Price Ceilings: Shortages and Quality Reduction

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.