The analysis of equilibrium in perfect competition above is a useful benchmark for market outcomes in the presence of a high level of competition: many buyers and sellers; identical products; free entry and exit; and a lack of market power. While this context certainly does not apply to all markets, it will be a useful reference point as we compare the competitive equilibrium outcome with outcomes driven by government policies.
In particular, we begin this chapter by examining policies that restrict legal prices in markets - known as price controls. A price control can take the form of a price floor, where the government sets a minimum legal price in the market, or a price ceiling, where the government sets a maximum legal price in the market. Price controls can exist in any market structure, including monopolies, monopsonies, and oligopolies; however, we will use the competitive market framework as our benchmark to compare market outcomes before and after a price control policy is implemented. 1
A price floor is a policy which sets a minimum legal price in a market. Price floor policies are common in markets for agricultural products like milk or cheese, where there can be fluctuations in production and harvests that put farms at risk of going out of business. The government may consider a price floor to ensure that sellers receive a sufficiently high price for each unit sold. How does the implementation of a price floor influence a perfectly competitive market?
Consider a market for milk, where demand is given as \(Q_D = 16 - 4P\) and supply is given as \(Q_S = 4P\text{.}\) The market-clearing price for a gallon of milk is \(P^* = 2.00\text{,}\) and at equilibrium, \(Q^* = 8\text{.}\) 2 So, if the milk market is left unregulated, then the market will always adjust toward an equilibrium price of $2.
What if the government sets a price floor at \(P_F = 1.50\text{?}\) This is one way the government could step in to aid sellers, ensuring that each unit of \(Q\) sells for at least 1.50. In this case, however, prohibiting the price from going below 1.50 does not have a strong impact, because the price does not want to adjust below 1.50 anyway! Market-clearing price is $2! Since the price floor at \(P_F = 1.50\) does not prevent the market from reaching equilibrium, we say the price floor here is non-binding. The price floor doesn’t change the market outcome, and the market remains at \((P^*, Q^*) = (2, 8)\text{.}\)
Additionally, since the market outcome is the equilibrium outcome, we know this outcome is efficient. Consumer surplus is \(CS^* = \frac{1}{2}(2)(8) = 8\) and \(PS^* = \frac{1}{2}(2)(8) = 8\) at equilibrium; total surplus is \(TS^* = CS^* + PS^* = 16\text{.}\)
Figure6.1.1.At a price of 1.50, the price floor is non-binding. Price is able to adjust to equilibrium. CS and PS are identical to the market equilibrium outcome.
What if, instead, the government sets a price floor at \(P_F = 3\text{?}\) We know that at that price, consumers will demand
or, 12 gallons of milk. There is a surplus of 8 gallons at a price of $3! Typically, the surplus puts downward pressure on the price, as lowering the price would reduce \(Q_S\) and incentivize more \(Q_D\text{.}\) However, the price floor prevents the price adjustment toward equilibrium from taking place! The price cannot adjust downward below $3, and the price floor is binding. A binding price floor changes the market outcome by preventing the market from reaching equilibrium. Since the price wants to adjust lower but cannot, the best it can do is to hit the price floor, and the market outcome in the presence of the price floor and ensuing surplus is \((P_F, Q_F) = (3, 4)\text{.}\)
Figure6.1.2.At a price of 3, the price floor is binding. The market is not able to reach equilibrium, forcing a surplus to persist in the market. The number of transactions shrinks, CS decreases, and PS increases.
How does a binding price floor influence consumer and producer surplus? Since the price and quantity exchanged both change, each surplus is impacted by both dimensions. For consumer surplus, notice:
each consumer who buys must pay a higher price (lower CS); and,
fewer consumers are able to buy (lower CS).
The high price and low quantity at \((P_F, Q_F)\) both contribute to smaller consumer surplus, which is confirmed when we calculate: \(CS_F = \frac{1}{2}(1)(4) = 2\text{.}\) So, consumers are unambiguously worse off under the price floor. But this should make sense. There are fewer consumers receiving benefits (lower \(Q\)) and those that are still able to buy get a smaller benefit because they must pay a higher price!
What about sellers? Price and quantity each influence producer surplus, but in different ways for sellers:
each seller who sells receives a higher price (higher PS); and,
fewer sellers are able to sell (lower PS).
Now the two impacts counteract each other. Keeping the price high with the price floor does benefit sellers, but only those sellers who are able to sell! The forced surplus at the high price floor price excludes some sellers from the market now, since there are too few buyers willing to buy at \(P_F\text{.}\) There is a tradeoff within sellers: some individual sellers are better off, while others are worse off. But, collectively, the trapezoidal area for producer surplus - which measures the total benefits to all sellers overall - increases: \(PS_F = \frac{1}{2}(1)(4) + (2)(4) = 10\text{.}\)
In total, then, consumers are worse off and sellers are better off. This was the rough objective of the price floor policy in the first place: provide better support for sellers by maintaining higher price in the market.
But how much better off are sellers? How much worse off are buyers? Our surplus measurements can tell the story. Consumer surplus decreased from $8 to $2, while producer surplus increased from $8 to $10! $6 was taken from consumers to provide $2 of benefit to sellers, which doesn’t sound efficient: $4 was lost in the transfer! In other words, the size of the total surplus pie shrank after the price floor was implemented, from \(TS^* = \$16\) to \(TS_F = \$12\text{.}\) If one definition of efficient market outcomes requires total surplus to be maximized, the price floor is decidedly not efficient.
Our second measure of efficiency requires that all mutually beneficial transactions take place. But recall that the binding price floor forces a surplus in the market and reduces the number of transactions that take place from 8 (at equilibrium) to 4. At prices below $3, there are buyers willing to pay a price above what the seller would sell for, yet because of the price floor, these exchanges do not occur. Since the price floor prevents these mutually beneficial transactions from happening, the market outcome \((P_F, Q_F)\) is not efficient.
Economists analyze efficiency loss in a market by calculating deadweight loss. Deadweight loss (DWL) measures the value of the loss of efficiency in two equivalent ways. First, we can think of deadweight loss as the difference between the maximum total surplus and the total surplus under the policy:
In the example above, \(TS^* = 16\) at equilibrium, while under the price floor, \(TS_F = 12\text{.}\) This means there is $4 of lost surplus, and therefore, deadweight loss is \(DWL = 4\text{.}\) 4 dollars of potential surplus is not realized under the price floor, which indicates the price floor leads to an inefficient outcome. The total size of the surplus pie under the price floor is smaller than it would be without it.
We can also think of deadweight loss as the value of the lost mutually beneficial transactions which do not take place under the policy. The price floor here forces a surplus to persist in the market, reducing the number of transactions from \(Q^* = 8\) to \(Q_F = 4\text{.}\) How much benefit would have been generated had those 4 transactions taken place?
The deadweight loss can be directly measured by calculating the area of the far-right triangle in the graph below. Each vertical strip in that triangle combines the consumer surplus and producer surplus of one transaction that does not occur. Collectively, they total all of the buyer and seller benefits that would have accrued had those transactions taken place. Since there are 4 transactions, and the triangle is 2 dollars high,
Figure6.1.3.Left: Since the price cannot reach below 3, a mutually beneficial transaction between a buyer with a WTP of 2.50 and a seller with MC of 1.50 does not occur. Right: Deadweight loss is the sum of these mutually beneficial transactions which cannot take place. It is represented by the rightmost shaded area.
Under this calculation, the deadweight loss is identical as our previous measure! 3 These are therefore two equivalent ways of thinking about deadweight loss:
Deadweight loss gives the reduction in total surplus under the policy;
Deadweight loss gives the value of the lost mutually beneficial transactions that do not occur under the policy.
Deadweight loss is a valuable metric, not just of whether a market outcome is efficient, but of degrees of efficiency. For example, market with little deadweight loss is more efficient than one with large deadweight loss. If, for a given market outcome, the deadweight loss is zero, then the market is efficient! By definition, \(DWL = 0\) means (1) there is NO reduction in total surplus under the policy; and (2) there is no lost value due to mutually beneficial transactions not occurring! This actually gives us a third way of characterizing an efficient market outcome: one with no deadweight loss.
Finally, we return to the price floor example. If the objective of the policy was to shift the benefits in the market in favor of sellers, the policy accomplishes this goal. Producer surplus goes up, while consumer surplus goes down. The price floor accomplishes this, however, at the expense of efficiency: to transfer $2 to sellers, the price floor reduces consumer surplus by $6. This is actually a generalizable result: in any perfectly competitive market, a price control can redistribute benefits but sacrifices efficiency to do so.
The relevant policy question often centers on this tradeoff. Is it more valuable to society to have a large pool of benefits collectively? Or is it worth the redistribution away from consumers and to sellers here, even at the cost of efficiency?
Key terms in this section:
price controls
price floor
price ceiling
non-binding price control
binding price control
deadweight loss
In Depth6.1.4.Price ceilings.
Price ceilings function similarly to price floors, just in the opposite direction! A price ceiling sets a maximum price in the market. Typically, a price ceiling is used to protect the interests of consumers by preventing the price from rising too high; we can observe price ceilings in practical policy in the form of rent control policies, which put a price ceiling on legal rents that can be charge to tenants.
A price ceiling will prevent the prevailing price in the market from adjusting upward toward equilibrium, resulting in a forced shortage in the market. This should make sense: with the price kept low by law, the quantity demanded will exceed the quantity supplied. As a result, at the price ceiling outcome, price and quantity are both lower than they would be at the associated equilibrium in the same market.
The price ceiling will unambiguously reduce producer surplus, since fewer sellers sell, and those who do continue to sell will sell at a lower price. There is a tradeoff on consumer surplus: some consumers are now unable to buy (a result of the shortage), but those who still buy now receive greater benefits as a result of the lower price. In most cases, however, consumer surplus grows as a result of the policy.
We observe a familiar pattern in terms of efficiency too. The policy takes more from producer surplus than it gives to consumer surplus. As a result, price ceilings are inefficient and result in deadweight loss.
