Prinecomi lectureppt ch05

Editor's Notes

• #4: Lecture notes: Unintended consequences: Loosely defined, this means that often, a policy has unforeseen results that are often harmful. Often, in a sort of economic irony, these unintended consequences mean that the policy actually can hurt the very people it was supposed to help!
• #5: Lecture notes: In most cases, and certainly in the United States, price controls are enacted to ease perceived burdens on the population. For example, when President Richard Nixon imposed price controls in 1971, he was trying to protect U.S. citizens from the threat of runaway inflation. To accomplish this objective, he imposed a 90-day wage and price freeze. The price freeze was greeted with cheers from consumers who had grown weary of rapidly escalating prices and believed that they were being gouged by firms. Price ceilings are legally established maximum prices for goods or services. Price floors are legally established minimum prices for goods or services. For example, a number of cities have rent control policies, a price ceiling. The minimum wage law is an example of a price floor.
• #6: Lecture notes: Main point to take home here: Price controls can really mess up markets and cause big problems. The result can be severe shortages and political and economic collapse. Most of the time, the “correct” price will be determined by the market, rather than by the government. Another example: In 301, the Roman government under Emperor Diocletian prescribed the maximum price of beef, grains, clothing, and many other articles. Almost immediately, markets for these goods disappeared.
• #7: Lecture notes: During the height of the war, the Office of Price Administration employed more than 50,000 workers and had a network of volunteer price-watchers who reported violations. As a result of the strict price controls, illegal or black markets, were common. Black markets exist because the sale of certain goods and services are outlawed. Narcotics and prostitution are illegal in most places. Since demand for these goods and services continues to exist despite the efforts to outlaw them, black markets have developed to match buyers and sellers who wish to circumvent the law. (When a good is prohibited to be sold, it is essentially a price ceiling of zero). Price controls generally do not work. They disrupt the normal functioning of the market. As we have seen, the forces of supply and demand ration goods and services by determining the market-clearing price. If the price is dictated by a governmental pronouncement, the market will not properly clear—shortages or surpluses will remain.
• #8: Lecture tip: Click through to reveal the table one row at a time. To see why price ceilings, like rent control, usually do not work as planned, consider the following thought experiment, in which we use the power of our economic imagination to solve a hypothetical problem. Suppose that inflation is rising and the government is concerned that the economically disadvantaged will not be able to afford essential foods. Therefore, the government caps the price of bread by establishing a price ceiling of $0.50 per loaf, about half the typical price of generic white bread today. Does the new policy accomplish its goal? What are its logical repercussions? The law of supply and demand tells us that if price drops, consumer demand will increase. At the same time, the quantity supplied will fall because producers are receiving lower profits for their efforts. The result will be a shortage of bread. Producers can maintain their profits by reducing the size of each loaf they produce. They can also lower the quality of their product by using cheaper ingredients and give up production of fancier varieties. We know that loaves of bread will become harder to find, smaller, and generally of lower quality. However, there is much more to think about. What happens to the opportunity cost of finding bread? Since bread is hard to find, people who want bread will have to wait in line to try to get it. Black markets will also develop to help supply meet demand. As a result, many of those who do not want to wait in line, or who do not succeed in obtaining bread despite waiting in line, will resort to illegal means to obtain it. This means that sellers will go underground, charge higher prices, and deliver customers the bread they want without all the hassle—much like alcoholic beverages under Prohibition in the 1920s.
• #9: Image: Animated Figure 5.1 Lecture notes: In this example, the price ceiling is set above the market price. Since market prices are set by the intersection of supply and demand, as long as the equilibrium price is below the price ceiling, the price ceiling is non-binding. Not all price ceilings are effective. When this is the case, the price ceiling is said to be non-binding. The figure shows a price ceiling of $2 a loaf in a market where $2 is above the equilibrium price. All prices at, or below, $2 (the green-shaded region) are legal. Prices above the price ceiling (the red-shaded area) are illegal. But since the market equilibrium, at point E, occurs in the green region, the price ceiling does not affect the functioning of the market and is, therefore, non-binding. Price is regulated by supply and demand as long as the equilibrium remains below the price ceiling.
• #10: Image: Animated Figure 5.2 Lecture notes: When a price ceiling is below the market price, it creates a binding constraint that prevents supply and demand from clearing the market. In the figure, the price ceiling for bread is set at $0.50 a loaf. Since $0.50 is well below the equilibrium price of $1.00, this creates a binding price ceiling. Notice that at a price of $0.50, QD is greater than QS. Because the quantity demanded is greater than the quantity supplied, a shortage exists. Shortages typically cause prices to rise, but under a price ceiling only the prices in the green-shaded area are legal. Therefore, the market cannot reach the equilibrium point E at $1.00 because it is located above the price ceiling in the red area. Since the price mechanism is no longer able to legally ration the good, a black market for bread arises. The black market price is also set by supply and demand. But notice in the figure that the supply curve, created by the price ceiling, is vertical. Since prices above $0.50 are illegal, sellers are unwilling to produce more than QS. Once the price ceiling is in place, producers cannot legally charge high prices so the incentive to produce along the original supply curve vanishes. Since a shortage still exists, the intersection of the vertical supply curve and the demand curve at point Eb establishes the black market price, Pb at $2.00. The black-market price eliminates the shortage caused by the price ceiling. However, the price ceiling has created two unintended consequences: a smaller supply of bread is produced (QS is less than QE) and a higher price exists for those who are forced to purchase bread on the black market.
• #11: Image: Animated Figure 5.3 Lecture notes: This figure shows the result of a price ceiling that remains in place over a long period of time. Here, the supply curve is more elastic than its short-run counterpart in the previous figure. The supply curve is flatter because producers are able to respond by producing less bread in the long run. As a result, QS is quite small. In the long run, producers will convert the equipment used to make price-controlled breads into equipment used to make similar products that are not price controlled (like bagels and rolls) where they can earn a reasonable return on their investments. Likewise, the demand curve is more elastic in the long run. For instance, as we remove short-term constraints on the consumer, more people will attempt to take advantage of the low price ceiling by adapting their eating habits and changing recipes to use more bread. A flatter demand curve means that consumers are more flexible. As a result, QD expands and becomes much larger than it was in the previous figure. Increased elasticity on the part of both producers and consumers creates the shortage shown in Figure 5.3 larger in the long run than it was in the short run. As a result, products subject to price ceilings become progressively harder to find in the long run. More importantly, the unintended consequences we observed in the short run are magnified.
• #12: Lecture notes: Often, the government intervenes in the market with the goal of helping a specific group. However, we usually see unintended consequences caused by intervention.
• #13: Lecture notes: Shortages are an obvious result. When the price is kept artificially below equilibrium, the Qd is greater and the Qs is smaller. Qd > Qs is the definition of shortage. However, long-term shortages may be even worse. An investor looking to invest in a project may decide to build an apartment complex if he can expect a return of $1,000 per unit per month. However, with rent control, the return on the apartments may only be $500 per unit per month. The investor decides not to build the apartments. This exacerbates the shortage in the long run. Because of rent controls, landlords cannot maximize their profits. They have a diminished incentive to maintain their properties, which become run down. Mumbai, India, provides a chilling example of what can happen when rent controls are applied over an extended period of time. In Mumbai, dilapidated buildings fall down on a regular basis during the monsoon season, often with tragic consequences. Rent-control policies have led to the decay of many apartment buildings and, contrary to the intent of the legislation, fewer housing choices for the poor. The real life history of New York City provides the explanation. A rent-control program began in 1943 in the midst of World War II when the federal government established the Emergency Price Control Act. The act was designed to keep inflation in check during the war when the supply of many essential commodities was under enormous pressure due to fluctuations in the supply and demand of key resources. When the war ended in 1945 and the soldiers started to return, they found a city with rental prices frozen in 1943 dollars. Shortly after the war ended, the federal government discontinued price controls but the state of New York decided to continue rent control. Today there are approximately one million rent-controlled units available in New York City. Rent controls limit the price a landlord can charge a tenant for rent. They also require that the landlord provide certain basic services, but not surprisingly, landlords limit the maintenance that they put into rent-controlled properties. They are required to maintain their properties, but that does not mean that those properties are freshly painted, have new carpets, or the latest amenities. The portmanteau “slumlord” comes from the words “slum” and “landlord.” It describes a landlord who does not maintain the property. With black markets and bribes to gain access to rent-controlled units, low-income people are often kept out due to the inability to pay a high entry fee to gain access to the unit. Landlords may also charge key money, high deposits, furniture rental fees, and other fees to make more revenues.
• #14: Lecture notes: Housing gridlock means that no one is moving, so no new units open up. People will be afraid to move out of a rent-controlled unit since they may not be able to find low prices again. Once the rent-controlled unit is vacated, the property is generally no longer subject to rent control. But many rent-controlled apartments are passed from one generation to the next in order to remain in the program. Rent-control units are already occupied and those who live in them are not likely to give them up. New York City is a prime example of a city where an acute shortage of affordable housing exists. Despite the shortage, rent control does appear to have benefited the many thousands of renters who are lucky enough (question: Is luck the best way to allocate resources?) to live in rent-controlled properties. Because these residents pay well below market price, they often have money leftover for other uses, including vacation housing. Since most of the rent-control apartments are passed from generation to generation, the program no longer remotely serves its original purpose—to help low-income households. The law makes it illegal to occupy a rent-stabilized property if it is not your primary residence, but this does not preclude owning weekend and vacation properties. Clearly, the law was never intended to subsidize fancy vacation homes, but that’s what it does! The attempt to make housing more affordable in the city has, ironically made housing harder to obtain, encouraged the building of upscale properties, as opposed to low-income units, and created a set of behaviors among landlords that is inconsistent with the ideals of justice and affordability that rent control was designed to address.
• #15: Lecture notes: The attempt to make housing more affordable in the city has, ironically, made housing harder to obtain, encouraged the building of upscale properties, as opposed to low-income units, and created a set of behaviors among landlords that is inconsistent with the ideals of justice and affordability that rent control was designed to address. As with any price ceiling, rent control causes a shortage to develop. Because rent-controlled apartments are vacated slowly, the supply of units contracts in the long run, which causes the supply curve to become more elastic. Demand also becomes more elastic in the long run, causing the quantity demanded to rise. The combination of fewer units available to rent and more consumers looking to find rent-controlled units leads to a larger shortage in the long run.
• #16: “Beyond the Book” Slide When rich people live in rent-controlled units, we have to ask if it really is the intended (and best) allocation of that resource. Websites Top bullet: http://www.spoa.com/pages/03rent-control.html http://www.tenant.net/Alerts/Guide/press/nypress/tucker.html Bottom bullet: http://www.cato.org/pubs/pas/pa-274.html From the cato.org site: There can be no doubt that rent control creates housing shortages. For almost 20 years, national vacancy rates have been at or above 7 %, a figure generally considered normal. Cities such as Dallas, Houston, and Phoenix, where development is welcomed, have often had vacancy rates above 15 percent. In these areas of the country, there usually is a surplus of housing rather than a shortage. Landlords commonly advertise "move-in specials," where rent is reduced for the first month or even where they pay moving expenses. In rent-controlled cities, on the other hand, vacancy rates have been uniformly below normal. New York City has not had a vacancy rate above 5% since World War II. (The state's rent-control law, supposedly temporary, would automatically expire if it did.) Before giving up rent control, Boston's vacancy rate was below 4%. (There are no figures as of yet on the rate since rent control ended.) In rent-controlled San Francisco, the vacancy rate is generally around 2%, and in San Jose the rate is 1%, the nation's lowest. Meanwhile, comparable non-rent-controlled cities, such as Chicago, Philadelphia, San Diego, and Seattle, have normal vacancy rates at or above 7%. Rent-controlled cities absorb these shortages in a variety of ways. Higher rates of homelessness are a manifestation of rent control. Another is the traditional difficulty individuals have in finding a new apartment in these cities. An article in New York Magazine entitled, "Finding an Apartment (Seriously)," recommended such techniques as "joining a church or synagogue" as a useful technique in meeting people who might provide good leads on an apartment. Young people who migrate to New York or San Francisco usually must settle for paying $600 a month to share a two-bedroom apartment with several other people or commuting from a nearby city. Crowding is a manifestation of rent control.
• #17: Lecture notes: Price gouging is a phrase that is probably used too often when consumers think they are paying prices that are too high. However, we often willingly purchase goods, even if we think they are too expensive. Think about snacks at the movie theater or airport. Price gouging laws often state, to some effect, that it is illegal for a company to raise prices in the event of a natural disaster. However, in the event of a disaster, the demand for goods such as generators, water, and gas rises, indicating a willingness to pay more. But, due to the law, it is illegal to raise prices. This creates a shortage. Prices act to ration scarce resources. When the demand for generators, or other necessities, is high, the price needs to rise to ensure that the available units are distributed to those who value them the most. More importantly, the ability to charge a higher price provides sellers with an incentive to make more units available. If you limit the ability of the price to change when demand increases, there will be a shortage. Therefore, price gouging legislation means that devastated communities are relying exclusively on the goodwill of others and the slow-moving machinery of government-relief efforts. This closes off a third avenue, entrepreneurial activity, as a means to alleviate their condition.
• #18: Image: Animated Figure 5.5 Lecture notes: Price gouging laws serve as non-binding price ceilings during normal times. However, when a natural disaster strikes, price gouging laws go into effect. Therefore, if the demand for gas generators increases immediately following a disaster, this would raise the market price from $529 before to $900 after. But since $900 is seen as profiting from the disaster, sales at that price point are illegal. This creates a binding price ceiling as long as a state of emergency is in effect. Whenever a price ceiling is binding, it creates a shortage. In this case, the normal functioning of supply and demand to ration the available generators is short-circuited. Since more people demand generators after the disaster than before it, those who do not get to the store in time find empty spaces where the generators used to be. When the emergency is lifted and the market returns to normal, the temporary shortage created by price gouging legislation is eliminated.
• #19: Economics in the Media Lecture tip: The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above. Another story from the textbook: Consider, David Medina from Miami Beach. Immediately after hurricane Wilma hit, he drove to North Carolina, purchased 35 generators, and returned to Florida, where he sold them from the back of his truck. He charged $900 for large generators, which he had purchased for $529.99, and $600 for small generators, which had cost him $279.99. After selling most of the units, Mr. Medina was arrested for price gouging. Under Florida law, his remaining generators were confiscated, and he was fined $1000 for each sale. In addition, he was charged for selling without a business license. While there is no doubt that Mr. Medina intended to capitalize on the misfortune of others, it is hard to prove that he did any harm. The people who bought from him did so voluntarily. In fact, it is hard to see how this differs from buying food and beverages at the concession counter in a movie theater. Movie patrons know they are overcharged but purchase items anyway. Charging exorbitant prices at the movie theater is legal, but charging a higher price after a natural disaster is not.
• #22: Image: Animated Figure 5.7 Lecture notes: The price floor is below the equilibrium price so the price floor is non-binding. Since the actual market price is above the legally established minimum price, the price floor does not prevent the market from reaching point e. Consequently, the price floor has no impact on the functioning of the market. Price is regulated by supply and demand as long as the equilibrium remains above the price floor.
• #23: Image: Animated Figure 5.8 Lecture notes: The price floor is above the equilibrium price so there is downward pressure on the price. Market forces always attempt to restore the equilibrium between supply and demand at point e. At a price floor of $6, we see that QS > QD, so a surplus exists. The surplus is the difference between Qs and QD. Since the price mechanism is no longer effective, sellers find themselves with unwanted inventories of milk. Buyers are unwilling to purchase more than QD since they are not allowed to pay less than the price floor. So, at prices below the price floor, demand becomes vertical at QD. When a price floor is mandated, the typical downward-sloping curve does not exist. As a consequence, the intersection of the vertical demand curve and the supply curve at point eb establishes a lower black market price, Pb, of $2, which eliminates the surplus caused by the price floor. However, the price floor has created two unintended consequences: a smaller demand for milk (QD < QE), and a black market to ration the sale of milk.
• #24: Image: Animated Figure 5.9 Lecture notes: The long run affords consumers a chance to find good substitutes for cow’s milk (soy, rice, and almond milk) at lower prices. This added flexibility on the part of consumers makes the long-run demand for milk more elastic in an unregulated market. As a result, the demand curve depicted here is more elastic than its short-run counterpart, and QD is quite small. What happens to supply? In the long run, producers are more flexible and therefore supply is more elastic. The pool of potential milk producers rises as other closely related businesses are able to retool their operations to supply more milk. The flatter supply curve reflects this flexibility. As a result, QS expands and becomes much larger than it was before. The increased elasticity on the part of both producers and consumers makes the surplus larger in the long run. As a result, products subject to price floors become progressively harder to find in the long run and the unintended consequences we observed in the short run are magnified.
• #26: “Beyond the Book” Slide Lecture notes: This is a bit of a review from the supply and demand chapter. The point is to make a comparison to a labor market.
• #27: “Beyond the Book” Slide Lecture notes: The firm purchases the labor that you are willing to supply at a given wage.
• #28: “Beyond the Book” Slide Lecture notes: The reason I’ve inserted the word “simple” into the supply curve note is that in labor economics courses, we often find that the supply curve for labor is backward-bending. In other words, when wages get very high, people may actually choose to work less hours when the income effect starts to dominate the substitution effect. That is probably beyond the scope of this course.
• #29: Image: Animated Figure 5.10 Lecture notes: A binding minimum wage results in unemployment in the short run; since QS(SR) > QD(SR), minimum wage workers can be skilled or unskilled and experienced or not. The common thread is that these workers, for a variety of reasons, lack better prospects. A minimum wage worker might be a high school student looking for a first job, a senior citizen supplementing retirement income, or an unemployed worker looking to help makes ends meet between higher-paying jobs. Since the market equilibrium wage is below the minimum wage, supply and demand cannot eliminate the surplus of workers. The minimum wage prevents the market from reaching We at E because only the wages in the green-shaded area are legal. Any wages below the minimum wage—$10 in this example—are illegal. The demand for labor is a function of its cost. Because the minimum wage raises the cost of hiring workers, a higher minimum wage will lower the quantity of labor demanded.
• #30: Lecture notes: Proponents of minimum wage are aware of the problems caused by minimum wage. That’s why they also advocate for additional training and education of low-skilled workers.
• #31: Lecture notes: The minimum wage is often non-binding, or below the market wage. Consider two non-binding minimum wage rates ($7 and $9); $7 an hour is far below the equilibrium wage of $10 so supply and demand will determine the wage. Suppose that politicians decide to raise the minimum wage to $9. The new minimum wage of $9 remains below the market wage so there is no impact on the labor market for workers who are willing to accept the minimum wage. Therefore, an increase in the minimum wage from $7 to $9 an hour will not create unemployment. Unemployment only occurs when the minimum wage rises above $10.
• #33: “Beyond the Book” Slide Lecture tip: Click through to show the price controls. It’s sort of difficult at first when we see that the binding floor is HIGH and the ceiling is LOW, since we often think of the ceiling being above us and floor being below us.
• #34: “Beyond the Book” Slide Lecture tips: For this slide, you (the instructor) can actually do a few visual demonstrations. For the binding price ceiling: have students look at the ceiling. No problems. Then, crawl under a desk or table, and ask what happens if the ceiling is too low. Knock on the bottom of the desk—“I want to go higher, but I can’t.” In a binding price ceiling, the price “wants” to rise, but can’t. For the binding price floor, stand on top of the table. Show the students that at this height you’ll have trouble reaching the computer, which is still further down.
• #35: Lecture notes: When the price signal is suppressed through a binding price floor or a binding price ceiling, the market’s ability to maintain order is diminished, surpluses and shortages develop and expand through time, and obtaining goods and services becomes difficult. Consumers and producers face significant challenges navigating a market without a functioning price signal to convey information about relative scarcity.
• #36: Lecture notes: Price ceiling: Under rent control, one example of a price ceiling, the prices of apartments are capped by the local government to keep housing more affordable. Since rent control prevents sellers from increasing their price, the quantity demanded will exceed the quantity supplied. The resulting shortage is problematic. Prices no longer signal relative scarcity. The price ceiling has created two unintended consequences: a smaller supply of the good (Qs) and a higher price for those who turn to the black market. Price floor: The minimum wage is an example of a price floor. If the minimum wage is set above the equilibrium wage, a surplus of the labor will develop. As a result, proponents of the minimum wage are concerned about finding ways to alleviate the resulting surplus of labor, or unemployment.
• #38: Clicker Question Correct answer: C If the price ceiling is non-binding (above the equilibrium), the equilibrium price is already in the legal range, so nothing will change.
• #39: Clicker Question Correct answer: A More trading may illegally take place at higher prices with a black market.
• #40: Clicker Question Correct answer: B With artificially low prices, the landlords may decide it is not worth the time or effort to keep units clean and fixed. The word “slumlord” comes to mind.
• #41: Clicker Question Correct answer: D The minimum wage is a price floor. Unemployment is a labor surplus. Firms demand labor (individuals supply the labor).
• #42: Clicker Question Correct answer: C Qd and Qs will be more responsive to price changes when demand and supply are more elastic. Thus, shortages are made worse because Qd rises faster and Qs falls faster.