We often hear reports in the news of consumer groups, unions, or politicians calling on the government to regulate the prices of various goods. The most recent example of this has been calls to put a price ceiling on the price of gasoline. Although they may appear to help the consumer, price ceilings and price floors cause inefficiencies and should be avoided.

A price ceiling is an upper limit on the price of a good enforced by the law. For example, in the summer of 2005 Hawaii passed a law capping the price that wholesalers can charge to retailers for gasoline at $2.74 in Honolulu (see http://www.cbsnews.com/stories/2005/08/25/national/main794947.shtml this article from CBS News). A price floor is the opposite: a legal limit the price of a good cannot fall below. These are often used to support agricultural products like wheat.

The problem with price ceilings and floors, is that they don't rely on markets to set prices. Prices in a capitalistic society are usually set by supply and demand—the point at which the quantity of consumers that are willing to pay is equal to the quantity of suppliers that are willing to supply will be the equilibrium price of the good. When a price ceiling is set, suppliers aren't allowed to raise the price of a good beyond a certain level. Many suppliers won't be willing to supply the good at the level of the price ceiling, so the number of suppliers willing to sell is limited. On the other hand, the number of consumers willing to buy is relatively large. This means that there are more consumers willing to buy than there are suppliers willing to sell. Thus a shortage is created. Remember the long lines to get gasoline in the 1970's? That's what happens when there is a shortage.

Price floors create the opposite problem: there are more suppliers willing to sell than there are consumers willing to buy. Instead of a shortage, there is a surplus. I remember an article in the New York Times in the fall of 2005 with a picture of a pile of wheat the size of a football field. That's what happens when there is a surplus. Often the government will buy up the surplus in order to support the price floor. The US government used to do this and then it would give the entire surplus to Africa. This sounds nice, but then all the African farmers couldn't sell their wheat and went out of business. That has since created a problem.

Remember how Hawaii set a price ceiling? Well 8 months later they had to http://www.cbsnews.com/stories/2006/05/08/ap/national/mainD8HFSCNO3.shtml repeal it. Of course, this was no surprise to all of the people with a basic understanding of economics who said it wouldn't work in the first place.