A price ceiling occurs when the government puts a legal limit on how high the price of a product can be. In order for a price ceiling to be effective, it must be set below the natural market equilibrium.
When a price ceiling is set, a shortage occurs. For the price that the ceiling is set at, there is more demand than there is at the equilibrium price. There is also less supply than there is at the equilibrium price, thus there is more quantity demanded than quantity supplied. An inefficiency occurs since at the price ceiling quantity supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss.
This graph shows a price ceiling. P* shows the legal price the government has set, but MB shows the price the marginal consumer is willing to pay at Q*, which is the quantity that the industry is willing to supply. Since MB > P* (MC), a deadweight welfare loss results. P' and Q' show the equilibrium price. At P* the quantity demanded is greater than the quantity supplied. This is what causes the shortage.
Recent increases in the price of gas have left many individuals asking for a price ceiling on gas. You now see why this is a bad idea. If the government sets a price ceiling on gas, there will be a shortage. Remember the long gas lines in the 1970's? This is exactly what happened.
If a price ceiling is set, then there must be a way to assign who gets the low supply of the product. Of course, since there is a legal limit on the price, the price can't simply be raised. There are several ways this is done without raising the price:
- Lottery: One way to distribute a product for which there is a shortage is to draw names out of a hat. In some states there is a high demand to be able to hunt for moose, but the government has a limit on the amount of permits it gives out. Often these states have a lottery and if you are lucky enough to get drawn, you can try your luck at finding and shooting a moose during the season.
- Black Market: For those lucky enough to get some of the short supply, they are often better off selling what they have obtained to the demanders that will get more benefit out of it. In some cities there have been ceilings put on the apartment rent. While the demand for apartments increases, the rent remains the same. When some renters are ready to move, they sublease their apartment instead of ending their contract. If they were renting for $500, but someone is willing to pay $1000, then the subleaser can continue paying $500 and pocket the extra $500 he gets from the subleasee.
- Queue/First Come First Serve: Had they raised the price of tickets to $100 the opening night of Star Wars: Episode I, I wouldn't have been willing to camp out two nights to get a ticket. Since they didn't let the market determine the price, however, there was a huge line and those that were there first got to buy tickets. Of course, in this case they may have wanted the "buzz" that would come from having people camp out a week early just to get tickets, but there are other cases where a buzz isn't useful.
- Historical Use: Sometimes the government will allow the consumers that were already consuming to continue consuming. This would be hard to do since after the price ceiling there will be many more people claiming they have consumed in the past. Also, the quantity supplied is decreased which will even leave some of the historical consumers wanting.
By B. Taylor, 2006