Question

In Allentown, Pennsylvania, in the summer of \(2014,\) the average price of a gallon of gasoline was \(\$ 3.68-\) a 22 -cent increase from the year before. Many consumers were upset by the increase. One consumer was quoted in a local newspaper as saying, "It's crazy. The government should step in." Suppose the government had stepped in and imposed a price ceiling equal to the old price of \(\$ 3.46\) per gallon. a. Draw a graph showing the effect of the price ceiling on the market for gasoline. Be sure that your graph shows: i. The price and quantity of gasoline before and after the price ceiling is imposed ii. The areas representing consumer surplus and producer surplus before and after the price ceiling is imposed iii. The area of deadweight loss b. Will the consumer who was complaining about the increase in the price of gasoline definitely be made better off by the price ceiling? Briefly explain.

Short answer

A price ceiling set below the market equilibrium price (\$3.68) at the old price (\$3.46) will lead to excess demand and shortage in the market causing a Deadweight Loss. While the price of gasoline is lower (benefiting some consumers), the shortage can leave others, possibly including the complainer, without adequate gasoline.

Step-by-step solution

Draw Initial Market Equilibrium

Start a graph with ‘Quantity of Gasoline’ on the X-axis and ‘Price’ on the Y-axis. Then, draw a downward sloping Demand Curve and an upward sloping Supply Curve. The intersection of both curves is the Market Equilibrium, representing the old price (\$3.46 per gallon) and corresponding quantity of gasoline.

Identify the Consumer and Producer Surplus

On the graph, the Consumer Surplus is the area above the price line (below the Demand curve, up to Market Equilibrium) and Producer Surplus is below the price line (above the Supply curve, up to Market Equilibrium).

Implement the Price Ceiling

Draw a horizontal line through the Y-axis at \$3.46, which is below the new price of \$3.68 (Market Equilibrium). This line represents the Price Ceiling imposed by the government.

Identify the Effect of Price Ceiling

Since the imposed price is lower than the new market price, it leads to excess demand and shortage of gasoline. It also changes the areas of Consumer and Producer Surpluses. The Consumer Surplus increases, but the Producer Surplus decreases.

Calculate the Deadweight Loss

The Deadweight Loss refers to the decrease in total social surplus (Consumer Surplus + Producer Surplus) caused by this price ceiling. On the graph, it is represented by the area between the Supply and Demand curves, from the vertical line from the quantity demanded at \$3.46 to the original equilibrium quantity.

Analyze the Impact on the Consumer

The consumer complaining about the price increase may not be better off. Despite a lower price, the decrease in supply may leave some consumers without gasoline due to shortage caused by the price ceiling.

Key concepts

Consumer Surplus

Consumer surplus is a key component in understanding how benefits are distributed in a market. Imagine it's the happy feeling you get when you pay less for a product than what you're willing to. In our gasoline market scenario, the consumer surplus is represented by the area above the price that consumers actually pay (the price line) and below the demand curve.

Before the price ceiling, consumers paid $3.68 per gallon, which was more than the old price of $3.46. When the government imposes the price ceiling at $3.46, consumer surplus initially increases because consumers are paying less per gallon of gasoline. However, while this seems like a win for consumers, not everyone benefits. Some consumers may end up without gasoline due to higher demand and a shortage stemming from the imposed price ceiling.

Producer Surplus

Producer surplus can be thought of as the extra benefit producers receive when they sell a product for more than the lowest price they are willing to accept. On a graph, it is the area below the price they actually receive and above the supply curve.

In the case of the gasoline market, producers were initially benefiting more when gasoline was priced at $3.68 per gallon. The imposition of the price ceiling at $3.46 reduces the price that producers receive, thus decreasing the producer surplus. Producers now earn less per gallon than before, which can result in reduced incentive to supply gasoline. This is why there's an excess demand and a supply shortage following the price ceiling imposition.

Deadweight Loss

Deadweight loss emerges when there is a loss in total economic surplus because market equilibrium is not achieved. This can happen due to factors like taxes, subsidies, or, in this case, a price ceiling.

In the gasoline market, when a price ceiling of $3.46 is imposed, it creates deadweight loss, represented graphically by the area between the supply and demand curves that is no longer exchanged. This loss arises because some trades that would have occurred at the equilibrium price are not happening. Less gasoline is being sold than people want at this lower price, leading to inefficiencies. Both consumer and producer surplus are reduced, reflecting these missed opportunities in the market.

Market Equilibrium

Market equilibrium occurs where the quantity of gasoline consumers want to buy equals the quantity producers want to sell. It is where the supply and demand curves intersect.

Before any price ceiling, the equilibrium price was at $3.68 per gallon. This price balanced the desires of both sellers and buyers in the gasoline market. However, once a price ceiling of $3.46 is imposed, this balance is disrupted. Demand exceeds supply since more buyers want gasoline at the lower price, but producers are less inclined to supply it. This imbalance causes a shortage, as the market can no longer reach its equilibrium point. For effective market function, it’s crucial for supply and demand to interact freely without external interventions such as a price ceiling.