CH-8-9 Price Ceilings and Floors – Modern Principles: Microeconomics : Chapter Notes

This Document Contains Chapters 8 to 9 Chapter 8 Price Ceilings and Floors Learning Objectives After completing this chapter, students should: > be able to explain why price ceilings cause shortages, reductions in product quality, wasteful lineups and other search costs, and lost gains from trade (deadweight loss). They should also be able illustrate these on a diagram. > understand how price ceilings cause a misallocation of resources in the controlled market and potentially other markets throughout the economy. > be able to explain why price floors cause surpluses, lost gains from trade (deadweight loss), and wasteful increases in product quality. They should also be able to illustrate these on a diagram. > understand why price floors cause a misallocation of resources. Chapter Outline Price Ceilings Shortages Reductions in Quality Wasteful Lines and Other Search Costs Lost Gains from Trade (Deadweight Loss) Misallocation of Resources Advanced Material: The Loss from Random Allocation Misallocation and Production Chaos The End of Price Ceilings Does UBER Price Gouge? Rent Controls (Optional Section) Shortages Reductions in Product Quality Wasteful Lines, Search Costs, and Lost Gains from Trade Misallocation of Resources Rent Regulation Arguments for Price Controls Universal Price Controls Price Floors Surpluses Lost Gains from Trade (Deadweight Loss) Wasteful Increases in Quality The Misallocation of Resources Takeaway Chapter Narrative This chapter covers price ceilings and price floors in more depth than most textbooks. All of the major effects of these price controls are covered extensively. The chapter starts with price ceilings and addresses the universal price control system put in place by the Nixon administration in August 1971 and then focuses on the effects in the market for oil. Rent control, a commonly cited price ceiling, is also covered. The chapter then uses the minimum wage and airline regulation as examples of price floors. Price Ceilings A price ceiling is a maximum price allowed by law. We call it a ceiling because prices are not allowed to rise above it. Price ceilings have five important effects: Shortages Reductions in product quality Wasteful lineups and search costs Lost gains from trade (deadweight loss) Misallocation of resources The MRU video Price Ceilings: The U.S. Economy Flounders in the 1970s introduces price ceilings and motivates the discussion that follows. This is a good way to open the discussion of price ceilings. Shortages When price is held below equilibrium, the quantity demanded exceeds the quantity supplied. The shortage is measured by the difference between these two points. Draw a simple supply and demand diagram with an effective price ceiling and illustrate the shortage to the students graphically. Potential Pitfall: When students graph a price ceiling on their own, they are often tempted to draw it above the equilibrium price, where it will, at least initially, have no effect. They seem to think, “Ceilings are high, so I’ll graph this above equilibrium.” It’s worth stressing to them now that ceilings prevent you from going up. Try drawing one above equilibrium for them to illustrate that it will not have the same effect. One possible example is to think about setting a thermostat for an air conditioner. Price ceilings are meant to keep prices from rising just as an air conditioner is meant to keep the temperature in a room or building from increasing. Ask the students if the temperature in the room was 80 degrees and they were hot (or wanted to make sure it did not get hotter), where would they set the thermostat? Would they set it above 80 degrees or below 80 degrees? Clearly below 80 because otherwise the air conditioner will not come on. It works the same with price ceilings; they must be set below the equilibrium in order for them to “come on” and work. When there were universal price controls in the 1970s, increased demand in the building industry made price controls hit that sector particularly hard. There were shortages of lumber, steel bar, and toilets. By 1973, shortages of wool, copper, aluminum, vinyl, denim jeans, paper, plastic bottles, and many more things were common. Reductions in Quality When price controls cause a shortage, sellers have more customers than goods. Rather than cutting price, it’s much easier to evade the price control and still sell all of their goods by cutting quality. During the 1970s, price controls caused books to be printed on poor-quality paper, 2″ × 4″ lumber shrank to 1⅝″ × 3⅝″ (you might point out that lumber is still smaller as an example of the long-term impacts of price controls), new cars got fewer coats of paint, and newspaper publishers conserved paper by printing in smaller fonts. Service can also decrease with price controls. In states where do-it-yourself pumping was legal, gasoline price controls made full-service stations disappear. The MRU video Price Ceilings: Shortages and Quality Reduction provides a general introduction to price ceilings and a detailed discussion of the shortages and reductions in quality that result from price ceilings. Wasteful Lines and Other Search Costs A line is a classic sign of a shortage, and lines for gasoline were common during the 1970s. Lines raise the real price that consumers pay for a good—they may pay only $1 in currency, but they also pay with the value of their wasted time standing in line. Figure 8.2 in the text illustrates the value of wasted time. Figure 8.2 Price Ceilings Create Wasteful Lines Buyers still compete with buyers, but now, since they cannot compete by bidding up the price, they compete by waiting in line. At the restricted quantity supplied they will wait in line until the total monetary and waiting cost exceeds the value of the product to them. This is found by tracing up to the demand curve from the supply curve at the restricted quantity. The total value of wasted time equals that vertical distance times the quantity. Buyers may also resort to bribery to ensure receiving the goods. If the buyers used bribes, the box in Figure 8.2 would simply be “total paid in bribes” rather than “total value of wasted time.” In either case, the competition among buyers makes them pay much more than the controlled price, with the total price higher than the market-clearing price would have been. Teaching Tip: Students are likely to think that waiting in line is preferable to bribing as a rationing mechanism. It’s important to emphasize that no one gains the lost value of waiting in line. It’s a cost borne without providing anyone with a benefit. At least with bribes, the money lost by the consumer ends up with the seller, so it is more efficient than lines. Teaching Tip: This is also a good time to point out to students that even in the face of a government-regulated price, the market price still prevailed. The government may be able to set the sticker price, but that does not paralyze market forces; it just slows them down. The MRU video Price Ceilings: Lines and Search Costs provides a detailed discussion of the lines and search costs that result from price ceilings. Lost Gains from Trade (Deadweight Loss) Price ceilings prevent buyers and sellers from engaging in mutually beneficial exchanges. Draw a supply and demand diagram like Figure 8.3 in the text and illustrate the triangle where demanders place a higher value on the goods than the sellers’ cost, but yet, because the supply curve is above the price ceiling in this range, the buyers and sellers are prohibited from engaging in these mutually beneficial exchanges. Any price above the supply curve and below the demand curve could have generated gains from trade. You can show how much consumer and producer surplus is lost because of the price ceiling. The deadweight loss is this lost consumer and producer surplus. The MRU video Price Ceilings: Deadweight Loss provides a detailed discussion of the lost gains from trade that result from price ceilings. Misallocation of Resources Prices convey information, so when price ceilings are imposed, they distort the market’s signals and lead to a misallocation of resources. During the cold winter of 1972–1973, the price controls on oil prevented people with a cold home on the East Coast from bidding oil away from the West Coast. As a result, pools were heated in California (a relatively low-value use of oil) while homes remained cold on the other side of the country (a higher-value use of oil). You can illustrate the potential loss of value from misallocated resources with a graph like Figure 8.5 in the text. Gains from trade are maximized only when goods flow to their highest-value uses. Yet the portion of the demand curve that is to the left of the quantity supplied is relatively Figure 8.3 A Price Celling Reduces the Gains from Trade Figure 8.5 When Prices Are Controlled, Resources Do Not Flow to Their Highest Value Uses small compared to the length of the demand curve that is to the right of the quantity supplied but still above the price-controlled price. With price controls, there is no way to guarantee that the higher-value demanders get the goods. Each time one of these lower-value demanders gets a good, there is a misallocation of resources. The next subsection gives an example of how to quantify this misallocation. The MRU video Price Ceilings: Misallocation of Resources provides a detailed discussion of the misallocation of resources that results from price ceilings. Advanced Material: The Loss from Random Allocation If there were no misallocation, then the total consumer surplus with a price ceiling would be the area between the demand curve and the price up to the quantity supplied. But since these demanders are not guaranteed to get the product, anyone with a demand above the price may get the goods. The text suggests showing how much consumer surplus would be lost if the goods were randomly allocated between high- and low-value uses. Teaching Tip: If you want to convey the idea of how random allocation can make things worse without the math required for this section, you can use the example of the “Black Friday” shopping event. Stores entice consumers with lower than usual prices on a limited quantity of highly desirable goods. While this is not a price ceiling, it is a shortage situation where bidding up price is usually not an option to solve the allocation problem. The solution most people use is to wait in line (just as in the chapter’s discussion). Ask the students who is willing to wait in the line the longest, the person with a high value or the person with a low value for the good? If the high-valued person waits the longest, then the allocation is just as before with the same consumer surplus shown in Figure 8.2. Now tell the students that the store, to promote fairness, hands out slips of paper with numbers on them and then randomly reorders the individuals just before the store opens (this is done in some cases). Now ask the students if this is move will increase the total consumer surplus generated or decrease it. You can pick several random points on a graph such as Figure 8.2 and assume those “consumers” get the good and add up the consumer surplus to show is it even smaller. Use a figure like Figure 8.7 in the text with a straight-line demand and supply curve. If there is an equal probability of satisfying each use between the maximum value of the demand curve and the value of the controlled price, the average good traded will have a value halfway between these two levels. With a random allocation of goods, more than half of the potential consumer surplus at a controlled price is eaten up by misallocation. Figure 8.7 Shorter Consumer Surplus Falls Under Random Allocation Misallocation and Production Chaos Remind students how markets are linked, as shown in Chapter 7. You can then demonstrate that if there is a shortage because of a price control in one market, that shortage will cause disruptions in other markets even if those other markets do not have price controls. In 1973, million-dollar construction projects were delayed because a few thousand dollars of steel bar was unavailable. Shortages of steel drilling equipment made it difficult to expand oil production even though the United States was in a severe energy crisis. In-Class Exercise: You can illustrate the linked nature of markets with some simple supply and demand diagrams. Take the example of steel. Start by placing a price control on steel and illustrate the shortage. Then draw a supply and demand diagram for automobiles. Ask what happens to the automobile market as a result of the steel shortage. (Supply decreases and prices rise.) Then ask your students to suggest some other high-demand items, such as apartments near the university or close to public transport. Illustrate what happens in these markets. Take the chain as far as you like. The End of Price Ceilings The price controls on most goods in the United States were lifted by April 1974. Oil price controls remained, however, and were eased over the next seven years. When Ronald Reagan took office as president in 1981, his first act was to eliminate the last of the price controls on oil. As could be anticipated, at first the monetary price of oil rose (after accounting for shorter lines, it’s quite possible the total price of oil decreased), but the shortage disappeared overnight. Within a year prices began to fall as supply increased, and within a few years prices were below 1979 levels. Does UBER Price Gouge? The ride-sharing service Uber raises prices during periods of high rider demand. The use of such “surge pricing” increases the quantity of rides supplied and decreases the quantity of rides demanded to ensure that quantity supplied and quantity demanded will be equal during these periods. Without surge pricing there would be a shortage of rides, as the regular price would be below the equilibrium price during high-demand periods. The text discusses laws that outlaw surge pricing (such as those proposed in New York City and already passed in New Delhi, India) as an example of a price ceiling that would lead to shortages of rides. If students are still not understanding how surge pricing is working, ask them if they would be willing to pay (or tip the driver more) if they were running short on time for an interview? When they say yes, ask them what the difference between that and surge pricing is. Rent Controls (Optional Section) Since rent control is a price ceiling on housing, everything covered on price ceilings applies to rent controls. Note to Instructor: The textbook and this instructor’s manual cover rent control more quickly than in the previous section. We introduce one new graph to distinguish between short- and long-run effects. Each subsection on rent control has some facts from the text and points out any differences between rent control and other price controls. Shortages Rent controls usually begin with a freeze at the current market rate, but they are usually implemented in cities where rents are increasing quickly, so the price control soon results in a shortage. Because apartments, unlike oil, are a long-lasting good that cannot be shipped elsewhere, owners of apartments can do little in the short run except absorb the lower price. The short-run supply of apartments is rather inelastic. Over the long run, fewer new apartment buildings are built and older units are turned into condominiums or commercial space or are torn down to make room for nonresidential structures. The long-run supply curve is more elastic. You can use a graph like Figure 8.8 in the text to illustrate the initial short-run shortage and then the longer-run shortage that develops with rent controls. Figure 8.8 Rent Control Creates Larger Shortages in the Long Run Than in the Short Run Ontario, Canada, provides a good illustration of how the long-run supply is more elastic. Rent control was put into place in 1975. In the five years prior to this, about 28,000 new apartments were built per year. In the five years after rent control was put in place, only about 5,500 apartments per year were built. The drop in construction began when rent control was being debated but before it was actually implemented. It’s unlikely the drop was due to other factors such as the state of the economy, because non-rent-controlled single-family housing starts and apartment starts were similar before the rent control, yet only apartment construction decreased after the rent control. Single-family construction remained high. (See Figure 8.9 in text.) Reductions in Product Quality Housing quality deteriorates with rent control because there are surplus demanders at the controlled price. Lawns are mowed less often, and lightbulbs and broken appliances are replaced more slowly. Low-quality apartments tend to deteriorate even more dramatically. In Manhattan, 18% of rent-controlled housing is dilapidated or deteriorating, a much higher percentage than in the uncontrolled sector. Economist Assar Lindbeck once said, “Rent control is the most effective method we know for destroying a city, except for bombing it.” However, Vietnam’s foreign minister said in 1989, “The Americans couldn’t destroy Hanoi [by bombing it], but we have destroyed our city by very low rents.” Wasteful Lineups, Search Costs, and Lost Gains from Trade Finding a rent-controlled apartment often involves costly search rather than lining up. One method of finding apartments in New York City is to read the obituary columns, find out where the deceased lived, and try to race to the landlord before someone else does. Because there is a surplus of renters, landlords can easily discriminate against someone who they believe isn’t an ideal tenant. This can take the form of racial discrimination. It also may come in the form of a bias against younger families or those with small children and pets. Because there are surplus renters, landlords can discriminate without worrying about losing revenue by doing so. In a free market, they would have to pay (lose revenue) to engage in discrimination. Bribes are illegal but can be disguised. A rent-controlled apartment may come with $5,000 worth of “furniture” that you must purchase from the landlord. Tie-in sales such as these are sometimes referred to as “key money.” Misallocation of Resources Apartments under rent control do not go to their highest-valued use. Because apartments can be hard to find, renters often stay in their apartment longer than they want to. They also stay because they don’t pay the full market value to rent. Often you’ll find an older couple staying in a large space after their children move out even though they don’t need the space, while at the same time young families who could use the larger apartment are stuck in cramped living quarters. Glaeser and Luttmer (2003) found that as many as 21% of renters in New York City would choose to live in an apartment with more or fewer rooms if not for rent controls. Teaching Tip: To highlight many of the issues with rent control you can point your students to the television show Friends, primarily season 5, episode 13, when one of the characters (Ross) attempts to rent an apartment across the street from the main apartment and must jump through the various hoops and obstacles created by New York rent control. While much is done for comedy’s sake, it does highlight the problems of rent control. As an added bonus, you can also point out that the apartment where most of the scenes take place (Monica’s apartment) is rented by the character’s grandmother, who has since moved to Florida. The granddaughter illegally subleases the apartment because otherwise the landlord could update the rent charged to market price. This highlights the idea of a misallocation of resources as well. Rent Regulation Rent regulation, unlike rent controls, doesn’t place an absolute ceiling on rents. Rent regulation usually begins with the current market rate and caps how quickly rents can increase, for example 5% per year. Rent regulations also typically allow landlords to pass along some of their costs if they make improvements to the property. The MRU video Price Ceilings: Rent Controls provides a detailed discussion of rent controls as an examples of a price ceiling. Arguments for Price Controls If price controls were the only way to help poor people consume oil or housing, then some people might accept all of the negative consequences and still support price controls. However, price controls are rarely the only way to help the poor. In general, policies to increase supply can help the poor and avoid these negative consequences. Reduced taxes on oil exploration or opening up government land for exploration could make oil more affordable. Reduced restrictions on new housing construction could encourage supply and lower housing prices. The textbook suggests that the best case for price controls is when they are placed on a monopoly that would otherwise restrict output to raise price. (Monopoly is covered later in the textbook.) In that case a price control could actually increase production. People complain when prices increase. Politicians often blame foreigners, speculators, or other scapegoats. Legislating a maximum price seems like an obvious response. People who have not studied economics rarely make the connection between the price control and the negative consequences. So ignorance is often a reason people support price controls. Teaching Tip: While the textbook uses the argument of “ignorance” of the effects of price controls as a justification for their support, it can also be framed as a misguided attempt to do good. Some controls are argued for to help certain segments of the population. Calling this “ignorance” may offend some students who have more liberal leaning views, causing them to tune out. Rather, acknowledge the desire to help and then show how it may end up doing more harm than good and that there may be other forms of help (such as housing vouchers) that do not produce the same market consequences. But as the next section shows, it’s also in some people’s self-interest to keep price controls even though they cause shortages. The MRU video Why Do Governments Enact Price Controls provides a discussion of arguments for and against the use of price controls. Universal Price Controls A command economy like the former Soviet Union has permanent and universal price controls. Hedrick Smith pointed out that among the facts of life in the Soviet Union was that scarce items “are not permanently out of stock, but their appearance is unpredictable . . . Leningrad can be overstocked with cross-country skis and yet go several months without soap . . . The accepted norm is that the Soviet woman daily spends two hours in line, seven days a week.” Price controls are often not eliminated even when they would make most people better off. Shortages benefited the party elite who controlled prices. Those who controlled scarce goods could gain favors and connections, known as blat in Russian, in exchange for their goods. They could use blat to obtain things for themselves. Those who benefited from shortages wanted to keep price controls. This is true even in the United States, which by world standards has relatively little corruption. During the 1973–1974 oil crisis the Federal Energy Office controlled the allocation of oil. Firms began to hire former politicians and bureaucrats to use their political connections to get more oil for their firms. Today about half of federal politicians become lobbyists when they leave office. The MRU video Price Controls and Communism discusses communism as a system of universal price controls and the resulting economy-wide effects of such a system. Price Floors A price floor, which is a minimum price allowed by law, has four important effects: Surpluses Lost gains from trade (deadweight loss) Wasteful increases in quality Misallocation of resources Surpluses An effective minimum wage is above the equilibrium wage. This results in a surplus, or more specifically when we’re discussing labor, unemployment. This can be shown in a graph like Figure 8.10 in the text. Potential Pitfall: It’s useful to remind students that a price floor prevents prices from going down, just as the floor of the classroom prevents them from falling into the basement. For a price floor to be effective, it has to be above the equilibrium. Try drawing a floor below the equilibrium to illustrate that it won’t have any effect. Many students, when left to graph on their own, mistakenly think, “Put ceiling high on the graph; put floor low on the graph.” Again, you can use a thermostat example. In the case of price floors, we are trying to keep prices from going too low, just as a heater attempts to keep the temperature from going too low. Ask the students where they would set the thermostat if they wished to warm up the room. Clearly, they would set it above the room’s current temperature, just as you would set a price floor above the current market price. How much unemployment a minimum wage will cause depends on how high it’s set. At $100 an hour, a minimum wage would cause a great deal of unemployment. The 2017 federal minimum wage of $7.25 won’t cause much unemployment because more than 95% of hourly employees earn more than that anyway. It can cause unemployment among the low-skilled, who tend to be young workers. About a quarter of workers earning the minimum wage are teenagers, and about half are under 25 years old. Figure 8.10 A price war creates a surplus (minimum wages create unemployment) Lost Gains from Trade (Deadweight Loss) Draw a supply and demand diagram with a minimum wage like Figure 8.11 in the text to illustrate the lost gains from trade. At prices below the minimum wage, there are demanders (firms) who would like to hire more labor, and there are workers willing to supply the labor. Any wage between the demand and supply curve at quantities to the left of equilibrium could make both demanders and suppliers better off. Illustrate the lost consumer and producer surplus compared to what an equilibrium wage would generate. Potential Pitfall: Students are used to thinking of firms constituting the supply curve and individual consumers constituting the demand curve. In labor markets this is of course reversed. It’s worth taking a minute to remind them that the individual workers are supplying the labor, and it is the firms that are demanding workers. Even though the minimum wage causes unemployment and lost gains from trade, the effect in the United States is rather small. Even though it is mostly young people who earn the minimum wage, 93.9% of those under 25 earn more than the minimum wage. Figure 8.11 A price floor reduces the gains from trade France combines a high minimum wage (nearly twice as high as that in the United States relative to the median wage) with laws that make it difficult to fire workers. Not coincidentally, about 23% of French workers under 25 years old were unemployed in 2010–2012. You can also tie this discussion to the Chapter 8 discussion of elasticity. As the book points out, most of the jobs where the minimum wage matters and where most impacts are observed are low-skilled jobs populated by young workers. Ask the class what they think the labor supply elasticity is for this group. Ask them to compare this to jobs where the minimum wage is not so much of an issue. This would also be a very good position to discuss recent trends in automation and increased research into automation. Specifically, give the students examples how that low-skilled labor is being substituted with automation, most notably the increased use of self-checkout lanes in stores and plans by some major fast-food chains to introduce self-service order kiosks. Again, you can tie to this to the idea of labor supply elasticity. The MRU video Price Floors: The Minimum Wage provides a general introduction to price floors and a detailed discussion of the minimum wage as an example of a price floor. Wasteful Increases in Quality The Civil Aeronautics Board (CAB) regulated entry, exit, prices, and routes of the airline industry from 1938 to 1978, and it set price floors above market-clearing levels. The CAB had authority to regulate only flights between states. Flights within states did not face the price controls. As a result, a flight between Boston and Washington, D.C., cost nearly twice as much as a similar-distance flight between San Francisco and Los Angeles. Figure 8.12 in the text illustrates the CAB price floor above the market-clearing price and also above the price that is needed to encourage suppliers to sell given the quantity demanded. At first the box between the regulated price and the sellers’ willingness to provide flights was windfall profits to the airlines, but because each firm wanted the customers for itself, the firms began to compete against each other in ways that were not regulated. They offered fancy meals, nice china, frequent flights, large seats, and so on. Eventually the windfall profits were eliminated by increases in costs related to wasteful quality improvements. Unions also demanded a share of the profits, further eroding the windfall. By 1978, airlines were no longer benefiting from regulation and were willing to deregulate. Since deregulation, air travel quality has decreased, but so have prices. Figure 8.12 A price floor creates quality waste Teaching Tip: Most students will be happy to complain about crowded, low-quality airline travel. Encourage them to. Then point out that many airlines offer first class and business class seats at higher prices but with better quality. Ask how many of them are willing to purchase the more expensive tickets. Few are likely to raise their hands. You can then point out that this is what made the quality competition wasteful under regulation: The quality of all flights was more like first class, but so were the prices. Because consumers prefer the cheaper prices to the higher quality, the quality competition under regulation was wasteful. The Misallocation of Resources The CAB limited the entry of airlines into the industry because more firms would put pressure on prices to decrease. There were 10 major airlines in 1974 (there were 16 in 1938) despite 79 requests to enter. This was a misallocation of resources because low-cost airlines like Southwest were kept out of the national market until deregulation in 1978. Southwest didn’t just increase the supply of flights; it also brought new ways of doing business, like consistently using the same aircraft to lower maintenance costs, increasing the use of smaller airports like Chicago’s Midway, and hedging its long-term fuel costs. Deregulation didn’t just lower consumer prices. It also decreased costs and increased innovation, leading to a better allocation of resources. The MRU video Price Floors: Airline Fares provides a detailed discussion of CAB regulated airfares as an example of a price floor. Takeaway Students should understand and be able to explain the five main effects of price ceilings: shortages, reductions in product quality, wasteful lineups and other search costs, a loss of gains from trade, and a misallocation of resources. They should also be able to graph a shortage, the wasteful losses from waiting in line, and the lost gains from trade. Likewise, students should be able to use supply and demand to explain why a price floor causes a surplus, a loss of gains from trade (deadweight loss), and a wasteful increase in quality, and they should be able to label these on a graph. They should also be able to explain how price floors cause resources to be misallocated. Students should also be able to see how the market forces will still operate in the face of such regulations, either by increasing prices through waiting or bribes or incentivizing the research into automation to substitute low-skilled labor. In- and Out-of-Class Activities If you chose to conduct the equilibrium experiment suggested after Chapter 4, it is very easy to continue that experiment now. You can use the same materials and setup you did in the initial equilibrium experiment. (See the end of Chapter 4 in this instructor’s manual.) To conserve time, you can use the same cards and equilibrium price as before. You should again get equilibrium outcomes within a couple of rounds. Now impose a price ceiling anywhere below 10. Buyers and sellers will quickly find that there is a shortage and that they are unable to make mutually beneficial exchanges. It should take only a round or two to illustrate this. Next, impose a price floor, explaining that no trades will be allowed at a price less than (pick a number above 10). You should immediately get a surplus and again have dissatisfied potential traders. The experiment will probably be more useful before you cover the material in Chapter 8; otherwise your students will be inclined to believe they were just illustrating what they have been taught. If you do the experiment before you cover the material, you can show how economic theory describes the way they behave even when they don’t know the economic laws. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU Video: Price Ceilings Price Ceilings: The US Economy Flounders in the 1970s Price Ceilings Price Ceilings: Shortages and Quality Reductions Price Ceilings Price Ceilings: Lines and Search Costs Price Ceilings Price Ceilings: Deadweight Loss Price Ceilings Price Ceilings: Misallocation of Resources Price Ceilings Price Ceilings: Rent Controls Price Floors Price Floors: The Minimum Wage Price Floors Price Floors: Airline Fares Arguments for Price Controls Why Do Governments Enact Price Controls? Universal Price Controls Price Controls and Communism Chapter 9 International Trade Learning Objectives After completing this chapter, students should: > understand that international trade is just trade: a basic economic activity that occurs voluntarily because of the benefits it provides to those who engage in it. > understand who wins and who loses when governments restrict trade—such as with tariffs and quotas—and why such protectionist policies are often used. > be able to respond to some of the common arguments against international trade. Chapter Outline Analyzing Trade with Supply and Demand Analyzing Tariffs with Demand and Supply The Costs of Protectionism Winners and Losers from Trade Arguments Against International Trade Trade and Jobs Child Labor Trade and National Security Key Industries Strategic Trade Protectionism Takeaway Chapter Narrative The chapter opens by reminding students that international trade is really just trade. That is, the same principles apply whether trade occurs within or across national borders, and the key insights from Chapter 2 always apply: Trade makes people better off when preferences differ. Trade increases productivity through specialization and the division of knowledge. Trade increases productivity through specialization and production according to comparative advantage. Analyzing Trade with Supply and Demand The chapter presents a familiar model for trade, analyzing domestic supply and demand for a particular good in comparison to the world price for the good. Figure 9.1 in the text shows the market for semiconductors, whose world price is lower than the domestic price. The diagram assumes that the domestic market is a small part of the world market, so that the world price is unaffected by the levels of domestic production or domestic consumption. In the absence of trade, the domestic price would be PNo trade, but with free trade, the price is the world price, so domestic producers produce QsFree trade units of the good, and domestic consumers consume QdFree trade units of the good. The difference, QdFree trade − QsFree trade, is imported. It might also be helpful for later discussions to highlight the increase in consumer surplus allowed by trade. Furthermore, show the students that there is a net gain in that the area of producer surplus lost by domestic producers is gained by consumers in the form of consumer surplus in addition to the area under the demand curve up to the free trade equilibrium. Figure 9.1 International trade using supply and demand Analyzing Tariffs with Demand and Supply Protectionism is the economic policy of restraining trade through quotas, tariffs, or other regulations that burden foreign producers but not domestic producers. Two common forms of protectionism are tariffs and trade quotas. Teaching Tip: Be sure to drive the point home that protectionism is protection of domestic firms from foreign competition. It does not protect consumers. Remind students that competitive markets maximize the gains from trade (consumer surplus plus producer surplus). Therefore, under protectionism, gains from trade are lower, and the reduction comes from consumer surplus. You can highlight this point if you showed the consumer surplus with trade in Figure 9.1. Now in Figure 9.2 it is clear that some of this is transferred to the producers, some is transferred to the government, and some is lost due to no trades taking place. Therefore, if we care about consumers, protectionism is not the way to go. A tariff can be analyzed starting with a diagram like Figure 9.1. But since the tariff is just a tax on imports, a tariff causes an upward parallel shift in the supply curve for imports (which is horizontal at the world price). The resulting diagram looks like Figure 9.2 in the text. Figure 9.2 International trade using demand and supply: tariffs The tariff increases the price in the domestic market, which has two effects: It increases the quantity supplied domestically and decreases the quantity demanded domestically. Both of these serve to reduce the quantity of imports. Tariffs, because they are taxes, also generate tax revenue. The area of the tariff revenue can be identified as a rectangle with dimensions equal to the size of the tariff (the vertical distance by which the world supply curve was shifted) and the number of units for which the tariff is paid. This area is shaded in Figure 9.2. Finally, the decrease in domestic consumption creates a loss of gains from trade (deadweight loss) just like with any tax. The first half of the MRU video Tariffs and Protectionism illustrates how to analyze trade and tariffs with supply and demand using diagrams similar to Figures 9.1 and 9.2 in the text. The Costs of Protectionism The chapter uses the market for sugar to illustrate the two costs of a tariff. The costs of the tariff are related to the two effects of the tariff: the increase in domestic quantity supplied and the decrease in domestic quantity demanded. Figure 9.3 in the text illustrates the sugar example and the two costs of protectionism. The increase in domestic quantity supplied is good for domestic producers (and possibly for workers in the domestic industry who might have lost their jobs under free trade), but these producers have higher costs than do foreign producers. This means that domestic resources are wasted producing the protected good, because the good could be produced at a lower cost elsewhere and the domestic resources reallocated to production of goods for which there is a comparative advantage. In Figure 9.3, triangle B, wasted resources, represents this cost. The height of the supply curve represents the cost of production, so that area B represents the unnecessary cost to produce sugar domestically because sugar could have been imported at the world price of 9 cents per pound. If you are going to point out the workers in the domestic industry who keep their jobs with the tariff, make sure to point out that they are part of those misallocated resources as they could be working in a more productive sector and likely earning higher wages. Figure 9.3 A restriction on trade wastes resources and creates lost gains from trade The decrease in domestic quantity demanded is also costly, because these discouraged domestic consumers (whose value of a good is shown by the demand curve) value the good more than its world price but less than the domestic price. In the sugar example in Figure 9.3, the buyers who value sugar more than 9 cents per pound but less than 20 cents per pound stop buying sugar after the tariff. Area C shows the lost gains from trade when these buyers are not allowed to purchase sugar, though they value sugar enough to pay a price that would draw more (foreign) sugar into the market. The costs can be expressed in dollars as well. As in Figure 9.3, the cost of the wasted resources is the area of triangle B: ½ × (20 billion) × ($0.20 − $0.09) = $1.1 billion. The cost of the lost gains from trade is the area of triangle C: ½ × (24 billion − 20 billion) × ($0.20 – $0.09) = $0.22 billion. The total cost of the sugar tariff is $1.1 billion + $0.22 billion = $1.32 billion. Chapter 4 gave three conditions that explain how a free market maximizes the gains from trade: (1) The supply of goods is bought by those with the highest willingness to pay. (2) The supply of goods is sold by those with the lowest costs. (3) Between buyers and sellers, there are no unexploited gains from trade or any wasteful trades. In the case of a tariff, or restricted trade in general, the second and third conditions are violated. Domestic sellers that produce only after the tariff are not the lowest-cost sellers, and the buyers driven from the market by the tariff represent unexploited gains from trade. Winners and Losers from Trade Figure 9.3 and the sugar example can be used to analyze the cost of the tariff in a different way. The tariff raises the price. The increase in price would take areas A and B away from the consumer surplus of buyers that remain in the market after the tariff. The increase in price would drive some buyers out of the market, and area C represents their surplus. Areas A, B, and C represent the total consumer surplus lost to the tariff. The total value of these three areas in the figure is $2.42 billion. However, the increase in price is good for domestic producers. Area A represents the increase in producer surplus due to the tariff (the area between the after-tariff price of 20 cents and the domestic supply curve). The area of triangle A represents $1.1 billion. Therefore, we can calculate the overall effect of the tariff as the sum of the effect on consumers (−$2.42 billion) and the effect on producers (+$1.1 billion), which is $1.32 billion. This is the same as the value that was calculated in the previous section. Domestic producers gain from tariffs and domestic consumers lose, and the losses for consumers are greater than the gains for producers. But the reason that tariffs and other policies continue to exist is that producers are fewer in number and better organized than are buyers. The costs of the sugar tariff, for example, are spread out on anyone who consumes sugar; the benefits of the sugar tariff are concentrated on only those who produce sugar. The second half of the MRU video Tariffs and Protectionism illustrates the welfare costs of protectionism using a diagram similar to Figure 9.3 in the text. Arguments Against International Trade The text discusses the most commonly used arguments against free trade: Trade destroys jobs. Trade promotes child labor. Trade jeopardizes national security. Trade should not occur at the expense of key industries. Strategic trade protectionism can increase benefits from trade. Trade and Jobs The argument that trade destroys jobs in the domestic economy is based on the immediate and obvious fact that when, say, the United States imports shirts from Mexico, jobs will be lost in the U.S. shirt industry. But this argument addresses only the obvious effect of trade. Less obvious is the effect of trade on other industries in the United States. For example, having spent less on imported shirts, consumers will have more to spend on other goods, thus increasing demand and employment in other industries. In addition, trade is a two-way street: It cannot occur in only one direction. For shirts to be imported into the United States, something else (say, computers) must be exported. As the United States specializes in computer production, employment in that industry will increase. In other words, trade actually shifts jobs from the inefficient, struggling U.S. shirt industry to the more productive, growing computer industry. Further, since productivity is higher in the computer industry, the jobs there will pay more than those lost in the shirt industry. Make sure to also point out that this same phenomenon is always part of economic growth and change and is not restricted to international trade. Many advances in one industry will lead to a loss of jobs in another. The book points to Thomas Edison and the invention of the electric light bulb. For another example, ask the students how many of them would like to start typing their homework on a manual typewriter rather than a computer. Point out that there are few, if any, manual typewriter repairman left in the U.S. because of the advances in personal computing. Should those jobs have been protected? What might the impact of protecting those jobs have been on the personal computing industry? Child Labor It is often argued that trade promotes child labor by shifting production to countries with ultra-low wages, often paid to children. In general, this is a myth. The truth about child labor is that most children who work do so out of necessity, to provide income for their families in poverty-stricken countries. Therefore, the key to ending child labor is to end poverty by raising living standards in those places. As we have learned, trade raises production, consumption, and living standards, while restricting trade can limit such benefits among potential trading partners. By limiting prosperity from trade, protectionist policies may actually increase the occurrence of child labor rather than reducing it. Furthermore, when trade restrictions are used specifically to reduce child labor, children can be forced into more dismal situations, such as starvation, lower-paying jobs, or prostitution. Teaching Tip: If students still have concerns with this point, remind them, as in the textbook, that there is a long history of child labor in developed countries such as the U.S. Challenge the students to look at examples of families in early America (pioneer times) and ask them the difference between child labor then and child labor today? Trade and National Security In regard to the argument that trade jeopardizes national security, it is possible that protection of domestic industries vital for national security is justified. However, it is also likely that few industries are legitimately vital in this regard. Where would such protection end? The automobile industry produced many of the tanks, planes, and other equipment used in World War II. Should the automobile industry be protected on those grounds? What about steel? Computers? Vaccines? Many industries may claim to have an important national security interest given a policy of protection based on such concerns. Key Industries The key industries argument is that trade should not occur at the expense of certain “key” industries—usually in reference to industries that generate spillovers—benefits that go beyond those of the specific good. Such an argument is often used in defense of protection of these key industries. The problem, in practice, is that it is often hard to identify in advance which industries have large spillovers. Further, if such spillovers can be identified, subsidies are generally a more effective way to promote these industries. If a subsidy isn’t possible, protectionism might be a second-best solution. Strategic Trade Protectionism The argument for strategic trade protectionism proposes that tariffs and quotas can be used to increase an exporting country’s share of the gains from trade. This essentially occurs as the government helps exporters act as a cartel—that is, raise prices—as they sell their goods to the rest of the world. The objective is to raise prices and increase net revenue from the sale of exports. The problems in practice with this strategy are as follows: It works only if there are few substitutes around the world for the exported good. Other countries will often retaliate by imposing their own tariffs or quotas on the products the protectionist country exports to them. The MRU video Arguments Against International Trade discusses the five common arguments against trade identified in this section of the texts. Takeaway Students should now be able to analyze trade—in both restricted and unrestricted forms—using the tools of supply and demand. They ought to be able to identify graphically, calculate numerically, and (most important) explain the nature of the benefits to producers and costs to consumers of trade restrictions. By shifting production to higher-cost domestic producers, trade restrictions waste resources. By driving some willing domestic buyers from the market, trade restrictions fail to exploit all available gains from trade. Students should also be able to present and rebut several common arguments in favor of trade restrictions. In- and Out-of-Class Activities Have your students use the tools of supply and demand to analyze trade in a different way to figure out where the world price comes from. To keep things simple, use an example of a world with only two countries. Construct two sets of domestic supply and demand curves (examples given in the table), one for each of two countries. The Market for Widgets in the United States The Market for Widgets in Canada Price Quantity Supplied Quantity Demanded Price Quantity Supplied Quantity Demanded $ 0 0 540 $ 0 0 320 10 0 480 10 100 260 20 100 420 20 200 200 30 200 360 30 300 140 40 300 300 40 400 100 50 400 240 50 500 60 Before beginning the numerical analysis, talk to your students about the numbers. Where are costs generally higher? (That is, where is supply lower?) Where do consumers value the good more? (That is, where is demand higher?) Based on the answers to these questions, ask them what their intuition says about the pattern of trade they would expect to observe between these two countries. Hopefully they observe that Canada can supply more widgets at each price (or likewise will accept a lower price for a given quantity) and that consumers in the United States demand more widgets at each price (or are willing to pay more for a given quantity). This should lead them to the conclusion that Canada should produce widgets and export them to the United States. Ask your students to figure out how many widgets each country would import or export at each price. Then see whether they can determine equilibrium between the two countries. They ought to be able to construct a table like this: At a World Price Of: The United States Will: Canada Will: $ 0 Import 540 Import 320 10 Import 480 Import 160 20 Import 320 Neither import nor export 30 Import 160 Export 160 40 Neither import nor export Export 300 50 Export 160 Export 440 At $30, consumers in the United States want to import 160 widgets and producers in Canada want to export 160 widgets. If trade between the United States and Canada is unrestricted, we expect the world price to be $30. You may wish to extend the example further by asking your students to calculate consumer and producer surplus in both countries under conditions of no trade and free trade. You can also show that in the U.S. market if the government imposed a $10 tariff, then there would be no imports from Canada, no tax revenue (because no imports), and a loss of gains from trade (deadweight loss) to U.S. consumers of $800 (160 units × $10 × 0.5). For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: Analyzing Trade with Supply and Demand Tariffs and Protectionism (first half) The Costs of Protectionism Tariffs and Protectionism (second half) Arguments Against International Trade Arguments Against International Trade Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766