Price Ceilings

… a core concept in Economic Analysis and Atlas102

Concept description

Alex Tabarrok (reference below, video on right), describes the five major unintended consequences of government-regulated price ceilings (a maximum price allowed by law).

Five effects of price ceilings

Tabarrok sets out the five major unintended consequences of price ceilings, each of which is addressed in more detail below:

1. Shortages
2. Reductions in product quality
3. Wasteful lines and other search costs
4. A loss in gains from trade (deadweight loss)
5. A misallocation of resources

Example of 1971 price controls in the U.S.

Tabarrok writes that:

“In 1971, President Nixon, in an effort to control inflation, declared price increases illegal. Because prices couldn’t increase, they began hitting a ceiling. With a price ceiling, buyers are unable to signal their increased demand by bidding prices up, and suppliers have no incentive to increase quantity supplied because they can’t raise the price. What results when the quantity demanded exceeds the quantity supplied? A shortage! In the 1970s, for example, buyers began to signal their demand for gasoline by waiting in long lines, if they even had access to gasoline at all. As you’ll recall from the previous section on the price system, prices help coordinate global economic activity. And with price controls in place, the economy became far less coordinated.”

Price ceilings create shortages

A shortage is the amount by which the quantity demanded exceeds the quantity supplied at the controlled price.

Tabarrok illustrates the shortage produced by a price ceiling.

Price ceilings lead to reductions in quality

Tabarrok uses examples from the Nixon controls to explain why price ceilings allow producers to reduce quality and still be able to sell all their product at the controlled price.

Price ceilings lead to wasteful lines and other search costs

Tabarrok emphasizes that price regulation does not eliminate competition because competition for scarce resources is an unalterable aspect of human social organization. What happens under price regulation, instead of competing on price, competition appears in other forms.

The most common other form is bidding up waiting time. One can estimate the extent to which waiting time will be bid up:

Tabarrok underlines the societal loss from this method of competition: when one competes on price, the seller receives the full value of what the buyer pays; when one competes through lineups the value paid by the buyer is not received by the buyer, it is simply wasted.

Price ceilings reduce gains from trade

Tabarrok’s demonstration that price ceilings produce a deadweight loss compared to the free market outcome as follows:

Price ceilings lead to misallocation of resources

Tabarrok explains how price ceilings prevent the highest value uses from outbidding lower valued uses, for example oil in the 1970s going to heating California swimming pools rather than getting to higher value use of keeping New England houses above freezing. He compares the consumer plus producer surplus when a free market allocates gasoline to its highest value to the consumer plus producer surplus if it is allocated randomly in the following diagram.

Practice questions

From http://www.mruniversity.com/courses/principles-economics-microeconomics/price-ceiling-practice-questions?utm_source=PrinciplesAnnot&utm_medium=PQAnnot&utm_campaign=MRUYTAnnotation, http://www.mruniversity.com/node/201740, http://www.mruniversity.com/node/201776?utm_source=PrinciplesAnnot&utm_medium=PQAnnot&utm_campaign=MRUYTAnnotation, http://www.mruniversity.com/node/201785, http://www.mruniversity.com/node/201790, accessed 1 May 2016.

1. How does a free market eliminate a shortage?
   1. By letting the price fall.
   2. By letting the price rise.
   3. By creating quotas. 
   4. By creating a price ceiling.
2. Business leaders often say that there is a “shortage” of skilled workers, and so they argue that immigrants need to be brought in to do these jobs. For example, an AP article entitled “New York farmers fear a shortage of skilled workers,” pointing out that a special U.S. visa program, the H-2A program, “allows employers to hire foreign workers temporarily if they show that they were not able to find U.S. workers for the jobs.” (Source: Thompson, Carolyn. May 13, 2008. N.Y. farmers fear a shortage of skilled workers Associated Press.) How do unregulated markets cure a “labor shortage” when there are no immigrants to boost the labor supply?
   1. Let the price of labor increase.
   2. Let the price of labor decrease.
   3. Contract production. 
   4. Expand production.
3. In the town of Freedonia, the government declares that all street parking must be free: There can be no parking meters. In an almost identical town of Meterville, parking costs $5 per hour (or $1.25 per 15 minutes). Where will it be easier to find parking: in Freedonia or Meterville?
   1. Freedonia
   2. Meterville
   3. Indeterminate with the given information.
4. One town will tend to attract shoppers who hate driving around looking for parking. Which one?
   1. Freedonia
   2. Meterville
5. Which town will likely attract shoppers with higher incomes?
   1. Freedonia
   2. Meterville
6. Suppose that the quantity demanded and quantity supplied in the market for milk is as follows: What is the equilibrium price and quantity of milk?
   1. price: $4; quantity: 4500
   2. price: $3; quantity: 3500
   3. price: $2, quantity: 2000 
   4. Indeterminate from the information given.
7. If the government places a price ceiling of $2 on milk, how large with the shortage be?
   1. 2300 gallons
   2. 2100 gallons 
   3. 3500 gallons 
   4. 2000 gallons
8. If a government decides to make health insurance affordable by requiring all health insurance companies to cut their prices by 30%, what will probably happen to the number of people covered by health insurance?
   1. More people will be covered because it’s cheaper and more people can now afford it. 
   2. Fewer people will be covered because health insurance companies will supply less. 
   3. The number of insured will not change. 
   4. Indeterminate with the given information.
9. If the government forced all bread manufacturers to sell their products at a “fair price” that was half the current, free-market price, what would happen to the quantity supplied of bread?
   1. quantity supplied decreases.
   2. quantity supplied increases. 
   3. Indeterminate with the given information.
10. With these price controls on bread, would you expect bread quality to rise or fall?
    1. Quality rises
    2. Quality falls 
    3. Indeterminate with the given information.
11. When a price ceiling is in place keeping the price below the market price, what’s larger: quantity demanded or quantity supplied?
    1. Quantity demanded.
    2. Quantity supplied. 
    3. Indeterminate with the given information. 
    4. Neither.
12. Suppose that the market for coats is described as follows: What is the equilibrium price of coats? 
    1. $120
    2. $100
    3. $80 
    4. $60
13. Suppose the government sets a price ceiling of $80. How large will the shortage be?
    1. 5 million coats 
    2. 4 million coats 
    3. 3 million coats 
    4. There is no shortage
14. Suppose again that the government sets a price ceiling of $80 and that people line up to get this good. For how long will people wait in line to obtain a coat if they value their time at $10 an hour?
    1. 2 hours
    2. 3 hours
    3. 4 hours
    4. Indeterminate from the given information.
15. Between 2000 and 2008, the price of oil increased from $30 per barrel to $140 per barrel, and the price of gasoline in the United States rose from about $1.50 per gallon to over $4.00 per gallon. Unlike in the 1970s when oil prices spiked, there were no long lines outside gas stations. Why?
    1. Government intervened to prevent lines.
    2. Government intervened to enact gasoline rations. 
    3. There was no price control on gasoline at the time.
16. Price controls distribute resources in many unintended ways. In the following cases below, who will probably spend more time waiting in line to get scarce, price-controlled goods? Choose one from each pair:
    1. Working people
    2. Retired people
17. Choose one from each pair:
    1. Fast-food employees who earn $8 per hour
    2. Lawyers who charge $800 per hour
18. Choose one from each pair:
    1. People with desk jobs 
    2. People who can disappear for a couple of hours during the day
19. Which job exists in part because time-sensitive wealthy individuals want to pay someone else to wait in line for them?
    1. Fast food employees
    2. Ticket scalpers 
    3. Construction workers
    4. Truck drivers
20. During a crisis such as Hurricane Katrina, governments often make it illegal to raise the price of emergency items like flashlights and bottled water. In practice, this means that these items get sold on a first-come, first-served basis. If a person has a flashlight that she values at $5, but its price on the black market is $40, what gains from trade are lost if the government shuts down the black market?
    1. $45
    2. $40 
    3. $35 
    4. $30 
    5. Indeterminate with the given information.
21. When will entrepreneurs be more likely to fill up their pickup trucks with flashlights and drive into a disaster area: when they can sell their flashlights for $5 each or when they can sell them for $40 each?
    1. $5
    2. $40 
    3. Equal numbers of entrepreneurs will be present at both prices.
22. In the late 1990s, the city of Santa Monica, California, made it illegal for banks to charge people ATM fees. As you probably know, it’s almost always free to use your own bank’s ATMs, but there’s usually a fee charged when you use another bank’s ATM. (Source: The War on ATM Fees, Time, November 29, 1999). As soon as Santa Monica passed this law, Bank of America stopped allowing customers from other banks to use their ATMs: In bank jargon, B of A banned “out-of-network” ATM usage. In fact, this ban only lasted for a few days, after which a judge allowed banks to continue to charge fees while awaiting a full court hearing on the issue. Eventually, the court declared the fee ban illegal under federal law. But let’s imagine the effect of a full ban on out-of-network fees. Calculate the exact amount of producer and consumer surplus in the out-of-network ATM market in Santa Monica after the ban. How large is consumer surplus? 
    1. 10 
    2. 0 
    3. 15 
    4. Indeterminate with the given information.
23. Suppose the government forced all bread manufacturers to sell their products at a “fair price” that was half the current, free-market price. To keep it simple, assume that people must wait in line to get bread at the controlled price. Would consumer surplus rise, fall, or can’t you tell with the information given?
    1. consumer surplus increases. 
    2. consumer surplus decreases. 
    3. Indeterminate with the given information.
24. The Canadian government has wage controls for medical doctors. To keep things simple, let’s assume that they set one wage for all doctors: $100,000 per year. It takes about 6 years to become a general practitioner or a pediatrician, but it takes about 8 or 9 years to become a specialist like a gynecologist, surgeon, or ophthalmologist. What kind of doctor would you want to become under this system? (Note: The actual Canadian system does allow a specialist to earn a bit more than general practitioners, but the difference isn’t big enough to matter.)
    1. Pediatrician
    2. Surgeon
25. Antibiotics are often given to people with colds (even though they are not useful for that purpose), but they are also used to treat life-threatening infections. If there was a price control on antibiotics, what do you think would happen to the allocation of antibiotics across these two uses?
    1. It would go to those who need it most.
    2. It would go to those who need it least.
    3. It would go to a mix of the two.

Atlas topic, subject, and course

The Price System and Price Regulation (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Alex Tabarrok, Price Ceilings (4-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-controls-definition-nixon, accessed 1 May 2016.

Alex Tabarrok, Price Ceilings: Shortages and Quality Reduction (6-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-ceiling-shortages-reduce-quality, accessed 1 May 2016.

Alex Tabarrok, Price Ceilings: Lines and Search Costs (10-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-ceiling-gasoline-example-search-costs, accessed 1 May 2016.

Alex Tabarrok, Price Ceilings: Deadweight Loss (4-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-ceiling-deadweight-loss, accessed 1 May 2016.

Alex Tabarrok, Price Ceilings: Misallocation of Resources (12-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-ceiling-misallocation-of-resources, accessed 1 May 2016.

Page created by: Ian Clark, last modified 1 May 2016.

Image: From the source videos noted above, accessed 1 May 2016.