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!

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.

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.

Fig. 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.

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.

Fig. 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.

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:

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

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

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.

Fig. 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.

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.

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.

Fig. 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?

Fig. 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.

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.

Fig. 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.

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

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

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.

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!