Worked Example: Price Controls

Price Controls

People often expect the government to solve problems that they seem unable to solve on their own. Sometimes this is effective and sometimes it is not. Price controls, either price ceilings or price floors, often have unanticipated side effects. Think about it—passing a law doesn’t by itself make economic problems go away!

Such is the case with claims of price gouging, the charging of “excessively high” prices, which was exemplified by what occurred in the wake of Hurricane Katrina. Imposing a price ceiling below the equilibrium price may create as many problems as it solves. The basic problem is that the demand for bottled water is dramatically higher, since fresh water supplies were compromised, while the supply of bottled water was less as a result of storm damage.

The question is how to deal with the shortage, that is, how to allocate the limited supply of bottled water among competing needs and wants. Figure 1 depicts the example of price control for water after Hurricane Katrina.

The initial equilibrium price for bottled water is $1 per gallon, visible on the graph at P1 and Q1, the intersection of the original supply S and the original demand curve D. As a result of Hurricane Katrina, there is a huge rightward shift (or increase) in the demand for water, represented by D-prime. At the same time, there is a huge leftward shift (or decrease) in the supply of bottled water, represented by S-prime. The resulting new equilibrium price is at the intersection of S-prime and D-prime, or $7. This is much higher than normal. Responding to public outrage about the high price of water, the government establishes price controls that cap the price at $2 per gallon, represented by P-Max. This creates a shortage. At $2 per gallon, the amount people want to buy is Q(D). But at this price it isn’t worthwhile for vendors to incur the cost and trouble of shipping water into the troubled area, so supply falls to Q(S). The shortage is represented by the rectangle under P-Max between Q(D) and Q(S). The result is an unintended consequence. With the price control in place, water IS cheaper for those who can find it. But far fewer people have access to water because at this artificially low price, suppliers are not incented to meet demand.

Figure 1. Price control for water after Hurricane Katrina.

When a price ceiling reduces the legal price of a product, businesses have less incentive to supply the product. Economically speaking, the law of supply says that at lower prices, the quantity supplied will be lower. At the same time, the law of demand states that at a lower price, the quantity demanded will be higher. This can be seen clearly in the graph. So who gets the limited supply? As Shakespeare said, that is the question.

Unfortunately, there is no clear answer to this. It could be first come, first serve. It could be friends of the seller. In many cases, what results are under-the-table payments by consumers willing to violate the law. What is certain is that less bottled water gets to consumers than would be the case if the price were allowed to rise. Many would argue that this shortfall is not the best outcome.