A price control (or a price ceiling) occurs when the government puts a legal limit on how high the price of a product can be. For a price control to be effective, it must be set below the natural market equilibrium.
Using a hypothetical perfectly competitive market called pharmaceutical drugs, let’s examine the microeconomics of price control.
When a price control or price ceiling is set, a shortage occurs. The red horizontal line markets the price ceiling that is set by the government.
The price control forces the price down from P to P2. At the lower price, more people can afford the drug and so the quantity of the drug demanded goes up from Q to Q2 (point A).
The suppliers of the drug (pharmaceutical company) immediately cut back on supply (point B) as they are now paid below what the equilibrium market price established. Instead, these suppliers focus on supplying most of their drugs to other consumers, perhaps in other states that pay the full market price for the drugs they make. A shortage is created by the difference in the quantities of drugs demanded, versus the quantities of drugs supplied as illustrated by the shaded area. Shortages within the pharmaceutical industry would likely result in deaths, depending on the drugs needed.
The government set a price ceiling of P2 and so quantity supplied contracted to point B. However, at that supply level, consumers would be willing to pay a price of P3. Since P3 is greater than P2, deadweight loss occurs. The deadweight loss is the elimination of trading between both suppliers and consumers.
Price controls are a bad idea. If the government sets a price ceiling, there will be a shortage.<< Back to Glossary Index