In the typical textbook treatment, one chapter walks students through the way in which markets tend toward the market‐​clearing (or equilibrium) price and quantity. At that price, the quantity demanded equals the quantity supplied and, given the price, no one walks away frustrated or disappointed. The plans of demanders are coordinated with those of suppliers. In that chapter, we normally motivate this by supposing that the price of a good is temporarily above or below that market‐​clearing price. We then walk through the ways this creates a knowledge signal and incentive for buyers and sellers to respond in such ways as to move that price toward market‐​clearing. On the assumption that all else remains constant, economic theory shows why the price will reach that market‐​clearing point.

We motivate this by pointing out that prices below or above market‐​clearing will cause shortages and surpluses, respectively. So if the price is below market‐​clearing, the quantity demanded (QD) of the product will be relatively high as the lower price attracts more buyers. The quantity supplied (QS) will be relatively low, as suppliers will be unwilling to part with their stock of the good at that low price. The result will be a shortage, which we define as QD > QS. How does this resolve itself? Some demanders who really want the good will be frustrated in not being able to get it at the current low price and will be willing to pay something more than that price for the good. As they offer more for it, some suppliers will now be willing to offer more for sale at that higher price. Other demanders will now make higher offers and this process will continue until the market‐​clearing price is reached. Note the competition here: demanders are competing with other demanders so that they can better cooperate with suppliers.

The process for prices temporarily above market‐​clearing is a mirror image. This time the QS of the good will be relatively high, as suppliers are willing to offer a large supply at the high price. The QD, by contrast, will be relatively low as the high price causes some potential demanders to walk away. When QS > QD we have a surplus, and suppliers find themselves with stocks of unsold goods. They soon realize that they can get rid of some of them by offering them at a somewhat lower price. As they do, some demanders are now willing to purchase, even as some suppliers back out of the market being unwilling to sell for the lower price. As QD rises and QS falls, we work our way back down to market clearing. Notice here that the competition is among suppliers: they are competing with each other to find demanders they can cooperate with. In both the shortage and surplus case, it is the entrepreneurial insight of the “long side” of the market (i.e.: the demanders who can’t find suppliers in a shortage, and then the suppliers who can’t find demanders in a surplus) that drives us toward the market clearing by changing their behavior in response to the market signal and the incentives it creates.

For markets to work as they should, market participants require the freedom to exercise the entrepreneurship involved in changing bids and asks. If demanders can’t offer a higher price or suppliers can’t offer a lower price, this process is short‐​circuited and we get permanent shortages and surpluses and the problems they cause. This is what happens when politicians pass laws that mandate a maximum price, what we call a “price ceiling,” or a minimum price, what we call a “price floor.” In the typical textbook presentation, an analysis of these price controls comes in the chapter after the one on market adjustment and market clearing.

If governments pass price ceilings that mandate the highest price a good or service can sell for, we will get those shortages. Think about rent control, perhaps one of the best examples of a price ceiling. If we force the rental price of apartments below market‐​clearing, a larger number of people will want to rent at that price, but a smaller number of owners of (potential) apartments will put them on the market. The result will be a shortage of apartments. But this time, because the disequilibrium price is legal maximum, there’s no way for potential renters to legally bid up the price to signal the higher value they place on renting and thereby encourage an increase in the QS. The result is that the shortage will persist as long as the price ceiling is below the market clearing rent.

Shortages create a number of problems. The main one is finding some way of allocating the limited supply among the much larger number of demanders. In general, shortages lead to queues, whether in the form of physical lines at a store, as in the former Soviet Union, or things like waitlists for apartments. The large pool of demanders gives the suppliers the power in this situation, as they can pick and choose among the demanders without worrying they are giving up a sale. This allows suppliers to discriminate by whatever criteria they think are important (and presumably legal). Suppliers will also find ways around the rent maximum by tacking all other kinds of charges on to the rental agreement such as key charges or rental charges for a mailbox. The limits on rents also discourage landlords from doing maintenance, either short run or long run. They can afford to not fix current problems quickly because there’s always someone else to rent to if the current tenant is unhappy. One result of this is the increase in complex bureaucratic rules about settling complaints, either privately or publicly. This is a consequence of rent control. The artificially low rent also means that owners are unlikely to update in more major ways, or bring other buildings onto the rental market, as they cannot recoup the costs at the legally permitted rent. Rent control and similar laws are one element of why there are housing shortages in so many US cities.

With laws that mandate a minimum price, what we call “price floors,” all of this analysis applies in reverse. Suppliers are prevented from lowering their price to draw in potential demanders for their good or service, which prevents prices from moving to market‐​clearing levels and makes the resulting surpluses permanent. One of the best examples of a price floor is minimum wage laws. The suppliers in this case are workers who are selling their labor to employers who demand it. At a minimum wage above market‐​clearing, people who are willing to work at a wage below the minimum are legally prevented from making an offer to do so, which means they cannot compete the wage down to market‐​clearing as they would without a law. With a large number of people wanting to work and employers only being willing to hire relatively few at the higher minimum wage, we get a surplus of labor, better known as unemployment. The law denies the potential workers the ability to send the signal that they are willing to work for less and thereby create the incentive for firms to hire them. The unemployment that results becomes persistent.

Much like price ceilings, price floors like minimum wage laws cause a number of problems. In parallel fashion to rent control, the party on the “short side” of the market has the power here. Firms can choose from among a very large pool of potential workers and know that if they don’t wish to hire someone for whatever reason, there’s always someone else who’ll take the job. Minimum wage laws create an incentive for employers to discriminate along any number of (legal) margins. Firms also respond to the higher wage by reducing other forms of compensation for those who do get the work. This might include reducing hours, but can also include eliminating free meals or free uniforms, increasing the workload expectation, or having supervisors become more micro‐​managing. All of these adjustments are not negotiated and likely make employees worse off. Most important, wages are linked to productivity, so a minimum wage law is also a minimum productivity law. The result is that minimum wage laws cut off the bottom rungs of the economic ladder to lower skilled workers, who are far more statistically likely to be young and non‐​white. Changes in minimum wage levels are closely correlated with changes in the black/​white youth unemployment ratio. It is often the most vulnerable, those who advocates of such laws claim to wish to help, who are harmed the most. The inability to signal through the price system creates any number of problems, whether in the form of price ceilings or price floors.