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Price Ceilings

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Price Ceilings

How many times have you heard people you know react to an increase in prices, whether it's gas prices or the new cell phones costing a hundred dollars more than the previous version? Wouldn't life be more enjoyable if the goods we wanted were affordable and stayed that way? It's very easy to imagine putting a price cap on goods to guarantee a quality standard of living for all citizens, however, economics is here to tell us it's not so simple. In this explanation, you will learn more about price ceilings and what happens to goods that have their prices altered. Quick! Read this before prices go up again!

What is a price ceiling?

A price ceiling is a legal limit to how high a price can be which is also known as a price cap. This is set by the governing body that controls the market, which can be implemented at a State or Federal level. Price ceilings are set to protect consumers from rapidly increasing prices.

Below is a graphical representation of how a price ceiling affects a market at equilibrium.

Price Ceilings Price Ceiling StudySmarterFigure 1. Price ceiling - StudySmarter

Figure 1. shows that before the price ceiling, competing market forces were initially at equilibrium at a price of P1 and quantity of Q1. When a price ceiling is introduced at P2 this disrupts the market as a change in price will affect the supply and demand in the market. Demand increases in Q3, however, supply is reduced in Q2. There is now a gap (Q3-Q2) between the quantity that the consumers are willing to demand and what the producers are willing to supply. This is known as a shortage.

A price ceiling is a legal limit to how high a price can be which is also known as a price cap

An example of price ceilings in the US occurred in WW2. A price ceiling was placed on New York City apartments in an attempt to keep resources available for the war effort. The cost of apartments was skyrocketing, so it was massively profitable to build apartments. However, the US government didn't want time and resources that could be used to win the war to go to anything else. Shockingly, these apartments are still under price controls to this day.

What is the economic effect of price ceilings?

The economic effect of a price ceiling is very complex, there are many different ways it can play out for better or worse.

Initially, right after a price ceiling is imposed, consumers who can purchase the goods at a lower cost will benefit greatly. In most cases, this price ceiling will generate increased demand and decreased supply leading to a shortage. Therefore, an additional mechanism would need to be put in place to ensure the vulnerable population the price control was intended to protect receives access to the goods. What happens if this mechanism isn't implemented? Read the deep dive below to learn more!

1973 price cap on gasoline in the US

In 1973 a price cap was put on gasoline, which was set to be about $1 per gallon. In addition to long waits at the pump as a result of fear of daily shortages, an emergence of leveraging customers and black-market activities arose. Small deviations in the sale of gasoline occurred such as required additional purchases, consumers were forced to purchase unnecessary amounts of potatoes or rye flour. Small-scale cronyism would occur where friends and family of the owner would receive preferential access. The most egregious activity was consumers who would pay extra cash for access, a form of bribery. In the case of bribery and forced purchases the lower price of gas was negated by payment for access. All of these deviations in the market hurt fair access to consumers trying to take advantage of the lower price. Even though all of these things occurred, many consumers who braved long lines were able to secure gas at a lower cost than the fluctuating global market.1

An element to consider when implementing a price control is an analysis of potential long-run effects. When a price ceiling is imposed on a competitive market, not every firm feels pressure the same. Firms with more financial stability or a cheaper production process will be hurt but can handle a market disruption. On the opposite end, firms that have high debt to assets ratio may not be able to pay all of their bills to stay open.

A firm that has a less efficient production may struggle with a price ceiling and have to cut their output and staff temporarily or even stop production altogether. To some degree, these companies should feel market pressure for taking on too much debt or be pushed out of the market for their inefficient production. However, any amount of firms leaving the market can lead to more monopoly power for existing firms which can lead to higher prices after the lifting of the price ceiling.

What are the advantages of price ceiling?

The advantage of a price ceiling is the halt to rising prices to protect vulnerable populations suffering from a disaster. For example, in 2012 New York and New Jersey put a price cap on bottled water and gasoline in an attempt to prevent price gouging, which helped people manage the disaster recovery. This compares sharply with the aftermath of Hurricane Katrina, which was significantly worse, yet calls for a price ceiling were left unanswered. During the Hurricane Katrina crisis bottled water cost more than $5 a gallon. This indicates a difference of opinion on what the role of government should take when comparing the responses to each disaster.2

Another advantage of a price ceiling is to put pressure on companies to allocate their resources efficiently. In markets that have little to no competitive pressure, quality can stagnate and innovation isn't as necessary. If monopolies are abusing their position by setting the prices too high, the government can create synthetic pressure by implementing price controls. By limiting their profit-earning potential, firms will be forced to innovate to reduce their costs of production. Methods like this can be dangerous as pressured firms may lay off workers.

A final advantage of a price ceiling is to ration resources by setting price ceilings to limit the consumption of resources. Government can limit industries by reducing the incentive they have to produce in high quantities, which allows the resources they would have used to be available to be used for something else.

Do price ceilings help ration economic resources?

The free market allocates resources to the most profitable sectors, however, sometimes governments may find these resources can be better used for something else. An example of price ceilings in the US occurred in WW2. A price ceiling was placed on New York City apartments in an attempt to keep resources available for the war effort.

Consider what that meant for the market? For starters this means fewer apartments were built, so for every apartment no longer deemed profitable enough, the materials were not purchased. That means everything from brick, concrete, metal, and wood will no longer be purchased for apartment buildings. That means that the market demand for those goods drops which lowers prices, allowing the US military to have cheaper prices.

Slowing the supply of apartment buildings also eliminates competition in the labor market. Builders and contractors will be more available for military production labor. Those who would have been building apartments may even join the military, now that they are faced with fewer job alternatives. By setting a price control on rent, the US government was able to make more production commodities and labor available to the military.

In the example above, a price ceiling on apartments affected a multitude of economic decisions. A price ceiling in this instance lowered the cost of commodities. It also increased the supply of money to be invested and freed up the labor supply. Though not all price controls are placed to have effects in this manner, whether these effects are the goal or not it's important to consider all relevant factors.

What is an example of a price ceiling?

This section will cover the effects of a price ceiling on a market at equilibrium, with graphical representation.

Price Ceilings Consumer Surplus StudySmarterFigure 2. Consumer surplus - StudySmarter

Figure 2. above shows the blue triangle, which represents the consumer surplus. This is the extra value that a consumer gets when buying at the equilibrium price if what they are willing to pay was more. Erica is a new homeowner and wanted to perform some maintenance, so they decided to buy a screwdriver. This screwdriver allows Erica to service multiple appliances and even put together furniture and many other uses. To Erica as a new homeowner, a screwdriver is very valuable and they are willing to pay $10 for one. Elise, a machine shop owner, has many similar tools and doesn't value a screwdriver that much: she is willing to pay only $6 for it. The consumer surplus represents the extra value Erica gets for purchasing the screwdriver at $6, whilst Elise does not have any consumer surplus.

Price Ceiling Producer Surplus StudySmarterFigure 3. Producer surplus - StudySmarter

In Figure 3. above the green triangle represents the producer surplus - the extra gain producers receive for producing up to the equilibrium quantity of Q while having a lower average cost of production. A manufacturer of screwdrivers named 'No Screws Loose' determines their average cost for a screwdriver is $5. While their competitor 'Screwdriver Madness' invested in an efficient way to make screwdrivers, their average cost is $4. Producer surplus is the extra gain both manufacturers receive. However, 'Screwdriver Madness' receives a little more since they have a lower average cost of production.

Suppose now that in the market for screwdrivers a price ceiling was placed at $4.

Figure 4. Deadweight loss - StudySmarter

Initially, this looks great for consumer surplus, even the machine shop owner is happy. However, manufacturers like 'No Screws Loose' can't afford to produce as many screwdrivers at a lower price, so they cut their production. This lowers the supply in the market (from Q to Q2), while demand increases (from Q to Q3) leading to a shortage (Q2-Q3). The overall producer surplus is reduced as well, as even 'Screwdriver Madness' isn't getting much surplus at the lower price.

The machine shop owner Elise is thrilled about the lower price and immediately goes to the store to buy handfuls of screwdrivers. She benefited because she could buy the screwdrivers at a much lower price. However, not everyone would be that happy in this market. The homeowner Erica goes to the store too, but no screwdrivers are available anymore, because they were bought up by Elise. This shortage is disastrous for Erica as she would gladly pay $10 for a screwdriver, but can't find one anymore.

With a price ceiling, the deadweight loss represents the lost income and economies of scale for producers and a shortage for consumers who'd gladly pay more but are unable to buy the product at all. In other words, in our market example, all producers were worse off from the price ceiling; some consumers were better off, but some were worse off. This is why the government should carefully consider the distribution effects when implementing a price ceiling.

Price Ceilings - Key takeaways

  • A price ceiling is a fixed number of how high the price of specified goods or services can be. A price ceiling can be used to secure affordable prices during times of crisis. Also, a price ceiling can discourage the unwanted expenditures of resources if a greater situation requires them.
  • The economic effect of a price ceiling varies in each scenario. Those who can buy the goods at the price-controlled level benefit from having cheaper access, however, it may be hard to find supply available as a price cap creates a shortage.
  • Deadweight loss is the lost efficiency of disrupting a free market equilibrium. This lost efficiency takes the form of the loss of economies of scale for producers and the decrease in supply for consumers who would willingly pay more than the price ceiling.
  • Price ceilings will have negative effects on the market as a result of deadweight loss, firms that are already struggling to stay competitive in the market may not be able to sustain themselves during the price control or recovery after its lifted.

1. Hugh Rockoff, Price Controls Econlib.org

2. Indeed Editorial Team, Types of Price Ceilings sourced from Indeed.com

Frequently Asked Questions about Price Ceilings

A price ceiling is a limit to how high a good or service can be exchanged for. This is set in place by a governing body to achieve a specified goal.

The economic effect of a price ceiling will be a shortage, as the lower price will decrease supply and increase demand. However, those who can find the good benefit from the lower price.

An example of a price ceiling is if the government puts a price cap on bottled water to $1 a gallon, in an attempt to mitigate rapid inflation in a crisis.

A price ceiling secures a lower price for vulnerable populations. A price ceiling can also ration resources by discouraging unwanted production.

A price ceiling can discourage production, and therefore decrease demand for inputs of production. A decrease in demand for inputs of production lowers their price for other uses.

Final Price Ceilings Quiz

Question

What is a price ceiling?

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Answer

A price ceiling is a maximum price for a specified good or service.

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Who imposes a price ceiling?

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Answer

The government or governing body.

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If a price ceiling is set on log cabins, how will this affect the supply of wood for paper products?

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The supply of wood will increase, making paper cheaper.

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Why are price ceilings not recommended in most cases?

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Answer

They create a shortage.

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A price ceiling causes lost efficiency, what is this term called?

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Answer

Deadweight Loss

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When a price ceiling is set in place, what happens to supply?

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Answer

Decreases

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When a price ceiling is set in place, what happens to demand?

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Answer

Increases

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If a price ceiling causes a shortage, where are transactions likely to occur?

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Answer

On the black market

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Will a price ceiling on gas for $1 help?

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No, gas companies can't afford to supply enough to meet demand at $1.

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What effect would a price ceiling of $10 have on gas prices currently at $4?

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No effect

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What effect would a price ceiling on gas have on renewable energy industries?

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Increased investment.

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What is Deadweight Loss?

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Answer

The lost efficiency caused by government intervention.

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What happens to consumer surplus under a price ceiling?

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Total consumer surplus is reduced.

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What happens to producer surplus under a price ceiling?

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Producer surplus is reduced.

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In order to be effective, a price ceiling is placed below or above equilibrium?

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Below.

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