Price Controls

• Price ceiling is the maximum legal price allowed by government. No good or service can be bought/sold above this upper limit.
• A price ceiling is considered effective only if it is set below the initial equilibrium price.
• A price ceiling creates a persistent shortage, as consumers increase quantity demanded for the good while producers decrease quantity supplied of the good.
• When a price ceiling is imposed,

  Consumer Expenditure = Producer Revenue = 0 Qs b Pc

  
• When a price ceiling is imposed,

  Consumer Surplus: Pc b e f

  Producer Surplus: a b Pc

  Deadweight Loss: b d e

  
• Price ceilings are most suited for goods that the government deems are basic necessities where the existing price is very high. In this case, price ceilings promote equity, as low-income consumers are able to afford the lower prices.
• Implementation problems of Price Ceiling:

  • Rise of black markets
  • Allocation by alternative means
  • Quality deterioration
  • Reduction in market supply in the long run
• When supply and demand are price elastic, SSe and DDe:

  • Price decreases from P0 to Pc
  • Quantity demanded increases from Q0 to Qed
  • Quantity supplied decreases from Q0 to Qes
  • This produces a larger shortage of Qed - Qes

  
• When supply and demand are price inelastic, SSi and DDi:

  • Price decreases from P0 to Pc
  • Quantity demanded increases from Q0 to Qid
  • Quantity supplied decreases from Q0 to Qis
  • This produces a smaller shortage of Qid - Qis

  
• With a price elastic supply and demand, consumer expenditure / producer revenue will decrease by a larger magnitude than with a price inelastic supply and demand.
• Price floor is the minimum legal price allowed by government. No good/service can be bought or sold at prices below this lower limit.
• A price floor is considered effective only if it is set above the initial equilibrium price.
• A price floor creates a persistent surplus, as consumers decrease quantity demanded for the good while producers increase quantity supplied of the good.
• When a price floor is imposed,

  Consumer expenditure: 0 Qd g Pf

  Producer revenue: 0 Qs d Pf

  Government spending: Qd Qs d g

  
• When a price floor is imposed,

  Consumer surplus: Pf g h

  Producer surplus: a d Pf

  Government spending: Qd Qs d g

  Deadweight loss: Qd Qs d e g

  
• If the market is efficient to begin with, price ceilings and price floors distort price signals and leads to a loss of allocative efficiency.
• When demand is price elastic, DDe:

  • Price increases from P0 to Pf
  • Quantity demanded decreases from Q0 to Qed
  • Quantity supplied increases from Q0 to Qs
  • Since change in price < change in quantity demanded, consumer expenditure decreases

  
• When demand is price inelastic, DDi:

  • Price increases from P0 to Pf
  • Quantity demanded decreases from Q0 to Qid
  • Quantity supplied increases from Q0 to Qs
  • Since change in price > change in quantity demanded, consumer expenditure increases