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Price Controls
Pp 70- 74 of text book
Price Controls
• Price Controls: the setting/controlling of the
prices of goods and services by the government
such that prices are unable to adjust to their
equilibrium level determined by the free markets
• Two types :
– 1. Price floor – setting a legal minimum price
– 2. Price ceiling – setting a legal maximum price
• This results in market disequilibrium either in the
excess demand or excess supply
1. Price Floors
• A price floor is a minimum price set by the
government or organisation for a particular
good. It means that the legal price must not
be lower than the legal minimum price. To be
EFFECTIVE, it is ABOVE the equilibrium price
Price Floors
• Seems to be a contradiction …
• But when the price (Pc) is set by the government at a
level above the equilibrium price, it leads to excess
supply since at Pc, the consumer is willing and able to
buy Qd is less than what the producers are willing and
able to sell of Qs
• Now, if the market were free and left alone, the forces of
D and S would force price down to Pe. But now, this
cannot happen because the price is legally set at Pc
•  by blocking the downward forces of the price, we are
essentially putting a “floor” on the price.
Why would governments impose a
Price Floor?
• 1) Price floors are usually set to protect and
support certain groups of people e.g. income
support for the unstable life of primary goods
producers (e.g. farmers) See graphs on H/O
• or minimum wage for low skilled, low wage
workers  again for the “people and society”,
“equity”, “for whom question”
• 2) To discourage consumption of certain
demerit goods
Impact on Market Outcomes (P and Q)
• With Pf set above Pe, price floor results in larger
quantity supplied of Qs
• It also leads to less quantity demanded by consumers
to Qd
• As the market does not clear, it results in disequilibrium
where there is a excess supply
• If the purpose is 1) (previous slides) governments often
maintain the price floor by buying the excess supply,
causing the demand curve to shift to the right (this can
also be interpreted as decreasing the supply of the food
by shifting it to the left until Pf is maintained)
– The cabbage article
What does the government do with the surplus?
• Several options practiced by the government:
– a. Store it, giving rise to additional cost for storage
above the purchase
– b. Export it other countries which often requires
granting a subsidy to lower the price to make it
competitive in world markets = DUMPING
– c. Use it as aid to help developing countries (ODA,
overseas development assistance) which often poses
problems for the receiving countries
– But if purpose is 2) (ie to deter consumption of
demerit goods), then the excess supply MIGHT
be………………………………..secret discounts OR just
might not produce the extra supply
Analysis of Price Floors on Market Outcomes ….
See H/O
Welfare Impacts and Stakeholder Analysis
• Consumers are worse off
– Smaller quantity (Qd) is purchased at higher price
(Wm)
– Consumer surplus is now area “a” as it loses area “b”
to producers and also lose area “c”
• Producers can be better off
– Less quantity of good is sold at a higher price (Wm) 
possible increase in total revenue (PxQ)
– Producer surplus gains area “b” (from consumers) but
loses “e”
– HOWEVER if govt buys the surplus………….
– Workers Less production from Qe to QD means that
fewer workers likely to be hired, resulting in
unemployment
(continued)
• Government There will be no gains or losses for
the government in terms of budget and spending
HOWEVER if govt buys the surplus…
• Society as a whole… There are too few
resources allocated to the production of the
good, resulting in underproduction relative to
the social optimum (Qe)
-
– Society is worse off due to allocative inefficiency
– Marginal Benefit ? Marginal Cost for the last unit
– WELFARE LOSS of ………….. (decrease in
social/community surplus)
• (but….if it is a DEMERIT good…..)
2. Price Ceilings
• A Price ceiling is a maximum price set by the
government for a particular good or service.
• To be EFFECTIVE, it is below the equilibrium
Price Ceilings
• Seems to be a contradiction again …………………
• It is because, when the price (Pc) is set by the government at a
level below the equilibrium price, it leads to a excess demand
• Now, if the market were free and left alone, the forces of D and
S would force price up to Pe. But now, this cannot happen
because the price is set at Pc
•  by blocking the upward forces of the price, we are essentially
putting a “ceiling” on the price.
Why would governments impose a
Price Ceiling?
• Price ceilings are usually set to make certain
goods/services considered to be necessities
more affordable to low income earners  for
the “people and society” and “equity”, to
change the answer to “for whom” question
• e.g. Rent controls and Food price controls
Especially during………………………………..
EXAMPLE:
• What is rent ?
Rent Controls
– Factor of payment to the resource Land. Price you pay for
borrowing a house, apartment, office space, land, etc.
• Rent controls consist of a maximum legal rent on
housing, which is below the market determined level
of rent
• It is undertaken in various cities or parts of cities
around the world to make housing more affordable to
low income earners
– Department of Housing and Urban Planning
– e.g. apartments in university districts  to assist students
to find affordable places to live
– e.g. social housing in UK
Food Price Controls
• Food tends to have a high price volatility (e.g. typhoon
hits and supply decreases)
• To make food more affordable to low income earners
especially during times when food prices are rapidly
increasing, government imposes food price controls
• Other primary goods as well e.g. post-war Japan on oil
and fossil fuel; etc.
• It is also used as means to control inflation (rise in cost
of goods and services and cost of living) in developing
countries such as Vietnam and Venezuala
Analysis of Price Ceiling on Market Outcomes (P, Q)
• By imposing a lower price of Pc  lower quantity is
supplied, while larger quantity is demanded (by
definition of D and S) than the market equilibrium Qe
• As price does not allow markets to clear, this creates
a disequilibrium where there is a excess demand
(Qd > Qs)
Mathematics and Quantitative Analysis
• Need find the Qs and Qd at the Pc through
substituting Pc into the D and S equations
• Apply the area formula for to calculate the
shortage, changes in consumer surplus, producer
surplus, and welfare loss (do new sheet)
Welfare Impacts and Stakeholder Analysis
• Consumers-Partly better off and partly worse off
– Consumer surplus gain area “c” from producers and
lose area “b”
– Some consumers who are able to buy and access the
good at lower price are better off while some remain
unsatisfied as there is not enough goods for all
• Producers
– Producers are worse off
– Smaller quantity of good is sold at a lower price 
less total revenue (PxQ)
– Producer surplus lose “c” (to consumers) and “d”
(continued)
• Workers
– Less production from Qe to Qs means that some
workers may be fired, resulting in higher
unemployment
• Government
– There will be no gains or losses for the
government in terms of budget and spending
– Could gain more political popularity by supporting
the consumers who are better off with the price
ceiling
• Society as a whole…
Consequences for the Society as a Whole
• The lower than equilibrium price results in
smaller quantity supplied than the amount
determined by the free market (Qe)
– There are too few resources allocated (and wasted)
to the production of the good, resulting in
underproduction relative the social optimum (Qe)
– Society is worse off due to allocative inefficiency
• This is indicated with a decrease in
social/community surplus of the area “c + d”
which represent the “welfare” or “dead weight”
loss
Other Consequences
• Non-price rationing
– Before, the price mechanism determined the rationing (what, how and
for whom) the good is produced and distributed
– Now, with the shortage, the question is how will the Qs be distributed
among the buyers?
– Non-price rationing which can be…
• Waiting in line and the first come first served ….
QUEUES
• Distribution of coupons
• Favoritism where sellers sell it to their preferred
customers
•
The case of Burma, Vietnam and other former or current command economies…
• Introduction to PARALLEL (underground or black or informal)
markets
• Overall………………………….
Allocative Efficiency and Pareto Optimality
• Allocative efficiency or Pareto Optimality refers to
producing the combination of the goods mostly wanted by
society. It is achieved when the economy allocates its
resources so that no one can become better off (in terms of
increasing benefits and utility) without someone else
becoming worse off.
• In other words, it best answers the very purpose and
definition of economics and exemplifies an equilibrium
• It is THE allocation of scarce resources that “best” and
“maximally” satisfies the unlimited wants…it is the “best”
and “optimal” choice and decision made for the society
given their scarce resources
• And the finding above shows that free or perfectly
competitive markets (under their many assumptions)
achieves Allocative Efficiency and Pareto Optimality
Allocative Inefficiency for both Max.
and Min. Prices
• Allocative inefficiency is also indicated because
MB > MC at the point of production
• The benefit consumers receive from the last unit
of the good they buy is greater than the marginal
cost of producing it
• Therefore, the society is not getting enough of
the good, as there is an underallocation of
resources to its production. The society would
have been better off if MORE of the good was
produced
FAO and World Food Price Index
(see H/O)
• World food price index:
• The FAO (Food and Agriculture Organization of the United
Nations) calculates the World Food Price Index which is a
measure of the monthly change in international prices of a
basket of food commodities. It consists of the average of
five commodity group price indices, weighted with the
average export shares of each of the groups for 2002-2004.
• Monthly release dates for 2014: 09 January, 06 February,
06 March, 03 April, 08 May, 05 June, 03 July, 07 August, 11
September, 09 October, 06 November, 04 December.
A little bit more to the story of Price
Floors depending on the case…
• END HERE
Case Study 1: Price Floors for Agricultural Products
• Farmers’ income in many countries resulting from
the sale of their products in free markets are
often unstable and too low
• The reasons were evident from the unstable and
volatile agricultural prices due to low elasticities
of demand and supply and the frequent supply
shocks i.e. natural disasters, even global warming,
unusual high production (“bumper crop”)
• Let’s take a look at some of the evidence…
Role of Price Floors
• One method governments use to support
farmers’ income is to set price floors with the
objective to raise the price above the
equilibrium price
• These price floors (minimum price) are also
called price supports
Welfare Analysis and Stakeholder Analysis
• Consumers
– Consumers are worse off as they pay a higher
price for smaller quantity of goods
• Producers
– Producers are better off as they receive a higher
price and produce a larger quantity
– Moreover, as the government buys the surplus,
their revenue increases further
(continued)
• Workers
– Workers are likely to gain as employment
increases with the increase in production
• Government
– Government incurs a cost through buying the
excess supply resulting in less budget for other
activities
– Further cost of storing or subsidizing the exports
• Stakeholders in other countries …
Consequences for the Society as a Whole
• As price floor is imposed, consumer surplus falls (to area a)
and the producers surplus increases (to areas b to f)
• The social surplus therefore gained the area “f” after the
price floor is imposed
• But as the government spending of the excess demand is
paid using the tax money (from the taxpayers and the
society), the total government spending of “Pf x (Qs – Qd)”
is a loss to society
• The society therefore has a gain of “f” and a loss of the
rectangle area Pf x (Qs – Qd), and as a whole the society
had a net loss (dead weight loss) of the green shaded area
as shown below…
(continued)
• The welfare or deadweight loss represents allocative
inefficiency caused overallocation of resources to the
production of the good (Qs > Qe)
• At the point of production Qs and Pf, MB < MC and the
society would be better off if less of the good were
produced
• Moreover, the DWL (with the above equilibrium P and
Q) signifies the protection of inefficient firms in the
industry
– Firms with high cost of production do not face the
competition from other low cost efficient producers
– They do not have strong incentives to become more
efficient and less likely go out of business
Case Study 2: Minimum Wage for Low Income
and Low Skilled Workers
• Many countries have minimum wage laws that determine
the minimum price of the labor (wage rate) the employers
(firms must) pay
• The objective is to protect by guaranteeing an adequate
income to low income earners who tend to be unskilled (for
“equity” and “fair society”)
• To graphically illustrate this, we now have a slight twist of
perspectives
– Demand (consumer) = now by firms who would like to employ
workers
– Supply = individuals or workers willing to supply work
–  we are now in the factor of production/resource market
also known as the Labor Market! (not the usual product
market). But the same idea and analysis prevail
Impact on the Labour Market Outcomes
(W and Q)
• The minimum wage (Wm) lies above the equilibrium
wage (We)
• The quantity of labor supplied increases and the
quantity of labor demanded decreases in comparison
to the market equilibrium
•  we have a surplus of labor of (Qs – Qd)
• In other words we have an increase in unemployment
either because
– Decrease in Qd and/or increase in Qs of labor
• We thereby have a misallocation (overallocation) of
labor as a factor of production/resource
Welfare and Stakeholder Analysis
• Firms
– Firms (producers, companies, employers of labor) are
worse off as they face higher costs of production
• Workers
– Workers (employees, suppliers of labor) are mixed as
some gain as they receive higher wage but some lose
as they cannot find a job
– The minimum wage creates an additional
unemployed workers of Qs – Qe
(continued)
• Consumers
– Consumers are worse off as increase in labor costs leads to
leftward shift of supply causing higher price of the product
and lower quantities produced
• Government
– No gain as no government budget is used
• Others
– Could lead to illegal employment i.e. illegal immigrants
willing to work below the minimum wage rates
• Society as a whole…
Welfare Analysis: Society as a whole…
• After the imposition of the minimum wage, employer
surplus (demanders and consumers of labor) is reduce
to area “a” while worker surplus (suppliers of labor)
because areas “d + b”
• The social surplus has decreased by “c + e” (the
welfare and dead weight loss) with the minimum
wage
• The welfare loss arises because there is an
overallocation of labor resources relative to the social
optimum (Qd < Qe)  Allocative Inefficiency
(continued)
• Wage rates (like prices) no longer act as signal and
incentive of the worker and firms to determine the
optional allocation of labor
• Firms that rely heavily on unskilled workers are more
likely to be affected with increase in unemployment
• The increase in cost of labor also shifts the supply to
the left, resulting in less quantity of output produced
 results in misallocation of resources in product
markets
In reality… very contentious and
ambiguous results..
• In reality, it is uncertain whether minimum wage leads to
the increase in unemployment as the theory/concepts
predict
• Some empirical (data based) studies have found conflicting
results
– E.g. some firms respond by cutting back other benefits such as
paid holiday and sick leaves to maintain the same employment
of unskilled workers
– E.g. with the insurance of minimum wage, labor productivity
also may increase (workers more motivated) leading to more
output and therefore more employment
• Economics is a social, human behavior science! Must test
the theories and predictions using data and evidence!