What are Price Ceilings? 

Price Ceilings and Price Floors strategy is used by the Government to control the prices of certain goods and services in the market. This method helps the Government to protect the interests of both buyers and suppliers in difficult economic times. 

The methodology used the concept of demand and supply for achieving its objective. The demand and supply law states that, ‘In an efficient market, the quantity supplied of a good and quantity demanded of that good is equal to each other’. The pricing is also determined by the point at which supply and demand are equal to each other. 

Laws enacted by the government to regulate prices are called price controls. A price ceiling controls the price from rising above a stipulated level.  

In many markets for goods and services, demand is more than supply. Resulting in suppliers charging a premium for selling. After a point, the price hike is so high that the consumers who are also the voters request the Government to control the rising prices. The government then comes out with policies to control pricing and imposes a cap above which you cannot charge. 

For example, when rent begins to rise rapidly in a city due to rising demand, citizens press political leaders to pass laws to control such rising rents. 

What are Price Floors? 

A price floor is the lowest legal price that can be paid in a market for goods and services, labor, or financial capital. A price floor keeps a price from falling below a stipulated level. 

Perhaps the best-known example of a price floor is the minimum wage policy, which is based on the view that someone working full time ought to be able to afford a basic standard of living. As inflation rises the cost rises leading to required changes in the wage policy. 

An example of price floors would be when government rationalizes the minimum payment by introducing subsidies on farm produce and market price. Another example is when there is too much liquidity interest rates fall, the Govt then enters the market and takes over all the liquidity just to control the rates from dropping.  

Effects of Price ceiling and Price floor 

The Price ceilings or Price floors do not cause demand or supply to change. They are just simple mechanisms used to set a price that can be legally charged in the market. 

The limits can cause a different choice of quantity demanded, but they do not move the demand curve. Similarly, Price controls can cause a different choice of quantity supplied along a supply curve, but they do not shift the supply curve. Thus, Price ceilings prevent a price from rising above a maximum level, while a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result. 

Price floors prevent a price from falling below a certain minimum level. When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and surplus in supply will result.  

The graph shows a price floor resulting in a surplus. The intersection of demand and supply is at the equilibrium point E. However, since we don’t want to drop prices, a price floor is set at P1 holds the price above E and prevents it from falling. This resulting in excess supply over demand which is depicted by Qs –Qd

Price floors prevent a price from falling below a certain minimum level. When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and surplus in supply will result.

The graph shows a price ceiling resulting in a shortage. The intersection of demand and supply is at the equilibrium point E. However, since we don’t want to rise prices, a price floor is set at P2 holds the price below E and prevents it from rising. This resulting in excess demand over supply which is depicted by Qd –Qs.

Change from the Price Ceiling and Price Floors 

The government imposed price floor or a price ceiling does not allow the market from getting back to its equilibrium price and quantity, and which will further create inefficient results. However, there is another controversy here. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to the supplier, or some producer surplus to buyers. 

Imagine that several firms develop a promising but expensive new drug for treating knee pain. If this therapy is left to the market, the equilibrium market price will be $600 per month and 20,000 consumers will use the drug. However, if the government decides to impose a maximum price ceiling of $400 to make the drug more affordable. At this price ceiling, the firm in the market will now produce only 15,000. 

In this scenario, two changes will occur. First, an inefficient outcome occurs and the total surplus of society will reduce. “The loss in social surplus that occurs when the economy produces at an inefficient quantity is called Deadweight loss.” In other words, Deadweight loss refers to the loss of economic efficiency when the equilibrium outcome is not achievable or not achieved.  

It indicates the cost borne by society due to market inefficiency. It is like money thrown away that benefits neither the supplier nor the buyer. When deadweight loss exists, both buyer and supplier surplus can be higher. In this case, because the price control is blocking some suppliers and demanders from transactions they would both be willing to make. 

A second chance from the price ceiling is that some of the supplier surpluses are transferred to the buyer. Note that the gain to buyers is less than the loss to the supplier, which is just another way of seeing the deadweight loss. 

The deadweight loss also arises in imperfect markets where demand and supply scenarios are not perfect. Example oligopolies and monopolies. In imperfect markets, suppliers restrict supply to increase the minimum price above their average total cost. Higher prices lower the demand thus the produce is wasted and this creates a deadweight loss. 

For example, if you are planning a trip to Vancouver. A Bus ticket to Vancouver is costing $25, and your value for the trip is $40. In this situation, the value of the trip ($40) is more than the cost ($25) and you would, therefore, take this trip. The net value that you get from this trip is $40 – $25 (benefit-cost) = $15. 

However, now before buying a bus ticket to Vancouver, the government suddenly decides to impose a 100% tax on bus tickets. Therefore, this would drive the price of bus tickets from $25 to $50. Now, the cost exceeds the benefit; you are paying $50 for a bus ticket from which you only derive $40 of value. Since you do not find the benefit higher than the cost in this situation, you end up not going to the true. 

Accordingly, since the trip would not happen and the government would not receive any tax revenue from you, the supplier or bus owners won’t get revenue and the consumer will remain cash-rich. In these scenarios, the deadweight loss is the value of the trips to Vancouver that do not happen because of the tax imposed by the government intervention. 

Meaning of Consumer Surplus and Producer Surplus

• Consumer surplus is the consumer’s gain from trade. “The consumer surplus is the area below the demand curve but above the equilibrium price and up to the quantity demand.”
• Producer surplus is the producer’s gain from trade. “The producer surplus is the area above the supply curve but below the equilibrium price and up to the quantity demand.”

What is Deadweight Loss?

Deadweight loss is the value of the trades on public goods that are not made due to the introduction of the tax.

Example:

At equilibrium, the price is $5 with a quantity demand of 500.

Above $5 there will be consumer surplus and below will be producer surplus.

• Equilibrium price = $5
• Equilibrium demand = 500

Let us now consider the effect a new after-tax selling price of $7.50 will have on the demand:

The market price would be $7.50 with a quantity demand will reduce to 450. Thus, it will create market surplus supply at a minimum price and deadweight loss. 50 units in our above example are deadweight losses.

Common Mistakes

• Applying the methods without having the demand and supply curves
• Assuming that price floor or ceiling affects demand

Context and Application

This topic is important for the students pursuing the below-mentioned disciplines.

• Masters in Economics 
• Master in Business Administration
• Masters in Commerce