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Tutorial 3: Demand and Supply (cont.)

 

The Effects of Government Price Controls

Markets are an institution for bringing together buyers and sellers of goods and services. A market reduces the cost to buyers of trying to locate someone offering what they want for sale, and it reduces the cost to sellers of trying to find someone interested in buying what they are offering for sale.

As an institution, markets are blind to the outcome of the transactions taking place when price and quantity are in equilibrium. It is unconcerned that rental housing is so expensive few families can afford a "decent sized" apartment. It is unconcerned that wages are so low many households must have both parents work at least one job to provide for life's essentials.

It is this perceived "failure" of markets to set "fair" prices and wages that leads to the suggestion that another institution, usually the government, step in and "fix" the problem. Let's explore how the government might attempt to fix such problems and discover the unintended consequences that result.

 

Price Ceilings Top of page.

Suppose the group, Citizens Against Rent Excesses (CARE), successfully convinces the city council in a large metropolitan area that weekly rental charges on apartments are too high. The city council passes an ordinance reducing weekly rents from the current level of $100 to "a more reasonable level" of $75. (See chart below...)

When the government places a legal limit on how high a price may rise, that limit is called a ceiling price. Just as a ceiling defines the maximum height of a room, a ceiling price defines the maximum price that may be charged. To be effective, the ceiling price must be set below the equilibrium price. (Why?)

At first blush, the government's response to the crisis sounds good. With lower rents, more families will be able to afford decent rental housing. A decrease in price, however, has the same effect here as in any market setting. A decrease in price simultaneously causes:

  • an increase in the quantity demanded; and

  • a decrease in the quantity supplied.

This creates a gap between the rising quantity demanded and the falling quantity supplied where none existed before (when the market was in equilibrium). This gap is called a shortage (or excess demand).

 

Graph showing government set price ceiling.

 

At a price ceiling of $75 per week, 250 apartments per year will be demanded, an increase from 200 apartments per year when the market was in equilibrium. The additional 50 apartments are now demanded because the lower price attracted buyers with lower reservation prices to attempt an exchange in the market. The quantity supplied at $75 per week will decrease to 150 apartments per year. The reduction of 50 apartments comes about as landlords convert apartments into condominiums, business office space, or simply fail to provide necessary maintenance. The quantity of apartments demanded now exceeds the quantity supplied by 250 - 150 = 100 apartments per year.

Under normal market conditions, a market price that led to a shortage of 100 apartments per year would result in upward pressure on price. But because the price is set by the government, firm's may not raise price in response to the shortage. So that shortage stubbornly remains.

Unintended consequences

A good that is in short supply will be rationed in some way, there's no way around it. Some mechanism for deciding who gets the good, and who doesn't, will be developed. This rationing could take the form of a long line; those willing to wait long enough may be able to get the good. This is what happens with concert tickets and what did happen when gasoline was in short supply in the mid and late 1970's. Those with lower opportunity costs are more likely to be found in such lines -- whether they are waiting in line for themself or for someone else.

Unique to the problem of a shortage is the existence of a group of buyers with reservation prices higher than the ceiling price. Because buyers in this group are willing to pay more than the ceiling price rather than do without, some mechanism will be devised -- by hook or by crook -- for them to signal their preferences to sellers. Imagine the following conversation between a potential renter and a landlord:

Buyer: "I'd like to rent an apartment."
Seller: "Sorry, they're all rented and I've got a waiting list."

B: "But I'd be willing to pay more than $75 per week."
S: "Sorry, the law forbids me charging more than $75 per week for rent."

B: "OK, then why not charge me an additional fee for, say, the keys to the apartment?"
S: "Say, that would get around the letter of the law. OK, the rent is $75 per week and it will cost you an additional $10 per week for the keys."

B: "It's a deal!"
S: "You just moved to the front of the line!"

The actual price to the next buyer has now risen to $85 per week; $75 for the apartment and $10 for the keys. But because a shortage still exists at $85 per week, the price paid for the keys will keep rising. How high will the price of keys go? Remember that the quantity of apartments supplied is limited by the rental price of $75 per week. So no additional apartments are offered for sale as the price of keys rises. As a result, the supply curve becomes vertical at prices above $75 at a quantity of 150 apartments per year. (See the bold red line in the chart below.) The key price that reduces the shortage to zero is $50; the maximum willingness to pay for the 150th apartment is $125 per week -- $75 per week for the apartment and $50 for the keys!

 

Graph showing unintended consequences of a government set price ceiling.

 

So now the govenment-set price ceiling of $75 per week becomes in fact, a price of $125 per week to those renting the first 150 apartments per year. Because the market price was $100 per week, things have got worse not better for those who could not afford "decent" housing. Furthermore, instead of 200 apartments, now only 150 apartments per year are being rented out. Although unintended, the program eventually causes more problems than it fixes...

 

Price Floors Top of page.

It has become part of the nation's collective "common sense" that the market wage paid unskilled workers is too low if it will not allow a single provider enough annual income to support a family of four. Suppose the government raises the minimum wage that may be paid unskilled workers from the equilibrium wage of $100 per day to $125 per day.

When the government places a legal limit on how low a wage or price may fall, that limit is called a floor price. Just as a floor defines the minimum height of a room, a floor price defines the minimum price that may be charged. To be effective, the floor price must be set above the equilibrium price. (Why?)

At first blush, the government's response to the crisis sounds good. With higher wages, more breadwinners will be able to provide for their family. An increase in wages, however, has the same effect here as in any market setting. An increase in wages simultaneously causes:

  • a decrease in the quantity of labor demanded by firms; and

  • an increase in the quantity of labor supplied.

This creates a gap between the falling quantity demanded and the rising quantity supplied where none existed before (when the market was in equilibrium). This gap is called a surplus.

 

Graph of government-set price floor.

 

At a price floor of $125 per day, 150 workers per day will be demanded, a decrease from 200 workers per day when the market was in equilibrium. The reduction of 50 workers per day comes about because many producers' reservation prices are below $125 per day; as wages rise they decrease the amount of workers demanded and look for substitutes. The quantity of labor supplied at $125 per week will increase from 100 to 150 workers per day. The increase of 50 workers comes about as the wage rate rises above some worker's reservation wages. The quantity of labor supplied now exceeds the quantity demanded by 250 - 150 = 100 workers per day.

Under normal market conditions, a market price that led to a surplus of 100 workers per day would result in downward pressure on price. But because the wage is set by the government, firm's may not lower wages in response to the surplus. So that surplus stubbornly remains.

Unintended consequences

For those 150 workers who kept their job after the minimum wage is set, this increase in wages represents an increase their income -- a clear improvement for them. However, these 100 unemployed workers is made up of 50 workers who used to have a job but do so no longer and 50 workers new to the labor market who cannot find work. That is, unemployment has now increased as a result of the price floor.

 

Now it's time to "do the thing".

Click on the following link to download the Demand and Supply Workbook. Work through Comparative Statics Questions 10 - 13 to improve your understanding of how government price controls alter market price and quantity.

Return here when you have finished.

Need help downloading the Excel file?

 

The next tutorial extends the preceding discussion of supply and demand. In it we explore issues pertaining to a buyer's or seller's responsiveness to a change in price or income.