Question

A few years ago, a major storm hit some part of southeaster regions of the U.S. The storm damaged water pipes, leaving many areas without clean drinking water. Travel was also difficult so supplies of food and other goods were disrupted. The storm created a shortage of bottled water. As a result, bottled water were sold at prices much higher than normal. These high prices provoked cries of “price gouging” and calls on the government to impose price controls on essential goods to prevent gouging. While no one likes to pay a higher price than normal for something, consider what would have happened with a price ceiling. The economic intuition is revealing.

Draw a diagram showing the market for bottled water BEFORE the storm with an equilibrium price at $5 per case. Now draw the impact after the storm (what happens to the supply and demand curves?) Then draw the impact of a price ceiling at $3 per case. What would be the impact of the price ceiling on the quantity demanded? On the quantity supplied? Who would benefit from the price ceiling and who would be harmed? Let the graph guide your thinking. Don’t start with your gut reaction! Did the price ceiling help the people it was designed to help? Explain the economic reasoning behind your analysis.

Answer 1

Price ceiling is a type of price regulation usually imposed by government on essential commodities. In the above case, there has been a storm, which has resulted in the shortage of bottled water. So in order to prevent price gouging and adminster that people are able to get bottled water, the govrenment imposed a price ceiling.

After the storm, the supply curve would shift to left, since the supply would reduce due to storm. Given the equilibrium price before storm was $5, now the price would have risen above $5. This implies that the equilibrium price would increase and equilibrium quantity would reduce.

If the government imposed a price ceiling at $3, which means that the price cannot go above $3. This would mean that the demand would be more, given the price is less than the equilibrium price. But the supply would be less. This could also be seen in the diagram above, where the ceiling Pc is binding in the market .

The price ceiling would create a shortage and would not reach to all the desired people. Rather some of them would receive it at a lower price, while others would not receive it at all. Hence price ceiling is not completely efficient, rather it could create certain welfare losses.

(You can comment for doubts)