Chapter 6 Price Ceilings

1. Chapter 6 Price Ceilings

2. Price Ceilings Policy makers may respond to buyers’ complaints that prices are “too high” by enacting price controls. A Price Ceilingis 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.

3. 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 Search Costs Loss of Gains from Trade Misallocation of Resources

4. Shortages When prices are held below the market price shortages emerge where the quantity demanded exceeds the quantity supplied. The shortage is measured by the difference between the quantity demanded at the controlled price and the quantity supplied at the controlled price. The lower the controlled price relative to the market equilibrium price, the larger the shortage.

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

6. Reduction in Product Quality At the controlled price, sellers have more customers than they have goods. In a free market, this would be an opportunity to profit by raising prices. When prices are controlled, however, sellers cannot raise prices without violating the law. Sellers respond to this problem and increase profits in two ways: Reduce quality Reduce service

7. Wasteful Lines and Other Search Costs Price controls that create shortages lead to bribery and wasteful lines. Shortages mean that not all buyers will be able to purchase the good. In free markets buyers compete with other buyers by offering a higher price. Since price is not allowed to rise above the price ceiling, buyers must compete in other ways.

8. Wasteful Lines and Other Search Costs Some buyers may be willing to bribe sellers in order to obtain the good. The maximum bribe a buyer would be willing to pay is the difference between the willingness to pay and the controlled price established by the price ceiling. If bribes are common, then the total price of the good is the legal price plus the bribe.

9. Wasteful Lines and Other Search Costs Buyers can also compete with each other through their willingness to wait in line. The maximum wait time (in monetary terms) for a buyer is the difference between the willingness to pay and the controlled price established by the price ceiling. Thus, the total price of the good is the legal price plus the time costs.

10. Wasteful Lines and Other Search Costs Bribes and waits both lead to a total price that is greater than the controlled price, but the net effects of the two approaches 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.

11. Wasteful Lines and Other Search Costs Price Ceilings Create Wasteful Lines Price Supply Per Unit Time Cost Willingness to Pay Total Value of Wasted Time Market Equilibrium Shortage Controlled Price (Ceiling) Demand Quantity Qsupplied at the Controlled Price Qdemanded at the Controlled Price

12. Lost Gains from Trade Price controls reduce the gains from trade. Price ceilings set below the market price cause quantity supplied to be less than the market quantity. For output levels below the equilibrium market quantity, consumers value the good (as indicated by the willingness to pay) more than the cost of its production. This represents a gain from trade that would not remain unexploited in a free market.

13. Lost Gains from Trade A Deadweight Lossis the total of lost consumer and producer surplus when all mutually profitable gains from trade are not exploited. Price ceilings create a deadweight loss by forcing quantity supplied below the market quantity. Buyers and sellers can both benefit from trade at a higher price, but it is illegal for price to rise.

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

15. Misallocation of Resources Price controls distort signals and eliminate incentives leading to a misallocation of resources. Consumers with high-value uses of the good are legally prevented from signaling their high value by offering sellers a price greater than the controlled price. Producers, therefore, have no incentive to supply the good just to the highest-value uses. As a result, in controlled markets goods are misallocated.

16. Misallocation of Resources Price Controls Prevent Resources to Flow to their Highest-Valued Uses Highest Valued Uses Price Lower Valued Uses Supply Least Valued Uses Controlled Price (Ceiling) Shortage Demand Quantity Qsupplied Qdemanded

17. Nixon’s price controls set price ceilings below the market price. What would have happened if the price ceilings had been set above market prices? • Under price controls why were there shortages of oil in some local markets but not in others?

18. Rent Controls A Rent Controlis a regulation that prevents rents from rising to equilibrium levels. Rent control is a price ceiling on rental housing that creates all the effects presented above. Furthermore, these effects can be more pronounced over time.

19. Rent Controls Rent Control Creates Larger Shortages in the Long Run than in the Short Run Price (rent) Short Run Supply Long Run Supply Market Equilibrium Controlled Rent Long Run Shortage Demand Short Run Shortage Quantity (rental apartments) Qsupplied Short Run Qdemanded Qsupplied Long Run

20. Rent Controls

21. If landlords under rent control have an incentive to do only the minimum upkeep, what inevitably must accompany rent control? Think of a tenant with a dripping faucet: how does it get fixed? • New York City has had rent control for decades. Assume you are appointed to the mayor’s housing commission and convince your commission members that rent control has been a bad thing for New York. How would you get rid of rent control, considering the vested interest?

22. Rent Controls An economy with permanent, universal price controls is referred to as a Command Economy. The command economy of the former Soviet Union was characterized by persistent shortages of goods. These never-ending shortages resulted in long lines and rampant corruption to allocate goods.

23. In the 1984 movie Moscow on the Hudson, a Soviet musician defects to the United States. Living in New York, he cannot believe the availability of goods and finds that he cannot break away from previous Soviet habits. In one memorable scene, he buys packages of toilet paper. Why? Using concepts from this chapter, explain why hoarding occurs under price controls and why it is wasteful. • Shortages in the Soviet Union were very common, but why were there also surpluses of some goods at some times?

24. A price ceiling is a maximum price allowed by law. • Price ceilings that involve a maximum price that is below the market price create five important effects. • Shortages • Reduction in Product Quality • Wasteful Lines and Other Search Costs • Loss of Gains from Trade • Misallocation of Resources

25. When prices are held below the market price shortages emerge where the quantity demanded exceeds the quantity supplied. • At the controlled price, sellers have more customers than they have goods and increase profits by reducing quality and service. • Price controls that create shortages lead to bribery and wasteful lines.

26. Price controls reduce the gains from trade by making some mutually profitable trades illegal. • Price controls distort signals and eliminate incentives leading to a misallocation of resources. • A rent control is a regulation that prevents rents from rising to equilibrium levels.