Price Ceiling Effects

Imagine that you were told that the price of your rent would be capped at $500 a month after you've been paying $1200 a month. How would you react to this news? You likely would be ecstatic! How could you not be? However, when this price cap is implemented, this could pose problems for the economy. Want to learn about how something so well-intentioned can result in poor outcomes? Then continue reading about the price ceiling and its effects on the economy!

Price Ceiling Effects Price Ceiling Effects

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Table of contents

    Effects of Price Ceiling and Price Floor

    What are the effects of a price ceiling and a price floor? First, we must define each term.

    A price ceiling is a government-imposed maximum price a seller can charge for a good or service.

    A price floor is a government-imposed minimum price a seller can charge for a good or service.

    A government may implement a price ceiling on house rents to prevent landlords from raising prices too high.

    Conversely, a government may implement a price floor for agricultural products to protect farmers' incomes.

    The purpose of a price ceiling is to keep prices from increasing too high so that consumers can afford a necessary good. The purpose of a price floor is to aid businesses that may not be rewarded with the current workings of the free market.

    Let's take a look at the effects of a price ceiling and a price floor on the supply and demand graph.

    Price Ceiling Effects Price Floor and Price Ceiling StudySmarterFig. 1 - Price floor and price ceiling.

    The graph above shows what a price ceiling and price floor may look like on the supply and demand graph. A price ceiling is represented by a line that occurs below the equilibrium point; a price floor is represented by a line that occurs above the equilibrium point.

    This makes intuitive sense. If a price ceiling is to be effective in capping the price of a good, it must occur below the market equilibrium price. If a price floor is to be effective in supporting the price, it must occur above the market equilibrium price. This distinction is critical when discussing the effects of a price ceiling and price floor.

    Want to learn more about price floors? Check out our explanation: Price Floor.

    Price Ceiling below Equilibrium

    What do we mean by price ceiling below equilibrium? Market equilibrium occurs when the supply and demand curves intersect in the market. Given that a price ceiling is a limit on the price of a good or service, a price ceiling will be below the equilibrium point. Figure 2 below shows a price ceiling.

    Price Ceiling Effects Price Ceiling StudySmarterFig. 2 - Price ceiling

    What does Figure 2 above show us? We can see where the initial equilibrium point is — this is where supply meets demand. But why is there a price ceiling in the first place?

    Let's look at an example that may cause a price ceiling to occur below the equilibrium point.

    For example, let's say that a hurricane struck Florida and caused massive damage! Generally, a natural disaster will cause a host of people to demand goods and services since they are in a precarious situation. This may cause businesses to raise prices since they know people are demanding more goods.

    The government can choose to implement a price ceiling to prevent businesses from price gouging and taking advantage of people during hard times. Therefore, a price ceiling like the one in Figure 2 will occur.

    The price ceiling caps the price at a level below where the equilibrium price would be in a free market. While this will be better for some consumers since the price is lower for them, it will also distort the market.

    In Figure 2, consumers will demand a quantity of 100, but producers will only supply a quantity of 5 at this price. Therefore, this price ceiling will lead to a shortage.

    The amount of shortage can be found with this formula:

    \(\hbox{Shortage} = \hbox{Quantity Demanded}-\hbox{Quantity Supplied}\)

    \(\hbox{Shortage} = 100-5=95\)

    Need a refresher? Check out our explanation: Market Equilibrium

    Effects of Price Ceiling on the Market

    What are the effects of a price ceiling on the market? Recall that a price ceiling is a government-mandated limit on the price of a good or service. Let's take a look at a price ceiling on the supply and demand graph.

    Price Ceiling Effects Price Ceiling StudySmarterFig. 3 - Price ceiling

    The graph above shows a price ceiling in the market. As we can see, given that it's a mandated limit on the price of a good, it occurs below the equilibrium point. We can also see that a price ceiling can engender a shortage in the market.

    \(\hbox{Shortage} = \hbox{Quantity Demanded}-\hbox{Quantity Supplied}\)

    \(\hbox{Shortage}=75-40=35\)

    Why might a price ceiling cause a shortage in the market?

    This makes sense given what we know about price ceilings — they are implemented to assist those who cannot afford a necessary good or service. However, since the price of this good has gone down, now more people will demand it, and producers are not willing to supply as much as before. Therefore, a price ceiling can often lead to a shortage of a particular good or service.

    Check out this article for more information on price controls:

    - Price Control

    Price Ceiling Effects on Consumer Surplus

    Let's go over the price ceiling effects on consumer surplus. First, let's define consumer surplus. Consumer surplus is the benefit that consumers gain when buying a good or service.

    Consumer surplus is the difference between the price that the consumers are willing to pay for a good or service and the price that they actually pay.

    Let's take a look at a brief example to see what this might look like.

    Riley is willing to pay $60 for a new pair of shoes, and the shoes end up costing $50, then her consumer surplus is $10.

    The surplus for one consumer is found by subtracting the price that the consumer is willing to pay for a good, and the actual price of the good. In this instance, Riley's consumer surplus is $10.

    \(Consumer\ Surplus = \$60-\$50\)

    \(Consumer\ Surplus = \$10\)

    We can also represent consumer surplus on the supply-demand graph.

    Price ceiling effects Consumer and producer surplus without price ceiling StudySmarterFig. 4 - Consumer and producer surplus without the price ceiling

    The graph above illustrates what the consumer surplus looks like in the market. It can be found by calculating the area of the green triangle.

    \(Consumer\ Surplus=1/2 \times Q_d \times (P_{max} - P_{equilibrium})\)

    Plug in values,

    \(Consumer\ Surplus=1/2 \times 5 \times \$5\)

    Multiply,

    \(Consumer\ Surplus= \$12.5\)

    However, if the United States were to implement a price ceiling, what would happen to consumer surplus?

    With this understanding, let's see how consumer surplus will be affected by a price ceiling. How does the consumer surplus change if a price ceiling of $4 is implemented by the government?

    Price ceiling effects Consumer surplus after price ceiling StudySmarterFig. 5 - Consumer surplus after the implementation of the price ceiling

    As we can see in Figure 5, after implementing a price ceiling, the consumer surplus area changed shape and increased in the area. Now, the area of consumer surplus is $15.

    This is an increase of $2.5 in consumer surplus as a result of a price ceiling! Therefore, we can say that in this case, consumer surplus increases due to the price ceiling. However, it is critical to note that there will also be consumers who cannot obtain the good due to the higher demand and lower supply for the said product. At the price of $4, consumers will demand a quantity of 8, but only a quantity of 3 is supplied to the market.

    Here is a real-life example.

    Currently, price ceilings are used by local governments to prevent skyrocketing price hikes in the house rental market.2 A price ceiling will prevent renters from paying high rents for housing. However, this will disorient the supply and demand in the market, and subsequently, lead to deadweight loss.

    There's more to read about regarding consumer surplus and producer surplus. Check these articles out:

    - Producer Surplus

    - Consumer Surplus

    Price Ceiling Effects on Supply and Demand

    To understand the price ceiling's effects on supply and demand, let's take a look at an example.

    Let's say that the United States is experiencing a supply chain issue that is causing food prices to skyrocket. People can't afford these high prices! Therefore, the United States will implement a price ceiling to ameliorate the high food costs.

    Price Ceiling Effects Price Ceiling and Floor Effects on Supply and Demand StudySmarterFig. 6 - Price ceiling and price floor effects on supply and demand

    The graph above illustrates a price ceiling on the supply and demand graph. As we can see, the price ceiling will cause a shortage in the supply and demand market. Why might this occur? A limit on the price of a good will increase the demand for it and reduce the supply. At the level of the price ceiling, consumers will demand a quantity of 28 while the producers are only willing to supply a quantity of 5.

    \(\hbox{Shortage} = \hbox{Quantity Demanded}-\hbox{Quantity Supplied}\)

    \(\hbox{Shortage} = 27-5=22\)

    1970s Gas Crisis

    In the 1970s, gas prices were astronomically high in the United States. The government attempted to implement a price ceiling to ameliorate the high prices for consumers. Unfortunately, what resulted was a shortage of gas in the United States and very long gas lines. The price ceiling, while well-intentioned, ended up causing other problems for consumers in the United States.1

    The price ceiling leads to a shortage because producers are unwilling to produce as much at a lower price. Of course, the government can choose another instrument to help keep the price low and to support a certain industry -- by providing subsidies. Learn more about it by reading our explanation: Effects of Subsidies.

    What about the effects of a price floor?

    A price floor will result in a surplus. Let's take a look at an example of a price floor.

    The United States may set a price floor for industries, such as the agricultural industry, that have trouble making a profit. If businesses are promised a minimum price that their goods will be sold for, they can ensure their businesses do not struggle.

    An increase in the price of goods will cause people to be unable to purchase the goods. Given that people can't purchase a particular good, this will cause producers to produce too much of that same good or service — producers can't sell their products!

    Learn more about price floors at this explanation: Price Floor and Its Effect On Equilibrium

    Price Ceiling Effects - Key takeaways

    • A price ceiling sets the maximum price that a seller can charge for a good or service. A price floor sets the minimum price that a seller can charge for a good or service.
    • A price ceiling occurs below the equilibrium point and can result in a shortage.
    • A price ceiling will cause consumer surplus to increase but will also lead to a deadweight loss.

    References

    1. Institute for Energy Research, https://www.instituteforenergyresearch.org/regulation/crazy-crude-oil-price-controls-1970s/
    2. Todd N. Tucker, PRICE CONTROLS: HOW THE US HAS USED THEM AND HOW THEY CAN HELP SHAPE INDUSTRIES, https://rooseveltinstitute.org/wp-content/uploads/2021/11/RI_Industrial-Policy-Price-Controls_Brief-202111.pdf
    Frequently Asked Questions about Price Ceiling Effects

    What effects do price ceilings have on economic activity?

    A price ceiling leads to a shortage and deadweight loss in the market.

    What are the effects of price floors?

    Price floors cause a surplus of goods and services.

    How do price ceilings affect consumer and producer surplus?

    Price ceilings usually cause consumer surplus to increase and cause producer surplus to decrease.

    Are price ceilings good or bad?

    Price ceilings are good for consumers who can purchase the newly priced good, but bad for consumers who cannot obtain the good due to shortages. 


    Price ceilings lead to deadweight loss, so they are not good from an efficiency point of view.

    Is there deadweight loss with a price ceiling?

    Yes, a deadweight loss will occur with a price ceiling.

    Test your knowledge with multiple choice flashcards

    What does a price ceiling do to the price?

    A price floor will cause consumer surplus to _____.

    A price ceiling will have no effect on the supply and demand.

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