7.1 Price Controls

In many markets, the State intervenes to modify the price and the quantity exchanged, with the aim of correcting inefficiencies or redistributing surplus among economic agents. These interventions can take various forms, including direct price regulation, the imposition of taxes or the granting of subsidies, and the introduction of import tariffs. In this chapter we will analyze these three types of intervention and their effects on the welfare of consumers and producers.

One of the simplest Until 2024, millions of Italian households purchased electricity and gas under conditions set by ARERA, the national regulatory authority. These tariffs acted as a price ceiling: suppliers were not allowed to offer worse conditions (with the end of the protected market, these rates now apply only to “vulnerable” customers). and most direct tools available to the State is price regulation. Through the introduction of a price ceiling or a price floor, the legislator modifies the market outcome by imposing constraints on the equilibrium price. A price ceiling sets an upper limit on the price that can legally be charged; its aim is to protect consumers when the free-market price is considered excessively high. In contrast, a price floor sets a level below which the price cannot fall; the objective is to guarantee a minimum income to producers. Both instruments affect the quantity exchanged and the distribution of surplus.

Price Floors and Ceilings in Competitive Markets

The effect of a price floor or ceiling depends on the structure of the market. In perfect competition, where the price is determined by the intersection of supply and demand, the introduction of a price floor above the equilibrium price creates an excess supply. Total surplus is no longer maximized; consumer surplus decreases, while the effect on producer surplus is ambiguous.

It is important to note that the figure assumes that, given a price floor above equilibrium, only the units produced at the lowest marginal cost are sold—those on the left side of the supply curve. We are therefore implicitly assuming an efficient rationing mechanism on the supply side: the excess supply is absorbed by excluding the higher-cost units (or higher-cost producers). In reality, this kind of selection does not happen automatically. If the State does not establish who has the right to sell—for example, by setting production quotas—there is a risk that more will be produced than can be sold, resulting in waste or the need for public purchases. In agriculture, for instance, governments often intervene by directly buying up the surplus to maintain the price floor. If this does not occur, the efficiency depicted in the figure is not achieved.

Symmetrically, the introduction of a price ceiling below the equilibrium price generates an excess demand. Here too, total surplus is no longer maximized. Producer surplus declines, while the effect on consumer surplus is ambiguous.

As in the case of the price floor, the figure above illustrates the case where the quantity supplied is sold to the consumers who are willing to pay the most—those located on the left side of the demand curve. It is thus assumed that the excess demand is absorbed by excluding less interested consumers. But again, this kind of rationing does not happen on its own. In the absence of an allocation mechanism—such as lotteries or priority criteria—the good may be distributed arbitrarily, possibly giving rise to a parallel market (black market) where it is traded at a price higher than the legal ceiling. In such cases, the loss of efficiency may be greater than what is shown in the diagram.

In summary, Figures 7.1 and 7.2 illustrate the effects of price controls assuming that rationing is efficient—that is, that scarce units go to those who value them most (on the demand side) or are sold by those who produce them at the lowest cost (on the supply side).

Price Ceilings in a Monopolistic Market

The situation is different when market power is present, as in the case of monopoly. A monopolist sets a higher price and produces a lower quantity compared to the competitive equilibrium. The introduction of a price ceiling can therefore have positive effects on efficiency: if the ceiling is set at a level between the monopoly price and the competitive price, the monopolist is incentivized to produce more, approaching the socially efficient level of output, thereby reducing the deadweight loss associated with monopoly.

In addition to imposing a price ceiling, the State can also limit a monopolist’s market power through other instruments. One option is to break up the firm into multiple competing entities, as in antitrust interventions. Another alternative is nationalization, with the aim of aligning production and pricing with the public interest.