Modern Principles Microeconomics 3rd

Edition Cowen Solutions Manual

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8
Price Ceilings and Floors

Learning Objectives
After completing this chapter, students should:
> be able to explain why price ceilings cause shortages, reductions in product quality,
wasteful lineups and other search costs, and deadweight loss (lost gains from trade).
They should also be able illustrate these on a diagram.
> understand how price ceilings cause a misallocation of resources in the controlled
market and potentially other markets throughout the economy.
> be able to explain why price floors cause surpluses, deadweight loss, and wasteful
increases in product quality. They should also be able to illustrate these on a diagram.
> understand why price floors cause a misallocation of resources.

Chapter Outline
Price Ceilings
Shortages
Reductions in Quality
Wasteful Lines and Other Search Costs
Lost Gains from Trade (Deadweight Loss)
Misallocation of Resources
Advanced Material: The Loss from Random Allocation
Misallocation and Production Chaos
The End of Price Ceilings
Rent Controls (Optional Section)
 CHAPTER 8 • Price Ceilings and Floors • 2

Shortages
Reductions in Product Quality
Wasteful Lines, Search Costs, and Lost Gains from Trade
Misallocation of Resources
Rent Regulation
Arguments for Price Controls
Universal Price Controls
Price Floors
Surpluses
Lost Gains from Trade (Deadweight Loss)
Wasteful Increases in Quality
The Misallocation of Resources
Takeaway

Chapter Narrative
This chapter covers price ceilings and price floors in more depth than most textbooks. All
of the major effects of these price controls are covered extensively. The chapter starts
with price ceilings and addresses the universal price control system put in place by the
Nixon administration in August 1971 and then focuses on the effects in the market for oil.
Rent control, a commonly cited price ceiling, is also covered. The chapter then uses the
minimum wage and airline regulation as examples of price floors.

Price Ceilings
A price ceiling is a maximum price allowed by law. We call it a ceiling because prices are
not allowed to rise above it. Price ceilings have five important effects:
1. Shortages
2. Reductions in product quality
3. Wasteful lineups and search costs
4. Lost gains from trade (deadweight loss)
5. Misallocation of resources

Shortages
When price is held below equilibrium, the quantity demanded exceeds the quantity
supplied. The shortage is measured by the difference between these two points. Draw a
simple supply and demand diagram with an effective price ceiling and illustrate the
shortage to the students graphically.
Potential Pitfall: When students graph a price ceiling on their own, they are
often tempted to draw it above the equilibrium price, where it will, at least
initially, have no effect. They seem to think, “Ceilings are high, so I’ll graph
this above equilibrium.” It’s worth stressing to them now that ceilings prevent
 CHAPTER 8 • Price Ceilings and Floors • 3

you from going up. Try drawing one above equilibrium for them to illustrate
that it will not have the same effect.
When there were universal price controls in the 1970s, increased demand in the
building industry made price controls hit that sector particularly hard. There were
shortages of lumber, steel bar, and toilets. By 1973, shortages of wool, copper, aluminum,
vinyl, denim jeans, paper, plastic bottles, and many more things were common.

Reductions in Quality
When price controls cause a shortage, sellers have more customers than goods. Rather
than cutting price, it’s much easier to evade the price control and still sell all of their
goods by cutting quality. During the 1970s, price controls caused books to be printed on
poor-quality paper, 2″ × 4″ lumber shrank to 1⅝″ × 3⅝″, new cars got fewer coats of
paint, and newspaper publishers conserved paper by printing in smaller fonts. Service can
also decrease with price controls. In states where do-it-yourself pumping was legal,
gasoline price controls made full-service stations disappear.

Wasteful Lines and Other Search Costs

A line is a classic sign of a shortage, and lines for gasoline were common during the
1970s. Lines raise the real price that consumers pay for a good—they may pay only $1 in
currency, but they also pay with the value of their wasted time standing in line. Figure 8.2
in the text illustrates the value of wasted time.

Figure 8.2 Price ceilings create wasteful lines

 CHAPTER 8 • Price Ceilings and Floors • 4

Buyers still compete with buyers, but now, since they cannot compete by bidding up
the price, they compete by waiting in line. At the restricted quantity supplied they will
wait in line until the total monetary and waiting cost exceeds the value of the product to
them. This is found by tracing up to the demand curve from the supply curve at the
restricted quantity. The total value of wasted time equals that vertical distance times the
quantity.
Buyers may also resort to bribery to ensure receiving the goods. If the buyers used
bribes, the box in Figure 8.2 would simply be “total paid in bribes” rather than “total
value of wasted time.” In either case, the competition among buyers makes them pay
much more than the controlled price, with the total price higher than the market-clearing
price would have been.
Teaching Tip: Students are likely to think that waiting in line is preferable to
bribing as a rationing mechanism. It’s important to emphasize that no one
gains the lost value of waiting in line. It’s a cost borne without providing
anyone with a benefit. At least with bribes, the money lost by the consumer
ends up with the seller, so it is more efficient than lines.
Teaching Tip: This is also a good time to point out to students that even in the
face of a government-regulated price, the market price still prevailed. The
government may be able to set the sticker price, but that does not paralyze
market forces; it just slows them down.

Lost Gains from Trade (Deadweight Loss)

Price ceilings prevent buyers and sellers from engaging in mutually beneficial exchanges.
Draw a supply and demand diagram like Figure 8.3 in the text and illustrate the triangle
where demanders place a higher value on the goods than the sellers’ cost, but yet, because
the supply curve is above the price ceiling in this range, the buyers and sellers are
prohibited from engaging in these mutually beneficial exchanges. Any price above the
supply curve and below the demand curve could have generated gains from trade. You
can show how much consumer and producer surplus is lost because of the price ceiling.
The deadweight loss is this lost consumer and producer surplus.

Misallocation of Resources
Prices convey information, so when price ceilings are imposed, they distort the market’s
signals and lead to a misallocation of resources. During the cold winter of 1972–1973 the
price controls on oil prevented people with a cold home on the East Coast from bidding
oil away from the West Coast. As a result, pools were heated in California (a relatively
low-value use of oil) while homes remained cold on the other side of the country (a
higher-value use of oil).
You can illustrate the potential loss of value from misallocated resources with a graph
like Figure 8.5 in the text.
Gains from trade are maximized only when goods flow to their highest-value uses.
Yet the portion of the demand curve that is to the left of the quantity supplied is relatively
 CHAPTER 8 • Price Ceilings and Floors • 5

Figure 8.3 A price celling reduces the gains from trade

Figure 8.5 When prices are controlled, resources do not flow to their highest value uses

small compared to the length of the demand curve that is to the right of the quantity supplied
but still above the price-controlled price. With price controls there is no way to guarantee that
the higher-value demanders get the goods. Each time one of these lower-value demanders
gets a good, there is a misallocation of resources. The next subsection gives an example of
how to quantify this misallocation.
 CHAPTER 8 • Price Ceilings and Floors • 6

Advanced Material: The Loss from Random Allocation

If there were no misallocation, then the total consumer surplus with a price ceiling would
be the area between the demand curve and the price up to the quantity supplied. But since
these demanders are not guaranteed to get the product, anyone with a demand above the
price may get the goods. The text suggests showing how much consumer surplus would
be lost if the goods were randomly allocated between high- and low-value uses.
Use a figure like Figure 8.7 in the text with a straight-line demand and supply curve.
If there is an equal probability of satisfying each use between the maximum value of the
demand curve and the value of the controlled price, the average good traded will have a
value halfway between these two levels. With a random allocation of goods, more than
half of the potential consumer surplus at a controlled price is eaten up by misallocation.

Figure 8.7 Shorter consumer surplus falls under random allocation

Misallocation and Production Chaos

Remind students how markets are linked, as shown in Chapter 7. You can then
demonstrate that if there is a shortage because of a price control in one market, that
shortage will cause disruptions in other markets even if those other markets do not have
price controls. In 1973 million-dollar construction projects were delayed because a few
thousand dollars of steel bar was unavailable. Shortages of steel drilling equipment made
it difficult to expand oil production even though the United States was in a severe energy
crisis.
In-Class Exercise: You can illustrate the linked nature of markets with
some simple supply and demand diagrams. Take the example of steel. Start by
placing a price control on steel and illustrate the shortage. Then draw a supply
and demand diagram for automobiles. Ask what happens to the automobile
market as a result of the steel shortage. (Supply decreases and prices rise.)
 CHAPTER 8 • Price Ceilings and Floors • 7

Then ask your students to suggest some other high-demand items, such as
apartments near the university or close to public transport. Illustrate what
happens in these markets. Take the chain as far as you like.

The End of Price Ceilings

The price controls on most goods in the United States were lifted by April 1974. Oil price
controls remained, however, and were eased over the next seven years. When Ronald
Reagan took office as president in 1981, his first act was to eliminate the last of the price
controls on oil. As could be anticipated, at first the monetary price of oil rose (after
accounting for shorter lines, it’s quite possible the total price of oil decreased), but the
shortage disappeared overnight. Within a year prices began to fall as supply increased,
and within a few years prices were below 1979 levels.

Rent Controls (Optional Section)

Since rent control is a price ceiling on housing, everything covered on price ceilings
applies to rent controls.
Note to Instructor: The textbook and this instructor’s manual cover rent
control more quickly than in the previous section. We introduce one new
graph to distinguish between short- and long-run effects. Each subsection on
rent control has some facts from the text and points out any differences
between rent control and other price controls.

Shortages
Rent controls usually begin with a freeze at the current market rate, but they are usually
implemented in cities where rents are increasing quickly, so the price control soon results
in a shortage. Because apartments, unlike oil, are a long-lasting good that cannot be
shipped elsewhere, owners of apartments can do little in the short run except absorb the
lower price. The short-run supply of apartments is rather inelastic.
Over the long run, fewer new apartment buildings are built and older units are turned
into condominiums or commercial space or are torn down to make room for
nonresidential structures. The long-run supply curve is more elastic. You can use a graph
like Figure 8.8 in the text to illustrate the initial short-run shortage and then the longer-
run shortage that develops with rent controls.
 CHAPTER 8 • Price Ceilings and Floors • 8

Figure 8.8 Rent control creates larger shortages in the long run than in the short run

Ontario, Canada, provides a good illustration of how the long-run supply is more
elastic. Rent control was put into place in 1975. In the five years prior to this, about
28,000 new apartments were built per year. In the five years after rent control was put in
place, only about 5,500 apartments per year were built. The drop in construction began
when rent control was being debated but before it was actually implemented. It’s unlikely
the drop was due to other factors such as the state of the economy, because non-rent-
controlled single-family housing starts and apartment starts were similar before the rent
control, yet only apartment construction decreased after the rent control. Single-family
construction remained high. (See Figure 8.9 in text.)

Reductions in Product Quality

Housing quality deteriorates with rent control because there are surplus demanders at the
controlled price. Lawns are mowed less often, and lightbulbs and broken appliances are
replaced more slowly. Low-quality apartments tend to deteriorate even more
dramatically. In Manhattan, 18% of rent-controlled housing is dilapidated or
deteriorating, a much higher percentage than in the uncontrolled sector.
Economist Assar Lindbeck once said, “Rent control is the most effective method we
know for destroying a city, except for bombing it.” However, Vietnam’s foreign minister
said in 1989, “The Americans couldn’t destroy Hanoi [by bombing it], but we have
destroyed our city by very low rents.”

Wasteful Lineups, Search Costs, and Lost Gains from Trade

Finding a rent-controlled apartment often involves costly search rather than lining up.
One method of finding apartments in New York City is to read the obituary columns, find
out where the deceased lived, and try to race to the landlord before someone else does.
 CHAPTER 8 • Price Ceilings and Floors • 9

Because there is a surplus of renters, landlords can easily discriminate against

someone who they believe isn’t an ideal tenant. This can take the form of racial
discrimination. It also may come in the form of a bias against younger families or those
with small children and pets. Because there are surplus renters, landlords can discriminate
without worrying about losing revenue by doing so. In a free market they would have to
pay (lose revenue) to engage in discrimination.
Bribes are illegal but can be disguised. A rent-controlled apartment may come with
$5,000 worth of “furniture” that you must purchase from the landlord. Tie-in sales such
as these are sometimes referred to as “key money.”

Misallocation of Resources
Apartments under rent control do not go to their highest-valued use. Because apartments
can be hard to find, renters often stay in their apartment longer than they want to. They
also stay because they don’t pay the full market value to rent. Often you’ll find an older
couple staying in a large space after their children move out even though they don’t need
the space, while at the same time young families who could use the larger apartment are
stuck in cramped living quarters. Glaeser and Luttmer (2003) found that as many as 21%
of renters in New York City would choose to live in an apartment with more or fewer
rooms if not for rent controls.

Rent Regulation
Rent regulation, unlike rent controls, doesn’t place an absolute ceiling on rents. Rent
regulation usually begins with the current market rate and caps how quickly rents can
increase, for example 5% per year. Rent regulations also typically allow landlords to pass
along some of their costs if they make improvements to the property.

Arguments for Price Controls

If price controls were the only way to help poor people consume oil or housing, then
some people might accept all of the negative consequences and still support price
controls. However, price controls are rarely the only way to help the poor. In general,
policies to increase supply can help the poor and avoid these negative consequences.
Reduced taxes on oil exploration or opening up government land for exploration could
make oil more affordable. Reduced restrictions on new housing construction could
encourage supply and lower housing prices.
The textbook suggests that the best case for price controls is when they are placed on
a monopoly that would otherwise restrict output to raise price. (Monopoly is covered later
in the textbook.) In that case a price control could actually increase production.
People complain when prices increase. Politicians often blame foreigners, specula-
tors, or other scapegoats. Legislating a maximum price seems like an obvious response.
People who have not studied economics rarely make the connection between the price
control and the negative consequences. So ignorance is often a reason people support
price controls. But as the next section shows, it’s also in some people’s self-interest to
keep price controls even though they cause shortages.
 CHAPTER 8 • Price Ceilings and Floors • 10

Universal Price Controls

A command economy like the former Soviet Union has permanent and universal price
controls. Hedrick Smith pointed out that among the facts of life in the Soviet Union was
that scarce items “are not permanently out of stock, but their appearance is unpredictable
. . . Leningrad can be overstocked with cross-country skis and yet go several months
without soap . . . The accepted norm is that the Soviet woman daily spends two hours in
line, seven days a week.” Price controls are often not eliminated even when they would
make most people better off. Shortages benefited the party elite who controlled prices.
Those who controlled scarce goods could gain favors and connections, blat, in exchange
for their goods. They could use blat to obtain things for themselves. Those who benefited
from shortages wanted to keep price controls.
This is true even in the United States, which by world standards has relatively little
corruption. During the 1973–1974 oil crisis the Federal Energy Office controlled the
allocation of oil. Firms began to hire former politicians and bureaucrats to use their
political connections to get more oil for their firms. Today about half of federal politicians
become lobbyists when they leave office.

Price Floors
A price floor, which is a minimum price allowed by law, has four important effects:
1. Surpluses
2. Lost gains from trade (deadweight loss)
3. Wasteful increases in quality
4. Misallocation of resources

Surpluses
An effective minimum wage is above the equilibrium wage. This results in a surplus, or
more specifically when we’re discussing labor, unemployment. This can be shown in a
graph like Figure 8.10 in the text.
Potential Pitfall: It’s useful to remind students that a price floor prevents
prices from going down, just as the floor of the classroom prevents them from
falling into the basement. For a price floor to be effective, it has to be above
the equilibrium. Try drawing a floor below the equilibrium to illustrate that it
won’t have any effect. Many students, when left to graph on their own,
mistakenly think, “Put ceiling high on the graph; put floor low on the graph.”
How much unemployment a minimum wage will cause depends on how high it’s set.
At $100 an hour, a minimum wage would cause a great deal of unemployment. The 2009
federal minimum wage of $7.25 won’t cause much unemployment because more than
95% of hourly employees earn more than that anyway. It can cause unemployment
among the low-skilled, who tend to be young workers. About a quarter of workers
earning the minimum wage are teenagers, and about half are under 25 years old.
 CHAPTER 8 • Price Ceilings and Floors • 11

Figure 8.10 A price war creates a surplus (minimum wages create unemployment)

Lost Gains from Trade (Deadweight Loss)

Draw a supply and demand diagram with a minimum wage like Figure 8.11 in the text to
illustrate the lost gains from trade. At prices below the minimum wage there are
demanders (firms) who would like to hire more labor, and there are workers willing to
supply the labor. Any wage between the demand and supply curve at quantities to the left
of equilibrium could make both demanders and suppliers better off. Illustrate the lost
consumer and producer surplus compared to what an equilibrium wage would generate.
Potential Pitfall: Students are used to thinking of firms constituting the supply
curve and individual consumers constituting the demand curve. In labor
markets this is of course reversed. It’s worth taking a minute to remind them
that the individual workers are supplying the labor and it is the firms that are
demanding workers.
Even though the minimum wage causes unemployment and lost gains from trade, the
effect in the United States is rather small. Even though it is mostly young people who
earn the minimum wage, 93.9% of those under 25 earn more than the minimum wage.
That doesn’t mean that the minimum wage is unimportant. Because Puerto Rico is a
U.S. territory, it was bound to obey the first federal minimum wage when it was passed in
1938 under the Fair Labor Standards Act. The act set the federal minimum at 25 cents an
hour. The average wage in the United States was 62.7 cents an hour in 1938, so the wage
had a relatively small impact here. But in Puerto Rico, where productivity was much
lower, the average wage was only 3 to 4 cents an hour. Because of the minimum wage
many Puerto Rican firms went bankrupt and there was massive unemployment.
Eventually Congress granted Puerto Rico an exemption to the minimum wage law.
 CHAPTER 8 • Price Ceilings and Floors • 12

Figure 8.11 A price floor reduces the gains from trade

France combines a high minimum wage (nearly twice as high as that in the United
States relative to the median wage) with laws that make it difficult to fire workers. Not
coincidentally, about 23% of French workers under 25 years old were unemployed in
2010–2012.

Wasteful Increases in Quality

The Civil Aeronautics Board (CAB) regulated entry, exit, prices, and routes of the airline
industry from 1938 to 1978, and it set price floors above market-clearing levels. The CAB
had authority to regulate only flights between states. Flights within states did not face the
price controls. As a result, a flight between Boston and Washington, D.C., cost nearly
twice as much as a similar-distance flight between San Francisco and Los Angeles.
Figure 8.12 in the text illustrates the CAB price floor above the market-clearing price
and also above the price that is needed to encourage suppliers to sell given the quantity
demanded. At first the box between the regulated price and the sellers’ willingness to
provide flights was windfall profits to the airlines, but because each firm wanted the
customers for itself, the firms began to compete against each other in ways that were not
regulated. They offered fancy meals, nice china, frequent flights, large seats, and so on.
Eventually the windfall profits were eliminated by increases in costs related to wasteful
quality improvements. Unions also demanded a share of the profits, further eroding the
windfall. By 1978, airlines were no longer benefiting from regulation and were willing to
deregulate. Since deregulation, air travel quality has decreased, but so have prices.
 CHAPTER 8 • Price Ceilings and Floors • 13

Figure 8.12 A price floor creates quality waste

Teaching Tip: Most students will be happy to complain about crowded, low-
quality airline travel. Encourage them to. Then point out that many airlines
offer first class and business class seats at higher prices but with better quality.
Ask how many of them are willing to purchase the more expensive tickets.
Few are likely to raise their hands. You can then point out that this is what
made the quality competition wasteful under regulation: the quality of all
flights was more like first class, but so were the prices. Because consumers
prefer the cheaper prices to the higher quality, the quality competition under
regulation was wasteful.

The Misallocation of Resources

The CAB limited the entry of airlines into the industry because more firms would put
pressure on prices to decrease. There were 10 major airlines in 1974 (there were 16 in
1938) despite 79 requests to enter. This was a misallocation of resources because low-
cost airlines like Southwest were kept out of the national market until deregulation in
1978. Southwest didn’t just increase the supply of flights; it also brought new ways of
doing business, like consistently using the same aircraft to lower maintenance costs,
increasing the use of smaller airports like Chicago’s Midway, and hedging its long-term
fuel costs. Deregulation didn’t just lower consumer prices. It also decreased costs and
increased innovation, leading to a better allocation of resources.

Takeaway
Students should understand and be able to explain the five main effects of price ceilings:
shortages, reductions in product quality, wasteful lineups and other search costs, a loss of
gains from trade, and a misallocation of resources. They should also be able to graph a
 CHAPTER 8 • Price Ceilings and Floors • 14

shortage, the wasteful losses from waiting in line, and the lost gains from trade.
Likewise, students should be able to use supply and demand to explain why a price
floor causes a surplus, a deadweight loss, and a wasteful increase in quality, and they
should be able to label these on a graph. They should also be able to explain how price
floors cause resources to be misallocated.

In- and Out-of-Class Activities

If you chose to conduct the equilibrium experiment suggested after Chapter 4, it is very
easy to continue that experiment now. You can use the same materials and setup you did
in the initial equilibrium experiment. (See the end of Chapter 4 in this instructor’s
manual.) To conserve time, you can use the same cards and equilibrium price as before.
You should again get equilibrium outcomes within a couple of rounds.
Now impose a price ceiling anywhere below 10. Buyers and sellers will quickly find
that there is a shortage and that they are unable to make mutually beneficial exchanges. It
should take only a round or two to illustrate this.
Next, impose a price floor, explaining that no trades will be allowed at a price less
than (pick a number above 10). You should immediately get a surplus and again have
dissatisfied potential traders.
The experiment will probably be more useful before you cover the material in Chapter
8; otherwise your students will be inclined to believe they were just illustrating what they
have been taught. If you do the experiment before you cover the material, you can show
how economic theory describes the way they behave even when they don’t know the
economic laws.