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Modern Principles: Macroeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok

Price Ceilings and

Price Floors

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Price Ceilings• Price controls create price ceilings when

the controlled price is below the market equilibrium price.

• Price ceilings create important consequences:1. Shortages

2. Reductions in product quality.

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Price Ceilings1. Shortages

Quantity

Price ($)

Demand

Supply

Market equilibrium

Controlled price(ceiling)

Quantity demanded at the controlled price

Quantity supplied at the controlled price

Shortage

Results:1.At the controlled price Qs < Qd

2.In 1973, there were shortages ofwool, copper, aluminum, vinyl,denim jeans, paper, …

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Price Ceilings2. Reductions in Product Quality

One way to evade the law is to cut quality. Examples from the 1970s:

• Books were printed on lower quality paper.

• 2" X 4" lumber shrank to 1⅝" X 3⅝"

• New automobiles were painted with fewer coats of paint.

Another way quality can fall is to cut service. Examples from the 1970s

• The full service gasoline state disappeared.*

• Gasoline stations would close whenever the owner wanted a break.

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CHECK YOURSELF

Since World War II, New York City has had rent control, with ceilings placed on the rent that apartment landlords can charge. You are moving to New York City. Will you find a surplus or shortage of apartments?

Some landlords in New York City demand that new tenants pay $500 or $1000 key money: landlords will not hand over a set of apartment keys until this non-refundable payment is made. How does key money fit in our model of the effects of price ceilings?

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CHECK YOURSELF

In rent-controlled New York City, over time, what do you think will happen to the upkeep of the rent-controlled buildings? What is the landlord’s incentive structure?

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Price Floors• A price floor is a minimum price allowed by

law.

• The best example of a price floor is the minimum wage.

• Price floors create an important effect:Surpluses.

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Price Floors1.Surpluses

Minimum wage leads to a surplus of labor (unemployment).

Higher productivity workers are unaffected. Minimum wage leads to ↓ employment among

younger workers• Young people lack skills and experience• More than half of minimum wage workers are

younger than 25 years old. The following diagram shows the effect of a

price floor (minimum wage)

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Price Floors1.Surpluses (cont.)

Wage($)

Quantity

Supply

Demand

Market employment

Minimum wage(floor)

Quantity demanded at minimum wage

Quantity suppliedat minimum wage

Market wage

Labor surplus

(Unemployment)Conclusion: the greater the differencebetween the minimum wage and the market wage, the greater is unemployment

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CHECK YOURSELF

The European Union has a minimum legal price for butter, a price floor, that is often above the market equilibrium price. What do you think has been the result of this?

The U.S. has set a price floor for milk above the equilibrium price. Has this led to shortages or surpluses? How do you think the U.S. government has dealt with this? (Hint: remember the cartons of milk you had in grammar school and high school? What was their price? 

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Takeaway• You should be able to:

draw a diagram showing the price ceiling and correctly labeling the shortage

• You should also understand how price ceilings… Reduce product quality. Cause shortages.

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Takeaway• Using the tools of supply and demand you

should be able to… Explain why a price floor creates a surplus. Label these areas on a diagram.