Question

Elaborate on how price ceilings and/or controls tend to generate misallocation of resources in the markets and create shortages/surpluses. Provide a real-world example.

Answer 1

a) Price Ceiling - This refers to a maximum possible price set by the government that can be charged for a good/service.

Consider an example of the Indian government imposing a price ceiling on the price setting for Uber rides during peak times.

What a price ceiling (when binding) does is that, it pulls down the price of a ride during peak times. This creates a greater demand for Uber rides during peak times than before (when the peak pricing was higher at P in the figure below).

The figure below represents the equilibrium price to be established at P and quantity demanded at Q. As soon as a price ceiling on peak pricing is imposed, the price is established at P*. This creates a 'shortage' for rides during peak timings. That is, quantity demanded (Qd) exceeds the quantity supplied (Qs) at this lower price which attracts more customers to a cab ride during peak timings (Qd - Qs).

​​​​​b) Price Floor - This refers to a minimum possible price set for a good/service by the government.

Example, minimum wage! Governments in various countries have minimum wage established where no worker can get less than a wage set by the government.

This is shown in the figure below. The initial equilibrium price is at P and the equilibrium labour employed is Q.

As the government sets a minimum wage (representing a price floor), there is an additional labour force willing to supply labour at a higher wage at W*. This creates an excess of labour supply over the labour demand since the demand decreases at Qd because firms are willing to high lesser labour at a higher than before wage. Hence, there is a 'surplus' of labour in the labour market (Qs - Qd).

Therefore, a price floor attracts more suppliers and thereby creates a surplus of a good or service.