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8 CHAPTER D YNAMIC P OWER P OINT S LIDES BY S OLINA L INDAHL Price Ceilings and Floors.

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Presentation on theme: "8 CHAPTER D YNAMIC P OWER P OINT S LIDES BY S OLINA L INDAHL Price Ceilings and Floors."— Presentation transcript:

1 8 CHAPTER D YNAMIC P OWER P OINT S LIDES BY S OLINA L INDAHL Price Ceilings and Floors

2 CHAPTER OUTLINE Price Ceilings Rent Control (Optional Section) Arguments for Price Controls Universal Price Controls Price Floors For applications, click herehere To Video To Video

3 Some good blogs and other sites to get the juices flowing: Food for Thought….

4 SEE THE INVISIBLE HAND Iraq 2003: Gas prices are frozen at $.05 per gallon. A good idea?

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

6 B ACK TO Price Ceilings Policy makers may respond to buyers complaints that prices are too high by enacting price controls. A Price Ceiling 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 B ACK TO Price Ceilings Price ceilings that involve a maximum price below the market price create five important effects. 1.Shortages 2.Reduction in Product Quality 3.Wasteful Lines and Other Costs of Search 4.Loss of Gains from Trade 5.Misallocation of Resources

8 B ACK TO Shortages 1.When prices are held below the market price shortages are created. The shortage The shortage = difference between the Q d and the Q s at the controlled price. The lower the controlled price relative to the market equilibrium price, the larger the shortage.

9 B ACK TO Shortages Price Ceilings Create Shortages Quantity Price Supply Demand Market Equilibrium Shortage Controlled Price (Ceiling) Q supplied at the Controlled Price Q demanded at the Controlled Price

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

11 Take a look….. 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) Why do you think farmers killed a million baby chickens in 1973? To next Video To next Video

12 B ACK TO Reduction of Product Quality 2.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

13 B ACK TO Wasteful Lines and Other Costs of Search 3.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.

14 Take a look….. 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) B ACK TO

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.

16 B ACK TO 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.

17 B ACK TO 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.

18 B ACK TO Wasteful Lines and Other Costs of Search Price Ceilings Create Wasteful Lines Quantity Price Supply Demand Market Equilibrium Controlled Price (Ceiling) Q supplied at the Controlled Price Q demanded at the Controlled Price Total Value of Wasted Time Shortage Willingness to Pay Time Cost

19 B ACK TO Lost Gains from Trade 4.Price controls reduce the gains from trade. Price ceilings set below the market price cause Q s 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).

20 B ACK TO Lost Gains from Trade Dead-weight Loss 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 Q s 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.

21 B ACK TO Q market Market Price Lost Gains from Trade Controlled Price (Ceiling) Q supplied Q demanded Willingness to Pay Consumer Surplus Shrinks to this Shortage Consumer surplus in market equilibrium Price Ceilings Reduce the Gains from Trade Quantity Price Supply Demand Market Equilibrium Producer Surplus Shrinks to this Producer Surplus in equilibrium

22 B ACK TO Q market Market Price Lost Gains from Trade Controlled Price (Ceiling) Q supplied Q demanded Willingness to Pay Deadweight Loss (lost gains from trade) = Lost Consumer Surplus + Lost Producer Surplus Shortage Lost Consumer Surplus Lost Producer Surplus Price Ceilings Reduce the Gains from Trade Quantity Price Supply Demand Market Equilibrium Total Value of Wasted Time

23 B ACK TO Misallocation of Resources 5.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.

24 B ACK TO Misallocation of Resources Price Controls Prevent Resources from flowing to their Highest-Valued Uses

25 B ACK TO 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…

26 B ACK TO Short Run Supply Demand Market Equilibrium Controlled Rent Q supplied (Short Run) Q demanded Rent Controls Quantity (rental apartments) Price (rent) Long Run Supply Q supplied (Long Run) …..than in the Long Run The shortage is smaller in the Short Run… Short Run Shortage Long Run Shortage

27 B ACK TO 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.

28 B ACK TO 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.

29 SEE THE INVISIBLE HAND Are you better or worse off when the food is included in your airfare?

30 B ACK TO Price Floors Price floor : Price floor : a minimum price allowed by law. not as common as price ceilings (but still important) Price floors have four common effects: 1. Surpluses 2. Lost gains from trade (deadweight loss) 3. Wasteful increases in quality 4. A misallocation of resources

31 If the government of the European Union sets a price floor for butter above the equilibrium market price, what will be the effect? a)Farmers will produce less butter and consumers will purchase more, resulting in a shortage of butter. b)The supply of butter will increase and the demand will decrease. c)Farmers will produce more butter and consumers will purchase less, resulting in a surplus of butter. d)The equilibrium price will rise to the price floor.

32 B ACK TO When prices are held above the market price (price floor) quantity supplied exceeds the quantity demanded. Surplus Quantity Price Q supplied at the Controlled Price Q demanded at the Controlled Price Surplus Controlled Price (Ceiling) Supply Demand Market Price Q market

33 B ACK TO Price controls reduce the gains from trade (create deadweight losses) Willingness to Sell Lost Producer Surplus Deadweight Loss = Lost Consumer Surplus + Lost Producer Surplus Lost Consumer Surplus Lost Gains from Trade Quantity Price Supply Demand Q market Market Price Q demanded Q supplied Controlled Price (Floor) Surplus

34 B ACK TO Price controls that create surpluses lead to wasteful increases in quality. Wasteful Increases in Quality If they cant lower price, sellers will find other ways to compete! Willingness to Sell Controlled Price (Floor) Q demanded at the Controlled Price Quantity Price Supply Demand Deadweight Loss Market Equilibrium Quality Waste

35 B ACK TO 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 B ACK TO 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 SEE THE INVISIBLE HAND 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? a)The price of trucking services fell. b)Truckers earned less money. c)Consumers saved a lot of money. d)All of the above are correct.

38 If the U.S. government sets a price floor on milk, it will not always lead to a surplus. Why not? a)The price floor would be rarely enforced. b)Because price floors most commonly lead to shortages, not surpluses. c)The market price of milk will sometimes rise above the price floor, rendering the price floor irrelevant. d)Price floors cause supply and demand to change, which leads to changes in equilibrium price.

39 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: a)Price ceiling b)Price floor c)Not enough information B ACK TO


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