Slide 2 of 36 Introduction In this chapter we learn how a controlled price… Causes a single market to result in a surplus or a shortage. Delinks some markets and links others in ways that are counterproductive.
Slide 3 of 36 Price Ceilings Price controls create price ceilings when the controlled price is below the market equilibrium price. Price ceilings create five important effects: 1.Shortages 2.Reductions in product quality. 3.Wasteful lines and other search costs. 4.A loss from gains from trade. 5.A misallocation of resources. Lets look at each of these in turn.
Slide 4 of 36 Price Ceilings 1.Shortages Quantity Price ($) Demand Supply Market equilibrium Controlled price (ceiling) Quantity demanded at the controlled price Quantity supplied at the controlled price Shortage Results: 1.At the controlled price Q s < Q d 2.In 1973, there were shortages of wool, copper, aluminum, vinyl, denim jeans, paper, …
Slide 5 of 36 Price Ceilings 2.Reductions in Product Quality One way to evade the law is to cut quality. Examples from the 1970s: Books were printed on lower quality paper. 2" X 4" lumber shrank to 1" X 3" New automobiles were painted with fewer coats of paint. Another way quality can fall is to cut service. Examples from the 1970s The full service gasoline state disappeared.* Gasoline stations would close whenever the owner wanted a break.
Slide 6 of 36 Price Ceilings 3.Wasteful Lines and Other Search Costs Quantity Price of gasoline per gallon Demand Supply Market equilibrium Controlled price (ceiling) QdQd QsQs Shortage $3 $1 Total value of wasted time Willingness to Pay for Q s Per gallon time cost
Slide 7 of 36 Price Ceilings 3.Wasteful Lines and Other Search Costs (cont.). Other search costs: other ways of paying for gas. Corruption and bribes: this was not a big problem in the U.S., but it is a huge problem in other countries. Unfortunately honesty doesnt eliminate the shortage so people simply line up…earlier…and earlier… Time wasted by the buyer cannot be transferred to the seller. It is simply lost.
Slide 8 of 36 Price Ceilings 4.Lost Gains from Trademutually profitable exchanges are forgone. Lost consumer surplus (CS) Lost producer surplus (PS) The total lost gains from trade = sum of the lost consumer surplus and lost producer surplus for all buyers and sellers. All of this is shown in the next figure
Slide 9 of 36 Price Ceilings 4.Lost Gains From Trade (cont.) Quantity Price of gasoline per gallon Demand Supply Market equilibrium Controlled price (ceiling) QdQd QsQs Shortage $3 $1 Willingness to Pay for Q s PmPm QmQm Lost gains from trade (deadweight loss) = lost consumer surplus (CS) + lost producer surplus (PS) CS PS
Slide 10 of 36 Price Ceilings 5.Misallocation of Resources Prices give incentives to move resources from low valued uses to higher valued uses. Price controls distort signals and eliminate incentives. Example: No matter how cold it gets, demanders of heating oil are prevented from bidding the price up. Result: There is no signal and no incentive to ship oil to where it is needed most. Resources are misallocated across different uses. Recall from chapter 2.
Slide 11 of 36 Price Ceilings Price of oil per barrel Quantity of oil (MBD) Demand 60040 $20 20 $80 $140 0 $100 $120 $40 $60 80100120140 Oil is used for lower valued uses at low prices As its price rises, oil is transferred from lower valued uses to higher valued uses. 5.Misallocation of Resources (cont.) Oil is used for higher valued uses at high prices
Slide 12 of 36 Price Ceilings 5.Misallocation of Resources (cont.) With price controls the consumers of oil with the highest value are unable to signal their high value by offering to pay a higher price. Like the lines at gas stations, it becomes first come, first served. Result: oil is allocated to random and often trivial uses. Only the least valued uses are left out (i.e., those uses that are valued less than the controlled price). The next diagram illustrates this result.
Slide 13 of 36 Price Ceilings 5.Misallocation of Resources (cont.) Price ($) Quantity Supply Demand Controlled Price (ceiling) Willingness to pay for Q s QsQs QdQd Highest valued uses Lower valued uses Least valued uses Conclusion: At the controlled price, there is no guarantee that oil will be allocated to the highest valued uses.
Slide 14 of 36 Price Ceilings 5.Misallocation of Resources (cont.) Misallocation and Production Chaos Shortages in one market create breakdowns and shortages in other markets. Examples from 1973: In 1973 construction projects were delayed because a few thousand dollars worth of steel bar were unavailable. Shortages of steel drilling equipment made it difficult to expand oil supplies. Schools, factories, and offices were forced to close.
Slide 15 of 36 Price Ceilings 5.Misallocation of Resources (cont.) Government allocated oil supplies. Created other problems: Ordering gasoline stations to close on Sunday encouraged people to fill up earlier. Daylight savings time and the 55 mph speed limit were implemented. Fuel for noncommercial aircraft was cut. Result: The local economy of Wichita, Kansas, where private aircraft producers were located went into a tailspin.
Slide 16 of 36 Price Ceilings 5.Misallocation of Resources (cont.) C. Jackson Grayson, chairman of President Nixons Price Commission, concluded: Our economic understanding and models are simply not powerful enough to handle such a large and complex economic system better than the market place. Price controls lifted on… Most goods: by April 1974 Oil: morning of January 20,1981, Ronald Reagans first act as president. Shortage ended overnight and within a few years the price fell below the levels of 1979.
Slide 17 of 36 Since World War II, New York City has had rent control, with ceilings placed on the rent that apartment landlords can charge. You are moving to New York City. Will you find a surplus or shortage of apartments? Some landlords in New York City demand that new tenants pay $500 or $1000 key money: landlords will not hand over a set of apartment keys until this non-refundable payment is made. How does key money fit in our model of the effects of price ceilings?
Slide 18 of 36 In rent-controlled New York City, over time, what do you think will happen to the upkeep of the rent-controlled buildings? What is the landlords incentive structure?
Slide 19 of 36 Price Floors A price floor is a minimum price allowed by law. The best example of a price floor is the minimum wage. Price floors create four important effects: 1.Surpluses 2.A loss of gains from trade (deadweight loss) 3.Wasteful increases in quality 4.A misallocation of resources Lets look at each of these in turn.
Slide 20 of 36 Price Floors 1.Surpluses Minimum wage leads to a surplus of labor (unemployment). Higher productivity workers are unaffected. Minimum wage leads to employment among younger workers Young people lack skills and experience More than half of minimum wage workers are younger than 25 years old. The following diagram shows the effect of a price floor (minimum wage)
Slide 21 of 36 Price Floors 1.Surpluses (cont.) Wage ($) Quantity Supply Demand Market employment Minimum wage (floor) Quantity demanded at minimum wage Quantity supplied at minimum wage Market wage Labor surplus (Unemployment) Conclusion: the greater the difference between the minimum wage and the market wage, the greater is unemployment
Slide 22 of 36 Price Floors 2.Lost Gains from Trade At the minimum wage Employers would be willing to hire more workers if they could offer lower wages. Unemployed workers would be willing to work at a lower wage. Implication: Mutually beneficial opportunities for exchange of labor that cant be exploited. The value of these lost opportunities represent the lost gains from trade. All of this is illustrated in the next diagram.
Slide 23 of 36 Price Floors 2.Lost Gains from Trade (cont.) Wage ($) Quantity Supply Demand Market employment Minimum wage (floor) Quantity demanded at minimum wage Quantity supplied at minimum wage Market wage Labor surplus Lost producer (worker) surplus Lost consumer (employer) surplus
Slide 24 of 36 Price Floors 2.Lost Gains from Trade (cont.) The overall effect on the economy is small. 93.9% of workers younger than 25 earn more than the minimum wage. Minimum wage legislation is the topic of hot political debate… Democrats: It must be raised to help working families. Republicans: It will create unemployment and raise prices. Both positions are overstated.
Slide 25 of 36 Price Floors 2.Lost Gains from Trade (cont.) Benefits and costs of the minimum wage in the U.S. At best: wages of some teenagers and younger workers Their wages will increase anyway. At worst: price of a hamburger unemployment among teenagers Many will choose to stay in school longer (not necessarily a bad thing).
Slide 26 of 36 Price Floors 2.Lost Gains from Trade (cont.) Large increases in the minimum wage could cause serious unemployment. Example: Puerto Rico (1938)–was surprised to learn that the newly passed minimum wage in the U.S. would apply to them as well. The new minimum wage was $.25 per hour; in Puerto Rico many workers were earning $0.02 to $0.03 per hour. Result: Many Puerto Rican firms went bankrupt causing devastating unemployment.
Slide 27 of 36 Price Floors 2.Lost Gains from Trade (cont.) Minimum wages in other countries are sometimes much higher than in the U.S. France Minimum wagenearly twice as high as the U.S. (relative to the median wage) Labor regulations make it difficult to fire workers. Combined result: 2005, 25% of French workers under 25 were unemployed. The highest quarterly average for the same age group in the U.S. in that year was 11.9%.
Slide 28 of 36 Price Floors 3.Wasteful Increases in Quality The Civil Aeronautics Board (CAB) regulated airlines from 1938 to 1978. Prices were kept well above market rates. How do we know this? CAB only had jurisdiction over travel between states, and... fares for routes within the same state were sometimes half the rate for similar routes between states. Price floors cause firms to compete for customers by offering higher quality.
Slide 29 of 36 Price Floors 3.Wasteful Increases in Quality (cont.) Example: When the airlines were regulated they competed by offering bone china, fancy meals, wide seats, and frequent flights. Sounds great! But… If consumers were willing to pay for fine meals and more comfort, airlines would offer that service. Obviously, they dont. Why not? Increase in quality comes at a price. Would you prefer a fine meal on your flight to Paris or more money to spend at a real Parisian restaurant?
Slide 30 of 36 Price Floors 3.Wasteful Increases in Quality (cont.) Conclusion: An increase in quality that consumers are not willing to pay for is a wasteful increase in quality. As firms competed by offering higher quality, the initial producer surplus was wasted away. This loss is shown in the next diagram.
Slide 31 of 36 Price Floors 3.Wasteful Increases in Quality (cont.) Price (fare) Quantity of flights Supply Demand CAB regulated fare (floor) Quantity demanded Willingness to sell Quality Waste Market equilibrium
Slide 32 of 36 Price Floors 4. The Misallocation of Resources Regulation of airline fares could not have been maintained for 40 years had the CAB not also regulated entry. Firms wanted to enter the industry because fares were kept high. Under the influence of the older airlines, the CAB routinely prevented new competitors from entering. Evidence: In 1938 there were 16 major airlines; by 1974 there were just 10 despite requests to enter the industry.
Slide 33 of 36 Price Floors 4. The Misallocation of Resources (cont.) Restrictions to entry misallocated resources because low-cost airlines were kept out. Southwest Airlines Began as a Texas-only airline. Entered the national market only after deregulation in 1978. Has become one of the largest and most profitable airlines in the U.S Deregulation improved the allocation of resources by allowing low-cost, innovative firms to expand nationally.
Slide 34 of 36 The European Union has a minimum legal price for butter, a price floor, that is often above the market equilibrium price. What do you think has been the result of this? The U.S. has set a price floor for milk above the equilibrium price. Has this led to shortages or surpluses? How do you think the U.S. government has dealt with this? (Hint: remember the cartons of milk you had in grammar school and high school? What was their price?
Slide 35 of 36 Takeaway You should be able to: draw a diagram showing the price ceiling and correctly labeling the shortage, and on the same diagram... Locate the wasteful losses from waiting in line and the lost gains from trade. You should also understand how price ceilings… Reduce product quality. Misallocate resources. Not only in the market with the price ceiling but throughout the economy.
Slide 36 of 36 Takeaway Using the tools of supply and demand you should be able to… Explain why a price floor creates: a surplus a deadweight loss wasteful increases in quality Label these areas on a diagram. You should also be able to explain how price floors cause resources to be misallocated.