Price Ceilings
In August 2005, the state of Hawaii did something that no other state in the country had done: it set a limit on the price of gasoline. Consumers in Hawaii were excited, because the state had by far the highest gasoline prices in the country. Officials for the Hawaii Public Utilities Commission decided that the equilibrium price of gas in that state was simply “too high,” and so they imposed regulations that required gasoline sellers to drop their prices.
In May 2006, the governor of Hawaii signed a bill to do away with these regulations. Hawaii’s gas prices were still the highest in the nation ($3.41 per gallon on the date that the regulations were removed). In short, the state of Hawaii admitted that its eight-month-long experiment to control the price of gasoline had failed.
What went wrong? Wasn’t it a good idea to try to rein in gas prices?
Definition
A price ceiling is defined as a legal maximum price set below the equilibrium price.
The goal of a price ceiling is to make consumers better off, by reducing the price that they pay.
We can represent a price ceiling graphically, as shown below. Suppose that the equilibrium price of gas in Hawaii was $3.50 per gallon, and the equilibrium quantity was Q0. Drivers in Hawaii were considered this price “too high.” In response, the state of Hawaii imposed a price ceiling, which stated that the maximum price of gas in Hawaii could be no more than, say, $2.75 per gallon.
The Effects of a Price Ceiling
Does the price ceiling make drivers in Hawaii better off? That, after all, is the goal of the price ceiling. So let’s consider the effects of this price ceiling.
1. The first thing we can say is that the price does come down. It has to, by law. It’s illegal for gas sellers to charge more than the price ceiling. That’s what a price ceiling is – it’s a legal maximum price. It is illegal to charge more than the ceiling price.
The ceiling means that is the highest that price will be allowed to go.
2. The price ceiling creates a shortage.
When the price ceiling forces the price down, what do consumers want to do? The Law of Demand tells us that when the price goes down, the quantity demanded will go up, everything else remaining the same. So the quantity demanded will no longer be the equilibrium quantity Q0; instead, the quantity demanded at a ceiling price of $2.75 will be shown by the demand curve. We’ll call it QD – the quantity demanded at the ceiling price. In other words, the price ceiling leads to an increase in the quantity demanded.
At the same time, the price ceiling will affect the quantity supplied. When the price ceiling forces price down, what do sellers want to do? They are less willing and able to produce and sell as the price goes down. So the quantity supplied will no longer be the equilibrium quantity Q0; instead, the quantity supplied at a ceiling price of $2.75 will be shown by the supply curve. We’ll call it QS – the quantity supplied at the ceiling price. In other words, the price ceiling leads to a decrease in the quantity supplied.
The price ceiling set below the equilibrium price causes the quantity demanded to rise and the quantity supplied to fall. With the price ceiling in place, the quantity demanded will be greater than the quantity supplied. The price ceiling creates a shortage.
3. Who gets to buy gas?
At the equilibrium price, everyone who is willing and able to pay that price is able to actually buy the product and everyone who is willing and able to sell at that price can actually sell the product. But that’s not the case with the price ceiling in place. The price ceiling creates a shortage. Some people who are willing and able to pay the price ceiling price of $2.75 are not able to find any gas to buy.
At a price of $2.75, people want to buy more gas than is offered for sale. So sellers get to pick and choose whom they want to sell to.
One possibility is that gas will be sold on a first-come, first-served basis. Gas stations would sell as much gas they were willing and able to sell at $2.75; gas would go to those who got there while the stations were willing and able to sell; people who got there after that would not get to buy. So what would people do? They’d try to make sure they got to the station early, and there would be lines of cars waiting to buy gas. So now the price of gas is not just $2.75 per gallon, it’s $2.75 plus the opportunity cost (remember that idea?) of waiting in line. In fact, adding in the opportunity cost (the value of time spent waiting) the price of gas rises to above $3.50 ($2.75 in money plus some in the value of time). And people will be less willing to drive around with a nearly empty tank, because they might not be able to buy gas when their tank is empty, so people will fill up more often, and not let tanks get very empty at all. That’s another cost, having to fill up more frequently.
Is this a good way of deciding who gets to buy gas? Who will wait in line? Those who have a low opportunity cost of time. People who don’t have anything better to do will be willing and able to wait in line and buy gas at the low price of $2.75. So this system is good for people with low opportunity cost of time. This system discriminates against people with a high opportunity cost of time.
Another way to ration gas with a price ceiling is through a lottery. That is, people get selected at random, and are allowed to buy gas for $2.75 per gallon. For example, we might announce each day that people with the number 2 in their license tags get to buy gas that day, and everybody else is out of luck for that day.
Is this a good way of deciding who gets to buy gas? It’s good for people who get lucky and get picked to buy gas at the low price. This system discriminates against people who are unlucky.
Is either of these systems better than rationing gas by price? With each system, some people will be favored and some people will be discriminated against.
In fact, even with the price ceiling, the market forces of supply and demand are still trying to work. For example, sellers might sell gas at a price of $2.75 only to people who also were willing to pay $10 for a couple of Twinkies. Or sellers might sell gas for $2.75 only to people who were willing to pay $10 to put air in their tires. This would in effect push the price back up to the equilibrium level.
We’ll have more to say about various methods of rationing next week
Let’s summarize our discussion of price ceilings:
And now you should be able to answer this question: Why did Hawaii do away with its price ceiling on gasoline?