Chapter 6 Price Ceilings and Price Floors 2005

Chapter 6 Price Ceilings and Price Floors © 2005

Economic Principles Government intervention in markets Price ceilings Price floors Parity pricing Target prices Crop limitation programs © 2005 Gottheil - Principles of Economics, 4 e 2

EXHIBIT 1 PRODUCTION POSSIBILITIES CURVE FOR CIVILIAN AND DEFENSE GOODS 3 © 2005

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. © 2005 Gottheil - Principles of Economics, 4 e 4

Exhibit 1: Production Possibilities Curve for Civilian and 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. © 2005 Gottheil - Principles of Economics, 4 e 5

EXHIBIT 2 THE FISH MARKET BEFORE AND AFTER THE DRAFT 6 © 2005

Exhibit 2: The Market Before 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. © 2005 Gottheil - Principles of Economics, 4 e 7

Exhibit 2: The Market Before 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. © 2005 Gottheil - Principles of Economics, 4 e 8

Exhibit 2: The Market Before 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. © 2005 Gottheil - Principles of Economics, 4 e 9

Exhibit 2: The Market Before and After the Draft Postdraft, the equilibrium price of fish: • The equilibrium price of fish increases from $4 to $10 after the draft. © 2005 Gottheil - Principles of Economics, 4 e 10

Exhibit 2: The Market Before 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. © 2005 Gottheil - Principles of Economics, 4 e 11

Exhibit 2: The Market Before and After the Draft The greater burden of the increased price for fish is felt by: • The poor • The rich © 2005 Gottheil - Principles of Economics, 4 e 12

Exhibit 2: The Market Before and After the Draft The greater burden of the increased price for fish is felt by: • The poor • The rich © 2005 Gottheil - Principles of Economics, 4 e 13

Exhibit 2: The Market Before 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. © 2005 Gottheil - Principles of Economics, 4 e 14

Price Ceiling Price ceiling • A maximum price set by government below the market-generated equilibrium price. © 2005 Gottheil - Principles of Economics, 4 e 15

EXHIBIT 3 SETTING A $4 PRICE CEILING IN THE FISH MARKET 16 © 2005

Exhibit 3: Setting a $4 Price Ceiling in the Fish 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. © 2005 Gottheil - Principles of Economics, 4 e 17

Exhibit 3: Setting a $4 Price Ceiling in the Fish 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. © 2005 Gottheil - Principles of Economics, 4 e 18

Exhibit 3: Setting a $4 Price Ceiling in the Fish Market In Exhibit 3, when a $4 price ceiling is set, the market for fish: • Based on the postdraft supply curve, there is a shortage—an unsatisfied excess demand—of 6, 000 fish. © 2005 Gottheil - Principles of Economics, 4 e 19

Exhibit 3: Setting a $4 Price Ceiling in the Fish Market Allocate a shortage of goods: • One method is through the use of ration coupons. © 2005 Gottheil - Principles of Economics, 4 e 20

Exhibit 3: Setting a $4 Price Ceiling in the Fish 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. © 2005 Gottheil - Principles of Economics, 4 e 21

Exhibit 3: Setting a $4 Price Ceiling in the Fish Market Allocate a shortage of goods: Ration coupons may be issued based on schemes such as: • First come, first served. • Household size. • Lottery. © 2005 Gottheil - Principles of Economics, 4 e 22

Price Ceiling and Housing Rent control is a government-set price ceiling on rent. © 2005 Gottheil - Principles of Economics, 4 e 23

Price Ceiling and Housing Arguments against rent control: • It dampens landlords’ incentives to properly maintain their existing rental units. • It discourages many people from investing in new construction. © 2005 Gottheil - Principles of Economics, 4 e 24

Price Floors Price floor • A minimum price set by government above the market-generated equilibrium price. © 2005 Gottheil - Principles of Economics, 4 e 25

EXHIBIT 4 EFFECT OF NEW TECHNOLOGY ON THE FISH MARKET 26 © 2005

Exhibit 4: Effect of New Technology on the Fish Market When a new technology is adopted, the supply curve in the fish market: • The supply curve shifts the right. © 2005 Gottheil - Principles of Economics, 4 e 27

Exhibit 4: Effect of New Technology on the Fish Market After adopting the new technology, total revenue for the fisherman: • Total revenue decreases. © 2005 Gottheil - Principles of Economics, 4 e 28

Exhibit 4: Effect of New Technology on the Fish Market 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. © 2005 Gottheil - Principles of Economics, 4 e 29

Exhibit 4: Effect of New Technology on the Fish Market 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. © 2005 Gottheil - Principles of Economics, 4 e 30

EXHIBIT 5 SETTING A $4 PRICE FLOOR IN THE FISH MARKET 31 © 2005

Exhibit 5: Setting a $4 Price Floor in the Fish Market In 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. © 2005 Gottheil - Principles of Economics, 4 e 32

Exhibit 5: Setting a $4 Price Floor in the Fish Market The 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. © 2005 Gottheil - Principles of Economics, 4 e 33

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. 34 © 2005

Exhibit 6: Growth of US Agricultural Productivity Throughout U. S. History Agricultural productivity has increased in the U. S. because: • Changes in the dominant energy source technology used on farms. © 2005 Gottheil - Principles of Economics, 4 e 35

Exhibit 6: Growth of US Agricultural Productivity Throughout U. S. History Agricultural productivity has increased in the US because: • Advances in modern chemistry to produce fertilizers, insecticides, crop ripeners and food preservatives. © 2005 Gottheil - Principles of Economics, 4 e 36

EXHIBIT 7 NUMBER AND SIZE OF U. S. FARMS 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. © 2005 Gottheil - Principles of Economics, 4 e 37

Exhibit 7: Number and Size of U. S. Farms Since 1945, the average size of U. S. farms: • The average size of US farms has steadily increased, from 195 acres in 1945 to 496 acres in 1995. © 2005 Gottheil - Principles of Economics, 4 e 38

Exhibit 7: Number and Size of U. S. Farms The number of farms in the U. S. : • The number of farms has declined from about 6 million in 1945 to about 2 million by 1995. © 2005 Gottheil - Principles of Economics, 4 e 39

EXHIBIT 8 INDEXES OF TOTAL FARM OUTPUT: 1950– 99 (1996 = 100) Source: Economic Report of the President, 2003, Washington, D. C. , p. 439. © 2005 Gottheil - Principles of Economics, 4 e 40

Exhibit 8: Indexes of Total Farm Output: 1950 -99 (1996 = 100) Total farm output in the U. S. between 1950 and 1999 almost: • Fell by one-half • Doubled • Tripled © 2005 Gottheil - Principles of Economics, 4 e 41

Exhibit 8: Indexes of Total Farm Output: 1950 -99 (1996 = 100) Total farm output in the U. S. between 1950 and 1999 almost: • Fell by one-half • Doubled • Tripled © 2005 Gottheil - Principles of Economics, 4 e 42

EXHIBIT 9 EFFECT OF NEW TECHNOLOGY IN FARMING 43 © 2005

Exhibit 9: Effect of New Technology 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. © 2005 Gottheil - Principles of Economics, 4 e 44

Parity Pricing Parity pricing • Parity pricing describes one criteria used to determine the level at which a price floor should be set. © 2005 Gottheil - Principles of Economics, 4 e 45

Parity 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. © 2005 Gottheil - Principles of Economics, 4 e 46

Parity Pricing Parity pricing • Parity pricing was adopted by the government in 1933 when Congress passed the Agricultural Adjustment Act. © 2005 Gottheil - Principles of Economics, 4 e 47

EXHIBIT 10 SHOES AND CORN: SHIFTS IN DEMAND SUPPLY: 1914– 2000 48 © 2005

Exhibit 10: Shoes and Corn: Shifts in Demand Supply: 1914 -2000 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. © 2005 Gottheil - Principles of Economics, 4 e 49

Exhibit 10: Shoes and Corn: Shifts in Demand Supply: 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. © 2005 Gottheil - Principles of Economics, 4 e 50

Exhibit 10: Shoes and Corn: Shifts in Demand Supply: 1914 -2000 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. © 2005 Gottheil - Principles of Economics, 4 e 51

Exhibit 10: Shoes and Corn: Shifts in Demand Supply: 1914 -2000 The market for corn changed in the same time period: • The equilibrium price of corn declined from $2 in 1914 to $1 in 1964. © 2005 Gottheil - Principles of Economics, 4 e 52

Exhibit 10: Shoes and Corn: Shifts in Demand Supply: 1914 -2000 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. © 2005 Gottheil - Principles of Economics, 4 e 53

Exhibit 10: Shoes and Corn: Shifts in Demand Supply: 1914 -2000 Parity pricing affects the quantity of corn demanded and supplied: • It also creates an excess supply of 50 million bushels of corn. © 2005 Gottheil - Principles of Economics, 4 e 54

Parity Price Ratio Parity price ratio • The relationship between prices received by farmers and prices paid by farmers. © 2005 Gottheil - Principles of Economics, 4 e 55

EXHIBIT 11 PARITY PRICE RATIOS OF PRICES RECEIVED AND PAID BY FARMERS: 1910– 2000 56 © 2005

Exhibit 11: Parity Price Ratios of Prices Received by Farmers and Paid by Farmers: 1910 -2000 Changes in the parity price ratio since 1910: • Except for the period between 1910 and 1920 and during the 1940 s, the parity price ratio has been on the decline. © 2005 Gottheil - Principles of Economics, 4 e 57

Commodity Credit Corporation 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. © 2005 Gottheil - Principles of Economics, 4 e 58

Commodity Credit Corporation’s Loans: Public Law 480 In 1954 Congress enacted the Food for Peace law: • Designed to help U. S. farmers, its impact on Third World countries has been the difference between survival and national disaster. © 2005 Gottheil - Principles of Economics, 4 e 59

Target Price Target price • A minimum price level for specific farm goods that the government sets and guarantees. © 2005 Gottheil - Principles of Economics, 4 e 60

Target 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. © 2005 Gottheil - Principles of Economics, 4 e 61

Target Price Target price • Congress moved from parity pricing to setting target prices in 1973 with the passage of the Agricultural and Consumer Protection Act. © 2005 Gottheil - Principles of Economics, 4 e 62

EXHIBIT 12 COMPARING THE OUTCOMES OF PARITY AND TARGET PRICING 63 © 2005

Exhibit 12: Comparing the Outcomes of Parity and Target Pricing Government 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. © 2005 Gottheil - Principles of Economics, 4 e 64

Exhibit 13: Comparing the Outcomes of Parity and Target Pricing Government 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. © 2005 Gottheil - Principles of Economics, 4 e 65

Exhibit 13: Comparing the Outcomes of Parity and Target Pricing The 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. © 2005 Gottheil - Principles of Economics, 4 e 66

Exhibit 13: Comparing the Outcomes of Parity and Target Pricing The 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. © 2005 Gottheil - Principles of Economics, 4 e 67