How to Study for Chapter 8 Price Floors and Ceilings
Chapter 8 introduces two ways of interfering with the normal working of markets --- maintaining the price above equilibrium (price floors) and maintaining the price below equilibrium (price ceilings).
1. Begin by looking over the Objectives listed below. This will tell you the main points you should be looking for as you read the chapter.
2. New words or definitions are highlighted in italics in the text. Other key points are highlighted in bold type. Answer the questions in the text as they are asked. Then, check your answer by reading further in the text.
3. You have more work with the demand-supply graph in this chapter. ...view middle of the document...
11. Use the analysis of price ceilings to analyze the problem relating to water in California.
12. Explain how a market for water in California is being created and the effects this is likely
Chapter 8 Price Floors and Ceilings (latest revision June 2006)
We have been considering the way markets work under normal conditions. Sometimes, markets are not allowed to work. This means that the price is not allowed to move to the equilibrium level. Two such conditions are price floors and price ceilings. Let us begin with price floors.
(1) Price Floors
A price floor exists when the price is artificially held above the equilibrium price and is not allowed to fall. There are many examples of price floors. In some cases, private businesses maintain the price floor while, in other cases, it is the government that maintains the price floor. One price floor that was maintained by the private businesses used to be called “fair trade”. In the case of fair trade, the manufacturer would set a price for the product that was above the equilibrium price. The manufacturer then told the retail stores that the price could not be lowered or the store would not be able to sell any of the manufacturer's products. From the late 1930s through the 1980s, this practice was legal. It is still occasionally conducted. Many familiar items were fair traded --- textbooks, televisions, radios, stereo sets, washing machines, automobiles, gasoline, liquor, and so forth.
In the graph below, the equilibrium price for stereo amplifiers is assumed to be $200. The floor on the price set by the manufacturer is $300. The price is not allowed to fall below $300. At this floor price, the quantity demanded is 500,000 and the quantity supplied is 1,000,000. As you can see, there is a surplus of 500,000 amplifiers. Price floors always generate surpluses. All who wish to buy at the floor price ($300) will be able to do so. The problem is: "what to do with the surpluses"?
Price of Amplifiers ($)
0 500,000 1,000,000 Quantity of Amplifiers
There were many ways to solve the problem of surpluses. Occasionally, a store simply broke the manufacturer's policy. The store lowered the price to get rid of the surplus. The manufacturer had threatened that the store would be prohibited from selling the manufacturer's product; the store either believed that the manufacturer would not carry-out the threat or did not care. For example, a company called Crown Books began lowering the prices of its books and a company called Discount Records began lowering the prices of phonograph records (vinyl).
More likely, stores would try to get around the price floor without actually violating it. One common solution was...