PRICE CONTROLS

Definition:
• Price Controls
• Another form government intervention might take in a market is price controls.
• Price controls refer to the setting of minimum or maximum prices by usually the
government so that prices are unable to adjust to their equilibrium level determined by
demand and supply.
• Price controls result in market disequilibrium, and therefore in shortages (excess demand)
or surpluses (excess supply).
• Why do governments enact price controls?
• Because although it may seem to be an optimum situation, the free market does not always
lead to the best outcomes for all the producers and consumers, or for society in general, and
so governments often choose to intervene in the market to achieve a different outcome
Price Controls
• Why do price controls differ from indirect taxes and subsidies in a fundamental way?
• This is because when a tax is imposed or a subsidy granted, the market settles at a new
equilibrium. Price controls differ because, once they are imposed, they do not allow a new
equilibrium to be established, and instead force a situation where there is persisting
market disequilibrium.
• Important note: Please bear in mind that the term surplus has two different meanings.
• 1- In one sense it refers to excess supply resulting when quantity supplied is greater than
quantity demanded.
• 2- In the second sense it refers to the benefits that consumers or producers receive from
buying or selling (e.g. ‘consumer surplus’, or ‘producer surplus’ or ‘social surplus’).
Meaning of Market Disequilibrium
• Market disequilibrium means that the market is prevented from reaching a
market-clearing price, and there emerge shortages (excess demand) or surpluses
(excess supply)
• Shortages and surpluses involve a misallocation of resources and welfare losses.
Price Ceilings (maximum price controls)

• Price ceilings (maximum price controls): This is a situation where the government set a legal
maximum price, below the equilibrium price, meant to help consumers of a product by preventing
the producers from raising the price above it and hence, keeping the price low.
• Demonstrate how this would work on a supply and demand graph
• Extra Q.: What if PMAX was set above PE?
• If PMAX was set above the If If PMAX was set above the equilibrium price, the
• market would achieve equilibrium , and the price
ceiling price ceiling would have no effect

• If PMAX was set above the

Impacts on market outcomes of a price ceiling:

By imposing a price that is below the equilibrium price, a price

ceiling results in a ____________ quantity supplied and sold than at
the equilibrium price. This is shown in the graph above, where the
price ceiling, _________, corresponds to quantity ________ that
firms supply, which is ___________than the equilibrium quantity Q e
that suppliers would supply at price ______.
In addition, the price ceiling gives rise to a ________ quantity
demanded than at the equilibrium price: the quantity consumers
want to buy at the price __________is given by ______, which is
__________ than quantity Qe that they would buy at price Pe.
A price ceiling does not allow the market to clear; it creates a
situation of ______________ where there is a ___________ (excess
__________).
• Since a lower than equilibrium price results in a _________ quantity supplied than
the amount determined at the free market equilibrium, there are too _________
resources allocated to the production of the good, resulting in _________________
relative to the social optimum (or ‘best’). Society is _________ off due to
_________________ of resources and allocative ___________________.
Consequences for the economy
• Examine the possible consequences of a price ceiling, including shortages, ineffi cient resource
allocation, welfare impacts, underground parallel markets and non-price rationing mechanisms.
• A price ceiling set below the equilibrium price of a good creates a shortage (excess demand), which creates
problems.
• The shortages may lead to the emergence of a black market (an illegal market), where the product is sold at
a higher price, somewhere between the maximum price and the equilibrium price.
• There may also be queues developing in the shops and producers may start to decide who is going to be
allowed to buy.

• A price ceiling, Pc, set below the equilibrium price of a good creates a shortage.
• At Pc, not all interested buyers who are willing and able to buy the good are able to do so because there is
not enough of the good being supplied.
• shortage is equal to Qd − Qs.
• Once a shortage arises due to a price ceiling, the price mechanism is no
longer able to achieve its rationing function. How will the quantity Qs be
distributed among all interested buyers? This can only be done through
non-price rationing methods
• Non-price rationing: Rationing refers to a method of dividing up something
among possible users. In a free market, this is achieved by the price system
• “Queues developing in the shops and producers starting to decide who is going to be
allowed to buy (favouritism)” are both examples of non-price rationing methods.
• Another example of non-price rationing methods is the distribution of coupons to
all interested buyers, so that they can purchase a fixed amount of the good in a
given time period.
• Underground (or parallel) markets : involve buying/selling transactions that are
unrecorded, and are usually illegal
• They involve buying a good at the maximum legal price, and then illegally
reselling it at a price above the legal maximum
• Underground markets are inequitable, and frustrate the objective sought by the
price ceiling, which is to set a maximum price
• Underallocation of resources to the good and allocative inefficiency :
• lower than equilibrium price results in a smaller quantity supplied than the
amount determined at the free market equilibrium
• there are too few resources allocated to the production of the good, resulting in
underproduction relative to the social optimum (or ‘best’).
• Society is worse off due to underallocation of resources and allocative ineffi
ciency.
• Price Ceilings (maximum price controls) Before the price ceiling is imposed:
Consumer surplus: a+b
• Negative welfare impacts:
Producer surplus: c+d+e
 
Total social surplus: a+b+c+d+e

At this point, consumer plus producer surplus is

maximum. Also, MB = MC, and there is allocative
efficiency.
• Price Ceilings (maximum price controls) After the price ceiling is imposed:
Consumer surplus: a+c
• Negative welfare impacts:  Producer surplus: e

Total social surplus: a+c+e

Deadweight loss: b+d

A price ceiling creates a welfare (deadweight) loss, indicating

that the price ceiling introduces allocative inefficiency due to an
underallocation of resources to the production of the good,
seen by Qs < Qe and MB > MC, indicating that society is not
getting enough of the good.
Consequences for various stakeholders

• Discuss the consequences of imposing a price ceiling on the stakeholders in a

market, including consumers, producers and the government: