When price controls (or preset prices) are implemented, the market forces of demand and supply are unable to function, and prices do not function as signals and incentives to indicate the level of output that should be produced. Thus, even if a price control is initially set at the equilibrium price where there is no surplus or shortage, changes in demand or supply would result in a disparity between quantity demanded and quantity supplied, as the producers are unable to vary their prices to meet the changing market conditions. Flexible prices, where market forces are allowed to function, would result in there being upward or downward pressures on price when there is a change in demand or supply patterns, allowing a new equilibrium price and quantity to be determined through the market forces of demand and supply. Hence, shortages and surpluses are less likely to occur in markets where there are flexible prices than preset prices.
Work Step by Step
With reference to the diagram above, when there is a ceiling implemented of Pc, there would be a shortage of Qd-Qs, as the quantity demanded is more than the quantity supplied, and if there were flexible prices, the market would clear where supply meets demand at Q2, and there would not be a shortage. In the price floor's case, the diagram below shows the resultant surplus, as the quantity supplied would be more than the quantity demanded. Similarly, if there were flexible prices, the market would clear at Q1, and there would not be a surplus.