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PRICES: FREE, CONTROLLED, AND RELATIVE

Introduction In the last chapter we discussed supply and demand. Mainly, we saw how supply and demand work together to determine prices. In this chapter we discuss prices at greater length. First, we discuss two of the key “jobs” that price performs: (1) rationing

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C HAPTER

resources and goods and (2) transmitting information. Second, we discuss government controls that can be imposed on price. Specifically, we discuss both price ceilings and price floors. Third, we discuss two types of price: absolute (or money) price and relative price.

PRICE To most people, price is a number with a dollar sign in front of it, such as $10. But price is much more. Price performs two major jobs: It acts (1) as a rationing device and (2) as a transmitter of information.

Price as a Rationing Device In Chapter 1 we said that wants (for goods) are unlimited and resources are limited; so scarcity exists. As a result of scarcity, a rationing device is needed to determine who gets what of the available limited resources and goods. (Because resources are limited, goods are also because the production of goods requires resources.) Price serves as a rationing device. It rations resources to the producers who pay the price for the resources. It rations goods to those buyers who pay the price for the goods. The process is as simple as this: Pay the price, and the resources or goods are yours. Don’t pay the price, and they aren’t. Is dollar price a fair rationing device? Doesn’t it discriminate against the poor? After all, the poor have fewer dollars than the rich; so the rich can get more of what they want than can the poor. True, dollar price does discriminate against the poor. But then, as economists know, every rationing device discriminates against someone. To illustrate, suppose for some reason that tomorrow dollar price could not be used as a rationing device. Some rationing device would still be necessary because scarcity would still exist. How would we ration gas at the gasoline station, food in the grocery store, or tickets for the Super Bowl? Let’s consider some alternatives to dollar price as a rationing device.

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Suppose first-come-first-served is the rationing device. For example, suppose only 40,000 Super Bowl tickets are available. If you are one of the first 40,000 in line for a Super Bowl ticket, you get a ticket. If you are person number 40,001 in line, you don’t. Such a method discriminates against those who can’t get in line quickly enough. What about slow walkers or people with disabilities? What about people without cars who can’t drive to where the tickets are distributed? Or suppose brute force is the rationing device. For example, of the 40,000 Super Bowl tickets, you get one as long as you can take it away from someone else. Against whom does this rationing method discriminate? Obviously, it discriminates against the weak and nonaggressive. Or suppose beauty is the rationing device. The more beautiful you are, the better your chances are of getting a Super Bowl ticket. Again, the rationing device discriminates against someone. These and many other alternatives to dollar price could be used as rationing devices. However, each discriminates against someone, and none is clearly superior to dollar price. In addition, if first-come-first-served, brute force, beauty, or another alternative to dollar price is the rationing device, what incentive would the producer of a good have to produce the good? With dollar price as a rationing device, a person produces computers and sells them for money. He then takes the money and buys what he wants. But if the rationing device were, say, brute force, he would not have an incentive to produce. Why produce anything when someone will end up taking it away from you? In short, in a world where dollar price isn’t the rationing device, people are likely to produce much less than in a world where dollar price is the rationing device.

Price as a Transmitter of Information Rationing isn’t the only job that price performs. Price also transmits information. That may sound odd. Consider the following story. On Saturday, Noelle walks into a local grocery store and purchases a half gallon of orange juice for $2.50. On Sunday, unknown to her, a cold spell hits Florida and wipes out half the orange crop. The cold spell ends up shifting the supply curve of oranges leftward, which drives up the price of oranges. Because oranges are a resource in the production of orange juice, the supply curve of orange juice shifts leftward, and the price of orange juice rises. Noelle returns to the grocery store in a week. She notices the half gallon of orange juice she bought last week for $2.50 has now risen to $3.50. Because Noelle has a downwardsloping demand curve for orange juice, she ends up buying less orange juice. She buys only a quart of orange juice instead of a half gallon. What role did price play in Noelle’s decision to cut back on the consumption of orange juice? It played a major role. If the price hadn’t risen, Noelle probably wouldn’t have reduced her purchases and consumption of orange juice. Noelle reacted to the price rise, but what the price rise was “saying”—if we had ears to hear it—is this: “The relative scarcity of a good has risen because of a cold spell in Florida. In other words, the gap between people’s wants for orange juice and the amount of orange juice available to satisfy those wants has widened.” Now we know that Noelle might not have “heard” price saying this. But if you understand economics, this is what price is saying. In other words, price is a transmitter of information that often relates to the relative scarcity of a good. A market system, oddly enough, is powerful enough to have people respond in appropriate ways to the information that price is transmitting, even if the people do not fully hear or understand it. In the case of Noelle, her cutting back on the consumption of orange juice conserves orange juice in the face of an act of nature that ended up making orange juice relatively scarcer. Think of how this reaction is similar to what people who tell you to conserve water want. For example, in California in the summer of 2009, advertisements on television asked people to cut back on their consumption of water because water in the state was in short

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supply. The appropriate behavior to take was to cut back on the consumption of water because it had become relatively scarcer. You were being civic minded if you did so. Well, movements in price can get you to be civic minded too. When the price of orange juice rises due to a cold spell in Florida, you might automatically cut back on your consumption, thus conserving on the consumption of a good that has become relatively more scarce.

SELF-TEST

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(Answers to Self-Test questions are in Answers to Self-Test Questions at the back of the book.) 1. Why is there a need for a rationing device, whether it is price or something else?

3. What kind of information does price often transmit?

2. If price is not the rationing device used, then individuals won’t have as sharp an incentive to produce. Explain.

PRICE CONTROLS A rationing device—such as dollar price—is needed because scarcity exists. But price is not always allowed to be a rationing device. Sometimes price is controlled. There are two types of price controls: price ceilings and price floors. In the discussion of price controls, the word “price” is used in the generic sense. It refers to the price of an apple, for example, the price of labor (a wage), the price of credit (the interest rate), and so on.

Price Ceiling DEFINITION AND EFFECTS A price ceiling is a government-mandated maximum price above which legal trades cannot be made. For example, suppose the government mandates that the maximum price at which good X can be bought and sold is $8. Therefore, $8 is a price ceiling. If $8 is below the equilibrium price of good X, as in Exhibit 1, any or all of the following effects may arise:1 shortages, fewer exchanges, nonprice-rationing devices, buying and selling at prohibited prices, and tiein sales. Shortages At the $12 equi-

librium price in Exhibit 1, the quantity demanded of good X (150) is equal to the quantity supplied (150). At the $8 price ceiling, a shortage exists. The quantity demanded (190) is greater than the quantity supplied (100). When a shortage exists, price and output tend to rise to equilibrium. But when a price ceiling exists, they cannot rise because it is unlawful to trade at the equilibrium price.

Price (dollars)

A Price Ceiling

S

18 Equilibrium Price Price Ceiling

A price ceiling creates a shortage.

12

8 Shortage

D 0

100

150 190

EXHIBIT 1

Quantity of Good X

Equilibrium Quantity

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1. If the price ceiling is above the equilibrium price (say, $8 is the price ceiling and $4 is the equilibrium price), it has no effect. Usually, however, a price ceiling is below the equilibrium price.

The price ceiling is $8 and the equilibrium price is $12. At $12, quantity demanded  quantity supplied. At $8 quantity demanded  quantity supplied. (Recall that price, on the vertical axis, always represents price per unit. Quantity, on the horizontal axis, always holds for a specific time period.)

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are bought and sold. At the price ceiling of $8, 100 units of good X are bought and sold. (Buyers would prefer to buy 190 units, but only 100 are supplied.) We conclude that price ceilings cause fewer exchanges to be made. Notice in Exhibit 1 that the demand curve is above the supply curve for all quantities less than 150 units. (At 150 units, the demand curve and the supply curve intersect and thus share the same point in the two-dimensional space.) Thus the maximum buying price is greater than the minimum selling price for all units less than 150. In particular, the maximum buying price is greater than the minimum selling price for units 101 to 149. For example, buyers might be willing to pay $17 for the 110th unit, and sellers might be willing to sell the 110th unit for $10. But no unit after the 100th unit (not the 110th unit, not the 114th unit, not the 130th unit) will be produced and sold because of the price ceiling. In short, the price ceiling prevents mutually advantageous trades from being realized.

Nonprice-Rationing Devices If the equilibrium price $12 fully rations good X before the price ceiling is imposed, then a lower price of $8 only partly rations this good. In short, price ceilings prevent price from rising to the level sufficient to ration goods fully. But if price is responsible for only part of the rationing, what accounts for the rest? The answer is that some other (nonprice) rationing device, such as first-come-firstserved (FCFS). In Exhibit 1, 100 units of good X will be sold at $8, although buyers are willing to buy 190 units at this price. What happens? Possibly, good X will be sold on an FCFS basis for $8 per unit. In other words, to buy good X, a person must not only pay $8 per unit but also be one of the first people in line. Buying and Selling at a Prohibited Price Buyers and sellers may regularly circumvent a

price ceiling by making their exchanges under the table. For example, some buyers may offer some sellers more than $8 per unit for good X. No doubt, some sellers will accept the offers. But why would some buyers offer more than $8 per unit when they can buy good X for $8? Because not all buyers can buy the amount of good X they want at $8. As Exhibit 1 shows, there is a shortage. Buyers are willing to buy 190 units at $8, but sellers are willing to sell only 100 units. In short, 90 fewer units will be sold than buyers would like to buy. Some buyers will go unsatisfied. How, then, does any one buyer make it more likely that sellers will sell to him or her instead of to someone else? The answer is by offering to pay a higher price. Because it is illegal to pay a higher price, the transaction must be made under the table. Tie-In Sales In Exhibit 1, the maximum price buyers would be willing and able to pay per

Tie-in Sale A sale whereby one good can be purchased only if another good is also purchased.

Price Ceiling A government-mandated maximum price above which legal trades cannot be made.

unit for 100 units of good X is $18. (This is the price on the demand curve at a quantity of 100 units.) The maximum legal price, however, is $8. This difference between the two prices often prompts a tie-in sale, a sale whereby one good can be purchased only if another good is also purchased. For example, if Ralph’s Gas Station sells gasoline to customers only if they buy a car wash, the two goods are linked in a tie-in sale. Suppose that the sellers of good X in Exhibit 1 also sell good Y. They might offer to sell buyers good X at $8 only if the buyers agree to buy good Y at, say, $10. We choose $10 as the price for good Y because $10 is the difference between the maximum per-unit price buyers are willing and able to pay for 100 units of good X ($18) and the maximum legal price ($8). In New York City and other communities with rent-control laws, tie-in sales sometimes result from rent ceilings on apartments. Occasionally, to rent an apartment, an individual must agree to buy the furniture in the apartment. BUYERS AND HIGHER AND LOWER PRICES Do buyers prefer lower to higher prices? “Of course,” you might say, “buyers prefer lower prices to higher prices. What buyer would want to pay a higher price for anything?” Even though price ceilings

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Fewer Exchanges At the equilibrium price of $12 in Exhibit 1, 150 units of good X

C H A P T E R 4 Prices: Free, Controlled, and Relative

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are often lower than equilibrium prices, does it follow that buyers prefer price ceilings to equilibrium prices? Not necessarily. Price ceilings have effects that equilibrium prices do not: shortages, use of first-come-first-served as a rationing device, tie-in sales, and so on. A buyer could prefer to pay a higher price (an equilibrium price) than to pay a lower price and have to deal with the effects of a price ceiling. All we can say for certain is that buyers prefer lower prices to higher prices, ceteris paribus. As in many cases, the ceteris paribus condition makes all the difference.

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PRICE CEILINGS AND FALSE INFORMATION Let’s go back to the orange juice

example in the first section of this chapter. In that example, a cold spell destroys part of the orange crop, leading to a higher price for oranges and orange juice. The market price of orange juice rose from $2.50 to $3.50 a half gallon. Now let’s change things. Suppose that instead of letting the new, lower supply of orange juice and demand for orange juice determine the market price of orange juice at $3.50 a half gallon, government imposes a price ceiling on orange juice at $2.50 a half gallon. Think about what the price ceiling does to prevent price from transmitting information. Specifically, the price ceiling prevents the correct information about the increased relative scarcity of orange juice (due to the cold spell) from getting through to consumers. It’s as if price is a radio signal, and the price ceiling jams the signal. Because of the jammed price signal, consumers mistakenly believe that nothing has changed. As far as they are concerned, they can continue buying orange juice at the same rate of consumption they did earlier. But, of course, they can’t: There are fewer oranges and less orange juice in the world. One way or another, some people are going to have to curtail their consumption of orange juice. The lesson is simple. Price ceilings (that are below the equilibrium price) distort the flow of accurate information to buyers. Buyers get a false view of reality; they then base their buying behavior on incorrect information. Problems follow, and the unintended, unexpected, and undesirable effects of price ceilings soon occur.

thinking like AN ECONOMIST Look for the Unintended Effects Economists think in terms of unintended effects. For example, a price ceiling policy intended to lower prices for the poor may cause shortages, the use of nonprice rationing devices, illegal market transactions, and tie-in sales. When we consider both the price ceiling and its effects, whether the poor have been helped is not so clear. The economist knows that wanting to do good (for others) is not sufficient. Knowing how to do good is important too.

Price Floor: Definition and Effects A price floor is a government-mandated minimum price below which legal trades cannot be made. For example, suppose the government mandates that the minimum price at which good X can be sold is $20. The $20 minimum is a price floor (see Exhibit 3).

Price Floor A government-mandated minimum price below which legal trades cannot be made.

EFFECTS OF A PRICE FLOOR If the price floor is above the equilibrium price, the following two effects arise:2 surpluses and fewer exchanges. Surpluses At the $15 equilibrium price in Exhibit 3, the quantity demanded of good X

(130) is equal to the quantity supplied (130). At the $20 price floor, a surplus exists. The quantity supplied (180) is greater than the quantity demanded (90). Usually, a surplus is temporary. When a surplus exists, price and output tend to fall to equilibrium. But when a price floor exists, they cannot because it is unlawful to trade at the equilibrium price.

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2. If the price floor is below the equilibrium price (say, $20 is the price floor and $25 is the equilibrium price), it has no effects. Usually, however, a price floor is above the equilibrium price.

Not For Sale A Price Ceiling in the Kidney Market

Notice that at $0 price, the quantity supplied of kidneys is 350. These kidneys are from people who donate their kidneys to others, asking nothing in return. They may donate upon their death, or they may donate one of their two kidneys while living. We have drawn the supply curve as upward sloping because we assume that some people who today are unwilling to donate a kidney for $0 might be willing to do so for some positive dollar amount. Specifically, we assume that as the price of a kidney rises, the quantity supplied of kidneys will rise. If there were a free market in kidneys, the price of a kidney would be P1 in Exhibit 2. At this price, 1,000 kidneys would be purchased and sold; that is, 1,000 kidney transplants would occur. Today, there is no free market in kidneys. Buying or selling kidneys is illegal at any dollar amount. In essence, then, there is a price ceiling in

the kidney market, and the ceiling is set at $0. What is the effect of the ceiling? If the demand curve for kidneys and the supply curve of kidneys intersected at $0, there would be neither a surplus nor a shortage of kidneys. But there is evidence that the demand and supply curves do not intersect at $0; they look more like those shown in Exhibit 2. In other words, there is a shortage of kidneys at $0: The quantity supplied of kidneys is 350, and the quantity demanded is 1,500. (Although these are not the actual numbers of kidneys demanded and supplied at $0, they are representative of the current situation in the kidney market.) This chapter has described the possible effects of a price ceiling set below equilibrium price: shortages, nonprice-rationing devices, fewer exchanges, tie-in sales, and buying and selling at prohibited prices (in other words, illegal trades). Are any of these effects occurring in the kidney market? First, there is evidence of a shortage. In almost every country in the world, more people on national lists want a kidney than there are kidneys available. Some of these people die waiting for a transplant.

EXHIBIT 2 The Market for Kidneys We have identified the demand for kidneys as DK and the supply of kidneys as SK. Given the demand for and supply of kidneys, the equilibrium price of a kidney is P1. It does not follow, though, that simply because there is an equilibrium price, people will be allowed to trade at this price. Today, it is unlawful to buy and sell kidneys at any positive price. In short, there is a price ceiling in the kidney market and the ceiling is $0. At the price ceiling, there is a shortage of kidneys, a nonprice rationing device for kidneys (first-come-first-served), fewer kidney transplants (than there would be at P1), and illegal purchases and sales of kidneys.

90

Price of a Kidney SK P2

Equilibrium P1 Price

Price Ceiling

0

DK 350

1,000

1,500

Quantity of Kidneys

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Just as some people want to buy houses, computers, and books, others want to buy kidneys. These people have kidney failure, and they will either die without a new kidney or have to endure years of costly and painful dialysis. This demand for kidneys is shown as DK in Exhibit 2, and the supply of kidneys is shown as SK.

C H A P T E R 4 Prices: Free, Controlled, and Relative

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Second, as just indicated, the nonprice rationing device used in the kidney market is (largely) first-come-first-served. A person who wants a kidney registers on a national waiting list. How long people wait is a function of how far down the list their names appear. Third, there are fewer exchanges; not everyone who needs a kidney gets one. With a price ceiling of $0, only 350 kidneys are supplied. All these kidneys are from people who freely donate their kidneys. If P1 were permitted, some people who are unwilling to supply a kidney (at $0) would be willing to do so. In short, monetary payment would provide the incentive for some people to supply a kidney. At P1, 1,000 kidneys are demanded and supplied; so more people would get kidney transplants when the price of a kidney is P1 (1,000 in all) than when the price of a kidney is $0 (350 in total). More transplants, of course, means fewer people die waiting for a kidney.

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Fourth, kidneys are bought and sold at prohibited prices. People buy and sell kidneys today; they just do so illegally. People are reported to have paid between $25,000 and $200,000 for a kidney. Some people argue that a free market in kidneys would be wrong. Such a system would place the poor at a disadvantage. Think of it: A rich person who needed a kidney could buy one, but a poor person could not. The rich person would get a second chance at life, whereas the poor person would not. No one enjoys contemplating this stark reality. But consider another stark reality. If it is unlawful to pay someone for a kidney, fewer kidneys will be forthcoming. In other words, the quantity supplied of kidneys is less at $0 than at, say, $20,000. Fewer kidneys supplied means fewer kidney transplants. And fewer kidney transplants means more people will die from kidney failure.

Fewer Exchanges At the equilibrium price in Exhibit 3, 130 units of good X are bought

and sold. At the price floor, 90 units are bought and sold. (Sellers want to sell 180 units, but buyers buy only 90.) Thus price floors cause fewer exchanges to be made. THE MINIMUM WAGE If a price floor is a legislated minimum price below which

trades cannot legally be made, then the minimum wage is a price floor—a governmentmandated minimum price for labor. It affects the market for unskilled labor. In Exhibit 4, we assume the minimum wage is WM and the equilibrium wage is WE . At the equilibrium wage, N1 workers are employed. At the higher minimum wage, N3 workers want to work, but only N2 actually do work. There is a surplus of workers equal to N3  N2 in this unskilled labor market. In addition, fewer workers are working at the minimum wage (N2) than at the equilibrium wage (N1). Overall, the effects of the minimum wage are (1) a surplus of unskilled workers and (2) fewer workers employed. Suppose two economists decide to test the theory that as the minimum wage rises, some Price unskilled workers will lose S (dollars) their jobs. They look at Surplus the number of unskilled Price 20 workers before and after Floor the minimum wage is Equilibrium A price floor raised, and surprisingly Price 15 creates a surplus. they find that the number of unskilled workers is the same. Is this sufficient evidence to conclude that an increase in the minimum D wage does not cause some workers to lose their jobs? 0 Quantity of Good X 180 130 90 The answer to that question depends on Equilibrium Quantity whether the economists

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EXHIBIT 3 A Price Floor The price floor is $20 and the equilibrium price is $15. At $15, quantity demanded  quantity supplied. At $20, quantity supplied  quantity demanded.

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EXHIBIT 4

Effects of the Minimum Wage At a minimum wage of WM an hour, there is a surplus of workers and fewer workers are employed than would be at the equilibrium wage WE .

Wage Rate (dollars) Minimum Wage

WM

Equilibrium Wage

WE

S Surplus

D 0

N2 Number of Workers Employed at Minimum Wage

N1

N3

Number of Unskilled Workers

Number of Workers Who Want to Work at Minimum Wage

Number of Workers Employed at Equilibrium Wage

have adequately tested their theory. Instead of focusing on the number of people who lose their jobs, suppose they look at the number of people who keep their jobs but have their hours reduced as a result of the higher minimum wage. Let’s look at an example. Suppose a local hardware store currently employs David and Francesca to work after school cleaning up and stocking shelves. The owner of the store pays each of them the minimum wage of, say, $7.25 an hour. Then the minimum wage is raised to $8.75 an hour. Will either David or Francesca lose their jobs as a result? Not necessarily. Instead, the owner of the store could reduce the number of hours he employs the two workers. For example, instead of having each of them work 20 hours a week, he might ask each to work only 14 hours a week. Now let’s reconsider our original question: Has the higher minimum wage eliminated jobs? In a way, no. It has, however, reduced the number of hours a person works in a job. (Of course, if we define a job as including both a particular task and a certain number of hours completing that task, then the minimum wage increase has eliminated “part” of the job.) This discussion argues for changing the label on the horizontal axis in Exhibit 4 from “Number of Unskilled Workers” to “Number of Unskilled Labor Hours.”

thinking like AN ECONOMIST Direction Versus Magnitude In economics, some questions relate to direction and some to magnitude. For example, suppose someone asks, “If the demand for labor is downward sloping and the labor market is competitive, how will a minimum wage that is above the equilibrium wage affect employment?” This person is asking a question that relates to the direction of the change in employment. Usually, these types of questions can be answered by applying a theory. Applying the theory of demand, an economist might say, “At higher wages, the quantity demanded of labor, or the employment level, will be lower than at lower wages.” The word “lower” speaks to the directional change in employment. (continued)

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thinking like AN ECONOMIST (continued) Now suppose someone asks, “How much will employment decline?” This question relates to magnitude. Usually, questions that deal with magnitude can be answered only through some kind of empirical (data-collecting and analyzing) work. In other words, we would have to collect employment figures at the equilibrium wage and at the minimum wage and then find the difference.

producers’ surplus, and price floors in terms of a specific example: a price floor on an agricultural foodstuff. Exhibit 5 shows the demand for and supply of an agricultural foodstuff (corn, wheat, soybeans, etc.). If the market is allowed to move to equilibrium, the equilibrium price will be P1, and the equilibrium quantity will be Q1. Consumers’ surplus will equal the area under the demand curve and above the equilibrium price: areas 1  2  3. Producers’ surplus will equal the area under the equilibrium price and above the supply curve: areas 4  5. Total surplus, of course, is the sum of consumers’ surplus and producers’ surplus: areas 1  2  3  4  5. Now suppose that the suppliers of the foodstuff argue for (and receive) a price floor, PF . At this higher price, consumers do not buy as much as they once did. They now buy Q 2, whereas they used to buy Q1. In addition, consumers’ surplus is now only area 1, and producers’ surplus is areas 2  4. Obviously, consumers have been hurt by the increased (government-mandated) price of PF; specifically, they have lost consumers’ surplus equal to areas 2  3. How have suppliers fared? Whereas their producers’ surplus was equal to areas 4  5 at P1, it is now equal to areas 2 Agricultural Price Floors  4. (Area 2, which used to be part of consumers’ surplus, The demand for and supply of an has been transferred to producers and is now part of produc- agricultural foodstuff are shown in ers’ surplus.) Whether producers are better off depends on this exhibit. The equilibrium price is whether area 2 (what they gain from PF ) is larger than area 5 P1; consumers’ surplus (CS) is areas 1  2  3; producers’ surplus is (what they lose from PF ). Visually, we can tell that area 2 is areas 4  5. A price floor of P F larger than area 5; so producers are better off. effectively transfers some of the What is the overall effect of the price floor? Have produc- consumers’ surplus to producers ers gained more than consumers have lost, or have consumers in the form of a gain in producers’ lost more than producers have gained? To answer this ques- surplus. Specifically, at PF, consumers’ tion, we note that consumers lose areas 2  3 in consumers’ surplus; producers gain area 2 in producers’ surplus and lose area 5 in producers’ surplus. So the gains and losses are: Losses to consumers:

areas 2  3

Gains to producers:

area 2

Losses to producers:

area 5

Part of the loss to consumers is offset by the gain to producers (area 2); so net losses amount to areas 3  5. In other words, the total surplus—the sum of consumers’ surplus and producers’ surplus—is lower than it was. Whereas it used to be areas 1  2  3  4  5, it now is areas 1  2  4. The total surplus lost is in areas 3  5. In short, (1) consumers lose, (2) producers gain, and (3) society (which is the sum of consumers and producers) loses. You can think of this example in terms of a pie. Initially, the pie was made up of areas 1  2  3  4  5.

PF

EXHIBIT 5 surplus is area 1 and producers’ surplus is areas 2  4. Consumers are net losers because consumers’ surplus has decreased by areas 2  3. Producers are net gainers because producers’ surplus has increased from areas 4  5 to areas 2  4 and area 2 is larger than area 5. Overall, the economic pie of CS  PS has decreased from areas 1  2  3  4  5 to areas 1  2  4.

S

1 2

Price

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PRICE FLOORS, CHANGES IN CONSUMERS’ AND PRODUCERS’ SURPLUS, AND DEADWEIGHT LOSSES We now turn to a discussion of consumers’ surplus,

3

P1

5

4

D

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Q2

Q1

Quantity

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Deadweight Loss. The loss to society of not producing the competitive, or supply-anddemand-determined, level of output.

This rather large pie registered all the gains of consumers and producers. After the price floor of PF was imposed, the pie shrank to areas 1  2  4; in other words, the pie was smaller by areas 3  5. A loss in total surplus—in our example, areas 3  5—is sometimes called a deadweight loss. This is the loss to society of not producing the competitive, or supply-and-demanddetermined, level of output. In terms of Exhibit 5, it is the loss to society of producing Q2 instead of producing Q1. floor creates a situation in which (1) someone wins and someone loses and (2) the gains for the winner are equal to the losses for the loser (e.g., one person loses $5, and another person wins $5). A quick look at Exhibit 5 tells us that (2) is not true. The losses (for consumers) are not offset by the gains (for producers). A price ceiling ends with a net loss, or deadweight loss, of areas 3  5. Now think of how hard it would have been to identify this deadweight loss without the tools of supply, demand, consumers’ surplus, and producers’ surplus. Economic tools often have the ability to make what is invisible visible.

SELF-TEST 1. Do buyers prefer lower prices to higher prices? 2. “When there are long-lasting shortages, there are long lines of people waiting to buy goods. It follows that the

shortages cause the long lines.” Do you agree or disagree? Explain your answer. 3. Who might argue for a price ceiling? A price floor?

TWO PRICES: ABSOLUTE AND RELATIVE In everyday language, we often use the word “price” without specifying the kind of price. Economists often distinguish the absolute, or money, price of a good from the relative price of a good.

Absolute (Money) Price and Relative Price Absolute (Money) Price The price of a good in money terms.

Relative Price The price of a good in terms of another good.

The absolute (money) price is the price of the good in money terms. For example, the absolute price of a car might be $30,000. The relative price is the price of the good in terms of another good. To illustrate, suppose the absolute price of a car is $30,000 and the absolute price of a computer is $2,000.The relative price of the car—that is, the price of the car in terms of computers—is 15 computers. A person gives up the opportunity to buy 15 computers when buying a car. Relative price of a car (in terms of computers)  

Absolute price of a car Absolute price of a computer $30,000 $2,000

 15

Now let’s compute the relative price of a computer—that is, the price of a computer in terms of a car: Relative price of a computer (in terms of cars) 

Absolute price of a computer

Absolute price of a car $2,000  $30,000 

1 15

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WHAT SOME PEOPLE GET WRONG In closing, some persons argue that a price

The percentage of the U.S. population that is deemed obese today is higher than it was 20 years ago. Obesity is a health problem; so often we hear proposals directed at trying to reduce the obesity rate in the country. One proposal is to place a tax on high-fat, high-calorie so-called junk food. A similar proposal is to place a tax on soda. We now know that a tax placed on one good (but not on another) will change the relative prices of the two goods. Placing a tax on good X, but not on good Y, will make good X relatively more expensive and Y relatively cheaper, prompting consumers to purchase relatively less X and relatively more Y.

PAUL BURNS/SHANNON FAGAN/JUPITER IMAGES

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Will a Soda Tax Reduce Obesity?

Consider a tax placed on soda. We would expect the absolute (money) price of soda to rise. And if the tax is placed only on soda, its relative price will rise too. As soda becomes relatively more expensive, we would expect fewer sodas to be consumed and obesity to decline. Right? Well, fewer sodas might be purchased and consumed, but whether obesity will decline is not so clear. Consider soda and sugared iced tea. Both soda and sugared iced tea are sweet drinks. They might even be substitutes. With this in

mind, suppose the absolute price of a soda is $1 and the absolute price of an iced tea (with sugar) is 50¢. It follows that the relative prices are: 1 soda  2 sugared iced teas 1 sugared iced tea  ½ soda Now let’s place a tax on soda that drives its price up to $2. The new relative prices for soda and iced tea are: 1 soda  4 sugared iced teas 1 sugared iced tea  ¼ soda As a result of the tax on soda, its relative price has risen, but the relative price of sugared iced tea has fallen. We would expect people to consume relatively less soda and relatively more sugared iced tea. Obesity is lessened by ingesting fewer calories, not the same number or more calories. Simply put, the soda tax might reduce the consumption of sodas, but it doesn’t necessarily reduce obesity. The soda tax, although it makes soda relatively more expensive, makes its substitutes (such as sugared iced tea) relatively less expensive and thus makes a rise in the consumption of sugared iced tea likely.

Thus, the relative price of a computer in this example is 1/15 of a car. A person gives up the opportunity to buy 1/15 of a car when buying a computer. Now consider this question: What happens to the relative price of a good if its absolute price rises and nothing else changes? For example, if the absolute price of a car rises from $30,000 to $40,000, what happens to its relative price? Obviously, the relative price rises from 15 computers to 20 computers. In short, if the absolute price of a good rises and nothing else changes, then its relative price rises too.

thinking like AN ECONOMIST Higher Absolute Price Can Sometimes Mean Lower Relative Price Economists know that a good can go up in price at the same time as it becomes relatively cheaper. How can this happen? Suppose the absolute price of a pen is $1, and the absolute price of a pencil is 10¢. The relative price of 1 pen, then, is 10 pencils. (continued)

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PART 1 Economics: The Science of Scarcity

thinking like AN ECONOMIST (continued)

Now let the absolute price of a pen rise to $1.20 at the same time that the absolute price of a pencil rises to 20¢. As a result, the relative price of 1 pen falls to 6 pencils. In other words, the absolute price of pens rises (from $1 to $1.20) at the same time as pens become relatively cheaper (in terms of how many pencils you have to give up to buy a pen). How does this happen? The absolute price of pen went up by 20 percent (from $1 to $1.20) at the same time as the absolute price of pencils doubled (from 10¢ to 20¢). Because the absolute price of a pen went up by less than the absolute price increase of a pencil, the relative price of a pen fell.

Suppose that the equilibrium price of good X is $10 and that the equilibrium price of good Y is $20. The relative price of good X is therefore ½ unit of good Y, and the relative price of good Y is 2 units of good X. 1X  ½Y 1Y  2X

Given these relative prices of X and Y, consumers will buy some combination of the two goods. For example, a given consumer might end up buying 10 units of X each week and 12 units of Y. Now suppose that the government imposes a tax only on the purchase of good X. The tax effectively raises the price the consumer pays for the good from $10 to $15. Because no tax is placed on good Y, its price remains at $20. The tax thus changes the relative prices of the two goods. The after-tax relative prices are: 1X  ¾Y 1Y  1.33X

Comparing the new relative prices with the old relative prices, we recognize that the tax makes X relatively more expensive (going from ½Y to ¾Y) and makes Y relatively cheaper (going from 2X to 1.33X ). In other words, a tax placed only on X ends up making X relatively more expensive and Y relatively cheaper. As a result, we would expect consumers to buy relatively less X and relatively more Y. Think in terms of two familiar goods: Coke and Pepsi. A tax placed on Coke, but not on Pepsi, will induce consumers to buy relatively less Coke and relatively more Pepsi.

SELF-TEST 1. If the absolute (or money) price of good A is $40 and the absolute price of good B is $60, what is the relative price of each good?

2. Someone says, “The price of good X has risen; so good X is more expensive than it used to be.” In what sense is this statement correct? In what sense is this statement either incorrect or misleading?

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Taxes on Specific Goods and Relative Price Changes

“I Thought Price Ceilings Were Good for Consumers”

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STUDENT:

I still don’t quite understand how a price ceiling can hurt consumers. After all, a price ceiling is usually set below the equilibrium price of a good, and everyone knows that consumers prefer lower prices to higher prices. INSTRUCTOR:

The problem is that when a price ceiling is imposed on a good, certain things happen that don’t benefit consumers. Look at it this way: Consumers like the lower price that goes along with the price ceiling, but what they don’t like are some of the effects of the price ceiling. STUDENT:

But it seems to me that if you picked 100 consumers at random and asked them whether they preferred the price of bread to be $1 a loaf as opposed to $2, all 100 consumers would say they prefer the lower price. Because a price ceiling is usually lower than the equilibrium price, doesn’t this example prove that consumers benefit from price ceilings? After all, why would they say they prefer paying $1 than $2 for a loaf of bread if they didn’t see it benefiting them? INSTRUCTOR:

A couple of things could be going on here. First, consumers might intuitively take the question to mean do they prefer the $1 supply-anddemand-determined price to the $2 supply-and-demand-determined price. If this is how they understand the question, then it certainly seems reasonable for them to say they prefer the lower price to the higher price. You might not get the same response from consumers, though, if you asked them this question: Which of the following two options do you prefer? Option A: $2 (equilibrium) price of bread

Option B: $1 (price ceiling) price of bread  shortages of bread  lines of people waiting to buy bread, and so on. STUDENT:

In other words, your point is that consumers prefer lower to higher prices, assuming that nothing else changes but the price of the good. But if lower prices as the result of price ceilings come with shortages and long lines of people waiting to buy bread, then they may not prefer lower to higher prices. INSTRUCTOR:

Yes, that is the point. STUDENT:

A slightly different question: Do you think all consumers know the adverse effects of price ceilings? INSTRUCTOR:

Probably not. In fact, even after government imposes a price ceiling and certain adverse effects set in (shortages, long lines, etc.), consumers may fail to relate the cause to the effects of the price ceiling. In other words, X causes Y, but individuals either don’t understand how (so they don’t connect the two), or they believe that something else—Z—causes Y. POINTS TO REMEMBER

1. Consumers may prefer a lower to higher price, ceteris paribus, but not a lower price with shortages to a higher price without shortages. 2. X may cause Y, but it doesn't necessarily follow that everyone will understand that X causes Y.

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CHAPTER SUMMARY

• As a result of scarcity, a rationing device is needed to determine who gets what of the available limited resources and goods. Price serves as a rationing device. • Price acts as a transmitter of information relating to the change in the relative scarcity of a good. PRICE CEILINGS • A price ceiling is a government-mandated maximum price. If a price ceiling is below the equilibrium price, some or all of the following effects arise: shortages, fewer exchanges, nonpricerationing devices, buying and selling at prohibited prices, and tie-in sales. • Consumers do not necessarily prefer (lower) price ceilings to (higher) equilibrium prices. They may prefer higher prices and

none of the effects of price ceilings to lower prices and some of the effects of price ceilings. All we can say for sure is that consumers prefer lower prices to higher prices, ceteris paribus. PRICE FLOORS • A price floor is a government-mandated minimum price. If a price floor is above the equilibrium price, the following effects arise: surpluses and fewer exchanges. ABSOLUTE PRICE AND RELATIVE PRICE • The absolute price of a good is the price of the good in terms of money. • The relative price of a good is the price of the good in terms of another good.

KEY TERMS AND CONCEPTS Price Ceiling Tie-in Sale

Price Floor Deadweight Loss

Absolute (Money) Price

Relative Price

QUESTIONS AND PROBLEMS 1. “If price were outlawed as the rationing device (used in markets), there would be no need for another rationing device to take its place. We would have reached utopia.” Discuss. 2. What kind of information does price transmit? 3. Should grades in an economics class be “rationed” according to dollar price instead of how well a student does on the exams? If they were and prospective employers learned of this, what effect might this have on the value of your college degree? 4. Think of ticket scalpers at a rock concert, a baseball game, and an opera. Might they exist because the tickets to these events were originally sold for less than the equilibrium price? Why or why not? In what way is a ticket scalper like and unlike your retail grocer, who buys food from a wholesaler and then sells it to you? 5. Many of the proponents of price ceilings argue that government-mandated maximum prices simply reduce producers’ profits and do not affect the quantity supplied of a good on the market. What must the supply curve look like if the price ceiling does not affect the quantity supplied?

6. James lives in a rent-controlled apartment and has for the past few weeks been trying to get the supervisor to fix his shower. What does waiting to get one’s shower fixed have to do with a rent-controlled apartment? 7. Explain why fewer exchanges are made when a disequilibrium price (below equilibrium price) exists than when the equilibrium price exists. 8. Buyers always prefer lower prices to higher prices. Do you agree or disagree with this statement? Explain your answer. 9. What is the difference between a price ceiling and a price floor? What effect is the same for both a price ceiling and a price floor? 10. If the absolute price of good X is $10 and the absolute price of good Y is $14, then what is (a) the relative price of good X in terms of good Y and (b) the relative price of good Y in terms of good X? 11. Give a numerical example that illustrates how a tax placed on the purchase of good X can change the relative price of good X in terms of Y.

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PRICE

C H A P T E R 4 Prices: Free, Controlled, and Relative

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WORKING WITH NUMBERS AND GRAPHS 1. In the diagram, what areas represent the deadweight loss due to the price ceiling (PC )?

P

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PM

S1 1 2

3

PE

5

4 PC

2. In the preceding diagram, what areas represent consumers’ surplus at the equilibrium price of PE ? At PC ? (Keep in mind that the equilibrium quantity is not produced and sold at PC .)

7

8

6 D1

0

Q3

Q1

Q2

Q

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