Price Ceilings: Shortages and Quality Reduction

Price ceilings result in five major unintended consequences, and in this video we cover two of them. Using the supply and demand curve, we show how price ceilings lead to a shortage of goods and to low quality goods. Prices are signals that indicate to suppliers how much is being demanded, but when prices are kept artificially low with price ceilings, suppliers have no way of knowing how many goods they should produce and sell, leading to a shortage of goods. Quality also decreases under price controls. Do you ever wonder why the quality of customer service at Starbucks is generally better than at the DMV? The answer lies in incentives and price ceilings. We’ll discuss further in this video. 

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- [Alex] 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, well, 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
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 deadweight 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

would 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 curve
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 this 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 price.

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, when 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-eighths
by three and five-eighths.

Automobiles were given
fewer coats of paint.

Throughout the U.S. 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 there 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.

So 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 at stores 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 at 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 and other search costs,

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

- [Narrator] If you want to test
yourself, click "Practice Questions."

Or, if you're ready to move on,
just click "Next Video."

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