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Chapter 8
Price Ceilings and
Floors
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
Price Ceilings
Rent Controls (Optional Section)
Arguments for Price Ceilings
Universal Price Controls
Price Floors
2
Special Interest Groups
3
Gasoline at $.05/Gallon
Getting in the Way of the Invisible Hand?
Introduction
Price controls are laws making it illegal for
prices to move above a maximum price (price
ceilings) or below a minimum price (price floors)
Price controls interfere with market signals.
Price controls delink some markets and link
others in ways that are counterproductive.
6
Definition
Price Ceiling:
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 create five important effects:
1. Shortages.
2. Reductions in product quality.
3. Wasteful lines and other search costs.
4. A loss of gains from trade.
5. A misallocation of resources.
8
Price Ceilings
1. Shortages
When the price ceiling is below market price,
Qd > Qs which leads to a shortage.
The shortage is measured by the difference
between Qd and Qs at the controlled price.
The lower the controlled price is relative to the
market equilibrium price, the larger the
shortage.
9
Price Ceilings
Price of
gasoline
per gallon
Supply
Market Equilibrium
Controlled
Price
(ceiling)
Shortage
Qs
Demand
Qd
Quantity
10
A shortage of vinyl in 1973 forced Capitol Records to melt down
slow sellers so they could keep pressing Beatles’ albums.
Self-Check
Price ceilings create shortages because when
the controlled price is lower than market price:
a. Qd = Qs.
b. Qd < Qs.
c. Qd > Qs.
Answer: c – The quantity demanded is greater
than the quantity supplied.
12
Price Ceilings
2. Reductions in Quality
At the controlled price, sellers find there is an
excess of demand.
Sellers can evade the law by reducing quality
rather than raising price.
Another way quality can fall is with reductions
in service.
13
Price Ceilings
3. Wasteful Lines
At the controlled price, demanders are willing to pay
more.
The price controls make a higher price illegal.
If price is not allowed to rise, buyers must compete in
other ways.
Other ways to pay:
• Bribes
• Waiting in line (includes value of time)
Bribe goes to supplier, while time in line goes to no
one.
14
Price Ceilings
Price
Supply
Willingness
to pay $3
Controlled
Price $1
(ceiling)
At the controlled
price
Total
value of
wasted
time
Buyers are willing to
pay $3/gallon
Line will grow until
total cost is price +
time, or $3
Shortage
Demand
Qs
Qd
Quantity
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.
Wasteful Lines
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
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
Price Ceilings
4. Lost Gains From Trade
As long as Pconsumers > Psellers are there are
are willing
to pay
willing to
accept
mutually profitable trades that can be made.
With price controls, some profitable trades will
not be made.
This creates a deadweight loss.
19
Deadweight Loss
Deadweight Loss - the total of lost consumer and
producer surplus when not all mutually profitable
gains from trade are exploited.
• 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
Price Ceilings
Price
Supply
Willingness
to pay $3
Controlled
Price $1
(ceiling)
Total
value of
wasted
time
A
B
A – consumer surplus
B – producer surplus
A + B = Lost gains
from trade
Shortage
Demand
Qs
Qd
Quantity
21
Price Ceilings
5. Misallocation of Resources
When prices are controlled, resources do not
flow to their highest valued uses.
Example: on the East Coast a cold winter
increases the demand for heating oil.
• The demanders of heating oil are prevented
from bidding up the price of oil.
• There’s no signal and no incentive to ship oil
to where it is needed most.
22
Price Ceilings
Other examples – hurricane relief supplies
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.
23
Price Ceilings
Price
Price controls prevent
highest valued
uses
Supply
from outbidding lower
valued uses.
Willingness
to pay $3
Result: some oil
flows to lower
valued uses
Controlled
Price $1
(ceiling)
Shortage
Demand
Qs
Qd
Quantity
24
Self-Check
Under a price ceiling, resources are misallocated
because:
a. Price can’t signal that there is a shortage.
b. Quantity can’t respond to changing prices.
c. Neither price nor quantity can increase or
decrease.
Answer: a – The price is not allowed to increase,
which would signal that there is a shortage.
25
Random Allocation
Under a price control, a good is not necessarily
allocated to its highest-valued uses.
Consumer surplus will be less than under market
allocation.
In the worst-case scenario all the goods are
allocated to the lower-valued uses.
More likely, goods are allocated randomly so that
a high-valued use is as likely as a low-valued
use.
26
Best Case Scenario
Price
$30
Highest-valued
uses
Supply
Best case scenario: goods
go to the highest valued
uses, consumer surplus is
the green area
Controlled
Price $6
Shortage
Demand
Qs
Qd
Quantity
27
Random Allocation
Price
$30
Average
Price $18
Controlled
Price $6
Highest-valued
uses
Lost
consumer
surplus
If goods are allocated randomly,
average value Supply
will be $18.
Resources are misallocated,
reducing consumer surplus to
green area.
Consumer
surplus
(random
allocation)
Shortage
Demand
Qs
Qd
Quantity
28
Price Controls and Production
Shortages in one market create breakdowns and
shortages in other markets.
Effect of price controls expands into markets
without price controls.
In an economy with many price controls,
shortages can appear at any time.
• Shortages of steel drilling equipment made it difficult
to expand oil production even as the United States
was undergoing the worst energy crisis in its history.
29
Self-Check
The effects of price controls:
a. Are restricted to one market.
b. Disappear over time.
c. Can spread to other markets without price
controls.
Answer: c – The effects of price controls can
spread to markets without price controls.
30
Definition
Rent Control:
a price ceiling on rental housing.
31
Rent Controls
Usually begin with a rent freeze, prohibiting
landlords from raising rents.
As overall rents rise, controlled rents fall below
the market equilibrium rent.
The short-run supply curve for apartments is
inelastic.
Landlords have few options other than to absorb
lower price.
32
Rent Controls
Price
(rent)
Short-run
supply
Market
equilibrium
Long-run
supply
Long-run
shortage
Short-run shortage
Controlled
rent
Demand
Qs
Long
run
Qs
Short
run
Qd
Quantity
(rental apartments
33
Rent Controls
Rent control reduces the building of new apartments.
34
Shortages
The long-run supply curve is much more elastic
than the short-run supply curve.
The shortage grows over time:
• Fewer new apartment units are built.
• Older units are turned into condominiums.
• Units are torn down to make way for other uses.
35
More On Rent Control
•Example: San Francisco
•Very hot home sales/rental market
•Average rent close to $4200/month, highest in
the country
•New construction is taking place but many rental
units are subject to rent control
•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
36
More On 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.
37
More On Rent Control
• PLF 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
38
More On Rent Control
•
•
•
•
•
Who pays???
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?
39
Self-Check
Shortages caused by rent controls:
a. Become more severe over time.
b. Become less severe over time.
c. Remain constant over time.
Answer: a – Since long-run supply is more
elastic than short-run supply, shortages caused by
rent controls become more severe over time.
40
Wasteful Lines, Search Costs, Lost Gains
Finding an apartment often involves a costly
search.
At controlled price, landlords have more renters
than apartments so they can
discriminate.
Bribes are illegal but can be
disguised:
“Key money”.
Charged for a
“furnished” apartment.
JG PHOTOGRAPHY/ALAMY
41
Reductions in Quality
Rent controls reduce housing quality.
• Maintenance costs rise.
• Owners respond by cutting costs.
When rent controls are strong:
• Apartment buildings turn into slums.
• Slums turn into abandoned and hollowed-out
buildings.
•
"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)
42
Misallocation of Resources
Apartments are not allocated to the renters who
value them the most.
Some people with a high willingness to pay can’t
buy as much housing as they want.
Others with a low willingness to pay consume
more housing than they would purchase at the
market rate.
43
Rent Regulation
In the 1990s many American cities eliminated or
eased rent controls.
Some changed to “rent regulation”.
• Limits are placed on the amount that rent can
be increased e.g., 10% per year.
• Usually allow landlords to pass along cost
increases so the incentive to cut back on
maintenance is reduced.
44
Arguments for Price Controls
Rent controls help the poor.
Controls are not the only way, and often not the
best way.
Vouchers are a better way to help the poor:
Do not create a shortage.
Can be targeted to the poor.
The best case for price controls is to discipline
monopolies.
45
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
46
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 a week.
Definition
Price Floor:
a minimum price allowed by law.
Not as common as price ceilings but still
important
48
Price Floors
Price floors create:
1. Surpluses
2. Lost gains from trade
(deadweight loss)
3. Wasteful increases in quality
4. A misallocation of resources
49
Surpluses
A good example of a price floor is the minimum
wage.
A minimum wage above the market price creates
a surplus - the quantity of labor supplied exceeds
the quantity demanded.
A surplus of labor is called unemployment.
50
Minimum Wage Creates a Surplus
Wage
($/hr)
Supply
of labor
Labor surplus
(unemployment)
Minimum
wage
Market
wage
Demand
for labor
Qd
Market
employment
Qs
Quantity
of labor
51
Self-Check
Price floors result in:
a. Higher prices in future.
b. A shortage.
c. A surplus.
Answer: c – Price floors result in a surplus.
52
Lost Gains From Trade
Wage
($/hr)
Supply
of labor
Labor surplus
(unemployment)
Minimum
wage
A
Market
wage
B
Demand
for labor
Qd
Market
employment
Qs
Quantity
of labor
53
Wasteful Increases in Quality
US airlines were extensively regulated from
1938 to 1978.
Unregulated fares were half the price of similarlength regulated flights.
The regulated prices were above the airlines’
willingness to sell.
Airlines couldn’t drop prices to compete for
customers.
They competed by offering higher quality that
buyers would otherwise not be willing to pay for.
54
Wasteful Increases in Quality
Price
(fare)
Supply
Deadweight
loss
Regulated
fare (floor)
“Quality”
waste
Market
equilibrium
Willingness
to sell
Demand
Quantity
demanded
Quantity of
flights
55
Misallocation of Resources
Entry of new firms was also regulated in the
airline industry.
Restrictions on entry misallocated resources
because low-cost airlines were kept out of the
industry.
Also kept out innovations, new ideas, and
experiments that are part of the market process.
56
Minimum Wage
•Minimum Wage Facts
•Mandatory wage that must be paid to workers
•Workers can not negotiate for a wage lower than the
minimum wage (right of contract)
•Currently $7.25/hour as per Federal law with efforts to
raise it to $10.10/hr
•California is at $9/hr with more than half of all states
above the Federal minimum
57
Minimum Wage
•Minimum Wage Facts
•Less than 3% of all workers earn minimum wage (tiny)
•Largest group at minimum wage are suburban
teenagers
•Historical fact: minimum wages originated as a means
to exclude women and minorities from competing
against white men
•It does not reduce poverty significantly since most MW
participants are not in “poverty” households
•Walmart is in favor of a higher minimum wage. Why?
58
How Are Wages Determined?
•
•
•
•
Employers do not pay workers on an arbitrary
basis (i.e. they don’t pay whatever they feel like
paying)
Economic theory applies to labor markets
Supply and demand determine price of labor
(wages)
Employers pay wages based on value of marginal
product for labor
•
i.e. employers will not pay a worker $15/hr if the worker’s
economic value (contribution) is $10/hr
59
How are Wages Determined?
•
Labor markets are competitive
•
•
•
Employers compete for labor, i.e. for high demand, highskilled workers via increased wages/benefits
Wages are based on worker productivity (output)
Worker output is determined by skills and productivity
(i.e. capital)
60
Efforts to Raise the Minimum Wage
•
•
•
•
Many municipalities with much higher min wages
Seattle $15/hr phase-in for 2017
Oakland - $12.25 (March 2, 2015)
San Francisco – Passed by referendum with 77% voter
approval
•
$11.05 now, rising to $12.25 in May and $15/hr in 2018
• Nevada has pending $15/hr minimum wage legislation
• Sacramento is looking into a higher minimum wage
61
Arguments in Favor of Minimum Wage
•
•
•
•
•
•
Workers need a living wage, especially those that
support a family of four
It is “fair”
Large corporations have plenty of profits to afford this,
look at WalMart’s profits
A higher minimum wage will not reduce employment
(Card-Kruger study)
Labor “deserves” higher share of profits in capitalist-type
economies
Higher minimum wage will stimulate economic activity
and spending, hence “pay” for the MW increase
62
Arguments in Favor of Minimum Wage
•
•
•
•
•
Raising the minimum wage will reduce spending by
government, i.e. less welfare & food stamps
Higher wages will increase worker productivity i.e.
workers will “earn” the increase
Employers are engaged in monopsonistic behavior
against low-skilled workers
Minimum wage increases are always followed by a
surge in economic growth (2007 increase?)
Seven Nobel Prize winners in economics are in favor of
a higher minimum wage, asserting that the loss of
employment is a negligible effect
63
Arguments Against the Minimum Wage
•
•
•
•
•
Increasing the MW will ultimately harm those
workers most in need of higher pay
Employers will hire less workers
Workers with the lowest skills will be the first to be laid
off or not hired as a result
Substitution of capital for labor (robots, automation)
Where does the money for increased labor costs come
from?
•
•
Less profits?
Higher prices? – Studies show higher prices disproportionately
affect lower income workers
64
Arguments Against the Minimum Wage
•
•
•
•
Minimum wage is a training wage, allows acquisition
of skills, higher productivity
Provides incentives to workers to acquire more skills
Working for a living breaks the culture of dependency
and increased taxes on others
If $9.00/hr min wage is good, why isn’t a $20/hr min
wage even better? How to draw the line?
•
•
When min wage goes to $15/hr, a large percentage of the
labor market gets an increase (20-25% ?)
Have we discovered the secret of higher standards of living?
Or the “something for nothing” principle?
65
Arguments Against Minimum Wage
•
Who else benefits from a higher minimum wage?
•
•
•
Low-skill, low pay workers are substitutes for higher-skilled,
higher pay workers
Labor unions are labor monopolies supported by US laws
such as the Wagner Act (Great Depression)
Higher minimum wages mean less competition for unions
• Where did all of the elevator operators, gas
station attendants, and movie theatre ushers
go?
• Whatever happened to “equal pay for equal
work?”
66
Minimum Wage Impacts
• All labor markets have downward sloping demand
curves
•
Raising wages results in less labor hired by employers
• Employers will cut non-wage worker benefits to
compensate for higher costs
• Workers may be pressured to work harder or face
termination
• Higher earnings may result in workers asking for fewer
hours due to loss of government benefits
•
•
ACA has amplified these problems
Casey Mulligan, University of Chicago labor economist
67
Evidence
• CBO Study 2014
• Increase from $7.25 to $10.10/hour will result in the loss
of 500,000 jobs
• Newmark Minimum Wage Study results
• Teenage unemployment rates much higher than overall
U3 unemployment rate
• European min wages are much higher than US and
teenage unemployment rates in EU are much higher
than US
• Announcements in SF, Seattle & elsewhere of small
business closings in response to $15/hr wage laws
68
Evidence
• Great Depression – minimum wage began at $.25/hour
•
Applied to Puerto Rico and caused massive layoffs
• Special case: American Samoa
•
•
Tuna processing plants exempted from US min wage laws
Why?
69
Minimum Wage Impacts
70
Minimum Wage – Economic Ignorance
From 7/12/14 advertisement:
71
Minimum Wage Impacts
• What’s wrong with this?
• Higher wages lead to more hiring?
• Wage increases for just 3% of the labor market stimulates
the economy sufficiently to produce significant job growth
overall?
• No other economic factors affect the job market?
• What would have happened to job growth if the minimum
wage increase had not been passed in these states?
• Time frame: minimum wages raises occurred in early
2014 and yet by July 2014 the claimed impact had
already occurred?
• This is an example of “lying with statistics” - it preys upon
the ignorant and harms society
72
Minimum Wage - Summary
• The minimum wage argument is and will always be
about politics and vote buying:
• Pro-min wage increase is the “compassionate caring”
position
• People against the min wage increase are uncaring,
haters
• Many pro-minimum wage arguments rely on the
ignorance of the (voting) public
• Confusion between money and real output
• Much of this goes back to bad economic theory, i.e.
Marx’s Labor Theory of Value
73
Minimum Wage Summary
• The REAL problem with the minimum wage:
• Unnecessary Government interference in the economy
• Good intentions do not guarantee good outcomes
• Minimum wage policy is a continual propaganda effort
that claims that the government “runs” the economy and
knows best how to control and adjust (i.e. “creating jobs”
or “Thank God for government spending”)
• Hayek called this – “The Pretense of Knowledge” and the
“Fatal Conceit”
• The belief that the government can improve overall
economic outcomes with price controls
• The mistaken collectivist belief in the “free lunch” and free
riders
74
Bastiat Sums It Up Over 100 Years Ago
• “Government is the great fiction,
through which everybody endeavors
to live at the expense of everybody
else.”
• – Frederic Bastiat
75
Tyler Cowen and Alex Tabarrok
Modern Principles: Microeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Takeaway
Price ceilings create:
• Shortages
• Reductions in quality
• Wasteful lines and other search costs
• A loss of gains from trade
• A misallocation of resources.
This affects not just the market with the price
ceiling but potentially the whole economy.
77
Takeaway
Price floors create:
Surpluses.
A loss of gains from trade.
Wasteful increases in quality
A misallocation of resources.
78