The Effects of Price Ceiling in Economics. Overview and Explanation

Price Ceiling

Let's think about the market for a college education in the United States. We'll have our price on the y-axis and let's just say that that's the price of one-year tuition at a college in the US and then we have on our x-axis the quantity demanded. Let's say that our equilibrium when we look at our demand and our supply and where they intersect we have our equilibrium. So our equilibrium price is $50,000 for one year's tuition and at that price let's say that there are 20 million students that are attending college. So that's the equilibrium point and then our consumer surplus would be this blue triangle and then our producer surplus would be the Yellow triangle that's shaded in.


Now we've got the equilibrium price of $50,000. What the price ceiling is? The price ceiling is the government coming in and saying "Look we're gonna set some ceiling that is $20,000 and the price cannot go above that." So our price ceiling will be $20,000. 


The Effect of the Price Celling

Now, this is going to have a number of effects. First of all, there is going to be a shortage because if you notice that at this point at $20,000 the quantity demanded is just say that that's 30 million students or 30 million seats but our quantity supplied at $20,000 the amount that universities or colleges are willing to supply is let's say that that's 10 million so this difference here is a shortage.


We have a shortage because at a price of $20,000 a year there are 30 million people who are demanding that "I would like to go to college for $20,000 a year." but there are only 10 million spots, suppliers are only willing to supply 10 million seats in colleges for that amount. So that difference between 30 million and 10 million we'd say that there's a shortage. 

Now, let's think about this what effect does this have on the market? Well, we see that here is where we normally ended up at our equilibrium but now with this price ceiling, even though the demand is over here at 30 million we're only going to have 10 million supplied. So that's going to be what happens in reality 20 million people are gonna be left out. So we're gonna end up over 10 million so because we end up over 10 million we can draw an imaginary line


So here's our imaginary line and all this amount to the right of our imaginary line all that amount is going to be lost. This is lost value, if we think of the surplus we had our consumer surplus and our producer surplus and if we added them together we have the total surplus. Now we are losing from that total surplus all this Red area it's called a deadweight loss. A deadweight loss is just a reduction so it's a reduction in the total surplus and so we are losing some surplus. 

Now if you think about it our consumer surplus, it used to be this blue triangle now we've lost this amount right side of our imaginary line, that's no longer part of the consumer surplus however the consumer surplus has grown to the producer surplus area, some of the amounts that used to be for producers some of the consumers are getting because they're getting a cheaper price. 


That doesn't mean it's a great policy but some people are there who are increasing the consumer surplus. So some of the consumers are benefiting but 20 million people are losing out. Because there's a shortage. However, the people who do get to college, those 10 million seats there's gonna be an increase in surplus for those people.

Now you see that our producer surplus this amount here, look how small it is. So the producer surplus has gotten smaller in some cases it might be big but the case that the consumer surplus actually grows larger or whatever. Bear in mind that this deadweight loss means that when we used to have the whole triangle we used to have that whole triangle was the total surplus but now the total surplus we only have the left part of the triangle. We lost the entire Red shaded region. That's not value for consumers that's not value for producers that are not valued for anybody. So the effect of the price ceiling is that we created a shortage and in terms of that there are more people demanding to go to college than there are seats that the producers are willing to provide. So we've got a shortage so a lot of people are losing out we've lost all this value here in the dark area, that's we just had a total reduction in total surplus. Now, sure there is a transfer for some of the producers to some of the consumers but it's not enough to outweigh this loss that we have here in the red area.

So this price ceiling, economists agree generally speaking that price ceilings are universally seen as a bad idea. It's gonna reduce the total surplus, it's gonna create a shortage and so forth and we see price ceilings I just gave the example of the University education here but you would commonly see it with something called rent controls. We'll have a lot of cities, particularly in the U.S, New York City, San Francisco different places that we will see some kind of rent control. Now the rent control could be something where you say "Look, this apartment here's the amount of the price that could be charged and that's it." It could be something where they said the price of the apartment can only go up 1% per year. 

There are lots of different ways to implement rent controls but they're generally price ceiling and we see that when we have a price ceiling we're losing all the value in the red area and we're creating a shortage and when we create the shortage who are the people most likely to be able to get around this? Might be wealthier people. We might even think we're helping people by price ceiling but it might be wealthy people who have the money to be able to figure out how do they get in one of those apartments even though there's a shortage of apartments. They can bribe the landlord etc and so forth. We have to think that the price ceiling leading to this shortage and reducing total surplus they're just universally seen as a bad idea for the economy.