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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- 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 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 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 and 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.