Principle 6: Markets work well with competition, the rule of law, information, property rights, and incentives
Principle 7: Public policies create winners and losers. Do the gains outweigh the losses?
Objectives:
Distinguish the disincentive that price provides to buyers and the incentive that it provides to sellers
Explain the distortion that price floors and ceiling have on market incentives of buyers and sellers
Use the concept of incentives to explain potential unintended consequences of price floors and ceilings
Why you want to know this Many well-intentioned policy makers impose rent controls, agricultural subsidies, and other price controls to help certain groups. Often the policies sound like good ideas until you delve into the unintended consequences. In this and later summaries, you will learn what questions to ask when voting on these policies.
Prices above and below the equilibrium price
I know that you remember that the equilibrium price is the price at which the quantity supplied and the quantity demanded are the same. All buyers who are willing and able to pay the price will receive the product; all sellers who are willing and able to supply the product at that price will sell their products. There are no surprises, the market “clears.” There are no leftover products on the shelves and there are no disappointed buyers who can’t get the product at the equilibrium price.
Markets, however, are not always in equilibrium. A non-equilibrium price is a price above or below the equilibrium; at a non-equilibrium price, quantity demanded will not equal quantity supplied. Assume that a price, for some strange reason, is above the equilibrium price. At that higher price, buyers and sellers are out of synch. Remember, price is a disincentive to buyers and an incentive to sellers. At a high price, buyers don’t want to buy much, but sellers want to supply a bunch. A surplus exists. A surplus is an excess quantity supplied compared to the quantity demanded; it can only exist at a price above the equilibrium.
Similarly, a price below the equilibrium will cause a problem. At a lower price, buyers will want to buy more and sellers will want to provide less; a shortage occurs. A shortage is an excess quantity demanded over the quantity supplied; it can only exist at a price below the equilibrium. So, from a consumer’s perspective, it is possible for a price to be too low if that low price means you don’t get the product!
Price floors and surpluses
A minimum price above the equilibrium price (usually set by government) is called a price floor. Be careful because this doesn’t seem to make sense; a floor is above the equilibrium? The price is trying to get down to the equilibrium but the floor won’t let it. Some government (local, state, or national) has decreed that the product can’t be sold below the price floor. If legislators dictate that the price of wheat in the U.S. must be above the world equilibrium price, to assist growers, a surplus will exist. There will be too much American wheat at too high a price. World buyers will turn to Canadian or Argentine or Russian or Ukrainian wheat. At the same time the high price provides an incentive for U.S. farmers to supply more wheat. Buyers buy less wheat and sellers supply more wheat. As long as the price remains above equilibrium, there will be a surplus of U.S. wheat. Because there is a surplus, farmers have to figure out what to do with the excess supply. In some cases, taxpayers buy the excess, store it, transport it to U.S. ports, and ship it to other countries where government officials often commandeer the food and sell it rather than give it away as intended by the U.S. The results of well-intentioned farm price supports are often expenses to U.S. taxpayers and benefits to corrupt government officials in recipient nations.
Price ceilings and shortages
A legal price below the equilibrium is called a price ceiling; it is a maximum price that may be charged. In some cities, citizens have voted to establish rent controls that regulate apartments. The regulated rent is a price ceiling which is below the equilibrium price. At a price below equilibrium, buyers (renters) and sellers (apartment owners) are out of synch. At a lower price, buyers want to rent a bunch, but sellers have little incentive to supply or build new apartment buildings. In fact, there can be unintended consequences. Apartment owners will try to find ways around the lower rent by turning the apartments into condominiums and selling them for a price that is at the equilibrium. Some apartment owners forgo ordinary maintenance and are likely to rent to people who are willing to pay a higher price under the table. The controlled price drives suppliers out of the market and attracts new renters into the market. (People who couldn’t afford to rent their own apartments at the equilibrium price can now consider an apartment.) The only problem is that they can’t find any. At the lower price, sellers supply less and buyers demand more. As long as the price remains below the equilibrium, there will be a shortage of apartments. In an attempt to provide low income housing for the poor, rent controls may have the unintended consequence of increasing homelessness, the problem they are meant to solve.
A warning: This section is likely to cause some confusion. As explained above, we usually think of floors as below us and ceilings as above us. In this section we discussed a floor as a price above the equilibrium and a ceiling as a price below the equilibrium. Think of it this way. A price floor won’t let the price go down to the equilibrium; price is stomping on the floor but can’t get below it. A price ceiling won’t let the price get above it. Price is jumping up and smashing on the ceiling but can’t get above it. Hope that helps. ☺
Bottom Line: Attempts to control prices of any goods or services artificially, when the regulated prices do not reflect the relative scarcity of the product, may result in unintended consequences --- shortages, surpluses and other effects.
Price floor above equilibrium, quantity supplied greater than quantity demanded, surplus
Price ceiling below equilibrium, quantity demanded greater than quantity supplied, shortage
1. Which of the following statements is true?
a. Prices are incentives to sellers.
b. Prices are disincentives to buyers.
c. At the equilibrium price buyers come together to make a transaction.
d. All of the above are true.
2. Which of the following statements is true? A price floor is a price
a. above the equilibrium and causes a surplus.
b. below the equilibrium and causes a surplus.
c. above the equilibrium and causes a shortage.
d. below the equilibrium and causes a shortage.
3. Which of the following statements is true? A price ceiling is a price
a. above the equilibrium and causes a surplus.
b. below the equilibrium and causes a surplus.
c. above the equilibrium and causes a shortage.
d. below the equilibrium and causes a shortage
Some people have suggested imposing a price ceiling on doctor’s salaries. Use the concepts of incentives and supply and demand to explain what effect that might have on the doctor market.
There has been a great deal of controversy about a minimum wage of $15/hour or above. What evidence do you see in shop windows that suggests this might be a moot issue today?