Chapter 6: Price Controls and Tax Incidence — Key Points

6-1 The Surprising Effects of Price Controls

Price controls are government-imposed legal limits on prices, established to influence market outcomes and achieve specific social or economic objectives, such as affordability or income support.
These controls interfere with the natural allocation of resources by supply and demand, often leading to unintended consequences.
Two main forms:
- Price ceiling (P_c): A legal maximum price that sellers are allowed to charge for a good or service. It is often implemented to keep goods affordable for consumers.
- Price floor (P_f): A legal minimum price that buyers must pay for a good or service. It is typically implemented to support sellers' incomes or to ensure a minimum standard for workers.
In a free and competitive market, the equilibrium price and quantity, denoted as $P^$ and $Q^$ , are determined by the intersection of the supply and demand curves. This equilibrium is generally considered efficient, maximizing total surplus.
Price controls, by preventing prices from reaching their natural equilibrium, can create undesirable outcomes such as: shortages (with price ceilings), surpluses (with price floors), inefficient non-price rationing mechanisms, and a reduction in overall market efficiency.

6-1a How Price Ceilings Affect Market Outcomes

A price ceiling sets a maximum price. Its impact depends on its relation to the equilibrium price:
- A price ceiling is binding (or effective) if P_c < P^, meaning the legal maximum price is set below the market equilibrium price. This prevents the market from clearing at $P^$ .
- A price ceiling is non-binding if $P_c \ge P^*$ , meaning the legal maximum price is set at or above the equilibrium price. In this case, the market can still reach its equilibrium, and the ceiling has no immediate effect on price or quantity.
A binding price ceiling leads to a shortage: At the artificially low ceiling price, the quantity demanded by consumers (Gd) exceeds the quantity supplied by producers (Gs), i.e., Qd > Qs. The magnitude of the shortage is $Qd - Qs$ . This occurs because the lower price encourages more buying while discouraging selling.
Example: If the equilibrium price for ice cream cones is $P^* = 3.00$ and a price ceiling is imposed at $Pc = 2.00$ , consumers will demand more cones (e.g., $Qd = 125$ ) than producers are willing to supply (e.g., $Q_s = 75$ ). This results in a shortage of $50$ cones ( $125 - 75$ ).
Non-binding ceiling: If the price ceiling were set at $P_c = 3.50$ (above $P^* = 3.00$ ), the market would operate at $P^* = 3.00$ , and the ceiling would be irrelevant.
When a binding ceiling creates a shortage, the traditional price signal can no longer ration the good. Instead, non-price rationing mechanisms emerge. These are often inefficient, arbitrary, and unfair:
- Long lines: Consumers may spend considerable time waiting to purchase the good.
- Seller biases/discrimination: Sellers may favor certain customers (e.g., friends, regulars) or discriminate based on arbitrary criteria.
- Black markets: Goods may be sold illegally at prices above the ceiling, undermining the policy's intent.
- Reduced quality: Producers may cut costs by reducing the quality of the good or service, as they cannot compete on price.

Case Study: How to Create Long Lines at the Gas Pump

During the 1970s, the Organization of Petroleum Exporting Countries (OPEC) significantly reduced crude oil production, causing a sharp contraction in the supply of gasoline. This supply shock would normally lead to much higher equilibrium prices for gasoline.
To prevent what was perceived as