- Rent control and deadweight loss
- Minimum wage and price floors
- How price controls reallocate surplus
- Price ceilings and price floors
- Price and quantity controls
- The effect of government interventions on surplus
- Taxation and dead weight loss
- Example breaking down tax incidence
- Percentage tax on hamburgers
- Taxes and perfectly inelastic demand
- Taxes and perfectly elastic demand
- Economic efficiency
- Lesson Overview: Taxation and Deadweight Loss
- Tax Incidence and Deadweight Loss
How does quantity demanded react to artificial constraints on price?
- Price ceilings prevent a price from rising above a certain level.
- When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result.
- Price floors prevent a price from falling below a certain level.
- When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and excess supply or surpluses will result.
- When government laws regulate prices instead of letting market forces determine prices, it is known as price control.
Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing “too high” or falling “too low”.
Economists can predict how people and firms will react to laws that control price by using the demand and supply model—by the end of this article, you'll be able to make these predictions as well!
Laws enacted by the government to regulate prices are called price controls. Price controls come in two flavors. A price ceiling keeps a price from rising above a certain level—the “ceiling”. A price floor keeps a price from falling below a certain level—the “floor”.
We can use the demand and supply framework to understand price ceilings.
In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite to convince the government to hold down a certain price.
For example, when rents begin to rise rapidly in a city—perhaps due to rising incomes or a change in tastes—renters may press political leaders to pass rent control laws, a price ceiling that usually works by stating that rents can be raised by only a certain maximum percentage each year.
Let's expand this example by thinking about a hypothetical town. Rent was fairly stable. But then, the town was featured on a top-ten-places-to-live article in a popular magazine. Eventually, rent control laws were passed.
We can use the demand and supply model below to understand how the market changed based on this event.
In the beginning, before the article was published, the equilibrium,
, lay at the intersection of supply curve and demand curve , corresponding to an equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing.
When the article inspired more people to want to move to our imaginary town, it shifted the demand curve for rental housing to the right, as shown by the data in the table below and the shift from
to on the graph. In the new market, at the new equilibrium , the price of a rental unit rose to $600 and the equilibrium quantity increased to 17,000 units.
|Price||Original quantity supplied||Original quantity demanded||New quantity demanded|
Now, let's suppose that a bunch of residents were pretty unhappy with paying a 20% increase in their rent. They pressured local politicians to pass a rent control law to keep the price at the original equilibrium of $500 for a typical apartment.
In the demand and supply model above, the horizontal line at the price of $500 shows the legally fixed maximum price set by the rent control law. However, the underlying forces that shifted the demand curve to the right are still there. At the fixed maximum price of $500, the quantity supplied remains at the same 15,000 rental units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing.
The effects of price ceilings are complex and sometimes unexpected. In the case of rent control, the price ceiling doesn't simply benefit renters at the expense of landlords. Rather, some renters—or potential renters—lose their housing as landlords convert apartments to co-ops and condos. There are actually fewer apartments rented out under the price ceiling—15,000 rental units—than would be the case at the market rent of $600—17,000 rental units. And, even when housing remains in the rental market, landlords tend to spend less on maintenance and on essentials like heating, cooling, hot water, and lighting.
The first rule of economics is you do not get something for nothing—everything has an opportunity cost. So if renters get “cheaper” housing than the market requires, they tend to also end up with lower quality housing.
Price ceilings are enacted in an attempt to keep prices low for those who demand the product—be it housing, prescription drugs, or auto insurance. But when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs.
Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate.
A price floor is the lowest legal price that can be paid in a market for goods and services, labor, or financial capital. Perhaps the best-known example of a price floor is the minimum wage, which is based on the normative view that someone working full time ought to be able to afford a basic standard of living. The federal minimum wage at the end of 2014 was $7.25 per hour, which yields an income for a single person slightly higher than the poverty line. As the cost of living rises over time, Congress periodically raises the federal minimum wage.
Price floors are sometimes called price supports because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices, and thus farm incomes, fluctuate—sometimes widely. So even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings.
The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be.
We can take a look at the demand and supply model below to understand better the effects of a government program that creates a price above the equilibrium. This particular model represents the market for wheat in Europe.
In the absence of government intervention, the price of wheat would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium point
, with price and quantity . However, policies to keep prices high for farmers keep the price above what would have been the market equilibrium level—the price shown by the horizontal line in the diagram. The result is a quantity supplied in excess of the quantity demanded— . When quantity supplied exceeds quantity demanded, a surplus exists.
Our example is hypothetical, but the concept plays out in the real world as well. If a government is willing to purchase excess agricultural supply—or to provide payments for others to purchase it—then farmers will benefit from the price floor, but taxpayers and consumers of food will pay the costs.
Do price ceilings and floors change demand or supply?
Neither price ceilings nor price floors cause demand or supply to change. They simply set a price that limits what can be legally charged in the market.
Remember, changes in price do not cause demand or supply to change. Price ceilings and price floors can cause a different choice of quantity demanded along a demand curve, but they do not move the demand curve. Price controls can cause a different choice of quantity supplied along a supply curve, but they do not shift the supply curve.
Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result.
Price floors prevent a price from falling below a certain level. When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and excess supply or surpluses will result.
Price floors and price ceilings often lead to unintended consequences.
- What is the effect of a price ceiling on the quantity demanded of the product? What is the effect of a price ceiling on the quantity supplied? Why exactly does a price ceiling cause a shortage?
- Does a price ceiling change the equilibrium price?
- What would be the impact of imposing a price floor below the equilibrium price?
- Does a price ceiling attempt to make a price higher or lower?
- How does a price ceiling set below the equilibrium level affect quantity demanded and quantity supplied?
- Does a price floor attempt to make a price higher or lower?
- How does a price floor set above the equilibrium level affect quantity demanded and quantity supplied?
Critical thinking questions
- What are the effects of raising the minimum wage? The answer is more complex than the idea that producers lose and workers gain. Who benefits and who loses, and what exactly do they gain and lose? To what extent does the policy change achieve its goals?
- Agricultural price supports result in governments holding large inventories of agricultural products. Why do you think the government cannot simply give the products away to people living in poverty?
- Can you propose a policy that would induce the market to supply more rental housing units?
A low-income country decides to set a price ceiling on bread so it can make sure that bread is affordable to people living in poverty.
The conditions of demand and supply are given in the table below.
What are the equilibrium price and equilibrium quantity before the price ceiling? What will the excess demand or the shortage—quantity demanded minus quantity supplied—be if the price ceiling is set at $2.40? At $2.00? At $3.60?
Want to join the conversation?
- How come the law of demand states that if all is held equal if the price of a good increases demand will decrease, and if the price of a good decreases demand will increase if within this lesson it is stated that 'changes in price do not cause demand or supply to change?' Isn't that a contradiction?(2 votes)
- You confuse demand with quantity demanded.
Quantity demanded is an exact amount of stuff (for example, 15,000 rental units) while demand is the entire curve.
A change in price doesn't change demand, but it does change quantity demanded.(31 votes)
- Does anyone have insights on Critical Thinking Question 2, on why the government cannot simply give away the excess quantity purchases due to a price floor?
I understand that in the absence of this purchase, the quantity supplied will fall and only consumers willing to pay a high price will buy the goods. It seems that giving the goods away should do nothing; I would still buy butter for 2 euro a stick even if I knew I could get it for free if I were poor. After all the intervention doesn't alter supply and demand, only the quantities.
Thanks in advance and thanks to the lecturer too.(2 votes)
- Look at this video: https://www.numerade.com/questions/agricultural-price-supports-result-in-governments-holding-large-inventories-of-agricultural-products/
Essentially, giving away free food to poor people would mean that they wouldn't try and buy the food from the farmers, which would decrease demand in the market for agricultural goods. But this is bad; the point of a price support is for the government to buy enough stuff, increasing demand so the artificial equilibrium price remains above a minimum price. If poor ppl stop buying and demand decreases, the government now has to buy even more to keep prices and demand artificially up.
Another problem is that some poor ppl might get free agricultural goods from the government, then attempt to resell them. This would increase supply in the agricultural market, which again would mean that the government would have to buy even more to keep the artificial equilibrium abov a certain price.
At least, this is how I understood it, everyone feel free to correct me if I'm wrong!(6 votes)
- Who are they beneficial and detrimental to?(2 votes)
- Approach the question from the perspective of the people it potentially influences.
So, consider minimum wage case. If the government increments the minimum wage above the equilibrium, that would result in lower quantity demanded but higher quantity supplied (by saying quantity of course I mean the labor force). What do you think this would mean? Well some people would enjoy their increased wages, but, due to the contraction in quantity demanded brought about by the increased minimum wages, SOME ACTUALLY WOULD LOSE THEIR JOB.
Now approach this problem from the demand (of labor) side. Visualize employers who are now forced to pay more wages to their employees. Obviously, this would indicate decrease in their revenues! Well if the problem further develops and the revenue fails to cover up the increased wages, employers would probably consider firing some of their employees. This would result in decreased production and consequently more decreased revenue, which are not any beneficial to the producer!(5 votes)
- Okay so I am writing my debate case. If price floors were put in place how would this help industry? What are it's benefits?(2 votes)
- Think about it intuitively: if you are selling a good in a market and a law was passed, what are some of the pros and cons of that? On the one hand, you get a higher price, but on the other hand, will buyers still be willing to pay that price? Would that maybe depend on the kind of good you are selling?
I would start brainstorming with those things in mind.(5 votes)
- How does minimum wage legislation leads to unemployment?(2 votes)
- In theory the minimum wage causes the quality demanded to decrease, which leads to a shortage of jobs.
The reason for the quantity demanded decreasing is that employers would be more reluctant to hire workers if they have to pay more. Think of how you would probably buy less apples if their cost increased.(3 votes)
- In the price ceiling example, if someone were to ask how large the shortage is in this scenario, would the answer be 4,000 rental units?(1 vote)
- Yes, as the quantity demanded is 19000 rental units and the quantity supplied is 15000 rental units and 19000-15000=4000.(2 votes)
- What is the solution for the surplus causing by the price floor in the market of labor ( minimum wage )(1 vote)
- Will the outcome be the same when a price floor on the minimum wage is imposed?(1 vote)