Modern Principles Macroeconomics 3rd

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of economics 8 macroeconomics 5
Price Ceilings and Floors

Facts and Tools

1. How does a free market eliminate a shortage?
Solution 1. By letting the price rise.This encourages demanders to demand less and suppliers to
supply more, ending the shortage.
2. When a price ceiling is in place keeping the price below the market price, what’s
larger: quantity demanded or quantity supplied? How does this explain the long
lines and wasteful searches we see in price-controlled markets?
Solution 2. A price ceiling will make quantity demanded larger than quantity supplied.Those
extra demanders wait in long lines and waste effort searching for scarce goods.
3. Suppose that the quantity demanded and quantity supplied in the market for milk is
as follows:
Price per Gallon Quantity Demanded Quantity Supplied
$5 1,000 5,000
$4 2,000 4,500
$3 3,500 3,500
$2 4,100 2,000
$1 6,000 1,000
 a. What is the equilibrium price and quantity of milk?
b. If the government places a price ceiling of $2 on milk, will there be a shortage
or surplus of milk? How large will it be? How many gallons of milk will be sold?
Solution 3. a. The equilibrium price is $3 and the equilibrium quantity is 3,500 gallons.
b. If the government places a price ceiling of $2 on milk, there will be a shortage
of 2,100 gallons.At a price of $2, suppliers will be willing to sell 2,000 gallons.
4. If a government decides to make health insurance
insurance companies to cut their prices by 30%, what will probably happen to the
number of people covered by health insurance?
Solution 4. This is just another price ceiling: It will create a shortage in health insurance, and
not all people demanding health insurance will be covered.
5. 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.
S-1

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What kind of doctor would you want to become under this system? (Note:The
actual Canadian system does allow specialist to earn a bit more than general
practitioners, but the difference isn’t big enough to matter.)
Solution 5. If both jobs pay about the same, most people would rather be a general practitioner—
the job is easier, the hours are better, and you get out of school sooner. That’s actually
what’s happening in Canada: They have lots of generalists and few specialists.
6. 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?
Solution 6. There were no gas lines because this time there were no price controls on oil or gasoline.
7. Price controls distribute resources in many unintended ways. In the following cases,
who will probably spend more time waiting in line to get scarce, price-controlled
goods? Choose one from each pair:
a. Working people or retired people?
b. Lawyers who charge $800 per hour or fast-food employees who earn $8 per hour?
c. People with desk jobs or people who can disappear for a couple of hours during
the day?
Solution 7. Retired people, fast-food employees, and people who can disappear are all more
willing to stand in line.The opportunity cost of free time is higher for the other
groups.Thus, some lawyers might pay some fast-food employees to wait in line on
their behalf, as happens with ticket scalping today.
8. In the chapter, we discussed how price ceilings can put goods in the wrong place, as
when too little heating oil wound up in New Jersey during a harsh winter in the
1970s. Price controls can also put goods in the wrong time as well. If there are price
controls on gasoline, can you think of some periods during which the shortage will
get worse? (Hint: Gas prices typically rise during the busy Memorial Day and Labor
Day weekends.)
Solution 8. Oil refiners and truck drivers won’t have an incentive to deliver the extra gasoline
that people are demanding during holiday periods, so some people will wait in long
lines for scarce gas just at the time when they most want to travel.
9. a. Consider Figure 8.8. In a price-controlled market like this one, when will
consumer surplus be larger: in the short run or in the long run?
b. In this market, supply is more elastic, more flexible, in the long run. In other
words, in the longer term, landlords and home builders can find something
else to do for a living. In light of this, and in light of the geometry of producer
surplus in this figure, do rent controls hurt landlords and home builders more in
the short run or in the long run?
Solution 9. a. Consumer surplus will be larger in the short run, since the short-run shortage
is small.Thus, in the short run, consumers get lower prices and more or less the
same quantity of goods. But in the long run, the shortage increases and consumer
surplus falls. In addition, in the long run, key money, long waiting times, and
reductions in quality will all tend to eat up any benefit from lower prices.
b. Landlords and home builders are hurt more in the short run; in the long run,
they can just leave the market if things get too bad. Geometrically, we can
tell this is so because less producer surplus is lost in the long run as producers
exit the industry.

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10. 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, a recent
AP article was entitled “New York farmers fear a shortage of skilled workers,” and
went on to point 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.)
a. How do unregulated markets cure a “labor shortage” when there are no
immigrants to boost the labor supply?
b. Why are businesses reluctant to let unregulated markets cure the shortage?
Solution 10. a. Unregulated markets cure a labor shortage by pushing up the wage.
b. Businesses don’t like paying higher wages.They’d rather increase the supply
of labor.
11. a. 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?
b. 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?
c. With these price controls on bread, would you expect bread quality to rise

or fall?
Solution 11. a. The quantity supplied must fall—that’s the easy part.
b. Consumer surplus must fall.The cost of waiting in line for the bread is the key:
That “time-wasting” rectangle (see Figure 8.2, p. 136) eats up any extra value
that might have gone to consumers.
c. Bread quality is likely to fall, just as the quality of any price-controlled good is
likely to fall.Think about the matzo balls! But one point to note is that if the
quality of the bread falls, so will the length of the line to get the bread, and we
do not want to double count the losses from price controls!
12. A review of the jargon: Is the minimum wage a “price ceiling” or a “price floor?”
What about rent control?
Solution 12. The minimum wage is a price floor, while rent control is a price ceiling.
13. How do U.S. business owners change their behavior when the minimum wage
rises? How does this impact teenagers?
Solution 13. When the minimum wage rises, businesses look harder for alternatives to hiring
low-skilled teenagers.They might hire a smaller number of skilled older workers,
they might have machines do more of the work, or they might shorten teenage
hours. If they can, businesses will also try to reduce other forms of on-the-job
compensation such as benefits or lunch breaks. None of these are good for
teenagers looking for work.
14. The basic idea of deadweight loss is that a willing buyer and a willing seller can’t find
a way to make an exchange. In the case of the minimum wage law, the reason they
can’t make an exchange is because it’s illegal for the buyer (the firm) to hire the seller
(the worker) at any wage below the legal minimum. But how can this really
be a “loss” from the worker’s point of view? It’s obvious why business owners would
love to hire workers for less than the minimum wage; but if all companies obey the
minimum wage law, why are some workers still willing to work for less than that?
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Solution 14. They’d be willing to work for less than minimum because for many workers a
low-paying job is better than not working at all.The minimum wage prices some
low-skilled workers out of the market. Nobel Laureate Paul Krugman wrote a
famous Slate magazine essay on this topic,“Bad jobs are better than no jobs at all,”
widely available online.

Thinking and Problem Solving

1. In rich countries, governments almost always set the fares for taxi rides.The prices for
taxi rides are the same in safe neighborhoods and in dangerous neighborhoods.Where
is it easier to find a cab? Why? If these taxi price controls were ended, what would
probably happen to the price and quantity of cab rides in dangerous neighborhoods?
Solution 1. Driving a taxi in a major city is a relatively dangerous job. Since taxi drivers prefer
to drive in safe neighborhoods it is probably easier to find a cab in a safe
neighborhood. If price controls were ended, taxis could charge more in dangerous
neighborhoods, and they would probably drive there more often.
2. When the United States had price controls on oil and gasoline, some parts of the
United States had a lot of heating oil while other states had long lines.As in the
chapter, let’s assume that winter oil demand is higher in New Jersey than in
California. If there had been no price controls, what would have happened to the
prices of heating oil in New Jersey and in California and how would “greedy
businesspeople” have responded to these price differences?
Solution 2. If the demand for heating oil rose in New Jersey, then the price in New Jersey
would rise.This would encourage greedy businesspeople to ship the gasoline
on trucks or in pipelines from California to New Jersey.This would reduce the
shortage in New Jersey.
3. On January 31, 1990, the first McDonald’s opened in Moscow, capital of the then
Soviet Union. Economists often described the Soviet Union as a “permanent short-
age economy,” where the government kept prices permanently low in order to
appear “fair.”
“An American journalist on the scene reported the customers seemed most
amazed at the ‘simple sight of polite shop workers . . . in this nation of
commercial boorishness.’ ” (Source: http://www.history.com/this-day-in-history.
do?action=Article&id=2563)
a. Why were most Soviet shop workers “boorish” while the McDonald’s workers
in Moscow were “polite”?
b. What does your answer to the previous question tell you about the power
of economic incentives to change human behavior? In other words, how
entrenched is “culture”?
Reuters/Corbis

McDonald’s in Moscow:The First Day

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 Price Ceilings and Floors • C H A P T E R 8 • S-5

Solution 3. a. T he Soviet shop workers were mean because they worked in a world of short-
ages: No matter how badly they behaved, all the goods would end up sold.The
McDonald’s workers were trained to be polite because McDonald’s always faces
competition from other restaurants. If their workers are boorish, customers will
go somewhere else.
b. This is an example of how market incentives can change human behavior.
Human “nature” looks pretty flexible, when money is on the line.
4. Let’s count the value of lost gains from trade in a regulated market. The government
decides it wants to make basic bicycles more affordable, so it passes a law requiring
that all one-speed bicycles sell for $30, well below the market price. Use the following
data to calculate the lost gains from trade, just as in Figure 8.3. Supply and demand are
straight lines.
Supply
Price of
bicycles
$80

30
Demand

0
100 200 Quantity of
bicycles

a. What is the total value of wasted time in the price-controlled market?

b. What is the value of the sum of lost consumer surplus and lost producer surplus?
c. Note that we haven’t given you the original market price of simple bicycles—why
don’t you need to know it? (Hint:The answer is a mix of geometry and economics.)
Solution 4. a. $50 3 100 5 $5,000
b. $50 3 100 3 0.5 5 $2,500. This is the triangle formula again.
c. You don’t need to know the market price because we don’t need to know all
the dimensions of a triangle to measure its area, and because “willingness to pay,”
“willingness to supply,” and the equilibrium quantity and the price-controlled
quantity tell us all we need to know.
5. During a crisis such as Hurricane Sandy, 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.
a. 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?
b. Why might a person want to sell a flashlight for $40 during an emergency?
c. Why might a person be willing to pay $40 for a flashlight during an emergency?
d. 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?
Solution 5. a. The total gains from trade if trade is allowed are $35, these gains from trade
would be split between the buyer and the seller depending on the exact price
they agreed upon.
b. Many reasons are possible.The person might have another flashlight, or might
have candles, or might need money to buy water or medicine or food more than
he needs a flashlight.

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 S-6 • C H A P T E R 8 • Price Ceilings and Floors

c. Aperson might really need a flashlight because she has no candles or other

lights, or she might need to visit a sick relative late at night.There are many
reasons why she might need it.
d. When the price is $40, entrepreneurs are more likely to drive in with pickup

trucks full of flashlights.

6. A “black market” is a place where people make illegal trades in goods and services.
For instance, during the Soviet era, it was common for American tourists to take a
few extra pairs of Levi’s jeans when visiting the Soviet Union:They would sell the
extra pairs at high prices on the illegal black market.
Consider the following claim:“Price-controlled markets tend to create black
markets.” Let’s illustrate with the following figure. If there is a price ceiling in the
market for cancer medication of $50 per pill, what is the widest price range within
which you can definitely find both a buyer and a seller who would be willing to il-
legally exchange a pill for money? (There is only one correct answer.)
Price of
cancer
medication
Supply
$160

100

50

Demand

100 Quantity of
cancer
medication

Solution 6. Between $50 and $160, you can find both a buyer and a seller who are definitely
willing to trade money for a pill.That creates a big incentive for a black market.
The price can’t be higher than $160 because those demanders might be getting
their pills in the price-controlled market.And it can’t be below $50 because those
suppliers might already be supplying the price-controlled market.
7. So, knowing what you know now about price controls, are you in favor of setting
a $2 per gallon price ceiling on gasoline? Create a pro–price control and an anti–
price control answer.
Solution 7. A plausible pro-price control answer: The people we worry about the most are
the poor, and the poor place a low value on their time, so it’s less of a waste if they
spend hours waiting in gas lines. So while there will be long lines, this might be a
reasonable way to redistribute wealth from the rich to the poor.
A plausible anti-price control answer: Price controls on gasoline create many
kinds of waste: waste from gasoline that doesn’t get supplied, waste from people
waiting in line, and the waste from the black markets that are likely to arise.Taken
together, it’s hard to argue that anyone would benefit much from price controls on
gasoline and many people will be harmed. It might feel good, but it will probably
create bad outcomes that we’ll regret.
8. a. As we noted,Assar Lindbeck once said that short of aerial bombardment, rent
control is the best way to destroy a city.What do you think Lindbeck might
mean by this?
b. How does paying “key money” to a landlord reduce the severity of Lindbeck’s
“bombardment”?

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 Price Ceilings and Floors • C H A P T E R 8 • S-7

Solution 8. a. Lindbeck probably means that in a rent-controlled city, landlords will let the
quality of their housing stock decline. In many price-controlled markets, product
quality does fall, and in housing markets, it’s easy for a landlord to just let the
apartment slowly fall apart.After all, with a government-created housing shortage,
it should be easy to rent out the room even if the electrical wiring is bad.
b. If people can pay “key money,” then this acts like a higher rent payment. It is a
way around the rent control. In places where it’s possible (though illegal) to pay
key money, we would expect more apartments to remain in good condition.
9. 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).
a. Where will it be easier to find parking: in Freedonia or Meterville?
b. One town will tend to attract shoppers who hate driving around looking for
parking.Which one?
c. Why will the town from part b also attract shoppers with higher incomes?
Solution 9. a. Meterville. In Freedonia, there will be a shortage of parking spots. In Meterville,
there will be parking for those willing to pay the price.
b. Meterville, again.Their stronger preference for easy-to-find parking suggests a
higher willingness to pay for it.Thus, the meters are a worthwhile price to pay
to ensure a parking space.
c. People who have money to spend on meters typically have a higher opportunity
cost for their free time.That typically means they earn higher wages.
10. 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 lasted for only 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.
a. In the figure, indicate the new price per out-of-network ATM transaction after
the fee ban.Also clearly label the shortage.
Out-of-
network Supply of
fee ATM transactions

$2
Demand for
ATM transactions

Number of out-of-network ATM

transactions in Santa Monica

b. 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
producer surplus? How large is consumer surplus?

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 S-8 • C H A P T E R 8 • Price Ceilings and Floors

Solution 10. a. Out-of- Supply of

network ATM transactions
fee

$2

Demand for
ATM transactions
Shortage
0

Number of ATM transactions

in Santa Monica

b. When a market is shut down completely, as occurs here, there is no producer

surplus and no consumer surplus. Surplus only comes from exchange, so where
there’s no exchange, there’s just no surplus! Both are zero.
11. Consider Figure 8.9.Your classmate looks at that chart and says,“Apartment con-
struction slowed down years before rent control was passed, and after rent control
was passed, more apartments were built. Rent control didn’t cut the number of new
apartments, it raised it.This proves that rent control works.” What is wrong with
this argument?
Solution 11. The problem is that builders changed their behavior before the bill became law:
As soon as politicians started debating the bill, new apartment starts dropped.They
only recovered a tiny amount after the bill was passed.To measure the effect of
legislation on economic decisions, we need to know when people learned about the
possibility of legislation. People are forward looking, reacting today to likely future
policy changes.This was one big insight of the rational expectations revolution of
1970s macroeconomics.
12. Rent control creates a shortage of housing, which makes it hard to find a place
to live. In a price-controlled market, people have to waste a lot of time trying to
find these scarce, artificially cheap products.Yet Congressman Charles B. Rangel,
the chairman of the powerful House Ways and Means Committee, lived in four
rent-stabilized apartments in Harlem.Why are powerful individuals often able to
“find” price-controlled goods much more often than the non-powerful? What does
this tell us about the political side effects of price controls? (Source: Republicans
question Rangel’s tax break support, The NewYork Times, November 25, 2008.)
Solution 12. If a scarce good can’t be rationed through prices, it will be rationed in some other
way. Landlords who must rent at below-market prices will attempt to ration out
their scarce goods so that they can get the most value possible. Landlords under
rent control will tend to favor powerful politicians, celebrities, or family members.
“Who you know” will matter quite a lot—this is just the U.S. equivalent of what
the Russians called “blat.”
13. In the 1970s,AirCal and Pacific Southwest Airlines flew only within California.
As we mentioned, the federal price floors didn’t apply to flights within just one
state.A major route for these airlines was flying from San Francisco to Los Angeles,
a distance of 350 miles.This is about the same distance as from Chicago, Illinois,
to Cleveland, Ohio. Do you think AirCal flights had nicer meals than flights from
Chicago to Cleveland? Why or why not?
Solution 13. AirCal flights were cheaper but had worse meals than flights from Chicago to
Cleveland.This is because in the unregulated California market, businesses didn’t
have to provide inefficiently high quality to make up for the extra-high price.
Instead, Californians could get lots of cheap flights with peanuts and soda.

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14. President Jimmy Carter didn’t just deregulate airline prices. He also deregulated
much of the trucking industry as well.Trucks carry almost all of the consumer
goods that you purchase, so almost every time you purchase something, you’re
paying money to a trucking company.
a. Based on what happened in the airline industry after prices were deregulated,
what do you think happened in the trucking industry after deregulation? You
can find some answers here: http://www.econlib.org/Library/Enc/Trucking-
Deregulation.html. For another look that is critical of trucking deregulation,
but comes to basically the same answers, see Michael Belzer, 2000. Sweatshops on
Wheels:Winners and Losers in Trucking Deregulation,Thousand Oaks,CA: SAGE.
b. Who do you think asked Congress and the president to keep price floors for
trucking: consumer groups, retail shops like Walmart, or the trucking companies?
Solution 14. a. After trucking deregulation, the price of trucking services fell:Truckers earned
less money and it became cheaper to ship goods across country.This saved
consumers a lot of money.
b. The trucking companies probably wanted the price floors:They liked getting
high prices for their trucking services.
15. Suppose you’re doing some history research on shoe production in ancient Rome,
during the reign of the famous Emperor Diocletian.Your records tell you how
many shoes were produced each year in the Roman Empire, but it doesn’t tell
you the price of shoes.You find a document stating that in the year 301, Emperor
Diocletian issued an “edict on prices,” but you don’t know whether he imposed
price ceilings or price floors—your Latin is a little rusty. However, you can clearly
tell from the documents that the number of shoes actually sold in markets fell
dramatically, and that both potential shoe sellers and potential shoe buyers were un-
happy with the edict.With the information given, can you tell whether Diocletian
imposed a ceiling or a floor? If so, which is it? (Yes, there really was an edict of
Diocletian, and Wikipedia has excellent coverage of ancient Roman history.)
Solution 15. You can’t tell with the information given. Both price ceilings and price floors
reduce the quantity of goods traded in markets. (Yes, a price floor creates a surplus
but in real life those goods don’t really get made after businesses realize they can’t
sell all the extra shoes.) But, in fact, Diocletian’s edict was a price ceiling: He made
it illegal to charge more than a certain price for various goods, specifically including
shoes. It really did hurt the quantity of trade in the Roman Empire, at a time when
the empire was already facing major political troubles.
16. In the market depicted in the figure, there is either a price ceiling or a price floor—
surprisingly, it doesn’t matter which one it is:Whether it’s an $80 price floor or a
$30 price ceiling, the chart looks the same.

Price Supply

$80

A B

30

Demand

100 200 Quantity

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 S-10 • C H A P T E R 8 • Price Ceilings and Floors

In the chart, there’s a rectangle and a triangle. One represents the value lost from the
“deals that don’t get made” and one represents the value lost from “the deals that do
get made.”Which is which?
Solution 16. Triangle B represents value lost from the “deals that don’t get made.” Rectangle A
represents the value lost in the “deals that do get made”: the waiting in line by con-
sumers if it’s a price ceiling, or the wasteful searching (e.g., advertising, marketing)
by suppliers if it’s a price floor.
17. We noted that in the 1970s price floors on airline tickets caused wasteful increases
in the quality of airline trips. Does the minimum wage cause wasteful increases
in the quality of workers? If so, how? In other words, how are minimum-wage
workers like airplane trips?
Solution 17. When workers cannot compete to obtain a job by offering to work at a lower
wage they will compete in other ways, such as by searching longer or by investing
more in skills. Similarly, firms who must pay a minimum wage will try harder to
sort workers so they can hire only the most skilled workers.Although it is good
to have skills it is possible to invest too much in skills (just as it is possible to have
a wastefully high quality of airline meal). If a minimum wage job at McDonald’s
paid $25 an hour, for example, McDonald’s might hire only workers who spoke
two or more languages.That’s nice, but it’s not the most productive use of a talented
workforce.

Challenges
1. If a government decided to impose price controls on gasoline, what could it do to
avoid the time wasted waiting in lines? There is surely more than one solution to
this problem.
Bettmann/Corbis

Solution 1. One method is to make it pointless to wait in line by restricting the quantity of
gasoline that any individual can consume. During World War II, for example, the
United States Office of Price Administration (OPA) limited every person in the
United States to a certain amount of coffee, sugar, shoes, and gasoline (as well as
many other goods). To purchase gasoline a driver had to certify that they needed
gasoline and that they owned no more than five tires. (All tires in excess of five per
driver were confiscated by the government, because of rubber shortages). Most cars
were limited to 3–4 gallons of gasoline a week.To buy gasoline the driver had to
present their ration book and a stamp for every gallon of gasoline that they wanted
to purchase.The ration books limited time wasted in lines although the rationing
system did require greater administrative expenses.

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2. In New York City, some apartments are under strict rent control, while others are
not.This is a theme in many novels and movies about New York, including Bonfire
of the Vanities and When Harry Met Sally. One predictable side effect of rent control
is the creation of a black market. Let’s think about whether it’s a good idea to allow
this black market to exist.
a. Harry is lucky enough to get a rent-controlled apartment for $300 per month.
The market rent on such an apartment is $3,000 per month. Harry himself
values the apartment at $2,000 per month, and he’d be quite happy with a
regular, $2,000 per month New York apartment. If he stays in the apartment,
how much consumer surplus does he enjoy?
b. If he illegally subleases his apartment to Sally on the black market for $2,500 per
month and instead rents a $2,000 apartment, is he better off or worse off than if
he obeyed the law?
Solution 2. a. $1,700 per month
b. He is better off if he subleases the apartment: He can move into a regular $2,000
per month apartment plus have $500 in spending money left over.This kind of
resale is very common in rent-controlled markets. It was made famous in the
Tom Wolfe novel Bonfire of the Vanities.
3. Let’s measure consumer surplus if the government imposes price controls and
goods end up being randomly allocated among those consumers willing to pay the
controlled price. If the demand and supply curves are as in the figure, then:
a. What is consumer surplus under the price control?
b. What would consumer surplus be if the quantity supplied were 1,000 but the
goods were allocated to the highest-value users?
Price
$110

100

Supply

Controlled
10
price
Demand
1,000 4,000 Quantity

Solution 3. a. If each consumer with value between $110 and $10 stands an equal chance of
getting the good, then on average each of the 1,000 units sold will be valued at
$60.Thus, consumer surplus under random allocation will be ($60 2 $10) 3
1,000 5 $50,000.
b. If there were no price control (but the quantity supplied was still 1,000), the
buyers with the highest valued uses would outbid the other buyers and total
consumer surplus would be the area under the demand curve and above the
price up to the quantity supplied—this has an area of 1/2 3 ($110 2 $100) 3
1,000 1 ($100 2 $10) 3 1,000 5 $95,000.

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 S-12 • C H A P T E R 8 • Price Ceilings and Floors

4. 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 alloca-
tion of antibiotics across these two uses?
Solution 4. Although antibiotics are often overused (for more on this see Chapter 10), if some-
one does have a life-threatening infection, they can usually get all the antibiotics
they need by outbidding other potential users of antibiotics who have less-valued
uses.A price control on antibiotics would create a shortage. If antibiotics were
allocated efficiently, the quantity supplied would go only to those with life-threat-
ening infections, the highest valued users. But it is also possible, and perhaps likely,
that under price controls the antibiotics would not be allocated efficiently.Without
prices, there would no longer be a signal nor an incentive to deliver antibiotics to
the users with the highest demands. Just as oil can be misallocated between warm
California and cold New Jersey, a price control on antibiotics would probably lead
to a tragic misallocation of antibiotics between high- and low-valued users.
5. In a command economy, such as the old Soviet Union, there were no prices for
almost all goods. Instead, goods were allocated by a “central planner.” Suppose that a
good like oil becomes more scarce.What problems would a central planner face in
reallocating oil to maximize consumer plus producer surplus?
Solution 5. This is a big question that goes to the heart of why a market economy is more
efficient than a centrally planned economy.All of the features of prices that we
have discussed are important, particularly the fact that a price signals information
and provides an incentive to use that information in a socially beneficial way. If oil
becomes scarce, the central planner would like (this is a big assumption!) to allocate
the remaining oil to the most highly valued uses—but how are those uses to be
discovered without prices? To allocate oil correctly, the central planner would need
to know every use of oil, the substitutes for oil in every use, the substitutes for the
substitutes, and so forth. Even collecting all the relevant information would be
impossible and by the time the information was collected, it would be irrelevant!
Remember that when the Department of Energy tried to allocate just one good,
oil, to its most highly valued uses, it did not allocate enough to oil rigs! What
would happen if a central planner had to allocate every good? Hayek’s “The Use of
Knowledge in Society” and Ludwig von Mises’s “Economic Calculation in the
Socialist Commonwealth,” both easily available on the web, are relevant. Of course,
this chapter and Chapter 7 are highly relevant, as well!
6. Labor unions are some of the strongest proponents of the minimum wage.Yet in
2008, the median full-time union member earned $886 per week, an average of
over $22 per hour (http://www.bls.gov/news.release/union2.nr0.htm).Therefore,
a rise in the minimum wage doesn’t directly raise the wage of many union workers.
So why do unions support minimum wage laws? Surely, there’s more than one
reason why this is so, but let’s see if economic theory can shed some light on the
subject.
a. Skilled and unskilled labor are substitutes: For example, imagine that you can
hire four low-skilled workers to move dirt with shovels at $5 an hour, or you
can hire one skilled worker at $24 an hour to move the same amount of dirt
with a skid loader. Using the tools developed in Chapter 4, what will happen
to the demand for skilled labor if the price of unskilled labor increases to $6.50
per hour?

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b. If the minimum wage rises, will that increase or decrease the demand for the
average union worker’s labor? Why?
c. Now, let’s put the pieces together:Why might high-wage labor unions support
an increase in the minimum wage?
Solution 6. a. At a wage of $5, it is cheaper to hire 4 low-skilled workers than to hire one
skilled worker. However, if the wage is $6.50, then 4 low-skilled workers would
cost $26, making the skilled worker cheaper.This increase in the wage of
low-skilled workers will reduce the demand for this type of work.
b. I f the minimum wage rises, that will increase the demand for the average union
worker’s labor, because the competition (unskilled labor) is getting priced out of
the market.
c. Unions might support a rise in the minimum wage because it makes high-wage
union labor more attractive than lower-wage labor.

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