The other day, I posted an exam question from my microeconomics Ph.D. preliminary exam. Here is my answer:
Part A: Textbook price theory predicts there would be no loss in welfare in the community following a price ceiling; producer surplus would just be transferred to consumers. Here we see the market in equilibrium:
Green represents consumer surplus, red is producer surplus. Following a price ceiling, we now have:
Price has fallen from P* to Pc due to government fiat. The amount of surplus in the rectangle between P* and Pc that was producer surplus is now consumer surplus. Other than that, no other welfare transactions are going on, thus leading to no deadweight loss.* From a purely welfare-economic viewpoint, the society is no worse off under the price ceiling than in laissez-faire.
Part B: In a more well-rounded sense, the society is now worse off. Since the price of the good has fallen, we have more quantity demanded than can be supplied. That means we will get some kind of non-price rationing and the product in question may end up with consumers who do not value it as much as others. As such, the uses of the good may not be the most efficient uses, despite the fact the pure theory tells us there is no welfare loss. We’d have allocative efficiency (no deadweight loss), but distributive inefficiency (the good is not used by those who value them highest).
*Some may ask at this point why is there no deadweight loss. Why isn’t the triangle to the right of the consumer surplus transfer deadweight loss? Simple: we have no change in quantity here. The characteristic of a perfectly inelastic supply curve is that the same amount of quantity is produced regardless of the price. Since the quantity in the market never changes, you cannot have welfare loss, just welfare transfer.