Effect of price ceiling on economic surplus

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This article attempts to discuss the effects of a price ceiling on the economic surplus. The reference point for studying these effects is a world without the price ceiling, where the price is the market price and the quantity traded is the equilibrium quantity traded at that market price.

In a world without the price ceiling, we have (assuming away external costs and external benefits):

economic surplus in absence of price ceiling = (economic surplus in absence of price ceiling)+ (consumer surplus in absence of price ceiling)

We also have:

economic surplus in presence of price ceiling = (economic surplus in presence of price ceiling)+ (consumer surplus in presence of price ceiling)

The goal is to ask the questions:

  • How does the producer surplus in the presence of a price ceiling compare with the producer surplus in the absence of a price ceiling? If the values differ, what accounts for this difference?
  • How does the consumer surplus in the presence of a price ceiling compare with the consumer surplus in the absence of a price ceiling? If the values differ, what accounts for this difference?
  • How does the overall social surplus in the presence of a price ceiling compare with the social surplus in the absence of a price ceiling? If the values differ, what accounts for this difference?

General overview

Here, a binding price ceiling is one that is lower than the free market price.

Type of market structure Effect on total social surplus of a binding price ceiling Effect on producer surplus of a binding price ceiling Effect on consumer surplus of a binding price ceiling
Perfectly competitive market Lower than the free market, and decreases as the price ceiling decreases Lower than the free market, and decreases as the price ceiling decreases Ambiguous
Monopoly market with increasing marginal cost curve Variable behavior: increases initially until the optimal price is reached, then decreases and equals the free market social surplus when it reaches the free market marginal cost Decreases Increases until the optimal price is reached, ambiguous thereafter

The perfectly competitive case

Indeterminacy arising from non-price competition

A price ceiling creates an indeterminate situation: there is excess demand, so that not all buyers willing to buy the good at the price are able to buy as much of the good as they want. There is non-price competition among buyers to determine who gets to successfully buy how much.

The most generous assumptions (from the point of view of maximizing surplus) are:

  • Perfect sorting: The buyers who get the good, and the amounts that they get the good in, are such as to maximize consumer surplus.
  • No additional costs of non-price competition: The non-price competition between buyers occurs efficiently, with no additional costs to buyers.

In contrast, the least generous assumption to buyers is one where all the extra consumer surplus that they would otherwise have obtained is spent in competing with one another.

Economic surplus cases

Harbergertriangle.png
Harbergertriangle.png
Harbergertriangle.png

We list all the surpluses and what they mean:

Quantity Area that computes it In the figure
Producer surplus in a world without price ceiling The area bounded by the price axis, the supply curve, and the horizontal line at the price level (for the market price without the sales tax). In other words, this is the area between the supply curve and the price level. It aggregates the individual surpluses of all producers. C + D + F
Consumer surplus in a world without price ceiling The area bounded by the price axis, the demand curve, and the horizontal line at the price level (for the market price without the sales tax). In other words, this is the area between the demand curve and the price level. It aggregates the individual surpluses of all consumer. A + B + E
Economic surplus in a world without price ceiling The region bounded by the price axis, demand curve, and supply curve. A + B + C + D + E + F
Producer surplus in a world with price ceiling, perfect sorting, and no non-price competition The area bounded by the price axis, the supply curve, and the horizontal line at the binding price ceiling level. D
Consumer surplus in a world with price ceiling, perfect sorting, and no non-price competition The area bounded by the price axis, the demand curve, and the horizontal line at the binding price ceiling level. A + B + C
Economic surplus in a world with price ceiling, perfect sorting, and no non-price competition The region bounded by the price axis, the demand curve, the vertical line for equilibrium quantity traded, and the supply curve. A + B + C + D
Producer surplus in a world with price ceiling, but without assumptions of perfect sorting and no non-price competition The area bounded by the price axis, the supply curve, and the horizontal line at the binding price ceiling level. D
Consumer surplus in a world with price ceiling but without additional assumptions No clear description Between 0 and A + B + C
Economic surplus in a world with price ceiling but without additional assumptions No clear description Between D and A + B + C + D

The key difference with the case of a sales tax (see effect of sales tax on economic surplus) is that the area B + C is captured as part of consumer surplus rather than government surplus. Note, however, that imperfect sorting or transaction costs of non-price competition could eat away this extra consumer surplus.

Monopoly case with increasing marginal costs

Here we assume that the good being sold has no external costs or external benefits.

The discussion here builds on that in Price ceiling#Basic theory: the effects of price ceilings in monopolistic markets. You may need to reference that for more context around some of the terminology used.

For some of the rows, we can draw definite conclusions only under the efficient allocation assumption: perfect sorting among buyers (the buyers who acquire the good are those who value it most highly), and the non-price competition imposes no extra costs on buyers and sellers. The caveats are noted in the corresponding cells where they apply.

The "optimal price" in the table below is obtained as the price point at the intersection of the marginal cost curve and the market demand curve. This is essentially what the price would be if the seller could be made to behave as if operating in perfect competition.

Price ceiling range Social surplus compared to no price ceiling Producer surplus compared to no price ceiling Consumer surplus compared to no price ceiling Direction of change of social surplus with decreasing price ceiling Direction of change of producer surplus with decreasing price ceiling Direction of change of consumer surplus with decreasing price ceiling Qualitative comments
Greater than or equal to the free market price Same Same Same None None None Deadweight loss is intact as the price ceiling has no effect
Less than the free market price and greater than the optimal price More Less More Increasing Decreasing Increasing Deadweight loss due to monopoly is ameliorated by the price ceiling
Equal to the optimal price More Less More Maximized Decreasing Ambiguous Deadweight loss is eliminated as perfect competition is emulated
Less than the optimal price and greater than the free market marginal cost More (assuming efficient allocation), indeterminate otherwise Less More (assuming efficient allocation), indeterminate otherwise Decreasing Decreasing Ambiguous Deadweight loss is now no longer due to monopolistic pricing but rather due to price ceilings cutting off beneficial transactions
Equal to the free market marginal cost Same (assuming efficient allocation), less otherwise Less More (assuming efficient allocation), indeterminate otherwise Decreasing Decreasing Ambiguous The quantity traded mimics that in the no-ceiling case, but the price at which the trades occur is lower. Assuming efficient allocation (i.e., the goods go to the buyers valuing them most highly), the social surplus is the same but it is distributed more to consumers. Without the efficient allocation assumption, total social surplus is down, with producer surplus down and the effect on consumer surplus indeterminate.
Less than the free market marginal cost Less Less Starts out as more (assuming efficient allocation), may later becomes less. Without the efficient allocation assumption, indeterminate. Decreasing Decreasing Ambiguous Deadweight loss now exceeds that of monopoly, even under the efficient allocation assumption.