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$7 -<br />

6 -<br />

5 -<br />

S 3<br />

S1 S 2<br />

Price 4 -<br />

3 -<br />

2 -<br />

1 -<br />

0 <br />

D<br />

<br />

0 5 10 15 20 25 30 35 40<br />

Price Controls<br />

Quantity<br />

Though markets are economically efficient, public dissatisfaction with market-determined prices<br />

has often led the government to impose price controls. One type of price control is a price ceiling.<br />

A price ceiling is a maximum legal price.<br />

As illustrated on the graph in Example 15 on the next page, a price ceiling leads to a shortage. In<br />

Example 15, the equilibrium price for Good X is $4. When a price ceiling of $3 is set, a shortage<br />

is created. Price ceilings also lead to:<br />

1. Fewer exchanges than at equilibrium. In Example 15, 15 units are exchanged at<br />

equilibrium, while only 10 units are exchanged at the ceiling price.<br />

2. The use of nonprice rationing devices. With a price ceiling in place, price is not allowed to<br />

adjust and ration goods. Nonprice rationing devices, such as government allocation, waiting in<br />

line, or favoritism will have to be used. Nonprice rationing devices are less efficient than using<br />

market price as the rationing device. Market price rations the goods produced to the<br />

consumers who are willing and able to pay the most for them, and thus apparently have the<br />

most valuable use for the goods. Nonprice rationing devices will not ration the goods produced<br />

to the consumers who are willing and able to pay the most.<br />

3. Illegal transactions at prices above the ceiling. Buyers and sellers can benefit from<br />

exchanges at prices above the ceiling. Some buyers and sellers will break the law to engage<br />

in these mutually beneficial transactions. In terms of economic efficiency, it is better if all<br />

buyers and sellers ignore the price ceiling, break the law, and engage in all mutually beneficial<br />

transactions.<br />

The other type of price control is a price floor. A price floor is a minimum legal price. As<br />

illustrated on the graph in Example 16 on the next page, a price floor leads to a surplus. In<br />

Example 16, the equilibrium price for Good X is $4. When a price floor of $5 is set, a surplus is<br />

created. Price floors lead to fewer exchanges than at equilibrium. In Example 16, 15 units are<br />

exchanged at equilibrium, while only 10 units are exchanged at the floor price. The floor will also<br />

mean that production is not necessarily allocated to the producers who can produce at the lowest<br />

cost.<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

To maintain the artificially high price mandated by a price floor, the government may step in and<br />

purchase the surplus goods. The government commonly uses this policy in agricultural markets.<br />

3 - 9 Demand, Supply, and Equilibrium

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