© 2007 Thomson South-Western Supply/Demand Review Video: Price Floor/Ceiling Review Video:

© 2007 Thomson South-Western CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors.

© 2007 Thomson South-Western CONTROLS ON PRICES Price Ceiling –A legal maximum on the price at which a good can be sold. Price Floor –A legal minimum on the price at which a good can be sold.

© 2007 Thomson South-Western How Price Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage.

© 2007 Thomson South-Western Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity $4 Price ceiling Equilibrium price Demand Supply The market clears at $3 and the price ceiling is ineffective.

© 2007 Thomson South-Western Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

© 2007 Thomson South-Western How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates Shortages because Q D > Q S. Example: Gasoline shortage of the 1970s

© 2007 Thomson South-Western CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline. In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline. $0.38 to $0.84 What was responsible for the long gas lines?

© 2007 Thomson South-Western Figure 2 The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

© 2007 Thomson South-Western Figure 2 The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS resulting in a shortage the price ceiling becomes binding but when supply falls... P2P2 QDQD P1P1 Q1Q1

© 2007 Thomson South-Western How Price Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus.

© 2007 Thomson South-Western Figure 4 A Market with a Price Floor (a) A Price Floor That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity 2 Price floor Equilibrium price Demand Supply $3 100 The government says that ice- cream cones must sell for at least $2; this legislation is ineffective at the current market price.

© 2007 Thomson South-Western Figure 4 A Market with a Price Floor (b) A Price Floor That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

© 2007 Thomson South-Western How Price Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. When the market price hits the floor, it can fall no further, and the market price equals the floor price.

© 2007 Thomson South-Western How Price Floors Affect Market Outcomes A binding price floor causes... a surplus because Q S > Q D.

© 2007 Thomson South-Western CASE STUDY: The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

© 2007 Thomson South-Western Figure 5 How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

© 2007 Thomson South-Western Figure 5 How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied

Summary © 2007 Thomson South-Western Price controls include price ceilings and price floors. A price ceiling is a legal maximum on the price of a good or service. –An example is rent control. A price floor is a legal minimum on the price of a good or a service. –An example is the minimum wage.