- In the next several videos, we'll dive deeper into price ceilings and also price
floors. These are important for two reasons. First, governments around the
world both today and historically often do impose price ceilings and floors.
So we want to understand their effects.
Second, in the last section we explained how a price is a signal wrapped up in an
incentive. In this section, we'll be explaining what happens when that signal,
that price, is not allowed to do its work. When the price is not allowed to rise or
fall, what happens when that signal is not sent?
What happens when that incentive is taken away?
A price ceiling is a maximum price allowed by law. So, for example, if the price
ceiling on gasoline is $2.50, it is illegal to buy or sell the gasoline at
above that price. It's called a ceiling because you cannot go above the ceiling.
So a ceiling is a maximum price. It has five important effects. It's going to
create shortages, reductions in product quality, wasteful lines and other search
costs, a loss in gains from trade or a dead weight loss
and a misallocation of resources.
We're going to go through each of these, let's begin with shortages. We can easily
show that price ceilings create shortages using our standard demand and supply
framework. We'll use the price of gasoline as an example because governments often
have imposed a maximum price on gasoline.
Now, ordinarily, we would know that the market equilibrium will be found where the
quantity demanded is equal to the quantity supplied. But suppose that the government
imposes a maximum price which is below the market equilibrium. So, this is a
controlled price, a maximum price above which it is
illegal to buy or sell this good.
What we want to do now is simply read off the diagram what happens. So at the
controlled price we can read that the quantity demanded given by the demand
curve is here. At the controlled price, the quantity supplied is given by the
supply group and is read here. Notice that at the controlled price, the quantity
demanded exceeds the quantity supplied and that's the shortage.
Now, ordinarily, if the quantity demanded exceeded the quantity supplied, buyers
want more of this good than they're able to get at the current price. Ordinarily,
the buyers would compete to push the price up and the price would increase to the
market price and we would get the usual equilibrium.
In this case, however, it's illegal to push the price up. So as a result, the
quantity demanded exceeds the quantity supplied and we get the shortage which
doesn't go away. The shortage is defined simply as the amount by which the quantity
demanded exceeds the quantity supplied at the controlled priced.
Let's give some examples. When goods are in shortage, that is when the quantity
demanded exceeds the quantity supplied, sellers have more customers than goods.
Usually, sellers have to compete to get customers but when goods are in shortage,
sellers have more customers than they need. As a result, then we have
shortages, the sellers can cut quality, cut their costs and still sell everything
they want to sell at the controlled price.
As a result, price controls reduce quality. We saw this in the 1970s, books
were printed on lower quality paper two-by-four lumber shrank to one and
five-eights by three and five-eights. Automobiles were given fewer coats of
paint. Throughout the US economy quality began to fall. Here's another example, the
great Matzo Ball Debate. In 1972 union leader, George Meany
complained that his favorite soup, Mrs. Adler's had shrunk from four to three
matzo balls. So serious was this that the Chairman of the Wage and Price Commission
had his staff buy up a bunch of cans of Mrs. Adler's Soup, and count in each one
of them how many matzo balls were in the soup. He said they were still four.
Whoever was right, however, the lesson is quite correct.
Price controls reduce quality.
When the quantity demanded exceeds the quantity supplied, when there's a surplus
of buyers, sellers have less of an incentive to give good service.
Another way to reduce quality is to reduce service. And indeed, full-service gasoline
stations disappeared in 1973. The owners would simply close up shop whenever they
wanted to take a break.
More generally there's a reason why the baristas at Starbucks are pleasant to us,
it's because they want more customers. Customers are profitable, but when you
can't raise the price, when there's a shortage, when a seller has more customers
than they need, it doesn't pay to be pleasant to customers. Indeed, it may pay
to be unpleasant to drive some of them off, so you don't have to serve them.
This is another reason why the workers at the DMV are on average probably a little
bit less pleasant to us than at stores which require our service, than the store
which want us to come into the store. This is a reason why in communist countries
like the ex-Soviet Union, the workers at the stores were much more unpleasant than
workers in McDonald's are because McDonald's has an incentive to get more
customers. They want to create a pleasant experience. They want to make it easy to
buy goods from the store. But when there's shortages, when there are more customers
than you need, it no longer pays to be pleasant.
Okay, price ceilings, let's remember five important effects.
Shortages and reductions in product quality.
That's what we covered today. Next we will be covering wasteful lines in other search
costs, a loss in gains and trade and a misallocation of resources.
If you want to test yourself, click practice questions or if you're ready to
move on, just click next video.