Price Ceilings and Floors

1. Price Ceilings and Floors

2. Price Ceilings Rent Control (Optional Section) Arguments for Price Controls Universal Price Controls Price Floors For applications, click here To Try it! questions To Video

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

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

6. Price Ceilings • Policy makers may respond to buyers’ complaints that prices are “too high” by enacting price controls. • 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. Price Ceilings • Price ceilings that involve a maximum price below the market price create five important effects. • Shortages • Reduction in Product Quality • Wasteful Lines and Other Costs of Search • Loss of Gains from Trade • Misallocation of Resources

8. Shortages • When prices are held below the market price shortages are created. • The shortage = difference between the Qd and the Qs at the controlled price. • The lower the controlled price relative to the market equilibrium price, the larger the shortage.

9. Shortages Price Ceilings Create Shortages Supply Price Market Equilibrium Shortage Controlled Price (Ceiling) Quantity Demand Qsupplied at the Controlled Price Qdemanded at the Controlled Price

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

11. Why do you think farmers killed a million baby chickens in 1973? 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) http://www.youtube.com/watch?v=IFbAwzU6G7s&NR=1 To next Video

12. Reduction of Product Quality • 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. Wasteful Lines and Other Costs of Search • 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. 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) http://yadayadayadaecon.com/clip/6/ Back 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. 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. 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. Wasteful Lines and Other Costs of Search Price Ceilings Create Wasteful Lines Price Supply Willingness to Pay Total Value of Wasted Time Market Equilibrium Time Cost Controlled Price (Ceiling) Shortage Demand Quantity Qdemanded at the Controlled Price Qsupplied at the Controlled Price

19. Lost Gains from Trade • Price controls reduce the gains from trade. • Price ceilings set below the market price cause Qs 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. Lost Gains from Trade • Dead-weight Lossis 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 Qs 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. Lost Gains from Trade Price Ceilings Reduce the Gains from Trade Price Consumer Surplus Shrinks to this Producer Surplus Shrinks to this Supply Willingness to Pay Consumer surplus in market equilibrium Market Price Market Equilibrium Producer Surplus in equilibrium Controlled Price (Ceiling) Shortage Quantity Demand Qsupplied Qmarket Qdemanded

22. Lost Gains from Trade Price Ceilings Reduce the Gains from Trade Price Deadweight Loss (lost gains from trade) = Lost Consumer Surplus + Lost Producer Surplus Willingness to Pay Supply Total Value of Wasted Time Lost Consumer Surplus Market Price Lost Producer Surplus Market Equilibrium Controlled Price (Ceiling) Shortage Quantity Demand Qsupplied Qdemanded Qmarket

23. Misallocation of Resources • 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. Misallocation of Resources Price Controls Prevent Resources from flowing to their Highest-Valued Uses

25. 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. Rent Control • Example: San Francisco • Very hot home sales/rental market • Average rent close to $3000/month, highest in the country • Sustained by high tech workers who live in the city • Rent controls and renter protection by city laws • Not charging renters fair market value is “fair” aka “Social Justice”

27. Rent Control • SF recently passed the “Relocation Assistance Payment Ordinance”  •  It requires rental property owners to pay their tenants oppressive and unconstitutional sums of money before the owners can regain personal use of their property — money the tenants can use for any private purpose they wish. • Pacific Legal Foundation attorneys filed the challenge to this ordinance on the basis of Constitutional protections of property rights.

28. Rent Control • Lawsuit is filed on behalf of homeowners Daniel and Maria Levin, a married couple who own a small two-unit house on Lombard Street.  • They live in the upper unit, but are effectively denied the right to take occupancy of the lower unit, because of the costly payment — $117,000, in their case — required by the new ordinance. • Some payments exceed $200K

29. Rent Control • Why would anyone own or build new rental units in SF if this ordinance stands? • What’s the likely impact on landlords? How will they react? • What’s the likely impact on rental rates? • Why would the SF City government pass such laws? • "In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing." - Assar Lindbeck (Swedish economist)

30. Rent Controls The shortage is smaller in the Short Run… …..than in the Long Run Short Run Supply Price (rent) Long Run Supply Market Equilibrium Controlled Rent Long Run Shortage Demand Short Run Shortage Qsupplied (Long Run) Qdemanded Qsupplied (Short Run) Quantity (rental apartments)

31. 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.

32. 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.

33. Are you better or worse off when the food is included in your airfare?

34. Price Floors Price floor: a minimum price allowed by law. • not as common as price ceilings (but still important) • Price floors have four common effects: • Surpluses • Lost gains from trade (deadweight loss) • Wasteful increases in quality • A misallocation of resources

35. To next Try it! If the government of the European Union sets a price floor for butter above the equilibrium market price, what will be the effect? Farmers will produce less butter and consumers will purchase more, resulting in a shortage of butter. The supply of butter will increase and the demand will decrease. Farmers will produce more butter and consumers will purchase less, resulting in a surplus of butter. The equilibrium price will rise to the price floor.

36. Surplus • When prices are held above the market price (price floor) quantity supplied exceeds the quantity demanded. Price Supply Surplus Controlled Price (Ceiling) Market Price Demand Quantity Qdemanded at the Controlled Price Qsupplied at the Controlled Price Qmarket

37. Lost Gains from Trade Price • Price controls reduce the gains from trade (create deadweight losses) Deadweight Loss = Lost Consumer Surplus + Lost Producer Surplus Supply Controlled Price (Floor) Surplus Lost Consumer Surplus Market Price Lost Producer Surplus Demand Willingness to Sell Quantity Qdemanded Qsupplied Qmarket

38. Wasteful Increases in Quality • Price controls that create surpluses lead to wasteful increases in quality. Supply Price Deadweight Loss Controlled Price (Floor) “Quality” Waste Market Equilibrium Willingness to Sell Demand Quantity Qdemanded at the Controlled Price If they can’t lower price, sellers will find other ways to compete!

39. 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

40. 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

41. 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? The price of trucking services fell. Truckers earned less money. Consumers saved a lot of money. All of the above are correct.

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

43. Back to 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: Price ceiling Price floor Not enough information