ECONOMICS LESSON: The Economics of Price Gouging

Given the current economic climate in the United States, many citizens are worried about their financial well-being. When citizens are confronted with rising prices on staple products, necessary items, and generally inelastic goods, they turn to the media, government, or anyone who will listen to their complaints. We see reports in the newspaper, or on television, about "price gouging" and unsympathetic businesses hurting middle class America. But is so-called "price gouging" really a bad thing? Or, is government control of prices really doing more harm than good?

This clip by John Stossel of ABC's 20/20 was made in the wake of Hurricane Katrina. But its message and reasoning are founded in Adam Smith's view of a free market economy, and certainly apply to America's current economic situation. It offers a great introduction to the topic of price ceilings and government intervention in the economy.

So, what is a PRICE CEILING?

• A price ceiling is a legal maximum price that can be charged for a good or service.
• When a price ceiling is set below the equilibrium price, it will cause shortages.
• Price ceilings occur when government is dissatisfied with the outcomes of free markets.
  

The figure below represents an artificial rent ceiling, such as the rent control policies of New York City in the 1950s:

• When government limits the price of rental units to $400 per month, the suppliers are only willing to provide 3000 units. The market, on the other hand, is demanding 6000 units. As you can see, the Rent Ceiling, represented by the red line, has resulted in 3000-unit shortage. In addition, when 3000 units are available to rent, consumers are willing to pay $625 per month. Since the price established by government is only $400, landlords are experiencing a loss of $225 per month, per unit. That is a $675,000 loss per month by all property owners in this market.

• Some questions to think about...

1. What are some additional economic and societal effects of this situation?
2. How might third-parties be affected by this?

Points to Ponder

• Government can also set prices greater than the equilibrium price created naturally by the market. This type of price control is known as a PRICE FLOOR and results in surpluses. Suppliers are willing to supply at the artificially high price, but consumers won't buy.

• Government doesn't have to set a specific price for shortages or surpluses to occur. Interventions such as trade barriers, tariffs, and subsidies can have the same effect.