Slide 1 of 36 Modern Principles: Macroeconomics Tyler Cowen and Alex Tabarrok Copyright © 2010...

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Modern Principles: Macroeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok

Chapter 4

Price Ceilings and

Price Floors

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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.

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Price Ceilings• Price controls create price ceilings when

the controlled price is below the market equilibrium price.

• Price ceilings create five important effects:1. Shortages

2. Reductions in product quality.

3. Wasteful lines and other search costs.

4. A loss from gains from trade.

5. A misallocation of resources.

• Let’s look at each of these in turn.

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Price Ceilings1. Shortages

Quantity

Price ($)

Demand

Supply

Market equilibrium

Controlled price(ceiling)

Quantity demanded at the controlled price

Quantity supplied at the controlled price

Shortage

Results:1.At the controlled price Qs < Qd

2.In 1973, there were shortages ofwool, copper, aluminum, vinyl,denim jeans, paper, …

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Price Ceilings2. 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.

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Price Ceilings3. Wasteful Lines and Other Search Costs

Quantity

Price of gasoline

per gallon

Demand

Supply

Market equilibrium

Controlled price

(ceiling)

QdQs

Shortage

$3

$1

Total value ofwasted time

Willingness toPay for Qs

Per gallon time cost

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Price Ceilings3. 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.

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Price Ceilings4. 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

priceSupply -price mequilibriuMarket PS =

price mequilibriuMarket -price Demand CS =

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Price Ceilings4. Lost Gains From Trade (cont.)

Quantity

Price of gasoline

per gallon

Demand

Supply

Market equilibrium

Controlled price

(ceiling)

QdQs

Shortage

$3

$1

Willingness toPay for Qs

Pm

Qm

Lost gains from trade(deadweight loss)= lost consumer surplus (CS)+ lost producer surplus (PS)

CS

PS

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Price Ceilings5. 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.

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Price Ceilings

Price of oil per barrel

Quantity of oil (MBD)

Demand

600 40

$20

20

$80

$140

0

$100

$120

$40

$60

80 100 120 140

Oil is used for lower valued uses at low prices

As its price rises, oil is transferred from lower valued uses to higher valued uses.

As its price rises, oil is transferred from lower valued uses to higher valued uses.

5. Misallocation of Resources (cont.)Oil is used for higher valued uses at high prices

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Price Ceilings5. 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.

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Price($)

Quantity

Supply

Demand

Controlled Price(ceiling)

Willingness topay for Qs

Qs Qd

Highest valued uses

Lower valueduses

Least valueduses

Conclusion: At the controlled price, there is no guarantee that oil will be allocated to the highest valued uses.

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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.

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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.

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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.

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CHECK YOURSELF

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?

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CHECK YOURSELF

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?

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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:1. Surpluses

2. A loss of gains from trade (deadweight loss)

3. Wasteful increases in quality

4. A misallocation of resources

• Let’s look at each of these in turn.

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Price Floors1.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)

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Price Floors1.Surpluses (cont.)

Wage($)

Quantity

Supply

Demand

Market employment

Minimum wage(floor)

Quantity demanded at minimum wage

Quantity suppliedat minimum wage

Market wage

Labor surplus

(Unemployment)Conclusion: the greater the differencebetween the minimum wage and the market wage, the greater is unemployment

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Price Floors2. 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.

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Price Floors2. Lost Gains from Trade (cont.)

Wage($)

Quantity

Supply

Demand

Market employment

Minimum wage(floor)

Quantity demanded at minimum wage

Quantity suppliedat minimum wage

Market wage

Labor surplus

Lost producer(worker)surplus

Lost consumer (employer)surplus

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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.

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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).

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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.

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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%.

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Price Floors3. 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.

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Price Floors3. 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?

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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.

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Price(fare)

Quantity of flights

Supply

Demand

CAB regulated fare

(floor)

Quantity demanded

Willingnessto sell

“Quality” Waste

Market equilibrium

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Price Floors4. 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.

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Price Floors4. 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.

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CHECK YOURSELF

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?

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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.

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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.

Slide 1 of 36 Modern Principles: Macroeconomics Tyler Cowen and Alex Tabarrok Copyright © 2010...

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