3. Controls on Price

What happens to market outcomes when Government imposes legal constraints on price?

Price Ceiling & Price Flooring

• Price Ceiling: A legal maximum on the price at which a good can be sold.
  • Binding price ceiling: A price ceiling that is below the equilibrium price. A shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers.
  • Non-binding price ceiling: A price ceiling that is above the equilibrium price. Market forces move the economy to the equilibrium, and the price ceiling has no effect on the price or the quantity sold.
• Price Floor: A legal minimum on the price at which a good can be sold.
  • Binding price floor: A price floor that is above the equilibrium price. A surplus of the good arises, and it can lead to undesirable rationing mechanisms.
  • Non-binding price floor: A price floor that is below the equilibrium price. Market forces move the economy to the equilibrium, and the price floor has no effect on the price or the quantity sold.

Economic Welfare & Market Efficiency

• The price that balances the supply and demand is, in a particular sense, the best one because it maximizes the total welfare of a product’s consumers and producers. No consumer or producer aims to achieve this goal, but their joint action directed by market prices moves them toward a welfare-maximizing outcome, as if led by an invisible hand.
• Willingness to pay: The maximum amount that a buyer will pay for a good. It measures how much that buyer values the good. Represented by his/her demand curve.
• Consumer Surplus: The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. Measures the benefit that buyers receive from a good. Thus, consumer surplus is a good measure of economic well-being if policymakers want to satisfy the preferences of buyers.
  • Graphically,
  • Fall in price increases consumer surplus.
  • Rise in price decreases consumer surplus.
• Willingness to sell: The minimum amount that a seller will receive as payment for a good. It measures the seller’s cost of producing the good. Represented by his/her supply curve.
• Producer Surplus: The amount a seller is paid for a good minus the seller’s cost of providing it. Measures the benefit that sellers receive from participating in a market. Thus, producer surplus is a good measure of economic well-being if policymakers want to satisfy the interests of sellers.
  • Graphically,
  • Fall in price decreases producer surplus.
  • Rise in price increases producer surplus.
• Total Surplus: Welfare to the society or Total Surplus, $TS = CS+PS$. Free markets produce the quantity of goods that maximizes the total surplus. Thus, allocation from a free market is efficient.
  • Graphically,

Welfare on Price Ceiling & Price Floor

• Price Flooring is imposed (binding):
  • A legal minimum price at P1 causes a surplus in the market. Q1 amount of the product is sold.
  • New CS has a smaller value, while new PS has a larger value.
  • TS is less than equilibrium.
  • Lost TS is called the Deadweight loss.
  • A non-binding price floor has no effect on the market outcome.
• Price Ceiling is imposed (binding):
  • A legal maximum price at P1 causes a shortage in the market. Q1 amount of the product is sold.
  • New CS has a greater value, while new PS has a smaller value.
  • TS is less than equilibrium.
  • Deadweight loss is created due to the price ceiling.
  • Again, a non-binding price ceiling has no effect on the market outcome.

Acknowledgement

• Reference: Class Lecture