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Price Controls Pp 70- 74 of text book Price Controls • Price Controls: the setting/controlling of the prices of goods and services by the government such that prices are unable to adjust to their equilibrium level determined by the free markets • Two types : – 1. Price floor – setting a legal minimum price – 2. Price ceiling – setting a legal maximum price • This results in market disequilibrium either in the excess demand or excess supply 1. Price Floors • A price floor is a minimum price set by the government or organisation for a particular good. It means that the legal price must not be lower than the legal minimum price. To be EFFECTIVE, it is ABOVE the equilibrium price Price Floors • Seems to be a contradiction … • But when the price (Pc) is set by the government at a level above the equilibrium price, it leads to excess supply since at Pc, the consumer is willing and able to buy Qd is less than what the producers are willing and able to sell of Qs • Now, if the market were free and left alone, the forces of D and S would force price down to Pe. But now, this cannot happen because the price is legally set at Pc • by blocking the downward forces of the price, we are essentially putting a “floor” on the price. Why would governments impose a Price Floor? • 1) Price floors are usually set to protect and support certain groups of people e.g. income support for the unstable life of primary goods producers (e.g. farmers) See graphs on H/O • or minimum wage for low skilled, low wage workers again for the “people and society”, “equity”, “for whom question” • 2) To discourage consumption of certain demerit goods Impact on Market Outcomes (P and Q) • With Pf set above Pe, price floor results in larger quantity supplied of Qs • It also leads to less quantity demanded by consumers to Qd • As the market does not clear, it results in disequilibrium where there is a excess supply • If the purpose is 1) (previous slides) governments often maintain the price floor by buying the excess supply, causing the demand curve to shift to the right (this can also be interpreted as decreasing the supply of the food by shifting it to the left until Pf is maintained) – The cabbage article What does the government do with the surplus? • Several options practiced by the government: – a. Store it, giving rise to additional cost for storage above the purchase – b. Export it other countries which often requires granting a subsidy to lower the price to make it competitive in world markets = DUMPING – c. Use it as aid to help developing countries (ODA, overseas development assistance) which often poses problems for the receiving countries – But if purpose is 2) (ie to deter consumption of demerit goods), then the excess supply MIGHT be………………………………..secret discounts OR just might not produce the extra supply Analysis of Price Floors on Market Outcomes …. See H/O Welfare Impacts and Stakeholder Analysis • Consumers are worse off – Smaller quantity (Qd) is purchased at higher price (Wm) – Consumer surplus is now area “a” as it loses area “b” to producers and also lose area “c” • Producers can be better off – Less quantity of good is sold at a higher price (Wm) possible increase in total revenue (PxQ) – Producer surplus gains area “b” (from consumers) but loses “e” – HOWEVER if govt buys the surplus…………. – Workers Less production from Qe to QD means that fewer workers likely to be hired, resulting in unemployment (continued) • Government There will be no gains or losses for the government in terms of budget and spending HOWEVER if govt buys the surplus… • Society as a whole… There are too few resources allocated to the production of the good, resulting in underproduction relative to the social optimum (Qe) - – Society is worse off due to allocative inefficiency – Marginal Benefit ? Marginal Cost for the last unit – WELFARE LOSS of ………….. (decrease in social/community surplus) • (but….if it is a DEMERIT good…..) 2. Price Ceilings • A Price ceiling is a maximum price set by the government for a particular good or service. • To be EFFECTIVE, it is below the equilibrium Price Ceilings • Seems to be a contradiction again ………………… • It is because, when the price (Pc) is set by the government at a level below the equilibrium price, it leads to a excess demand • Now, if the market were free and left alone, the forces of D and S would force price up to Pe. But now, this cannot happen because the price is set at Pc • by blocking the upward forces of the price, we are essentially putting a “ceiling” on the price. Why would governments impose a Price Ceiling? • Price ceilings are usually set to make certain goods/services considered to be necessities more affordable to low income earners for the “people and society” and “equity”, to change the answer to “for whom” question • e.g. Rent controls and Food price controls Especially during……………………………….. EXAMPLE: • What is rent ? Rent Controls – Factor of payment to the resource Land. Price you pay for borrowing a house, apartment, office space, land, etc. • Rent controls consist of a maximum legal rent on housing, which is below the market determined level of rent • It is undertaken in various cities or parts of cities around the world to make housing more affordable to low income earners – Department of Housing and Urban Planning – e.g. apartments in university districts to assist students to find affordable places to live – e.g. social housing in UK Food Price Controls • Food tends to have a high price volatility (e.g. typhoon hits and supply decreases) • To make food more affordable to low income earners especially during times when food prices are rapidly increasing, government imposes food price controls • Other primary goods as well e.g. post-war Japan on oil and fossil fuel; etc. • It is also used as means to control inflation (rise in cost of goods and services and cost of living) in developing countries such as Vietnam and Venezuala Analysis of Price Ceiling on Market Outcomes (P, Q) • By imposing a lower price of Pc lower quantity is supplied, while larger quantity is demanded (by definition of D and S) than the market equilibrium Qe • As price does not allow markets to clear, this creates a disequilibrium where there is a excess demand (Qd > Qs) Mathematics and Quantitative Analysis • Need find the Qs and Qd at the Pc through substituting Pc into the D and S equations • Apply the area formula for to calculate the shortage, changes in consumer surplus, producer surplus, and welfare loss (do new sheet) Welfare Impacts and Stakeholder Analysis • Consumers-Partly better off and partly worse off – Consumer surplus gain area “c” from producers and lose area “b” – Some consumers who are able to buy and access the good at lower price are better off while some remain unsatisfied as there is not enough goods for all • Producers – Producers are worse off – Smaller quantity of good is sold at a lower price less total revenue (PxQ) – Producer surplus lose “c” (to consumers) and “d” (continued) • Workers – Less production from Qe to Qs means that some workers may be fired, resulting in higher unemployment • Government – There will be no gains or losses for the government in terms of budget and spending – Could gain more political popularity by supporting the consumers who are better off with the price ceiling • Society as a whole… Consequences for the Society as a Whole • The lower than equilibrium price results in smaller quantity supplied than the amount determined by the free market (Qe) – There are too few resources allocated (and wasted) to the production of the good, resulting in underproduction relative the social optimum (Qe) – Society is worse off due to allocative inefficiency • This is indicated with a decrease in social/community surplus of the area “c + d” which represent the “welfare” or “dead weight” loss Other Consequences • Non-price rationing – Before, the price mechanism determined the rationing (what, how and for whom) the good is produced and distributed – Now, with the shortage, the question is how will the Qs be distributed among the buyers? – Non-price rationing which can be… • Waiting in line and the first come first served …. QUEUES • Distribution of coupons • Favoritism where sellers sell it to their preferred customers • The case of Burma, Vietnam and other former or current command economies… • Introduction to PARALLEL (underground or black or informal) markets • Overall…………………………. Allocative Efficiency and Pareto Optimality • Allocative efficiency or Pareto Optimality refers to producing the combination of the goods mostly wanted by society. It is achieved when the economy allocates its resources so that no one can become better off (in terms of increasing benefits and utility) without someone else becoming worse off. • In other words, it best answers the very purpose and definition of economics and exemplifies an equilibrium • It is THE allocation of scarce resources that “best” and “maximally” satisfies the unlimited wants…it is the “best” and “optimal” choice and decision made for the society given their scarce resources • And the finding above shows that free or perfectly competitive markets (under their many assumptions) achieves Allocative Efficiency and Pareto Optimality Allocative Inefficiency for both Max. and Min. Prices • Allocative inefficiency is also indicated because MB > MC at the point of production • The benefit consumers receive from the last unit of the good they buy is greater than the marginal cost of producing it • Therefore, the society is not getting enough of the good, as there is an underallocation of resources to its production. The society would have been better off if MORE of the good was produced FAO and World Food Price Index (see H/O) • World food price index: • The FAO (Food and Agriculture Organization of the United Nations) calculates the World Food Price Index which is a measure of the monthly change in international prices of a basket of food commodities. It consists of the average of five commodity group price indices, weighted with the average export shares of each of the groups for 2002-2004. • Monthly release dates for 2014: 09 January, 06 February, 06 March, 03 April, 08 May, 05 June, 03 July, 07 August, 11 September, 09 October, 06 November, 04 December. A little bit more to the story of Price Floors depending on the case… • END HERE Case Study 1: Price Floors for Agricultural Products • Farmers’ income in many countries resulting from the sale of their products in free markets are often unstable and too low • The reasons were evident from the unstable and volatile agricultural prices due to low elasticities of demand and supply and the frequent supply shocks i.e. natural disasters, even global warming, unusual high production (“bumper crop”) • Let’s take a look at some of the evidence… Role of Price Floors • One method governments use to support farmers’ income is to set price floors with the objective to raise the price above the equilibrium price • These price floors (minimum price) are also called price supports Welfare Analysis and Stakeholder Analysis • Consumers – Consumers are worse off as they pay a higher price for smaller quantity of goods • Producers – Producers are better off as they receive a higher price and produce a larger quantity – Moreover, as the government buys the surplus, their revenue increases further (continued) • Workers – Workers are likely to gain as employment increases with the increase in production • Government – Government incurs a cost through buying the excess supply resulting in less budget for other activities – Further cost of storing or subsidizing the exports • Stakeholders in other countries … Consequences for the Society as a Whole • As price floor is imposed, consumer surplus falls (to area a) and the producers surplus increases (to areas b to f) • The social surplus therefore gained the area “f” after the price floor is imposed • But as the government spending of the excess demand is paid using the tax money (from the taxpayers and the society), the total government spending of “Pf x (Qs – Qd)” is a loss to society • The society therefore has a gain of “f” and a loss of the rectangle area Pf x (Qs – Qd), and as a whole the society had a net loss (dead weight loss) of the green shaded area as shown below… (continued) • The welfare or deadweight loss represents allocative inefficiency caused overallocation of resources to the production of the good (Qs > Qe) • At the point of production Qs and Pf, MB < MC and the society would be better off if less of the good were produced • Moreover, the DWL (with the above equilibrium P and Q) signifies the protection of inefficient firms in the industry – Firms with high cost of production do not face the competition from other low cost efficient producers – They do not have strong incentives to become more efficient and less likely go out of business Case Study 2: Minimum Wage for Low Income and Low Skilled Workers • Many countries have minimum wage laws that determine the minimum price of the labor (wage rate) the employers (firms must) pay • The objective is to protect by guaranteeing an adequate income to low income earners who tend to be unskilled (for “equity” and “fair society”) • To graphically illustrate this, we now have a slight twist of perspectives – Demand (consumer) = now by firms who would like to employ workers – Supply = individuals or workers willing to supply work – we are now in the factor of production/resource market also known as the Labor Market! (not the usual product market). But the same idea and analysis prevail Impact on the Labour Market Outcomes (W and Q) • The minimum wage (Wm) lies above the equilibrium wage (We) • The quantity of labor supplied increases and the quantity of labor demanded decreases in comparison to the market equilibrium • we have a surplus of labor of (Qs – Qd) • In other words we have an increase in unemployment either because – Decrease in Qd and/or increase in Qs of labor • We thereby have a misallocation (overallocation) of labor as a factor of production/resource Welfare and Stakeholder Analysis • Firms – Firms (producers, companies, employers of labor) are worse off as they face higher costs of production • Workers – Workers (employees, suppliers of labor) are mixed as some gain as they receive higher wage but some lose as they cannot find a job – The minimum wage creates an additional unemployed workers of Qs – Qe (continued) • Consumers – Consumers are worse off as increase in labor costs leads to leftward shift of supply causing higher price of the product and lower quantities produced • Government – No gain as no government budget is used • Others – Could lead to illegal employment i.e. illegal immigrants willing to work below the minimum wage rates • Society as a whole… Welfare Analysis: Society as a whole… • After the imposition of the minimum wage, employer surplus (demanders and consumers of labor) is reduce to area “a” while worker surplus (suppliers of labor) because areas “d + b” • The social surplus has decreased by “c + e” (the welfare and dead weight loss) with the minimum wage • The welfare loss arises because there is an overallocation of labor resources relative to the social optimum (Qd < Qe) Allocative Inefficiency (continued) • Wage rates (like prices) no longer act as signal and incentive of the worker and firms to determine the optional allocation of labor • Firms that rely heavily on unskilled workers are more likely to be affected with increase in unemployment • The increase in cost of labor also shifts the supply to the left, resulting in less quantity of output produced results in misallocation of resources in product markets In reality… very contentious and ambiguous results.. • In reality, it is uncertain whether minimum wage leads to the increase in unemployment as the theory/concepts predict • Some empirical (data based) studies have found conflicting results – E.g. some firms respond by cutting back other benefits such as paid holiday and sick leaves to maintain the same employment of unskilled workers – E.g. with the insurance of minimum wage, labor productivity also may increase (workers more motivated) leading to more output and therefore more employment • Economics is a social, human behavior science! Must test the theories and predictions using data and evidence!