price ceilings & price floors (consumer surplus & producer surplus) krugman section 2,...

PRICE CEILINGS & PRICE FLOORS

(Consumer Surplus & Producer Surplus)

Krugman Section 2, Module 8

What you will learnWhat you will learnin thisin this ModuleModule::• The meaning of price controls, one way

government intervenes in markets

• How price controls can create problems and make a market inefficient

• Why economists are often deeply skeptical of attempts to intervene in markets

• Who benefits and who loses from price controls, and why they are used despite their well-known problems

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What you will learnWhat you will learnin thisin this ModuleModule::• The meaning of quantity controls, another

way government intervenes in markets

• How quantity controls create problems and can make a market inefficient

• Who benefits and who loses from quantity controls, and why they are used despite their well-known problems

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• Unpopular market prices

• Political pressure

Why Governments Control PricesWhy Governments Control Prices

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What happens when prices are “fixed” by the

government?

Let’s look at a graph which shows the average consumption of beer

in the United States.

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In this example, the average beers consumed per week is 6

at an average price of $2.50.

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This chart illustrates the effects upon people if they were forced to go from Ge to zero.

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You might be You might be willing to pay $4 willing to pay $4 for your first beer, for your first beer, but price is $2.50 but price is $2.50 …..now you are …..now you are $1.50 better off. $1.50 better off. This is called This is called CONSUMER CONSUMER SURPLUS.SURPLUS.

The 9th beer is worth to people what it is worth to people.

It is different for everybody.

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From the From the suppliers’ suppliers’ standpoint, they standpoint, they could could supply at a supply at a lower price but lower price but they they CAN CAN get get more. This is more. This is called PRODUCER called PRODUCER SURPLUS.SURPLUS.

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The colored The colored area is the area is the total valuetotal value to society of to society of the cost of 6 the cost of 6 beers.beers.

Consumer Surplus

Producer Surplus

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Four beers is Four beers is not enough not enough (too little, (too little, inefficient) inefficient) ….This is called ….This is called DEADWEIGHT DEADWEIGHT loss.loss.

What if government mandate limited the maximum What if government mandate limited the maximum number of beers one could drink to 4 per week?number of beers one could drink to 4 per week?

Government Mandated Supply

http://www.yadayadayadaecon.com/clip/16/Deadweight loss of gift giving

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• Quantity Control - Quota• Licenses

Controlling QuantitiesControlling Quantities

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The Anatomy of Quantity ControlsThe Anatomy of Quantity Controls

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The Anatomy of Quantity ControlsThe Anatomy of Quantity Controls

•Demand Price

•Supply Price

•Wedge - Quota Rent

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The Cost of Quantity ControlsThe Cost of Quantity Controls

•Deadweight Loss

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What if government mandate limited the What if government mandate limited the maximum price of a beer to $1.00?maximum price of a beer to $1.00?

Consumers would want to buy more beer.

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However, suppliers would not want to produce as much beer.

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If government If government limited the limited the maximum price maximum price of a beer to of a beer to $1.00, it would $1.00, it would create a create a shortage.shortage.

shortage

Producers will not want to produce for low prices.

The legal maximum price that can be charged is called a PRICE CEILINGPRICE CEILING. A

legal minimum price that can be charged is called a PRICE FLOORPRICE FLOOR. Price ceilings and floors keep markets from

reaching equilibriumequilibrium..

• Legal maximum price• Examples

– Resource prices during WWII

– Oil Prices in1970s– California electricity– New York City apartments

Price CeilingsPrice Ceilings

Modeling a Price CeilingModeling a Price Ceiling

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How a Price Ceiling Causes How a Price Ceiling Causes InefficiencyInefficiency

• Inefficient Allocation to Consumers

•Wasted Resources

• Inefficiently Low Quality

• Black Markets

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So Why Are There Price Ceilings?So Why Are There Price Ceilings?

• Benefit some

•Uncertainty

• Lack of understanding

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Politically popular ideas include:

--$ minimums on inputs (wages).

--$ maximums on outputs (prices).

When POLITICS vs. ECONOMICS => POLITICS vs. ECONOMICS => Politics always winsPolitics always wins

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The The government government mandating mandating the maximum the maximum price of a beer price of a beer is called a is called a PRICE PRICE CEILINGCEILING.. shortage

A price ceiling keeps the market from reaching equilibrium.

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shortage

The shortage created from the price ceiling will result in increased demand.

X

The increased demand and a willingness to pay higher prices will result in a BLACK MARKET for beer.

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When the government mandates a the When the government mandates a the minimum price of something, it is called a minimum price of something, it is called a PRICE PRICE FLOORFLOOR..

The minimum wage is an example of a price floor.

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The minimum wage increases the number of people who want to work (supply of labor). . . . . . And decreases the number of businesses who want to hire (demand for labor)

Creating a SURPLUS of labor.

SURPLUS

A price floor stops the market from reaching equilibrium and creates a surplus.

A price ceiling stops the market from reaching equilibrium and creates a shortage.

CONCLUSION:

Typically, the government jumps in during a surplus, buys the surplus….

and the surplus rots.and the surplus rots.

• Legal minimum price• Examples

– Agricultural products– Minimum wage– Trucking– Air travel

Price FloorsPrice Floors

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Modeling a Price FloorModeling a Price Floor

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How a Price Floor Causes How a Price Floor Causes InefficiencyInefficiency

• Inefficiently Low Quantity

• Inefficient Allocation of Sales Among Sellers

•Wasted Resources

• Inefficiently High Quality

• Illegal ActivityModule 8

So Why Are There Price Floors?So Why Are There Price Floors?

• Benefit some

• Disregard

• Lack of understanding

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PROBLEM SOLVING

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ANSWER: The 18th Amendment created a shortage of alcohol for consumption

When the price of alcohol increased under black market conditions, this initiated the development of the syndicate and the notoriety of such underworld figures as Al Capone.

Using economic principles and the impact of government mandate, why was the 18th Amendment to the U.S. Constitution considered “the great experiment that failed?”

QUESTION 1:

Using economic principles, explain the impact of government mandates on the supply and demand of the illegal marijuana market.

QUESTION 2:

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ANSWER: In 1937, the government reduced the availability of marijuana to zero by making it illegal.

Because people have been willing to pay a high price for the product, black market conditions have existed since the shortage was created.

This created a shortage in the market.

In 1973, President Nixon froze gasoline prices after the OPEC cartel created a shortage in the United States. What impact did this have on the market economy at that time?

QUESTION 3:

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ANSWER: ANSWER: President Nixon President Nixon initiated a price initiated a price ceiling of $1.60.ceiling of $1.60.

shortage

REMEMBER: Producers will not want to produce for low prices.

Consequently, a Consequently, a shortage existed shortage existed because gas because gas companies were companies were taking a loss. This taking a loss. This resulted in long lines resulted in long lines and gas stations and gas stations running out of fuel.running out of fuel.

Using economic principles and the impact of government mandate, explain what would happen if cigarette smoking were made illegal.

What would be the opportunity cost of making cigarettes illegal?

QUESTION 4:

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ANSWER: The government would reduce the supply of cigarettes to zero by making it illegal.

Because some people will be willing to pay a high price for the product, black market conditions will exist and the price of cigarettes will increase.

This will create a shortage in the market.

ANSWER: The opportunity costs would include:

•Lower environmental costs

•Cleaner air

•Lower costs for health care

•Healthier population

•Higher unemployment for lost jobs

Many experts contend that the Food and Drug Administration (FDA) directly creates the high price of prescription drugs. Do you agree? Why or why not? Explain your answer.

Question 5:

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ANSWER: The FDA, a government regulatory agency, reduces the supply of certain drugs by making them unavailable to certain people through the use of prescriptions.

Because doctors prescribe drugs for illness and the patient requests good health, they pay the higher price created by the government.

This results in a limited market.

In May 2001, President Bush visited with Governor Gray of California to discuss the energy crisis in that state. It will take 10 years to build the power plants necessary to provide the electricity needed to support the population and costs will skyrocket as demand exceeds supply. Governor Gray is requesting that President Bush place a federal price ceiling on the cost of energy. Why did President Bush refuse?

Question 6:

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ANSWER: ANSWER: President Bush realizes that a price ceiling will result in a shortage of electricity.

shortage

REMEMBER: Producers will not want to produce for low prices.

Limiting the price that Limiting the price that power companies can power companies can charge for electricity charge for electricity will cause them to lose will cause them to lose money, not produce money, not produce efficiently, and result in efficiently, and result in a shortage of power.a shortage of power.

THE END

Compiled by Virginia Meachum Economics Teacher, Coral Springs High School, Florida

Sources:

Economics for AP, by Krugman, Wells.

Economics, by McConnell, Brue

Economics, by Mankiw