Chapter 4 PDF

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PRICE AS A RATIONING DEVICE A rationing device is a mechanism used to determine who gets what of available limited goods and resources. One of the most commonly used rationing devices used in a capitalistic (market-based) economic system is price. Those who are willing and able to pay the price for a given good (or resource) can purchase it. Other rationing devices are used, as well. One of the most common is first-come-first-served. One example of this rationing device occurs when tickets for a popular band go on sale, and the tickets are sold to those who are first in line (at a real or virtual box office). Another commonly used rationing device is brute force.

PRICE AS A TRANSMITTER OF INFORMATION Price serves purposes other than that of a rationing device. In a market-based economy, price also transmits information about the relative scarcity of a good. Goods that are relatively more scarce have a higher price and those that are relatively less scarce have a lower price.

PRICE CONTROLS Up until this point in our study of supply and demand, we have assumed that the government has stayed out of the pricing decisions and allowed prices to adjust to equilibrium. However, sometimes the government chooses (for a variety of reasons) to intervene and impose price controls. There are two main types of price controls: price ceilings and price floors.

PRICE CEILINGS A price ceiling is the highest price that a product can legally be sold for as determined by the government. The placement of the price ceiling, in relation to the equilibrium price, will have a lot to do with whether or not the price ceiling will actually have any impact on the price the product is sold for. If a price ceiling is set above the equilibrium price, it will not have an impact on the price the product sells for (since the price ceiling is not blocking the price from reaching its equilibrium). In order for a price ceiling to have an impact on the market it must be set below the equilibrium price. See Exhibit 1, for an example of a price ceiling this would have an impact on the market. A price ceiling set below the equilibrium price will result in a shortage of the product (the quantity demanded of the product will exceed the quantity supplied at that price) and fewer actual exchanges (purchases) of the good will be made than would have been made at equilibrium. In the absence of a price ceiling, the price would just adjust upward to resolve the shortage. With the price ceiling, the price cannot legally rise to its equilibrium level, and some other rationing device will need to be used in order to resolve the shortage. For example, when gasoline prices rise, you often hear people suggest that we should have a price ceiling on the price of gas. On the surface this might sound like a good idea, but think about the impact that this would have on the market and your everyday life. Would you be willing to wait in very long lines to buy

gas (first-come-first-served rationing device)? Some sort of coupon system could be used to ration gas, but this would likely lead to some sort of black market in which the coupons were sold. For each possible solution that you can think of resulting from the gas shortage caused by a price ceiling, some undesirable consequence is likely to result.

Example of price ceiling: Suppose that the table below represents the market for some product. What would happen if the government imposes a price ceiling on the price of this product at $2? Note that this price ceiling is below the equilibrium price of $4. The result of this price ceiling would be a shortage of (250 – 130) = 120 units. Compared to at the equilibrium price, would fewer units or more units be exchanged (produced and sold) at the price ceiling? The answer is that fewer units would be exchanged at the price ceiling than at the equilibrium price. At the equilibrium price, 150 units would be exchanged, but at the price ceiling only 130 units would be exchanged (since that is the quantity of units that producers are willing to sell at that price). Therefore, 20 fewer units would be exchanged at the price ceiling than in equilibrium.

Price

Quantity Demanded

Quantity Supplied

$1

300

120

2

250

130

3

200

140

4

150

150

5

100

160

6

50

170

PRICE FLOORS A price floor is the lowest price that a product can legally be sold for as determined by the government. The placement of the price floor, in relation to the equilibrium price, will have a lot to do with whether or not the price floor will actually have any impact on the price the product is sold for. If a price floor is set below the equilibrium price, it will not have an impact on the price the product sells for (since the price floor is not blocking the price from reaching its equilibrium). In order for a price floor to have an impact on the market it must be set above the equilibrium price. See Exhibit 3, for an

example of a price floor that would have an impact on the market. A price floor set above the equilibrium price will result in a surplus of the product (the quantity demanded of the product will be less than the quantity supplied at that price). In the absence of a price floor, the price would just adjust downward to resolve the surplus. With the price floor, the price cannot legally fall to its equilibrium level, and some other rationing device will need to be used in order to resolve the surplus. Minimum wage is a great example of a price floor as it sets a minimum price at which labor can be purchased by companies.

Example of price floor (minimum wage): Suppose that the table below represents the market for unskilled labor. What would happen if the government imposes a price floor on the price of this labor (minimum wage) at $12? Note that this price floor is above the equilibrium wage of $10. The result of this price floor would be a surplus of (240 – 110) = 130 workers. Compared to at the equilibrium wage, would fewer workers or more workers be hired at the minimum wage? The answer is that fewer workers would be hired at the minimum wage than at the equilibrium wage. At the equilibrium wage, 200 workers would be hired, but at the minimum wage only 110 workers would be hired (since that is the quantity of workers that firms are willing to hire at that wage). Therefore, 90 fewer workers would be hired at the minimum wage than in equilibrium.

Wage

Quantity Demanded of Labor

Quantity Supplied of Labor

$8

300

160

9

250

180

10

200

200

11

150

220

12

110

240

Note that there are no practice problems assigned for this chapter....