Lesson: Demand, Supply, and Efficiency

Inefficiency of Price Floors and Price Ceilings

Inefficiency of Price Floors and Price Ceilings

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  • Price controls are described as price ceilings or price floors. A price ceiling prevents a price from rising above a certain level. A price floor keeps a price from dropping below a certain level.
  • If a price ceiling is set above the existing market price, the ceiling has no impact on the market. If the price ceiling is set below the market price, there will be a shortage.
  • When price ceilings are below the market price, producers slow or stop their production. This results in fewer of the product in the market. With the lower price, consumers increase demand for the product.
  • A price floor leads to an oversupply or goods and services. The price floor sets prices at a point where consumers are not willing to pay, but producers supply more because they think they will get a greater return. 
  • Deadweight loss is the loss in social surplus when the economy produces an inefficient quantity. 

The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome. However, there is something else to consider. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to producers or some producer surplus to consumers. 

Imagine that several firms develop a promising but expensive new drug for treating back pain. If this type of treatment is left to the market, the equilibrium price will be $600 per month and 20,000 people will use the drug, as shown in the figure. The original level of consumer surplus is T + U and producer surplus is V + W + X. However, the government decides to impose a price ceiling of $400 to make the drug more affordable. At this price ceiling, firms in the market now produce only 15,000.

As a result, two changes occur. First, an inefficient outcome occurs, and the total surplus of society is reduced. The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In the figure above, the deadweight loss is the area U + W. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher in this case because the price control is blocking some suppliers and demanders from transactions they would both be willing to make.

A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is T + V, while the new producer surplus is X. In other words, the price ceiling transfers the area of surplus (V) from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss.