Question

The Governor of Hawaii, alarmed about the rapidly rising price of gasoline, requests your advice about whether Hawaii should put a price cap on the wholesale price of gasoline. As the Governor’s senior economic advisor, what do you advise and why? Your primary concerns are economic efficiency and the welfare of the citizens of Hawaii. Demonstrate that the citizens of Hawaii will be better off if the Governor follows your recommendation.

Answer 1

As an economic advisor, I would never recommend putting a price cap on the wholesale price of the gasoline, when a price cap is put the price of the goods are artificially kept low. At a lower price, the supply of the goods is reduced and the demand remains unfulfilled creating a shortage in the market.

At this price artificially lowered by the government, the deadweight loss is more than what it would be in case of a free market. IF the government really want to keep the prices low, I would recommend increasing the supply of the gasoline which will glut the market and bring the price down.

Here, without the price floor, the equilibrium was "a" and the quantity sold in the market was Q with the price floor the quantity decreased to Qs and deadweight loss will be the area equivalent to "abc".