Earlier this week, I posed the following problem in price theory.
The government imposes a binding price ceiling on oranges. But it does not impose any price ceiling on orange juice. After the price ceiling on oranges is imposed, what will happen to the price of orange juice? (Assume a competitive market for oranges.) Show your work.
I said I would post my answer. I also said that I would post a diagram of demand and supply. But the diagram got complicated because there are both demand and supply for oranges and demand and supply for orange juice. And, of course, while oranges are a crucial input into orange juice, oranges are also sold at retail as, simply, oranges.
The good news is that you don’t need to show the demand and supply for orange juice to get the answer. All you need do is recognize that a binding ceiling on oranges will cause the number of oranges produced to fall. That drives the result. You can show that result—the reduced number of oranges produced and sold—on a demand and supply curve for oranges, but you don’t need to. (I did have my students do it.)
When I taught the economics of binding price controls, whether price ceilings or price floors, the way I put it in my last 15 or so years of teaching is, “the short side of the market dominates.” If it’s a price ceiling, then the amount sold in the market is lower than if there’s no price ceiling; the supply side dominates—you can’t buy what no one is selling. If it’s a price floor, the amount sold in the market is lower than if there is no price floor; the demand side dominates—you can’t sell what no one is buying.
Now, back to the issue. With a smaller output of oranges produced, there will be less orange juice. The demand for orange juice is unchanged. (If it does change, it would rise as people realized that oranges are in shorter supply and so they substitute into buying orange juice; but this is a needless complication.) So with an unchanged demand curve for orange juice and reduced supply, the price of orange juice would rise. QED.
One commenter raised questions that are relevant to how much the price of orange juice would rise, but are not relevant to whether it rises.
AMW wrote:
Is this an open or closed economy? Is it possible to import/export oranges and orange juice? And how elastic are international supply and demand for oranges and orange juice?
All those are relevant questions for estimating the degree of increase. But let’s say orange producers export in order to avoid domestic price controls. That makes the domestic amount supplied even lower than otherwise and the price increase on orange juice even greater than otherwise.
Henri Hein put it well:
I’m with Jon Murphy and trying to keep it simple. With a price ceiling on oranges, the supply of oranges will fall. Presumably the demand for orange juice (at the price before the change) will remain the same. So the price of orange juice will have to rise.
Postcript:
One way to think about the problem is to think about the market for cars in 1946, after the U.S. government started allowing domestic car manufacturers to once again produce cars for the domestic market. Either car producers were hesitant to raise prices or remaining price controls forbade them from raising prices; I’ve forgotten which.
Either way, prices for new cars did not clear the market. So some car buyers would buy a car and “flip” it, that is, immediately sell at a higher price than they paid. Think of orange juice producers as “flipping” oranges.
