Price Ceilings: Misallocation of Resources
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0:09 - 0:14- Welcome back. Another cost of
price ceilings, is that they misallocate -
0:14 - 0:18resources. This is actually a point not
covered in most textbooks, but it's very -
0:19 - 0:23important. It's going to be important not
just to understand price controls, but -
0:24 - 0:29also to give us real insight and deeper
understanding into how the price system -
0:29 - 0:38works. Let's get started. Let's begin with
an intuitive but a real and important -
0:38 - 0:42example. Suppose that over here on the
west coast of the United States, we're -
0:42 - 0:48having a very mild winter. Temperatures
are high. The sun is shining. No problems. -
0:48 - 0:52Let's suppose however, that on the east
coast the winter is really bad. It's cold. -
0:52 - 0:57There's a lot of snow and so forth. As a
result of the weather, the people on the -
0:57 - 1:01east coast are going to be demanding a lot
of home heating oil. So the demand for -
1:02 - 1:07heating oil goes up, and because of that
increase in demand we get a higher price -
1:07 - 1:12of heating oil. Now, what are
entrepreneurs going to do? Seeing this -
1:12 - 1:18signal of a higher price, they're going to
be incentivized to take oil from where it -
1:19 - 1:24has low-value over here on the west coast,
and bring it to where the oil has high -
1:25 - 1:31value on the east coast. Oil will flow
from the west to the east. It will flow -
1:31 - 1:35from areas where it has low-value. In
response to the signal of the higher -
1:36 - 1:43price, it will flow to areas where it has
higher-value. Let us suppose, that as in -
1:43 - 1:50the 1970s, we now have a price control on
oil. So it is illegal for the price of -
1:50 - 1:56oil to increase. As before, with the price
control we're going to get higher demand -
1:57 - 2:04but no higher price. There will not be
that signal of a higher price, and because -
2:04 - 2:09there isn't a signal there won't be an
incentive to bring oil from where it has -
2:10 - 2:15low-value to where it has high-value.
So the oil will no longer flow. As a -
2:15 - 2:21result, people over here on the west
coast, they're going to be using that oil -
2:21 - 2:26for low-value items, things like heating
their swimming pool. At the same time, -
2:26 - 2:33people on the east coast may not have
enough oil to heat their homes. In fact, -
2:33 - 2:39this is exactly what happened in the
1970's. There was a misallocation of oil -
2:39 - 2:45because of the price controls. Oil was
used in some low uses, some low-value uses -
2:45 - 2:50such as heating swimming pools, at the
same time when there wasn't enough oil for -
2:50 - 2:56the high-valued uses. That's what we mean
by misallocation of resources. Let's take -
2:56 - 3:00a look at how we can show this in a
diagram. Here's our standard diagram of -
3:00 - 3:04the shortage. Let's remember from chapter
three that we could read the demand curve -
3:04 - 3:09in the following way. At the top of the
demand curve are the highest valued uses -
3:10 - 3:14for the good. This is a air force one, if
you recall the example from chapter three. -
3:14 - 3:18Down here, are the lowered-valued uses of
the good. This is the rubber ducky, was -
3:19 - 3:26down here. Now, at the controlled price of
one dollar, Qs units are going to be -
3:26 - 3:31supplied. Given that Qs units are going to
be supplied, the most valuable uses for -
3:31 - 3:37those units are these uses up here. These
are the high-valued uses. In a free -
3:37 - 3:44market, these uses or users would outbid
the other uses. Good would flow from the -
3:44 - 3:48low-valued uses to the high-valued uses,
and these would end up being the uses -
3:48 - 3:54which would be supplied in a free market.
Here's the key point, the price control -
3:55 - 4:00prevents the highest-valued uses from
outbidding the lower-valued uses. -
4:00 - 4:07As a result, some oil will flow to
lower-valued uses. In other words, as a -
4:07 - 4:12result of the price control, some rubber
duckies will end up being produced even -
4:12 - 4:20when we don't have enough oil to fly jet
aircraft. These uses or users will not be -
4:20 - 4:25able to outbid these guys down here
because of the price control, because the -
4:26 - 4:32price is limited to one dollar. By the
way, these guys have the really low-valued -
4:32 - 4:36uses, but they're not even willing to pay
the controlled price. They're not even -
4:36 - 4:41being willing to pay the dollar, so they
won't get any oil at all, which is a good -
4:41 - 4:47thing, because they have very low-valued
uses. On the other hand, the high-valued -
4:47 - 4:52uses, they're not going to be able to
outbid these guys, so some of the oil is -
4:52 - 4:56going to be misallocated. It's going to go
to low-valued uses even when there's not -
4:57 - 5:02enough to satisfy all of the
highest-valued uses. The most important -
5:02 - 5:07point is the one I just gave, that with
price controls prices no longer serve -
5:07 - 5:10their signaling and incentive function,
and as the result, we get the -
5:10 - 5:15misallocation of resources. Resources no
longer flow from their high-valued uses to -
5:16 - 5:21their low-valued uses, and as a result of
that we get less use out of our resources. -
5:21 - 5:27We get less value from our resources. I
want to show also, that you can use the -
5:28 - 5:34diagram to quantify this a little bit, to
show this on a diagram. Let's ignore the -
5:34 - 5:38wasteful time in search costs from price
control, and what we want to do is to -
5:38 - 5:43compare the maximum consumer surplus given
Qs, given Qs is supplied, with a lost -
5:44 - 5:51under, say random allocation. So suppose
that any use which is willing to pay the -
5:51 - 5:57controlled price is equally likely to be
allocated a unit of the good, in this -
5:57 - 6:02case, a unit of the gasoline. How much
will that reduce value? -
6:02 - 6:07How much will that reduce total consumer
surplus? Let's take a look at how to do -
6:08 - 6:15this. Let's just remind ourselves that if
the gasoline goes to the highest valued -
6:15 - 6:21uses, that is there are Qs units, and if
these Qs units were to flow to the highest -
6:21 - 6:28valued uses, then consumer surplus would
be given by the area underneath the demand -
6:28 - 6:33curve above the price. So it would be
given by this green area. This is the -
6:33 - 6:40maximum consumer surplus available from Qs
units. This is the way we would get the -
6:40 - 6:45most out of these Qs units. We would get
the most value by allocating it to the -
6:45 - 6:49highest-valued units, and then the total
consumer surplus created would be this -
6:49 - 6:56amount right here. Let's now compare with
random allocation. Because the good is not -
6:56 - 7:00necessarily allocated to the highest
valued uses with a price control, consumer -
7:00 - 7:04surplus is going to be less than the
amount which we just showed. How much -
7:04 - 7:08less? Let's do some calculations, and to
do that to build our intuition, we're -
7:08 - 7:14going to consider how one gallon of
gasoline might be allocated under the best -
7:14 - 7:17and worst conditions for random
allocation. So we're going to take one -
7:17 - 7:21gallon of gasoline, and we're going to
allocate it randomly. Suppose we were -
7:21 - 7:26really lucky. What's the best case for
random allocation? Suppose we're really -
7:26 - 7:33unlucky. What's the worst case for random
allocation? Let's take a look. The best -
7:33 - 7:39case scenario for random allocation, is
that this one gallon of gasoline goes to -
7:39 - 7:45the buyer with the highest-valued use.
Which buyer is that? It's this buyer up -
7:46 - 7:53here. In that case, four dollars of value
is created, and consumer surplus is three -
7:53 - 7:59dollars. The four dollar of value created
minus the one dollar for the price. What's -
7:59 - 8:04the worst case?
The worst case scenario, is that the buyer -
8:04 - 8:08with the lowest-valued uses randomly ends
up with the good, with the gallon of -
8:09 - 8:14gasoline. In that case, the value created
is one dollar. This is the buyer with the -
8:15 - 8:19lowest-valued use, but this buyer's still
willing to pay the controlled price. So -
8:20 - 8:26that's one dollar of value created or
consumer surplus of zero. It costs them a -
8:26 - 8:29dollar. They get something which is worth
a dollar to them. So the consumer surplus -
8:29 - 8:34is zero. Those are the best and worst
cases for randomly allocating one gallon -
8:34 - 8:40of gasoline. Using that intuition, let's
look at a scenario where a gallon of -
8:40 - 8:46gasoline is randomly allocated with equal
probability to any user who is willing to -
8:47 - 8:51pay the controlled price. That is the
gallon of gasoline is randomly allocated -
8:51 - 8:56to any user between four dollars and one
dollar with a value between four dollars -
8:56 - 9:03and one dollar. In this case, because it's
an equal probability, a uniformed -
9:03 - 9:09distribution, the average value, turns out
we can calculate it easily, it's just one -
9:09 - 9:15half times the maximum four dollars, plus
one half the minimum possible value which -
9:15 - 9:21is one dollar. The average use to which
gasoline will be put will be $2.50. Let's -
9:21 - 9:26in fact put that on the diagram. When the
good is randomly allocated to any user -
9:27 - 9:32between a value of four dollars and one
dollars, the average use will have a value -
9:32 - 9:39of $2.50. That means that the consumer
surplus is this green area right here, the -
9:39 - 9:44difference between the average value and
the controlled price. Here's the key -
9:44 - 9:52point. Remember, earlier we showed that
the maximum value would have been the area -
9:52 - 9:55underneath the highest-valued users,
underneath the demand curve for the -
9:55 - 10:01highest-valued users up to the quantity
supplied. The maximum value, the maximum -
10:01 - 10:06consumer surplus from Qs units, if all
those Qs units went to the highest-valued -
10:06 - 10:11users, is the red pus the green.
When the gasoline is instead allocated -
10:11 - 10:15randomly, sometimes it goes to a
high-valued user, but sometimes it goes to -
10:15 - 10:20a low-valued user. Then, on average, the
value of that gasoline is less. We get -
10:20 - 10:26less value out of that gasoline when it is
allocated randomly than when it is -
10:26 - 10:30allocated by the price system. As a
result, consumer surplus is considerably -
10:30 - 10:37lower under random allocation than it is
when it's allocated by the price system -
10:37 - 10:42which maximizes the consumer surplus.
That's just a diagrammatic way of -
10:42 - 10:47illustrating our first example of what
happens when we don't have the price -
10:47 - 10:52system. Oil no longer flows from its
low-valued uses to its high-valued uses, -
10:52 - 11:00so we get less value from the same
resources. The resources become worth less -
11:00 - 11:04than they were before, because they're no
longer allocated to the highest-valued -
11:05 - 11:10uses. We've now covered all the five
important effects of price controls, -
11:10 - 11:15shortages, reductions in product quality,
wasteful lines and other search costs, a -
11:15 - 11:20loss in gains from trade, and a
misallocation of resources. Next, we're -
11:20 - 11:24going to apply all of these ideas to rent
control. Since we understand the ideas we -
11:24 - 11:28should move through that fairly quickly.
And then we're going to look at price -
11:28 - 11:32floors. What happens when the government
says you cannot sell -
11:32 - 11:35a good for less than a certain amount?
-
11:36 - 11:41- If you want to test yourself
click Practice Questions. Or if you're -
11:41 - 11:43ready to move on, just click Next Video.
- Title:
- Price Ceilings: Misallocation of Resources
- Description:
-
Suppose there is a mild winter on the West Coast and a harsh winter on the East Coast. As a result of the weather, people on East Coast will demand more home heating oil, bidding up the price. Under the price system, entrepreneurs will be incentivized to take oil from where it has lower value on West Coast to where it has higher value on the East Coast. But when price controls are in place, even though the demand is still there from the East Coast, there is no signal of a higher price, eliminating the incentive for entrepreneurs to transport oil from west to east. In fact, this happened in the 1970s, resulting in oil going to lower valued uses on the West Coast while many people on the East Coast didn’t have enough oil to heat their homes. In this video, we’ll look at a diagram to visualize this misallocation of resources.
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- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 11:49
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