1. Chapter 4 Price Ceilings and Price Floors

2. In this chapter we learn how a controlled price…
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.

3. Price Ceilings
Price controls create price ceilings when the controlled price is below the market equilibrium price.
Price ceilings create five important effects:
Shortages
Reductions in product quality.
Wasteful lines and other search costs.
A loss from gains from trade.
A misallocation of resources.
Let’s look at each of these in turn.
Instructor Note: President Nixon’s price controls are only the latest in a long history of price controls. For some good examples see “Four Thousands Years of Price Controls” found at

4. Price Ceilings Shortages Price ($) Quantity Results:
At the controlled price Qs < Qd
In 1973, there were shortages of
wool, copper, aluminum, vinyl,
denim jeans, paper, …
Price ($)
Supply
Market
equilibrium
Controlled price
(ceiling)
Instructor Notes: This is an animated diagram so you can explain as you “draw”.
Shortage
Demand
Quantity supplied
at the controlled price
Quantity demanded
at the controlled price
Quantity

5. Price Ceilings 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 1⅝" X 3⅝"
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.
* There are exceptions; states such as New Jersey and Oregon which forbid self-service

6. Price Ceilings Wasteful Lines and Other Search Costs Price of gasoline
per gallon
Total value of
wasted time
Supply
Per gallon time cost
Willingness to
Pay for Qs $3
Market
equilibrium
Controlled
price
(ceiling)
Instructor Notes:
This is an animated diagram so you can explain as you “draw”.
At the controlled price, people who are willing to pay a higher price will wait in line to the gas they want. In other words they are trading paying for the gasoline with more dollars with paying in terms of time. The value they place on their time is equal to what would be willing to pay in dollars if they could. For other people, their time is more valuable and they don’t line up for gasoline. $1
Shortage
Demand Qs Qd
Quantity

7. Price Ceilings 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 doesn’t 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.

8. Price Ceilings
Lost Gains from Trade—mutually 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
Instructor Note:
The demand price is the height of the demand curve at any quantity and is the maximum amount the consumer is willing to pay for one more unit. This is a measure of the marginal benefit of an additional unit consumed.
The supply price is the minimum price the seller would be willing to accept to sell one more unit. It measures the marginal cost of one more unit.

9. Price Ceilings Lost Gains From Trade (cont.) CS PS Qs Qd Quantity
(deadweight loss)
= lost consumer surplus (CS)
+ lost producer surplus (PS)
Price of
gasoline
per gallon
Supply
Willingness to
Pay for Qs $3 CS
Market
equilibrium Pm PS
Controlled
price
(ceiling)
Instructor Note:
The total area under the demand curve and above the market equilibrium price is CS.
The total area under the market equilibrium price and above the supply curve is PS. $1
Shortage
Demand Qs Qm Qd
Quantity

10. Price Ceilings 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.
Instructor Notes:

11. Price Ceilings Misallocation of Resources (cont.) Demand
Price of oil per barrel
Oil is used for higher valued uses at high prices
$140
$120
$100
$80
Oil is used for lower valued uses at low prices
$60
Instructor Notes: This is an animated graph.
$40
$20
Demand
As its price rises, oil is transferred from lower valued uses to higher valued uses. 20 40 60 80
100
120
140
Quantity of oil (MBD)

12. Price Ceilings 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.
Instructor Notes:

13. Price Ceilings Misallocation of Resources (cont.) Price ($)
Highest valued
uses
Supply
Willingness to
pay for Qs
Lower valued
uses
Conclusion:
At the controlled price,
there is no guarantee
that oil will be allocated
to the highest valued
uses.
Least valued
uses
Instructor Notes: This is an animated diagram so you can explain while you “draw”.
Controlled Price
(ceiling)
Demand Qs Qd
Quantity

14. Price Ceilings 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.
Instructor Note:
Beginning in 1973 we had our first “energy crisis” created by OPEC’s restricting supplies of oil to raise the world price of oil. This along with expansionary monetary policy created inflation. In response to rising prices, President Nixon impose wage and price controls. These are some of this policy’s effects.
When government allocates oil supplies, who makes this decision? Will political considerations influence the allocation? What guarantee will there be that the oil will be allocated to the highest valued uses? These are just a couple of questions you could ask your class.

15. Price Ceilings 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.
Instructor Note: Recent changes in daylight problems created problems because electronic devices and machines often have built-in calendars and clocks. Because this is so prevalent, this is not a trivial problem.

16. Price Ceilings Misallocation of Resources (cont.)
C. Jackson Grayson, chairman of President Nixon’s 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 Reagan’s first act as president.
Shortage ended overnight and within a few years the price fell below the levels of 1979.

17. 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?

18. 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 landlord’s incentive structure?

19. 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:
Surpluses
A loss of gains from trade (deadweight loss)
Wasteful increases in quality
A misallocation of resources
Let’s look at each of these in turn.

20. Price Floors 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)
Instructor Note:
As of July 2009 the minimum wage is $7.25.
A good way to start the discussion of minimum wage is to ask your students “I the minimum wage is a good thing, why not set it much higher?”.

21. Price Floors Surpluses (cont.) Quantity Wage ($) Supply Labor surplus
Minimum wage
(floor)
(Unemployment)
Conclusion: the greater the difference
between the minimum wage and the market wage, the greater is unemployment
Market wage
Instructor Notes: This is an animated diagram so you can explain while you “draw”.
Demand
Quantity
Quantity demanded
at minimum wage
Market
employment
Quantity supplied
at minimum wage

22. Price Floors 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 can’t be exploited.
The value of these lost opportunities represent the lost gains from trade.
All of this is illustrated in the next diagram.
Instructor Notes:

23. Price Floors Lost Gains from Trade (cont.) Quantity Wage ($) Supply
Labor surplus
Minimum wage
(floor)
Lost consumer
(employer)
surplus
Lost producer
(worker)
surplus
Market wage
Instructor Notes:
This is an animated diagram so you can explain while you “draw”.
Lost consumer (employer) surplus is equal to the area above the market wage and below the demand curve between the market level of employment and the quantity demanded at the minimum wage.
Lost producer (worker) surplus is the loss to the sellers of labor is equal to the area above the supply curve and the market wage between the same two levels of output as above.
The total is the “dead weight” loss due to the minimum wage.
Demand
Quantity
Quantity demanded
at minimum wage
Market
employment
Quantity supplied
at minimum wage

24. Price Floors 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.

25. Price Floors 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).

26. Price Floors 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.

27. Price Floors Lost Gains from Trade (cont.)
Minimum wages in other countries are sometimes much higher than in the U.S.
France
Minimum wage—nearly 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%.

28. Price Floors 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.

29. Price Floors 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 don’t. 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?
Instructor Note:
Quantas Airlines announced in May 2009 that it was suspending its first class service between Melbourne, Hong Kong, and London was a few months due to lack of demand. See:

30. Price Floors 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.
Instructor Note: Providing quality that people are not willing to pay for is wasteful because if people are not willing to pay for the quality, the value they place upon the quality is less than the cost of providing it. Therefore, resources would be better used to produce some other alternative.

31. Price Floors Wasteful Increases in Quality (cont.) “Quality” Waste
(fare)
“Quality”
Waste
Supply
CAB regulated
fare
(floor)
Market
equilibrium
Willingness
to sell
Instructor Notes:
This is an animated diagram so you can explain while you “draw”.
The maximum amount of money firms are willing to pay to attract one more customer is the difference between what the CAB says they will charge and the minimum price they are willing to accept. Adding this up for all customers is the red area.
Firms forced to compete by offering better service eventually end up spending all of their surplus on quality improvements. This becomes our measure of quality waste.
Demand
Quantity
of flights
Quantity
demanded

32. Price Floors 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.
Instructor Notes:

33. Price Floors 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.
Instructor Notes:
Southwest Airlines became famous for several innovations:
Using the same airplane reduced maintenance costs.
Greater use of smaller airports like Chicago’s Midway
Long-term hedging of fuel costs.

34. 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? 

35. 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.
Instructor Notes:

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.
Instructor Notes: