1. Price Ceilings and Floors

2. Rent Control (Optional Section) Arguments for Price Controls
Price Ceilings
Rent Control (Optional Section)
Arguments for Price Controls
Universal Price Controls
Price Floors
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4. Iraq 2003: Gas prices are frozen at $.05 per gallon.
A good idea?

5. Getting in the way of the invisible hand?
Distorted price signals cause resources to be misallocated.

6. Price Ceilings
Policy makers may respond to buyers’ complaints that prices are “too high” by enacting price controls.
A Price Ceiling is a maximum price allowed by law.
Price ceilings limit the price sellers can charge for their goods to the maximum price.
Prices cannot legally go higher than the ceiling.

7. Price Ceilings
Price ceilings that involve a maximum price below the market price create five important effects.
Shortages
Reduction in Product Quality
Wasteful Lines and Other Costs of Search
Loss of Gains from Trade
Misallocation of Resources

8. Shortages
When prices are held below the market price shortages are created.
The shortage = difference between the Qd and the Qs at the controlled price.
The lower the controlled price relative to the market equilibrium price, the larger the shortage.
Instructor Notes:

9. Price Ceilings Create Shortages
Quantity
Price
Supply
Market Equilibrium
Shortage
Controlled Price (Ceiling)
Qsupplied at the Controlled Price
Qdemanded at the Controlled Price
Instructor Notes: Figure 6.1: Price Ceilings Create Shortages
At the controlled price, the quantity demanded exceeds the quantity supplied, creating a shortage.
It should be noted that price is not allowed to rise to eliminate the shortage as would be the case in a free market.
Demand

10. A shortage of vinyl in 1973 forced Capitol
Records to melt down slow sellers so they
could keep pressing Beatles’ albums.

11. Why do you think farmers killed a million baby chickens in 1973?
Does it matter that chicken prices were subject to a price ceiling but their feed was not? Click on the picture for a short video (first 1:40 min of the clip)
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12. Reduction of Product Quality
At the controlled price, sellers have more customers than goods.
In a free market, this would be an opportunity to profit by raising prices.
But when prices are controlled, sellers cannot.
Sellers respond to this problem in two ways:
Reduce quality
Reduce service
Instructor Notes:

13. Wasteful Lines and Other Costs of Search
Price controls that create shortages lead to bribery and wasteful lines.
Shortages: not all buyers will be able to purchase the good.
Normally, buyers would compete with each other by offering a higher price.
If price is not allowed to rise, buyers must compete in other ways.
Instructor Notes:

14. How do rent-controlled apartments get distributed
How do rent-controlled apartments get distributed? Click on the picture below to find out in this clip from the “Economics of Seinfeld”. (1:20 minutes)
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15. Wasteful Lines and Other Costs of Search
Some buyers may be willing to bribe sellers in order to obtain the good.
The highest bribe a buyer would pay is the difference between his max price and the price ceiling.
If bribes are common, then the total price of the good is the legal price plus the bribe.
Instructor Notes:

16. Wasteful Lines and Other Costs of Search
Buyers can also compete with each other through their willingness to wait in line.
The maximum wait time (translated into monetary terms) for a buyer is the difference between the max price and the price ceiling.
So the total price of the good is the legal price plus the time costs.
Instructor Notes: It may be necessary to remind students of opportunity costs here. Wages are a good estimate of the opportunity cost of someone’s time.

17. Wasteful Lines and Other Costs of Search
Bribes and waits both lead to a total price that is greater than the controlled price, (but they are different.)
Bribes involve a simple transfer from buyers to sellers.
The time spent waiting in line, however, is simply lost – paying in time is much more wasteful.
Instructor Notes:

18. Wasteful Lines and Other Costs of Search
Price Ceilings Create Wasteful Lines
Price
Supply
Willingness to Pay
Total Value of Wasted Time
Market Equilibrium
Time Cost
Shortage
Controlled Price (Ceiling)
Instructor Notes: Figure 6.2: Price Ceilings Create Wasteful Lines
At Qsupplied the willingness to pay is greater than the controlled price. The difference between what buyers are willing to pay and what sellers can charge encourages buyers to line up to buy the good. Buyers will lineup until the total price of the good, the out-of-pocket price plus the time cost, increases to the willingness to pay. Time spent waiting in line is wasted time. The total value of the wasted time is given by the time cost per unit multiplied by the quantity bought.
Qdemanded at the Controlled Price
Demand
Quantity
Qsupplied at the Controlled Price

19. Price controls reduce the gains from trade.
Lost Gains from Trade
Price controls reduce the gains from trade.
Price ceilings set below the market price cause Qs to be less than the market Q.
When Q is below the equilibrium market Q, consumers value the good more than the cost of its production.
This represents a gain from trade that would be exploited (if the market were free).
Instructor Notes:

20. Lost Gains from Trade
Dead-weight Loss is the total of lost consumer and producer surplus when all mutually profitable gains from trade are not exploited.
Price ceilings create a dead-weight loss by forcing Qs below the market Q.
Buyers and sellers would both benefit from trade at a higher price, but cannot since it is illegal for price to rise.
Instructor Notes:

21. Price Ceilings Reduce the Gains from Trade
Lost Gains from Trade
Price Ceilings Reduce the Gains from Trade
Quantity
Price
Consumer Surplus Shrinks to this
Producer Surplus Shrinks to this
Supply
Willingness to Pay
Consumer surplus in market equilibrium
Market Price
Market Equilibrium
Producer Surplus in equilibrium
Instructor Notes: Figure 6.3 Price Ceilings Reduce the Gains from Trade
At quantities between Qsupplied and Qmarket, the willingness to pay is greater than the cost of production. Although mutually profitable, these trades are illegal. If all mutually profitable trades were legal, the gains from trade would increase by the green plus blue triangles.
The lost gains from trade represent a dead-weight loss.
Controlled Price (Ceiling)
Shortage
Demand
Qsupplied
Qmarket
Qdemanded

22. Price Ceilings Reduce the Gains from Trade
Lost Gains from Trade
Price Ceilings Reduce the Gains from Trade
Quantity
Price
Controlled Price (Ceiling)
Qsupplied
Qdemanded
Willingness to Pay
Deadweight Loss (lost gains from trade)
= Lost Consumer Surplus
+ Lost Producer Surplus
Shortage
Lost Consumer Surplus
Lost Producer Surplus
Supply
Total Value of Wasted Time
Market Price
Instructor Notes: Figure 6.3 Price Ceilings Reduce the Gains from Trade
At quantities between Qsupplied and Qmarket, the willingness to pay is greater than the cost of production. Although mutually profitable, these trades are illegal. If all mutually profitable trades were legal, the gains from trade would increase by the green plus blue triangles.
The lost gains from trade represent a dead-weight loss.
Market Equilibrium
Demand
Qmarket

23. Misallocation of Resources
Price controls distort signals and eliminate incentives-- leading to a misallocation of resources.
Consumers who value a good most are prevented from signaling their preference (by offering sellers a higher price.)
So producers have no incentive to supply the good to the “right” people first.
As a result, goods are misallocated.
Instructor Notes:

24. Misallocation of Resources
Price Controls Prevent Resources from flowing to their Highest-Valued Uses
Instructor Notes: Figure 6.5: When Prices are Controlled Resources Do Not Flow to their Highest Valued Uses
Gains from trade are maximized when goods flow to their highest valued uses. A price control prevents the highest valued uses from outbidding lower valued uses, so some goods flow to lower valued uses even though it would be more valuable if used elsewhere.

25. Rent Controls
Rent Control: a regulation that prevents rents from rising to equilibrium levels.
Rent control is a price ceiling whose effects worsen over time
No one wants to build new apartments if the rents will be artificially low…
Instructor Notes:

26. Rent Controls The shortage is smaller in the Short Run…
…..than in the Long Run
Quantity
(rental apartments)
Price
(rent)
Short Run Supply
Demand
Market Equilibrium
Controlled Rent
Qsupplied
(Short Run)
Qdemanded
Long Run Supply
Qsupplied
(Long Run)
Instructor Notes: Figure 6.8: Rent Control Creates Larger Shortages in the Long Run than in the Short Run
It may be necessary to remind students that supply is inelastic in the short run and elastic in the long run.
Long Run Shortage
Short Run Shortage

27. Arguments for Price Controls
So why do price controls ever get passed?
The general public may not understand the nasty side-effects of price controls
Shortages may benefit the ruling elite…
In the former USSR, the communist party elite used Blat to obtain goods.
Blat= having connections that can be used to get favors.
The party elite can use their connections and power to obtain goods for themselves or others.
Without such leverage their power dissipates.
Instructor Notes:

28. Universal Price Controls
Just Another Day in a USSR Bread Line
Universal price controls caused widespread and persistent shortages in the USSR.
Average time in line for a Soviet woman?
2 hours every day, 7 days/week.
The accepted norm is that the Soviet woman daily spends two hours in
line, seven days a week I have known of people who stood in line
90 minutes to buy four pineapples three and a half hours to buy three
large heads of cabbage only to find the cabbages were gone as they approached
the front of the line, 18 hours to sign up to purchase a rug at
some later date, all through a freezing December night to register on a list
for buying a car, and then waiting 18 months for actual delivery, and terribly
lucky at that.

29. Are you better or worse off when the food is included in your airfare?

30. Price floor: a minimum price allowed by law.
Price Floors
Price floor: a minimum price allowed by law.
not as common as price ceilings (but still important)
Price floors have four common effects:
Surpluses
Lost gains from trade (deadweight loss)
Wasteful increases in quality
A misallocation of resources

31. The supply of butter will increase and the demand will decrease.
If the government of the European Union sets a price floor for butter above the equilibrium market price, what will be the effect?
Farmers will produce less butter and consumers will purchase more, resulting in a shortage of butter.
The supply of butter will increase and the demand will decrease.
Farmers will produce more butter and consumers will purchase less, resulting in a surplus of butter.
The equilibrium price will rise to the price floor.
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32. Surplus
When prices are held above the market price (price floor) quantity supplied exceeds the quantity demanded.
Quantity
Price
Supply
Demand
Market Price
Qmarket
Qsupplied at the Controlled Price
Qdemanded at the Controlled Price
Surplus
Controlled Price (Ceiling)

33. Lost Gains from Trade
Price controls reduce the gains from trade (create deadweight losses)
Quantity
Price
Lost Producer Surplus
Deadweight Loss
= Lost Consumer Surplus
+ Lost Producer Surplus
Lost Consumer Surplus
Supply
Demand
Controlled Price
(Floor)
Surplus
Market Price
Willingness to Sell
Qdemanded
Qsupplied
Qmarket

34. Wasteful Increases in Quality
Price controls that create surpluses lead to wasteful increases in quality.
Quantity
Price
Supply
Demand
Deadweight Loss
Controlled Price (Floor)
Qdemanded at the Controlled Price
“Quality” Waste
Market Equilibrium
Willingness to Sell
If they can’t lower price, sellers will find other ways to compete!

35. Wasteful Increases in Quality
Higher quality raises costs and reduces seller profit.
Buyers get higher quality, but would prefer a lower price.
Price floors encourage sellers to waste resources:
higher quality than buyers are willing to pay for
Most flyers prefer a lower price

36. Misallocation of Resources
Price controls misallocate resources by:
Allowing high-cost firms to operate.
Preventing low-cost firms from entering the industry.
Regulation prevented Southwest (and 79 other firms) from entering the national market

37. President Jimmy Carter deregulated the price floors in much of the trucking industry. Trucks carry almost all of the consumer goods that you purchase, so almost every time you purchase something, you're paying money to a trucking company. What do you think happened in the trucking industry after deregulation?
The price of trucking services fell.
Truckers earned less money.
Consumers saved a lot of money.
All of the above are correct.

38. The price floor would be rarely enforced.
If the U.S. government sets a price floor on milk, it will not always lead to a surplus. Why not?
The price floor would be rarely enforced.
Because price floors most commonly lead to shortages, not surpluses.
The market price of milk will sometimes rise above the price floor, rendering the price floor irrelevant.
Price floors cause supply and demand to change, which leads to changes in equilibrium price.
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39. Not enough information
During research for a class you find out that in the year 301, the Roman Emperor Diocletian issued an “Edict on Prices” for shoes and you want to find out if it was a price ceiling or a price floor. Further research tells you that the number of shoes sold dropped dramatically and that both sellers and buyers were very upset. Was it a:
Price ceiling
Price floor
Not enough information
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