Price Controls5

Previously

• Equilibrium is determined by the forces of supply and demand.

• A shortage (excess demand) will occur at prices below the equilibrium.

• A surplus (excess supply) will occur at prices above the equilibrium.

• Sliding along a demand or supply curve is caused by a change in the price of the good.

Learning Objectives

1. To appreciate the differences between price ceilings and price floors.

2. To understand that all price controls have unintended consequences.

What Are Price Controls?

• Price controls– Attempt to set, or manipulate, prices through

government involvement in the market– Meant to ease perceived burdens on the population

• Price ceiling– Legally established maximum price for a good or

service

• Price floor– Legally established minimum price for a good or

service

Price Controls, Historically

• Price controls in ancient Egypt– Farmers revolted and economy collapsed

• Price ceiling on grain in ancient Greece– Supply of grain disappeared

• Throughout history, price controls– Disrupt the normal functions of the market– Prevent the market from clearing

More Recent Price Controls

• 1941: U.S. Office of Price Administration– Price controls after WWII

resulted in black markets.

• Black markets– Illegal markets that arise

when price controlsare in place.

– Best known example is Prohibition

• Other ways to circumvent price controls– Reducing size or quality of product

Thought Experiment$0.50 Price Ceiling on BreadQuestion Explanation In pictures

Will there be more or less

bread for sale?

Consumers want to purchase more, but producers will manufacture less.

Shortage!Empty shelves

Will the size of a typical loaf

change?

Manufacturers will try to maintain profits by reducing the size of each loaf.

No more giant loaves

Will the quality change?

Expensive brands will no longer be profitable to produce.

Focaccia bread would disappear

Will the opportunity

cost of finding bread change?

Opportunity cost of finding bread will rise. Resources spent looking for bread in

different stores and waiting in line.

Bread lines would become the norm

Would you buy illegal bread if

you could?

Since bread is hard to find, and people still need it, a black market will develop.

Black market bread dealers

reduce the shortage

Non-binding Price Ceiling

Binding Price Ceiling

Price Ceilings in the Long Run

Case Studies on Price Ceilings

• Rent control– Price ceiling on apartments or housing

• Goal:– Help low-income renters find affordable

places to live

Rent Control

• Unintended consequences of rent control:– Shortages (Qd > Qs)

– Decreases in long-terminvestment in thebuilding of new units

– Reduction in quality of apartments– Black markets with higher prices– Landlords “nickel and diming” tenants

with fees to increase revenues

Rent Control

• Unintended consequences of rent control– “Housing gridlock”– Units are actually harder to find.– Policy often ends up hurting the very people it

was supposed to help.

Rent Control in the Short Run and Long Run

Rent Control and the Rich

• The rich and rent control– Massachusetts decided to end rent control in part

because only 6% of people in rent-controlled units were poor.

– Actresses Mia Farrow and Faye Dunaway lived in rent-controlled units for years.

– Ask: Best allocation of resources?

• Long-term development issues– Cities without rent controls (Dallas, Phoenix) have

vacancy rates above 15%.– Rent-controlled cities (New York) have vacancy rates

around 5%.

Price Gouging

• Price gouging laws– Laws that place a temporary ceiling on

prices– Usually after a natural disaster or

emergency

• Consequences– Restricted prices can’t ration efficiently.– Resources may not go where they are

needed the most.– Goods that people need disappear due

to severe shortages.

Price Gouging

Economics in Stossel in the Classroom

• Is price gouging bad?

Price Floors

• Recall that a price floor is– A minimum legal price

• Who do you think lobbies for price floors?– Producers of the product

Thought Experiment$6 Price Floor on MilkQuestion Explanation In picturesWill the

quantity of milk for sale

change?

Consumers will purchase less but producers will manufacture more.

Surplus!

There will be a surplus of milk

Will the size of a typical container change?

Since the price floor is $6.00, manufacturers can make their

product more attractive by increasing the size of each container.

Milk containers would get

bigger

Would producers sell

below the price floor?

Due to the surplus, sellers would have a strong incentive to undercut

the price floor in order to avoid having to discard leftover milk.

Illegal discounts would help to

reduce the milk surplus

Are milk producers better off?

Not if they have trouble selling what they produce.

There will be a lot of spoiled

milk

Binding Price Floor

Binding Price Floor

Binding Price Floor in the Long Run

Minimum Wage

• Minimum wage– The lowest hourly wage rate that firms may

legally pay their workers; it functions as a price floor.

• Rationale for minimum wage:– Provide a “living wage”– Help the working poor

who are often unskilled

Labor Markets

• In the supply and demand framework for goods and services:– Consumers (all of you) are the

demanders of goods

– Firms (the businesses) are the suppliers (producers) of the goods

Labor Markets

• In the supply and demand framework for labor:– Consumers (all of you) are the suppliers of labor.– Firms (the businesses) are the demanders of labor.

• The axes on a graph of a labor market– Wage (W) is the vertical axis. This is the price of

labor.– Labor (L) is the horizontal axis. This is the number of

workers.

Labor Markets

• The demand curve for labor is downward-sloping. Firms are willing to buy:– More labor at low wages– Less labor at high wages

• A simple supply curve for labor is upward-sloping. Individuals are willing to supply:– More labor at higher wages– Less labor at lower wages

Non-binding Minimum Wage

Minimum Wage

• The unintended consequence of a binding minimum wage is unemployment. Caused by:– Decrease in quantity demanded for labor– Increase in quantity supplied of labor– Firms replacing low-skilled jobs with capital, if

possible– Firm relocation to countries without wage laws– Shortening hours for workers

• Proponents of minimum wage also advocate– Training, education, job programs

Non-binding Minimum Wage

Politics and Minimum Wage

• Politically– Raising a non-binding wage floor will seem caring and

benevolent.

• Economically– Raising a non-binding wage floor will have no effect,

as long as the new floor is still below the equilibrium wage.

• Locally– States with the highest (binding) minimum wages also

have some of the highest unemployment.– Washington, Oregon, California

Remembering Price Controls

P

QD

S

EquilibriumP*

Q*

Binding price floor

Binding price ceiling

Remembering Price Controls

• Look at the ceiling in your room. Is it causing you any problems?– What happens if the ceiling is only 4 feet

high?

• Look at the floor. Can you still get to your desk at the current floor height?– What if the floor was too high? You would

have to change your behavior to reach your desk.

Conclusion

• Prices act as signals and give information to consumers and producers.

• Price controls can distort the signals.

• Price control policy should be done with caution.

Summary

• A price ceiling is a legally imposed maximum price.– The resulting shortage is problematic.– Prices no longer signal relative scarcity.– Two unintended consequences: a smaller supply of

the good (Qs) and a higher price for those who turn to the black market.

•  A price floor is a legally imposed minimum price.– The minimum wage is an example of a price floor.

Summary

• Price controls lead to many unintended consequences.– Shortages or surpluses

– Black markets

– Artificial attempts to bring the market back into balance

Practice What You Know

What will be the effect of a non-binding price ceiling?

a. A surplus will be created.

b. A shortage will be created.

c. There will be no effect.

d. The effect is unknown.

Practice What You Know

In the event of a binding price ceiling, what is one function that a black market serves?

a. reduces the shortage caused by the price ceiling

b. decreases the price even further

c. creates a monopoly

d. causes a surplus of the good

Practice What You Know

What is one unintended consequence of rent control?

a. People in rent-controlled units will relocate more often.

b. Landlords may not maintain rental units.

c. Too many apartments will be built, creating a surplus of units.

d. People will choose not to live in big cities.

Practice What You Know

Which of the following is true about labor markets?

a. The minimum wage is a price ceiling.

b. Unemployment is a labor shortage.

c. Firms supply the labor.

d. None of the above.

Practice What You Know

Supply and demand generally become more elastic in the long run. This means that shortages caused by price ceilings _________ in the long run.

a. disappear completely

b. become smaller

c. become larger

d. become infinitely large