WEBVTT

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♪ [music] ♪

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- [Alex] Welcome back.

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Another cost of price ceilings
is that they misallocate resources.

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This is actually a point
not covered in most textbooks,

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but it's very important.

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And it's going to be important
not just to understand

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price controls, but also to give us
real insight

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and deeper understanding
into how the price system works.

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Let's get started.

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Let's begin with an intuitive,
but a real and important example.

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Suppose that over here
on the west coast

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of the United States,
we're having a very mild winter.

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Temperatures are high.
The sun is shining. No problems.

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Let's suppose however,
that on the east coast the winter

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is really bad.

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It's cold. There's a lot
of snow and so forth.

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As a result of the weather, 
the people on the east coast

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are going to be demanding
a lot of home heating oil.

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So the demand
for heating oil goes up,

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and because of that increase
in demand we get a higher price

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of heating oil.

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Now, what are entrepreneurs
going to do?

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Seeing this signal
of a higher price,

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they're going to be incentivized
to take oil from where

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it has low value,
over here on the west coast,

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and bring it to where the oil
has high value on the east coast.

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So oil will flow
from the west to the east.

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It will flow from areas
where it has low value.

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In response to the signal
of the higher price,

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it will flow to areas
where it has higher value.

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Now, let us suppose,
that as in the 1970s,

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we now have a price control on oil.

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So it is illegal for the price
of oil to increase.

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Well, as before,
with the price control,

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we're going to get higher demand
but no higher price.

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There will not be that signal
of a higher price,

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and because there isn't a signal
there won't be an incentive

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to bring oil from where
it has low value

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to where it has high value.

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So the oil will no longer flow.

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As a result, people over here
on the west coast,

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they're going to be using that oil
for low-value items,

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things like heating
their swimming pool.

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At the same time,
people on the east coast

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may not have enough oil
to heat their homes.

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In fact, this is exactly
what happened in the 1970s.

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There was a misallocation of oil
because of the price controls.

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Oil was used in some low uses,
some low-value uses

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such as heating swimming pools,
at the same time

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when there wasn't enough oil
for the high-valued uses.

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That's what we mean
by misallocation of resources.

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Let's take a look
at how we can show this

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in a diagram.

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Here's our standard diagram
of the shortage.

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Let's remember from chapter three
that we could read

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the demand curve
in the following way.

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At the top of the demand curve
are the highest-valued uses

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for the good.

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This is Air Force One,
if you recall the example

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from chapter three.

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Down here,
are the lower-valued uses

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of the good.

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This is the rubber ducky,
was down here.

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Now, at the controlled price of $1,

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Qs units are going to be supplied.

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Given that Qs units
are going to be supplied,

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the most valuable uses
for those units

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are these uses up here.

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These are the high-valued uses.

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In a free market, these uses
or users would outbid

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the other uses.

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Goods would flow
from the low-valued uses

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to the high-valued uses,
and these would end up

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being the uses
which would be supplied

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in a free market.

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Here's the key point --
the price control

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prevents the highest-valued uses
from outbidding

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the lower-valued uses.

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As a result, some oil
will flow to lower-valued uses.

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In other words, as a result
of the price control,

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some rubber duckies
will end up being produced

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even when we don't have enough oil
to fly jet aircraft.

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These uses or users
will not be able to outbid

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these guys down here
because of the price control,

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because the price is limited to $1.

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By the way, these guys
have the really low-valued uses,

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but they're not even willing
to pay the controlled price.

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They're not even being willing
to pay the dollar,

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so they won't get any oil at all,
which is a good thing,

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because they have
very low-valued uses.

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On the other hand,
the high-valued uses,

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they're not going to be able
to outbid these guys,

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so some of the oil
is going to be misallocated.

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It's going to go to low-valued uses
even when there's not enough

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to satisfy all
of the highest-valued uses.

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The most important point
is the one I just gave --

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that with price controls
prices no longer serve

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their signaling
and incentive function,

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and as the result, we get
the misallocation of resources.

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Resources no longer flow
from their high-valued uses

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to their low-valued uses,
and as a result of that,

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we get less use
out of our resources.

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We get less value
from our resources.

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I want to show also,
that you can use the diagram

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to quantify this a little bit,
to show this on a diagram.

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Let's ignore the wasteful time
in search costs from price control,

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and what we want to do
is to compare

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the maximum consumer surplus
given Qs, given Qs is supplied,

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with a loss under, say,
random allocation.

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So suppose that any use
which is willing to pay

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the controlled price
is equally likely to be allocated

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a unit of the good, in this case,
a unit of the gasoline.

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How much will that reduce value?

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How much will that reduce
total consumer surplus?

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Let's take a look
at how to do this.

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Let's just remind ourselves
that if the gasoline goes

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to the highest-valued uses,
that is there are Qs units,

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and if these Qs units were to flow
to the highest-valued uses,

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then consumer surplus
would be given by the area

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underneath the demand curve
above the price.

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So it would be given
by this green area.

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This is the maximum
consumer surplus available

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from Qs units.

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This is the way we would get 
the most out of these Qs units.

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We would get the most value
by allocating it

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to the highest-valued units,

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and then the total consumer
surplus created

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would be this amount right here.

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Let's now compare
with random allocation.

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Because the good
is not necessarily allocated

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to the highest valued uses
with a price control,

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consumer surplus
is going to be less

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than the amount
which we just showed.

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How much less?

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Let's do some calculations,
and to do that

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to build our intuition,
we're going to consider

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how one gallon of gasoline
might be allocated

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under the best and worst conditions
for random allocation.

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So we're going to take
one gallon of gasoline,

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and we're going
to allocate it randomly.

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Suppose we were really lucky.

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What's the best case
for random allocation?

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Suppose we're really unlucky.

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What's the worst case
for random allocation?

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Let's take a look.

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The best case scenario
for random allocation,

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is that this one gallon
of gasoline goes to the buyer

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with the highest-valued use.

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Which buyer is that?
It's this buyer up here.

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In that case, $4
of value is created,

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and consumer surplus is $3.

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The $4 of value created
minus the $1 for the price.

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What's the worst case?

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The worst case scenario,
is that the buyer

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with the lowest-valued uses
randomly ends up with the good,

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with the gallon of gasoline.

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In that case,
the value created is $1.

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This is the buyer
with the lowest-valued use,

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but this buyer's still willing
to pay the controlled price.

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So that's $1 of value created

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or consumer surplus of zero.

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It costs them a dollar.

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They get something
which is worth a dollar to them.

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So the consumer surplus is zero.

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Those are the best and worst cases
for randomly allocating

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one gallon of gasoline.

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Using that intuition, let's look
at a scenario

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where a gallon of gasoline
is randomly allocated

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with equal probability to any user
who is willing to pay

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the controlled price.

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That is the gallon of gasoline
is randomly allocated

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to any user between $4 and $1,
with a value between $4 and $1.

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In this case,
because it's an equal probability,

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a uniformed distribution,
the average value,

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turns out we
can calculate it easily,

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it's just one half
times the maximum $4,

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plus one half times the minimum
possible value, which is $1.

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The average use to which gasoline
will be put will be $2.50.

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Let's in fact put that
on the diagram.

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When the good is randomly allocated
to any user between a value

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of $4 and $1, the average use
will have a value of $2.50.

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That means
that the consumer surplus

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is this green area right here --

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the difference
between the average value

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and the controlled price.

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Here's the key point.

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Remember, earlier we showed
that the maximum value

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would have been the area underneath
the highest-valued users,

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underneath the demand curve
for the highest-valued users,

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up to the quantity supplied.

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The maximum value,
the maximum consumer surplus

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from Qs units,
if all those Qs units

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went to the highest-valued users,
is the red plus the green.

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When the gasoline
is instead allocated randomly,

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sometimes it goes
to a high-valued user,

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but sometimes it goes
to a low-valued user.

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Then on average, the value
of that gasoline is less.

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We get less value
out of that gasoline

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when it is allocated randomly
than when it is allocated

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by the price system.

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As a result, consumer surplus
is considerably lower

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under random allocation
than it is when it's allocated

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by the price system,
which maximizes

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the consumer surplus.

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That's just a diagrammatic way
of illustrating our first example

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of what happens when we don't have
the price system.

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Oil no longer flows
from its low-valued uses

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to its high-valued uses,
so we get less value

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from the same resources.

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The resources become worth less
than they were before,

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because they're no longer allocated
to the highest-valued uses.

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We've now covered
all the five important effects

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of price controls: shortages,
reductions in product quality,

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wasteful lines
and other search costs,

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a loss in gains from trade,
and a misallocation of resources.

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Next, we're going to apply
all of these ideas to rent control.

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Since we understand the ideas,

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we should move
through that fairly quickly.

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And then we're going
to look at price floors.

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What happens
when the government says

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you cannot sell a good
for less than a certain amount?

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- [Narrator] If you want
to test yourself,

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click "Practice Questions."

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Or, if you're ready to move on,
just click "Next Video."

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♪ [music] ♪