The Good vs the Bad Economics

The following is a question from the GMU Microeconomics Ph.D. Comprehensive exam I took last night:

A government is considering imposing a price ceiling on a good that has a supply curve with zero elasticity [perfectly inelastic].  The price ceiling would be binding, so the government-imposed price would be lower than the lassez-faire price.  In your two-part answer, explain:

a. What does textbook price theory predict about the implications of a price ceiling?

b. What would a more sophisticated, well-rounded economics, predict about the implications of a price ceiling?  Ignore public choice issues.

I particularly liked this question.  The difference between a good economist and a bad economist is the ability to see beyond just the seen (in this case, the model) and to see the unseen (in this case, the mix of things that affect people and resources beyond the model).  The poor economist (or poor econometrician) looks only at his model and treats it as the Gospel.  People will come up with all kinds of models to justify their various pet projects, whether it be tariffs, minimum wage, or what-have-you, and ignore all the economics around them.

Any good discussion of economic phenomena must involve a discussion beyond just the scope of the model and, as in the worlds of the GMU microeconomic committee above, involve “a more sophisticated, well-rounded economics.”

12 thoughts on “The Good vs the Bad Economics

    • The initial result is that you’d have a shortage that good. Unless you’re able to make the demand curve equally inelastic, the demand at the lower price will exceed the supply.
      You’re going to wind up with some other non-price factors coming in to play to limit who gets that good, even if it’s only a matter of favoring those who get to the supplier first.
      Eventually, you have people looking for substitutes, of course, and the demand for any already-existing substitutes will increase. (Long-term elasticities are always greater than short-term ones.)

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        • A bit confused here….

          The supply curve is vertical. Given a downward sloping demand curve and a price below what the unregulated market price would arrive at, the price ceiling would lead to excess demand, no? Isn’t this what most people/economists think of as a shortage? Or are you arguing there would not be a shortage because things like queuing and the other non-price related methods of determining who gets the goods would in effect take over the function of price? Of course, most people would still say “There is a shortage,” because now they have to queue, whereas before they did not. It is funny how people do not see this kind of thing. They clearly understand it is a cost, but somehow don’t factor the lack of queuing into their thinking of these issues.

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        • I need to apologize. This rarely happens but I made a mistake. When I responded, I read “dead weight loss” not “shortage.”. There is no DWL, but there is a shortage in that more is demanded than supplied.

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  1. My answer is “Venezuela”.

    Consumption of sufficient calories is inelastic. Of course wealthier people will spend elastic amounts on various qualities and types of food. But, when food is in overall short supply, the same amount of calories will be purchased within a wide range of price. This is not entirely inelastic. Poor people will buy less at higher prices, but will lose weight until they starve.

    Dear Leader Maduro has run this experiment. He set food price ceilings at such low levels that producers stopped production and shipping. Much of the population is starving at the set price. Wealthier Venezuelans are paying whatever they must.

    For part (a), people will pay any price to eat, including hunting dogs in the streets and killing zoo animals.
    One can read the news to find additional answers to part (b).

    Price/Demand curves encode the willingness of people to buy, but say nothing about the willingness of people to produce. We need the Price/Production curve to do a reasonable analysis.

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    • The “calories” example would be for the relative inelasticity of demand.
      The original question postulated a supply curve with zero elasticity. Unless I’ve completely forgotten my Econ 101, that means that the total quantity of the good available to be sold cannot be changed regardless of the market price (or in this case, the fiat price.)

      If the fiat price is set less than the market clearing price, textbook theory says you’d have a shortage. In real life, you’d have arbitrage (unless it could be suppressed*) that would set the black market price somewhere near the lf price. Example: tickets to popular sporting events or theater performances.

      * Airline tickets are an example where the government has successfully suppressed a secondary market by tying the ticket purchase firmly to the original ID supplied.

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  2. Complementing to what Andrew Garland wrote, I would summarize subsequent effect with the word “corruption”. Resources would be devoted to bribe officials to provide the good in question to government favored families or friend or lovers or whatever groups. Black markets would ensue, resources would be diverted into the informal sector, and these resources (manpower, inputs, time, effort) would necessarily come from other sectors in the economy.
    The upshot is that you end up with an economy with a highly distorted resource allocation, á la Venezuela (or any other statist, dirigiste, government hyperregulated economy).

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