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- In the next several videos, we'll dive
deeper into price ceilings and also price

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floors. These are important for two
reasons. First, governments around the

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world both today and historically often do
impose price ceilings and floors.

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So we want to understand their effects.

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Second, in the last section we explained
how a price is a signal wrapped up in an

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incentive. In this section, we'll be
explaining what happens when that signal,

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that price, is not allowed to do its work.
When the price is not allowed to rise or

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fall, what happens when that signal
is not sent?

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What happens when that
incentive is taken away?

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A price ceiling is a maximum price allowed
by law. So, for example, if the price

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ceiling on gasoline is $2.50, it is
illegal to buy or sell the gasoline at

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above that price. It's called a ceiling
because you cannot go above the ceiling.

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So a ceiling is a maximum price. It has
five important effects. It's going to

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create shortages, reductions in product
quality, wasteful lines and other search

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costs, a loss in gains from trade
or a dead weight loss

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and a misallocation of resources.

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We're going to go through each of these,
let's begin with shortages. We can easily

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show that price ceilings create shortages
using our standard demand and supply

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framework. We'll use the price of gasoline
as an example because governments often

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have imposed a maximum price on gasoline.

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Now, ordinarily, we would know that the
market equilibrium will be found where the

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quantity demanded is equal to the quantity
supplied. But suppose that the government

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imposes a maximum price which is below the
market equilibrium. So, this is a

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controlled price, a maximum
price above which it is

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illegal to buy or sell this good.

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What we want to do now is simply read off
the diagram what happens. So at the

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controlled price we can read that the
quantity demanded given by the demand

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curve is here. At the controlled price,
the quantity supplied is given by the

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supply group and is read here. Notice that
at the controlled price, the quantity

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demanded exceeds the quantity
supplied and that's the shortage.

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Now, ordinarily, if the quantity demanded
exceeded the quantity supplied, buyers

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want more of this good than they're able
to get at the current price. Ordinarily,

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the buyers would compete to push the price
up and the price would increase to the

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market price and we would get the
usual equilibrium.

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In this case, however, it's illegal to
push the price up. So as a result, the

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quantity demanded exceeds the quantity
supplied and we get the shortage which

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doesn't go away. The shortage is defined
simply as the amount by which the quantity

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demanded exceeds the quantity
supplied at the controlled priced.

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Let's give some examples. When goods are
in shortage, that is when the quantity

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demanded exceeds the quantity supplied,
sellers have more customers than goods.

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Usually, sellers have to compete to get
customers but when goods are in shortage,

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sellers have more customers than they
need. As a result, then we have

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shortages, the sellers can cut quality,
cut their costs and still sell everything

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they want to sell at the controlled price.

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As a result, price controls reduce
quality. We saw this in the 1970s, books

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were printed on lower quality paper
two-by-four lumber shrank to one and

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five-eights by three and five-eights.
Automobiles were given fewer coats of

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paint. Throughout the US economy quality
began to fall. Here's another example, the

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great Matzo Ball Debate.
In 1972 union leader, George Meany

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complained that his favorite soup, Mrs.
Adler's had shrunk from four to three

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matzo balls. So serious was this that the
Chairman of the Wage and Price Commission

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had his staff buy up a bunch of cans of
Mrs. Adler's Soup, and count in each one

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of them how many matzo balls were in the
soup. He said they were still four.

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Whoever was right, however, the lesson is
quite correct.

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Price controls reduce quality.

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When the quantity demanded exceeds the
quantity supplied, when there's a surplus

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of buyers, sellers have less of an
incentive to give good service.

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Another way to reduce quality is to reduce
service. And indeed, full-service gasoline

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stations disappeared in 1973. The owners
would simply close up shop whenever they

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wanted to take a break.

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More generally there's a reason why the
baristas at Starbucks are pleasant to us,

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it's because they want more customers.
Customers are profitable, but when you

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can't raise the price, when there's a
shortage, when a seller has more customers

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than they need, it doesn't pay to be
pleasant to customers. Indeed, it may pay

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to be unpleasant to drive some of them
off, so you don't have to serve them.

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This is another reason why the workers at
the DMV are on average probably a little

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bit less pleasant to us than at stores
which require our service, than the store

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which want us to come into the store. This
is a reason why in communist countries

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like the ex-Soviet Union, the workers at
the stores were much more unpleasant than

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workers in McDonald's are because
McDonald's has an incentive to get more

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customers. They want to create a pleasant
experience. They want to make it easy to

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buy goods from the store. But when there's
shortages, when there are more customers

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than you need, it no longer
pays to be pleasant.

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Okay, price ceilings, let's remember five
important effects.

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Shortages and reductions in
product quality.

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That's what we covered today. Next we will
be covering wasteful lines in other search

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costs, a loss in gains and trade and a
misallocation of resources.

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If you want to test yourself, click
practice questions or if you're ready to

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move on, just click next video.