Introduction to Price Ceilings

01
of 09

What Is a Price Ceiling?

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In some situations, policy makers want to ensure that prices for certain goods and services don't get too high. One seemingly straightforward way to keep prices from getting too high is to mandate that the price charged in a market must not exceed a particular value. This sort of regulation is referred to as a price ceiling- i.e. a legally mandated maximum price.

By this definition, the term "ceiling" has a pretty intuitive interpretation, and this is illustrated in the diagram above. (Note that the price ceiling is represented by the horizontal line labeled PC.)

02
of 09

A Non-Binding Price Ceiling

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Just because a price ceiling is enacted in a market, however, doesn't mean that the market outcome will change as a result. For example, if the market price of socks is $2 per pair and a price ceiling of $5 per pair is put in place, nothing changes in the market, since all the price ceiling says is that the price in the market cannot be greater than $5.

A price ceiling that doesn't have an effect on the market price is referred to as a non-binding price ceiling. In general, a price ceiling will be non-binding whenever the level of the price ceiling is greater than or equal to the equilibrium price that would prevail in an unregulated market. For competitive markets like the one shown above, we can say that a price ceiling is non-binding when PC >= P*. In addition, we can see that the market price and quantity in a market with a non-binding price ceiling (P*PC and Q*PC, respectively) are equal to the free market price and quantity P* and Q*. (In fact, a common error is to assume that the equilibrium price in a market will increase to the level of the price ceiling, which is not the case!)

03
of 09

A Binding Price Ceiling

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When the level of a price ceiling is set below the equilibrium price that would occur in a free market, on the other hand, the price ceiling makes the free market price illegal and therefore changes the market outcome.  Therefore, we can start analyzing the effects of a price ceiling by determining how a binding price ceiling will affect a competitive market.  (Remember that we are implicitly assuming that markets are competitive when we use supply and demand diagrams!)

Because market forces will try to bring the market as close to the free-market equilibrium as possible, the price that will prevail under the price ceiling is, in fact, the price at which the price ceiling is set. At this price, consumers demand more of the good or service (QD on the diagram above) than suppliers are willing to supply (QS on the diagram above). Since it requires both a buyer and a seller in order to make a transaction happen, the quantity supplied in the market becomes the limiting factor, and the equilibrium quantity under the price ceiling is equal to the quantity supplied at the price ceiling price.

Note that, because most supply curves slope upward, a binding price ceiling will generally reduce the quantity of a good transacted in a market.

04
of 09

Binding Price Ceilings Create Shortages

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When demand exceeds supply at the price that is sustained in a market, a shortage results. In other words, some people will attempt to buy the good supplied by the market at the prevailing price but will find that it is sold out. The amount of the shortage is the difference between the quantity demanded and the quantity supplied at the prevailing market price, as shown above.

05
of 09

The Size of a Shortage Depends on Several Factors

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The size of the shortage created by a price ceiling depends on several factors. One of these factors is how far below the free-market equilibrium price the price ceiling is set- all else being equal, price ceilings that are set further below the free-market equilibrium price will result in larger shortages and vice versa. This is illustrated in the diagram above.

06
of 09

The Size of a Shortage Depends on Several Factors

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The size of the shortage created by a price ceiling also depends on the elasticities of supply and demand. All else being equal (i.e. controlling for how far below the free-market equilibrium price the price ceiling is set), markets with more elastic supply and/or demand will experience larger shortages under a price ceiling, and vice versa.

One important implication of this principle is that shortages created by price ceilings will tend to become larger over time, since supply and demand tend to be more price elastic over longer time horizons than over short ones.

07
of 09

Price Ceilings Affect Non-Competitive Markets Differently

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As stated earlier, supply and demand diagrams refer to markets that are (at least approximately) perfectly competitive. So what happens when a non-competitive market has a price ceiling put on it? Let's begin by analyzing a monopoly with a price ceiling.

The diagram on the left shows the profit-maximization decision for an unregulated monopoly. In this case, the monopolist limits output in order to keep the market price high, creating a situation where the market price is greater than marginal cost.

The diagram on the right shows how the monopolist's decision changes once a price ceiling is placed on the market. Strangely enough, it appears that the price ceiling actually encouraged the monopolist to increase rather than decrease output! How can this be? To understand this, recall that monopolists have an incentive to keep prices high because, without price discrimination, they have to lower their price to all consumers in order to sell more output, and this gives monopolists a disincentive to produce and sell more. The price ceiling mitigates the need for the monopolist to lower its price in order to sell more (at least over some range of output), so it can actually make monopolists willing to increase production.

Mathematically, the price ceiling creates a range over which marginal revenue is equal to price (since over this range the monopolist doesn't have to lower price in order to sell more). Therefore, the marginal curve over this range of output is horizontal at a level equal to the price ceiling and then jumps down to the original marginal revenue curve when the monopolist has to start lowering price in order to sell more. (The vertical part of the marginal revenue curve is technically a discontinuity in the curve.) Like in an unregulated market, the monopolist produces the quantity where marginal revenue is equal to marginal cost and sets the highest price that it can for that quantity of output, and this can result in a larger quantity once a price ceiling is put in place.

It does, however, have to be the case that the price ceiling doesn't cause the monopolist to sustain negative economic profits, since, if this were the case, the monopolist would eventually go out of business, resulting in a production quantity of zero.

08
of 09

Price Ceilings Affect Non-Competitive Markets Differently

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If a price ceiling on a monopoly is set low enough, a shortage in the market will result. This is shown in the diagram above. (The marginal revenue curve goes off of the diagram because it jumps down to a point that is negative at that quantity.) In fact, if the price ceiling on a monopoly is set low enough, it could decrease the quantity that the monopolist produces, just as a price ceiling on a competitive market does.

09
of 09

Variations on Price Ceilings

In some cases, price ceilings take the form of limits on interest rates or limits on how much prices can increase over a given period of time. Even though these types of regulations differ in their specific effects a bit, they share the same general characteristics as a basic price ceiling.

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Beggs, Jodi. "Introduction to Price Ceilings." ThoughtCo, Mar. 27, 2017, thoughtco.com/introduction-to-price-ceilings-1146817. Beggs, Jodi. (2017, March 27). Introduction to Price Ceilings. Retrieved from https://www.thoughtco.com/introduction-to-price-ceilings-1146817 Beggs, Jodi. "Introduction to Price Ceilings." ThoughtCo. https://www.thoughtco.com/introduction-to-price-ceilings-1146817 (accessed May 22, 2018).