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 their effects on the economy. We will also provide you with examples and diagrams explaining the concept of price ceilings. Quick! Read this before prices go up again!
What is a price ceiling?
A price ceiling is a government-imposed limit on how much a product or service can be sold for. It is like a maximum price that can be charged for something, and it is usually set below the market price. The goal of a price ceiling is to make a product or service more affordable for consumers, but it can also lead to shortages and other unintended consequences.
A price ceiling is a legal restriction that sets the maximum price at which a good or service can be sold. It is typically set below the market price to make goods or services more affordable for consumers.
For example, imagine the government setting a price ceiling on rent. A price ceiling can help prevent landlords from exploiting renters and charging excessive rent. This can ensure that people of all income levels have access to affordable housing, reducing the risk of homelessness and improving a community's overall quality of life.
Price Ceiling Diagram
Below is a graphical representation of how a price ceiling affects a market at equilibrium.
Fig. 1 - Price ceiling
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.
Economic effects 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 gas price 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 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 a price ceiling?
The advantages of price ceilings include:
- Price ceilings can protect vulnerable populations from price gouging during disasters
- Price ceilings can pressure companies to allocate their resources efficiently and reduce costs
- Price ceilings can promote innovation and prevent monopolies from setting excessively high prices
- Price ceilings can ration resources by limiting consumption, allowing resources to be used for other purposes
Let's take a look at them in more detail!
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.
What are the disadvantages of price ceilings?
While a price ceiling, when correctly implemented, brings a lot of benefits to society, there are several disadvantages to price ceilings that might occur, such as shortages and quality decline.
Shortages: When prices are artificially restricted, the quantity of goods demanded often exceeds the quantity supplied. This leads to shortages, as producers cannot increase their prices to incentivize more production.
Quality decline: To maintain profitability, producers may reduce the quality of goods or services to cut costs. Consumers may end up with lower-quality products than they would have received if prices were not artificially limited.
Black markets: Shortages might lead to the creation of black markets where consumers may be willing to pay more than the legal price to obtain the good or service.
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 the materials were not purchased for every apartment any longer deemed profitable enough. 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, lowering prices and 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.
Price ceiling examples
The most common examples of price ceilings are:
- rent control
- price caps on medicines
- gasoline prices
- Rent Control: Rent control is a form of price ceiling that is used in many cities around the world to limit the amount that landlords can charge for rent. The aim is to make housing more affordable and protect renters from being priced out of their homes. In New York City, rent control was implemented in the 1940s to help address a housing shortage and prevent landlords from taking advantage of the high demand for rental properties. Rent control has helped many low-income residents remain in their homes.
- Price caps on medicines: In some countries, the government sets price ceilings on prescription drugs and other medical treatments to make them more affordable for patients. This is particularly important for people with chronic conditions who need regular medications to manage their health. For example, in the United Kingdom, the National Health Service negotiates prices with drug companies and sets a price ceiling on the drugs that are covered by the NHS. This enables us to keep healthcare costs down and ensure everyone can access the treatments they need.
- Price ceiling on gasoline during emergencies: During natural disasters or other emergencies, governments may impose price ceilings on gasoline to prevent price gouging by suppliers. For example, in 2012, Hurricane Sandy caused widespread damage in New York and New Jersey, and the state governments imposed price ceilings on gasoline to prevent suppliers from charging exorbitant prices. It allowed to keep gasoline prices at a reasonable level and ensured that people could access fuel for their cars and generators during the recovery period.
Price ceiling example with graph
This section will cover the effects of a price ceiling on the market at equilibrium with a graphical representation.
Fig. 2 - Consumer surplus
Figure 2. above shows the blue triangle representing the consumer surplus. This is the extra value a consumer gets when buying at the equilibrium price if they are willing to pay 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 much: she is willing to pay only $6. The consumer surplus represents the extra value Erica gets for purchasing the screwdriver at $6, whilst Elise does not have any consumer surplus.
Fig. 3 - Producer surplus
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 Original
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.
References
- Hugh Rockoff, Price Controls Econlib.org
- Indeed Editorial Team, Types of Price Ceilings sourced from Indeed.com
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