surpluses which the government may be required to buy and destroy.
Minimum wages result in fewer jobs available and so would-be workers waste time searching for a job.
What do we do with the surplus tacos?
Maybe they go to waste, even if the government purchases them.
5. Goods of inefficiently high quality:
Sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price.
The high price may induce taco suppliers to provide extravagantly expensive ingredients that would be unprofitable at the lower market price.
Taco consumers would probably just rather have a low-priced taco without the fancy bells and whistles.
If they were really wanting expensive ingredients, their preferences would have been reflected in a stronger demand curve to begin with and the market price would have been $6 or higher.
6. Illegal activity.
Bribery of sellers or government officials.
Examples of working for less than minimum wage (off the books) because there is a surplus of labor willing to work.
Minimum wage laws are an example of price floors. Relatively high minimum wages in Europe lead to higher levels of unemployment and black markets in labor. In contrast, the minimum wage in the United States is set closer to the equilibrium wage, and labor is relatively more productive in the United States.
Module 8

35. So Why Are There Price Floors?
Benefit some
Disregard
Lack of understanding
Price floors are enacted because:
They do benefit some producers. Producers may have the political clout to persuade government that the equilibrium price is unfairly low. This is a normative argument.
Price floors create a persistent surplus of the good.
Inefficiencies arising from the persistent surplus come in the form of inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and an inefficiently high level of quality offered by suppliers.
There is also the temptation to engage in illegal activity, particularly bribery and corruption of government officials.
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37. PROBLEM SOLVING

38. 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 $3 $2 $1 E D
Beers per week Ge

39. 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?”

40. QUESTION 2:
Using economic principles, explain the impact of government mandates on the supply and demand of the illegal marijuana market.

41. Ge This created a shortage in the market. 0 1 2 3 4 5 6 7
ANSWER: In 1937, the government reduced the availability of marijuana to zero by making it illegal.
This created a shortage in the market. S
Because people have been willing to pay a high price for the product, black market conditions have existed since the shortage was created.
$300
$250
$200
$150
$100
$ 50 E D
Marijuana use Ge

42. 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?

43. ANSWER: President Nixon initiated a price ceiling of $1.60.
REMEMBER: Producers will not want to produce for low prices. S $4 $3 $2 $1
Consequently, a shortage existed because gas companies were taking a loss. This resulted in long lines and gas stations running out of fuel. E
shortage D
Gallons of Gas Ge

44. What would be the opportunity cost of making cigarettes illegal?
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?

45. Ge This will create a shortage in the market. $10 $8 $6 $4 $2
ANSWER: The government would reduce the supply of cigarettes to zero by making it illegal.
This will create a shortage in the market. S
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.
$10 $8 $6 $4 $2 E D
Cigarette use Ge

46. Lower environmental costs Cleaner air Lower costs for health care
ANSWER: The opportunity costs would include:
Lower environmental costs
Cleaner air
Lower costs for health care
Healthier population
Higher unemployment for lost jobs

47. 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.

48. Ge 0 1 2 3 4 5 6 7 This results in a limited market. $100 $80 $60 $40
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. S
Because doctors prescribe drugs for illness and the patient requests good health, they pay the higher price created by the government.
$100
$80
$60
$40
$20 E D
Drug use Ge

49. 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?

50. ANSWER: President Bush realizes that a price ceiling will result in a shortage of electricity.
REMEMBER: Producers will not want to produce for low prices. S $D $C $B $A
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. E
shortage D
0 a b c d e f g
Kilowatts Ge

51. Sources: Economics for AP, by Krugman, Wells.
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