Question

What do economists mean when they say, “Price floors and ceilings stifle the rationing function of prices and distort resource allocation?”

Short answer

Price floors and ceilings set the prices away from the market-determined price, which distorts the market’s resources allocation and the price mechanism.

Step-by-step solution

Meaning of price floor and price ceiling

Price floor means setting the minimum price for sellers and buyers to sell and buy a good or service in a market. The government sets this price to protect producers or sellers. Any price below the price floor is not legal.

Price ceiling means setting the maximum price at which sellers and buyers can sell and buy a good or service in a market. The government sets this to protect consumers. Any price above the price ceiling is not legal.

 Effect of price ceiling and price floor on the market equilibrium

At the higher price PF (>P*), the sellers are supplying a greater quantity than what is demanded. The price floor stops the market from clearing, and the situation of surplus persists.

At the lower price PC (<P*), the consumers are encouraged to demand more than what is being produced and supplied in the market. The price ceiling stops the market from clearing, and the situation of shortage persists.

• The rationing mechanism of the market price is not allowed to act as the prices are fixed under the price ceiling and price flooring. Prices cannot change to adjust excess supply or demand.
• An allocative inefficiency distorts the resources allocation that would have happened under a free market. Price ceiling shifts the allocation of resources toward other profitable goods (PC<P*), and price flooring shifts the resources from profitable goods to the said price floored goods (PF>P*).
• For example, the price floor enables high-cost producers to compete in the market with others when he/she should be reallocating resources toward a low-cost business.