SAD - Price Controls Lesson

Price Controls Lesson

In theory, when a market is left to function without interference, it will seek to attain equilibrium. At the equilibrium price, the market "clears" and no shortage or surplus will exist. The result is allocative efficiency - the amount consumers wish to buy exactly equals the amount producers are willing to supply. From time to time (and for a variety of reasons), the government intervenes in the market and the result is a deviation from allocative efficiency.

Price Floors and Ceilings Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

Price Floors

Occasionally, the government will intervene in a market to help the producers of a good by setting a price floor. In the market for gas established earlier in the module, the government may believe that the equilibrium price of $2.10 is too low. By setting a price floor at $2.20, which is a legal minimum price that can be charged for a good, the government is keeping the price of gas artificially high for the benefit of the producer.

However, at this high price, the QS is greater than the QD. Looking at either the schedule or the graph below, the QS is 95,000 gallons and the QD is 75,000 gallons. The price floor has created a surplus and reduced the allocative efficiency of the market. Before the price floor, the market only wanted 80,000 gallons. Now it is producing 95,000 (15,000 gallons more than the amount for allocative efficiency).

In a market without intervention, there would be a natural decrease in price to correct the surplus. Since it is illegal to charge less than the price floor, the market cannot correct the surplus.

The Market for Gasoline

Market for Gasoline Graph
X-axis - Quantity
Y-axis - Price per Gallon
Graph shows the areas of surplus (above equilibrium) and shortage (below equilibrium) of gasoline. Equilibrium is at the center where the quantity demanded and supplied is equal. Equilibrium is at a quantity of 80,000 gallons and a price of $2.10.

Price Ceilings

Occasionally, the government will intervene in a market to help the consumers of a good by setting a price ceiling. Let's continue to consider the market for gas shown above. The government may believe that the equilibrium price of $2.10 is too high. By setting a price ceiling at $2.00, which is a legal maximum price that can be charged for a good, the government is keeping the price of gas artificially low for the benefit of the consumer.

However, at this low price, the QD is greater than the QS. Looking at either the schedule or the graph, the QD is 90,000 gallons and the QS is 70,000 gallons. The price ceiling has created a shortage and reduced the allocative efficiency of the market. Consumers can only purchase 70,000 gallons - the amount supplied - at the price ceiling (10,000 gallons less than what would have been purchased if the market had been left alone).

In a market without intervention, there would be a natural increase in price to correct the shortage. Since it is illegal to charge more than the price ceiling, the market cannot correct the shortage.

IMAGES CREATED BY GAVS (Creative Commons License Attribution)