c hapter 6 price ceilings and price floors © 2002 south-western

CChapter 6hapter 6

Price Ceilings and Price Floors

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Government Intervention in Markets

• Price Ceilings

• Price Floors

• Parity Pricing

• Target Prices

• Crop Limitation Programs

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EXHIBIT 1 PRODUCTION POSSIBILITIES CURVE FOR CIVILIAN AND DEFENSE GOODS

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Exhibit 1: Production Exhibit 1: Production Possibilities Curve for Civilian Possibilities Curve for Civilian

and Defense Goodsand Defense Goods

The production possibilities curve in Exhibit 1 provides information on:

• The production possibilities curve shows the possible combination of civilian and defense goods that could be produced.

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Exhibit 1: Production Exhibit 1: Production Possibilities Curve for Civilian Possibilities Curve for Civilian

and Defense Goodsand Defense Goods

When there is a national security crisis, the number of civilian goods produced:

• The production of civilian goods declines as more defense goods are produced.

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EXHIBIT 2 THE FISH MARKET BEFORE AND AFTER THE DRAFT

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

In Exhibit 2, the community’s predraft and postdraft demand for fish does not change.

• Demand for fish doesn’t change just because there’s a national security problem.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

In Exhibit 2, the community’s predraft and postdraft demand for fish does not change.

• Note that the demand curves before and after the supply curve has shifted are identical.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

After the draft, the quantity of fish supplied:

• With fishermen being drafted and fewer boats in the water, the supply of fish declines and the supply curve shifts to the left.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

Postdraft, the equilibrium price of fish:

• The equilibrium price of fish increases from $4 to $10 after the draft.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

After the draft, the quantity of fish bought and sold:

• The quantity of fish bought and sold declines from 10,000 to 7,000 fish.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

The greater burden of the increased price for fish is felt by:

• The poor.

• The rich.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

The greater burden of the increased price for fish is felt by:

• The poor.

• The rich.

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Exhibit 2: The Market Exhibit 2: The Market Before and After the DraftBefore and After the Draft

The greater burden of the increased price for fish is felt by:

• The increase in the price of fish makes it unthinkable for the poor to purchase fish, while the rich hardly notice the increase and continue to buy fish. e rich.

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Price CeilingPrice Ceiling

Price Ceiling:

• A maximum price set by government below the market-generated equilibrium price.

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EXHIBIT 3 SETTING A $4 PRICE CEILING IN THE FISH MARKET

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Exhibit 3: Setting a $4 Exhibit 3: Setting a $4 Price Ceiling in the Price Ceiling in the

Fish MarketFish Market

In Exhibit 3, when a $4 price ceiling is set, the market for fish:

• When the price ceiling is set at $4, the quantity of fish demanded increases from 7,000 to 10,000.

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Exhibit 3: Setting a $4 Exhibit 3: Setting a $4 Price Ceiling in the Price Ceiling in the

Fish MarketFish Market

In Exhibit 3, when a $4 price ceiling is set, the market for fish:

• Based on the post-draft supply curve, the quantity of fish supplied falls from 7,000 to 4,000.

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Exhibit 3: Setting a $4 Exhibit 3: Setting a $4 Price Ceiling in the Price Ceiling in the

Fish MarketFish Market

In Exhibit 3, when a $4 price ceiling is set, the market for fish:

• Based on the post-draft supply curve, there is a shortage -- an unsatisfied excess demand -- of 6,000 fish.

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Exhibit 3: Setting a $4 Exhibit 3: Setting a $4 Price Ceiling in the Price Ceiling in the

Fish MarketFish Market

Allocate a shortage of goods:

• One method is through the use of ration coupons.

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Exhibit 3: Setting a $4 Exhibit 3: Setting a $4 Price Ceiling in the Price Ceiling in the

Fish MarketFish Market

Allocate a shortage of goods:

• Ration coupons are issued by the government, entitling the holder to purchase a specific quantity of a good at or below the price ceiling.

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Exhibit 3: Setting a $4 Exhibit 3: Setting a $4 Price Ceiling in the Price Ceiling in the

Fish MarketFish Market

Allocate a shortage of goods:

• Ration coupons may be issued based on schemes such as:

• First come, first served.

• Lottery.

• Household size.

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Price Ceiling and Price Ceiling and HousingHousing

Rent control is a government-set price ceiling on rent.

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Price Ceiling and Price Ceiling and HousingHousing

Arguments against rent control:

• It dampens landlords’ incentives to properly maintain their existing rental units.

• It discourages many people from investing in new construction.

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Price FloorsPrice Floors

Price floor:

• A minimum price set by government above the market-generated equilibrium price.

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EXHIBIT 4 EFFECT OF NEW TECHNOLOGY ON THE FISH MARKET

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Exhibit 4: Effect of New Exhibit 4: Effect of New Technology on the Fish Technology on the Fish

MarketMarket

When a new technology is adopted, the supply curve in the fish market:

• The supply curve shifts the the right.

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Exhibit 4: Effect of New Exhibit 4: Effect of New Technology on the Fish Technology on the Fish

MarketMarket

After adopting the new technology, total revenue for the fisherman:

• Total revenue decreases.

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Exhibit 4: Effect of New Exhibit 4: Effect of New Technology on the Fish Technology on the Fish

MarketMarket

After adopting the new technology, total revenue for the fisherman:

• Prior to adopting the new technology, 10,000 fish were sold at an equilibrium price of $4 each, for

a total revenue of $40,000.

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Exhibit 4: Effect of New Exhibit 4: Effect of New Technology on the Fish Technology on the Fish

MarketMarket

After adopting the new technology, total revenue for the fisherman:

• After adopting the new technology, 12,000 fish are sold at an equilibrium price of $2 each, for a total revenue of $24,000.

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EXHIBIT 5 SETTING A $4 PRICE FLOOR IN THE FISH MARKET

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Exhibit 5: Setting a $4 Exhibit 5: Setting a $4 Price Floor in the Fish Price Floor in the Fish

MarketMarketIn Exhibit 5, when a $4 price floor is set, the market for fish:

• The quantity of fish supplied increases from 12,000 to 15,000.

• The quantity of fish demanded declines from 12,000 to 10,000. • A surplus, or excess supply, of 5,000 fish is created.

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Exhibit 5: Setting a $4 Exhibit 5: Setting a $4 Price Floor in the Fish Price Floor in the Fish

MarketMarketThe excess supply of fish can be dealt with:

• The decision to support a price floor is a societal matter.

• If the community represented by the government wants to support the fishermen through a price floor, then the government will buy the excess supply.

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EXHIBIT 6 GROWTH OF U.S. AGRICULTURAL PRODUCTIVITY THROUGHOUT U.S. HISTORY

* Precise data are not available.

Source: James Zelner and R.M. Lamm, “Agriculture’s Vital Role for Us All,” Food—From Farm to Table, 1982 Yearbook of Agriculture, Department of Agriculture, Washington, D.C., p. 3.

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Exhibit 6: Growth of US Exhibit 6: Growth of US Agricultural Productivity Agricultural Productivity Throughout US HistoryThroughout US History

Agricultural productivity has increased in the US because:

• Changes in the dominant energy source technology used on farms.

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Exhibit 6: Growth of US Exhibit 6: Growth of US Agricultural Productivity Agricultural Productivity Throughout US HistoryThroughout US History

Agricultural productivity has increased in the US because:

• Advances in modern chemistry to produce fertilizers, insecticides, crop ripeners and food preservatives.

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EXHIBIT 7 NUMBER AND SIZE OF U.S. FARMS: 1945–95

Source: Public Policy and the Changing Structure of American Agriculture, Congressional Budge Office, The Congress of the United States, Washington, D.C., September 1978, p. 2; Agricultural Statistics, 1995–1996, United States Department of Agriculture, Washington, D.C., 1996.

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Exhibit 7: Number and Size Exhibit 7: Number and Size of US Farms: 1945-1995of US Farms: 1945-1995

Since 1945, the average size of US farms:

• The average size of US farms has steadily increased, from 195 acres in 1945 to 496 acres in 1995.

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Exhibit 7: Number and Size Exhibit 7: Number and Size of US Farms: 1945-1995of US Farms: 1945-1995

The number of farms in the US:

• The number of farms has declined from about 6 million in 1945 to about 2 million by 1995.

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EXHIBIT 8 INDEXES OF TOTAL FARM OUTPUT: 1940–96 (1982 = 100)

Source: Historical Statistics of the United States: Colonial Times to 1970: Part 1, Bicentennial Edition, Bureau of the Census, U.S. Department of Commerce, Series K, Washington, D.C., pp. 414–29, 498–99; Economic Report of the President, 2000, Washington, D.C., p. 416.

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Exhibit 8: Indexes of Total Exhibit 8: Indexes of Total Farm Output: 1940-93 Farm Output: 1940-93

(1982 = 100)(1982 = 100)

Total farm output in the US between 1940 and 1993 almost:

• Fell by one-half.

• Doubled.

• Tripled.

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Exhibit 8: Indexes of Total Exhibit 8: Indexes of Total Farm Output: 1940-93 Farm Output: 1940-93

(1982 = 100)(1982 = 100)

Total farm output in the US between 1940 and 1993 almost:

•Fell by one-half.

•Doubled.

• Tripled.

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EXHIBIT 9 EFFECT OF NEW TECHNOLOGY IN FARMING

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Exhibit 9: Effect of New Exhibit 9: Effect of New Technology In FarmingTechnology In Farming

As new energy source technologies and modern chemistry increase productivity and shift the supply curve to the right, price:

• Price declines with each shift of the supply curve to the right.

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Parity PricingParity Pricing

Parity Pricing:

• Parity pricing describes one criteria used to determine the level at which a price floor should be set.

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Parity PricingParity Pricing

Parity Pricing:

• It asks for equality between the prices that farmers have to pay for the goods they buy, and the prices they get for the goods they sell.

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Parity PricingParity Pricing

Parity Pricing:

• Parity pricing was adopted by the government in 1933 when Congress passed the Agricultural

Adjustment Act.

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EXHIBIT 10SHOES AND CORN: SHIFTS IN DEMANDAND SUPPLY: 1914–64

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Exhibit 10: Shoes and Corn: Exhibit 10: Shoes and Corn: Shifts in Demand and Shifts in Demand and

Supply: 1914-64Supply: 1914-64

In Exhibit 10, the market for shoes changes from 1914 to 1964:

• While the supply curve for shoes remained unchanged, the demand curve for shoes shifted to the right.

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Exhibit 10: Shoes and Corn: Exhibit 10: Shoes and Corn: Shifts in Demand and Shifts in Demand and

Supply: 1914-64Supply: 1914-64

In Exhibit 10, the market for shoes changes from 1914 to 1964:

• The shift in demand raised the equilibrium price for shoes from $2 to $4.

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Exhibit 10: Shoes and Corn: Exhibit 10: Shoes and Corn: Shifts in Demand and Shifts in Demand and

Supply: 1914-64Supply: 1914-64

The market for corn changed in the same time period:

• The demand curve for corn remained unchanged, while breakthroughs in technology and chemicals shifted the

supply curve for corn to the right.

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Exhibit 10: Shoes and Corn: Exhibit 10: Shoes and Corn: Shifts in Demand and Shifts in Demand and

Supply: 1914-64Supply: 1914-64

The market for corn changed in the same time period:

• The equilibrium price of corn declined from $2 in 1914 to $1 in 1964.

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Exhibit 10: Shoes and Corn: Exhibit 10: Shoes and Corn: Shifts in Demand and Shifts in Demand and

Supply: 1914-64Supply: 1914-64

Parity pricing affects the quantity of corn demanded and supplied:

• Parity pricing, setting a price floor of $4 for corn, restores the exchange parity

between corn and shoes.

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Exhibit 10: Shoes and Corn: Exhibit 10: Shoes and Corn: Shifts in Demand and Shifts in Demand and

Supply: 1914-64Supply: 1914-64

Parity pricing affects the quantity of corn demanded and supplied:

• It also creates an excess supply of 50 million bushels of corn.

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Parity Price RatioParity Price Ratio

Parity Price Ratio:

• The relationship between prices received by farmers and prices paid by farmers.

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EXHIBIT 11 PARITY PRICE RATIOS OF PRICES RECEIVED AND PAID BY FARMERS: 1910–96

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Exhibit 11: Parity Price Exhibit 11: Parity Price Ratios of Prices Received by Ratios of Prices Received by

Farmers and Paid by Farmers and Paid by Farmers: 1910-90Farmers: 1910-90

Changes in the parity price ratio since 1910:

• Except for the period between 1910 and 1920 and during the 1940s, the parity price ratio has been on the decline.

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Commodity Credit Commodity Credit CorporationCorporation

The Commodity Credit Corporation (CCC):

• The CCC is the federal agency established by the Agricultural Adjustment Act of 1933 to absorb the excess farm supply created by parity pricing.

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Commodity Credit Commodity Credit Corporation’s Loans: 1940-Corporation’s Loans: 1940-

9595

Since 1940, the dollar value of loans changed:

• Loans by the CCC have increased substantially, from $308 million in 1940 to over $6 billion in 1995.

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Target PriceTarget Price

Target Price:

• A minimum price level for specific farm goods that the government sets and guarantees.

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Target PriceTarget Price

Target Price:

• A deficiency payment is a government payment to farmers based on the difference between the target price set by government and the market price.

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Target PriceTarget Price

Target Price:

• Congress moved from parity pricing to setting target prices in 1973 with the passage of the Agricultural and Consumer Protection Act.

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EXHIBIT 12 COMPARING THE OUTCOMES OF PARITY AND TARGET PRICING

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Exhibit 13: Comparing the Exhibit 13: Comparing the Outcomes of Parity and Outcomes of Parity and

Target PricingTarget PricingGovernment expenditures on corn differ between the parity system and the target system:

• With parity pricing, the government absorbs the excess corn supply:

• Of 50 million bushels.

• At a subsidy price of $4 per bushel.

• A total subsidy of $200 million.

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Exhibit 13: Comparing the Exhibit 13: Comparing the Outcomes of Parity and Outcomes of Parity and

Target PricingTarget PricingGovernment expenditures on corn differ between the parity system and the target system:

• With target pricing:

• Government guarantees farmers $4 per bushel.

• Consumers purchase all 135 million bushels at the equilibrium price of $1 per bushel.

• Government must make up the difference of $3 per bushel for a total of $405 million.

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Exhibit 13: Comparing the Exhibit 13: Comparing the Outcomes of Parity and Outcomes of Parity and

Target PricingTarget PricingThe crop restriction in target pricing affects the deficiency payment:

• The crop restriction limits the number of acres a farmer can plant.

• Reducing the quantity of corn supplied from 135 million to 100 million bushels.

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Exhibit 13: Comparing the Exhibit 13: Comparing the Outcomes of Parity and Outcomes of Parity and

Target PricingTarget PricingThe crop restriction in target pricing affects the deficiency payment:

• Consumers pay the new equilibrium price of $3 per bushel.

• Government pays the $1 per bushel deficiency payment.

• The total payment is $100 million.