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Lecture Notes to Accompany Price Controls Experiment

Thus far, we have seen how prices and quantities are determined in a competitive equilibrium market. In any competitive market, there will consumers with a low willingness to pay who will not purchase in the market and suppliers with a high cost who will not sell in the market. In some markets, government might intervene to set prices lower (price ceiling) than the prevailing price so more consumers can purchase, or it might set prices higher (price floor) than the prevailing price so suppliers can sell. In each case, there are trade-offs. With prices set at a level out of equilibrium, the quantity supplied will not equal the quantity demanded and there will be a welfare loss.

Price Ceiling Example

Let's take a closer look at an example. A price ceiling is the maximum price that can be charged. If the price is set below the equilibrium price, the price ceiling is said to be effective (or binding). For example, post World War II, many returning GI's were finding apartment costs in New York to be too high as the demand for apartments grew rapidly. The City of New York instituted rent control by fixing the price of some apartments. While other apartment prices rose in the city as more and more people moved into the city, the rents in rent-controlled apartments stayed fixed.

The following figures illustrate this idea. Figure 1 shows the case before the government fixed rents. Before fixed rents, apartments rented for $600/month and there were 500,000 apartments demanded and 500,000 apartments supplied. Now, suppose the City of New York fixes rent prices at $400. Figure 2 illustrates this. Note how, at this lower price, consumers now demand 700,000 apartments, but, at this lower price, suppliers are only willing to supply 300,000 apartments. So, there will be a shortage of 400,000 apartments in the market at the price of $400.

Figure 1. Market with no price controls.

Figure 2. Market with a price ceiling.

Who benefits and who loses from this policy? Depends. There are 200,000 fewer apartments supplied in the market at this lower price, so both consumers and producers lose out by not renting out apartments. This is the dead-weight loss triangle (DWL) in the graph on the right. Those consumers who manage to find an apartment at this lower price gain because they now pay a price $200 lower than before, so their consumer surplus goes up (CS). Suppliers are the clear losers. They rent out fewer apartments and the producer surplus in the economy goes down (PS).

What would have happened if the City of New York set the rent control price at $800? Nothing. If apartments were renting at a price of $600/month, the policy would have no effect on rental prices. Recall that a price ceiling is the maximum price that can be charged. There is no prohibition to charge price below the price ceiling.

Price Floor Example

Let's take a look at another example of a price control. A price floor is the minimum price that can be charged. If the price is set above the equilibrium price, the price floor is said to be effective (or binding). For example, many agricultural producers are guaranteed a certain price through price support programs. These prices are guaranteed because agricultural farmers do not necessarily know at what price they can sell their product at the time of planting. By assuring a certain price for farmers, this policy assures that there will be sufficient production of agricultural products for the U.S. market.

The following figures illustrate this idea for the corn market. Figure 3 shows the market before the government institutes a price floor. Each bushel of corn trades for $6. The number of bushels of corn demanded is 500,000, and the number of bushels of corn supplied is 500,000. Figure 4 shows the market after the government guarantees a price of $8 per bushel to corn farmers. At this higher price, consumers are only willing to buy 300,000 bushels, but farmers are willing to supply 700,000 bushels. There will be a surplus of 400,000 bushels in the market.

Figure 3. Market with no price controls.

Figure 4. Market with a price floor.

Who wins and who loses with this policy? Clearly consumers lose because they now pay higher prices (CS in the graph on the right is smaller) and there are some consumer that are not going to buy, so there is dead-weight loss (DWL) on the consumer side. On the producer side, there are some producers who will not trade, so there is also some dead-weight loss (DWL) on the producer side. But, for those producers who do sell their product at a higher price, they gain more producer surplus (PS). Note how producer surplus has increased for those who sell.

What would happen if the government set the price floor to $4, instead of $8? Nothing. A price floor is a guaranteed minimum price, and producers and consumers can trade at higher prices. So a price floor set at $4 is not effective.

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