When markets are free to choose a price and quantity, the result is an equilibrium. Prices become the mechanism that directs demanders and suppliers toward this point. If, in the opinion of government decisionmakers, the resulting equilibrium price is too high or too low, then the government may intervene in the market by imposing price controls. Those controls are then enacted to prevent prices from falling into unacceptable ranges. Of course, normative concerns like fairness are arbitrary and represent something that government must define. That is, government must decide exactly how high is too high or how far a price can fall before it’s too low.
Price controls are important because they can alter the behavior within a market. Prices act as an incentive to buy and sell. For example, if government deems a price too high, then it is possible that the government may restrict the price from rising above a certain point by placing a price ceiling on the good sold in this market. The price ceiling serves as a price maximum. Similarly, if the price was too low, then the government could impose a price floor (price minimum).
The point here is that if prices cannot reach what would be the equilibrium, then a gap will emerge between the quantity demanded and quantity supplied. In turn, a lack of equality between the quantity demanded and supplied causes other events to occur. Although these secondary effects are indirectly related to the price control, they may be of a sufficient magnitude and therefore deserving of our attention.
Let’s consider an example where a price ceiling is imposed on a specific market. Our market will be the market for regular unleaded gasoline (87 octane) and we'll assume that this market can be described by the demand and supply model in the following graph (note the steep slope of demand implies something about how people respond to changes in the price of regular unleaded gas):
In this setting, Q* units of regular unleaded gasoline, which we’ll assume is 9.5 units (we'll assume that each unit is one hundred thousand gallons), are sold at a price of P*, which we’ll also assume is $1.45 per gallon. Click here for an explanation as to where these values come from.
Suppose consumers lobby the government, asking for intervention in this market. Their claim is that the high price of regular unleaded gasoline hurts middle and lower income individuals more than higher income drivers because rich people use cars that require a higher octane that what’s provided in regular unleaded. Let’s assume that these people are successful and that the government places a price ceiling of $1 on regular unleaded gas (but no ceiling on the more premium brands). Demanders and suppliers can still agree to transact at any price they want, but only as long as that price is below the ceiling.
We can illustrate this ceiling on the previous graph as follows:
Because the price cannot legally rise above $1, demanders and suppliers must interact at this new price (not the price that would otherwise be the equilibrium price). We determine how much suppliers would provide at this price by looking at the quantity supplied (Qs) at the $1 price. Let's suppose that the resulting quantity supplied is 5.25 units (i.e. 525,000 gallons of regular unleaded gasoline). Similarly, if we consider the quantity demanded (Qd) at $1, then we observe 1 million gallons being demanded. Of course, demanders will not be able to get this one million gallons, because only 525,000 gallons are being supplied. Therefore, the price ceiling leads to a shortage of 475,000 gallons. The change in quantity demanded and supplied, and resulting shortage, is a direct effect of the price ceiling.
Note also that there are fewer gallons being exchanged in this market. That is, not only does the price ceiling cause a 475,000 gallon shortage to occur, but there are also 425,000 fewer gallons of regular unleaded being sold. Many of the drivers who formerly purchased regular unleaded gas will have to turn to an alternative fuel (or fuel source) because they cannot buy the gasoline they used to buy before the price ceiling.
The price ceiling may also have some indirect effects on this market. Whereas the price ceiling may directly lead to a shortage, the shortage may (in turn) have an effect on the behavior of demanders and suppliers.
Several outcomes are possible, but let’s consider the short run possibilities first. We'll define the short run as a period of time where demanders and suppliers face at least some adjustment constraints on their behavior. For instance, it's difficult for suppliers to just leave the market in a short time because existing firms not only must first liquidate their assets, pay off creditors, etc., but also might want to wait and see if the market changes after a while (e.g. perhaps the government might change its mind about the price ceiling). Consequently, we think of exiting the market as something firms would do in the long run rather than the short run.
Some of the possible short run adjustments might include changes in the purchasing patterns of demanders, or selling patterns of suppliers. Demanders need gas because of the shortage, so perhaps they’ll turn to buying one of the more expensive, higher octane gasolines. If demanders cannot afford these higher priced brands, then they may also drive further to buy regular unleaded gas in markets where there is no shortage (or price ceiling). It’s also possible that suppliers may decide to impose certain fees on the sale of regular unleaded. For example, a 25 cents per gallon "pumping charge" might be imposed on every gallon sold during busy times of the day.
In the long run, suppliers might adjust by shifting toward supplying more of these higher octane gasolines. Suppliers might expand their ability to supply higher octane gas by increasing their ability to store higher octane gas (and buying smaller storage tanks for regular unleaded gas). It is also possible that some gasoline suppliers will not sell gasoline any more. Some may leave the market, some may shift over to providing mechanic services instead. Overall, there will be a decrease in the number of suppliers of regular unleaded gas. When the number of suppliers decreases, the supply curve shifts left and the shortage only grows.