A price ceiling occurs when the government puts a legal limit on how high the price of a product can be. In order for a price ceiling to be effective, it must be set below the natural market equilibrium.
When a price ceiling is set, a shortage occurs. For the price that the ceiling is set at, there is more demand than there is at the equilibrium price. There is also less supply than there is at the equilibrium price, thus there is more quantity demanded than quantity supplied. An inefficiency occurs since at the price ceiling quantity supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss.
Graph of a Price Ceiling This graph shows a price ceiling. P* shows the legal price the government has set, but MB shows the price the marginal consumer is willing to pay at Q*, which is the quantity that the industry is willing to supply. Since MB > P* (MC), a deadweight welfare loss results. P' and Q' show the equilibrium price. At P* the quantity demanded is greater than the quantity supplied. This is what causes the shortage.
Recent increases in the price of gas have left many individuals asking for a price ceiling on gas. You now see why this is a bad idea. If the government sets a price ceiling on gas, there will be a shortage. Remember the long gas lines in the 1970's? This is exactly what happened.
If a price ceiling is set, then there must be a way to assign who gets the low supply of the product. Of course, since there is a legal limit on the price, the price can't simply be raised. There are several ways this is done without raising the price:
•Lottery: One way to distribute a product for which there is a shortage is to draw names out of a hat. In some states there is a high demand to be able to hunt for moose, but the government has a limit on the amount of permits it gives out. Often these states have a lottery and if you are lucky enough to get drawn, you can try...