Price Ceiling Flashcards
What is a price ceiling
This is when a government sets a price below equilibrium, this means producers aren’t legally allowed to sell goods and services above this price.
Why are price ceilings imposed? (3)
1) In order to make certain goods more affordable to people on low incomes.
2) To make necessities/, merit goods more affordable.
3) Price ceilings also promote equity in the distribution of essential goods and services. When equilibrium prices rise too high, they can create significant disparities in access, favoring higher-income individuals. By capping prices, governments can facilitate a fairer distribution, ensuring that all individuals have a reasonable chance of accessing necessary goods and services, regardless of their financial status.
What happens if price ceiling is set above equilibrium?
If the price ceiling were set above the equilibrium price, it would have no impact because the market would already be operating at a price that balances supply and demand. In this case, there’s no pressure to maintain a higher-than-equilibrium price, so the market would naturally “self-correct” back to the equilibrium, where there’s no excess demand or supply. Therefore, only a ceiling below equilibrium effectively restricts prices and affects market dynamics.
Impact of maximum prices in market for rental accomodation
The govt imposes a maximum price, due to this the quantity demanded increases but the quantity supplied contracts. Creating a shortage in the market.
Consequences of Price Ceilings (5)
1) Shortages - A price ceiling creates a supply shortage. Due to the shortage, black markets (or parallel markets) are formed.
2) Non-Price Rationing
3) Creation of Black markets - Happens when transactions take place outside of official, regulated channels, often unrecorded. In price ceilings, black markets are created when individuals buy goods at the maximum price and then illegally resell them at a higher price, often above both the price ceiling and even the original equilibrium price. This is a consequence of the shortage created by the price ceiling, as dissatisfied consumers who cannot buy the good through official means may be willing to pay higher prices in the black market. Consequently, black market prices frequently exceed the legal maximum and equilibrium price, reflecting the unmet demand and the restricted supply in the regulated market.
4) A price ceiling results in underallocation of resources toward the good, leading to allocative inefficiency. With the ceiling price limiting how much suppliers can charge, the quantity supplied (Qs) falls below the equilibrium quantity (Qe) because producers lack the incentive to produce at the lower price. This results in underproduction relative to the socially optimal level, as fewer resources are directed to the production of the good than what would maximize societal welfare. Consequently, society is worse off due to this resource misallocation, as the market fails to meet consumer demand adequately, causing inefficiencies that prevent optimal distribution and satisfaction of needs.
5) Negative welfare impacts - max price decreased producer surplus because suppliers receive less revenue per unit sold. The lower price discourages production, meaning fewer goods are supplied, and producers’ earnings are diminished.
What is Non-Price Rationing?
In a free market, the price mechanism allocates goods and services by allowing those who are willing and able to pay to purchase them. Goods are thus rationed according to buyers’ willingness to pay at the market price. However, when a price ceiling is imposed and creates a shortage, this allocation system breaks down because the artificially low price prevents the market from reaching equilibrium. With demand exceeding supply at the ceiling price, the price mechanism no longer functions effectively, and non-price rationing methods must be used to distribute the limited supply.
Examples of non-price rationing include:
1) Queuing (Waiting in Line) and First-Come, First-Served: Goods are distributed to those who arrive first, leading to long wait times and potential dissatisfaction among buyers who cannot secure the product.
2) Distribution of Coupons or Vouchers: The government or suppliers issue coupons that allow each interested buyer to purchase a fixed quantity of the good within a certain timeframe, helping to ration limited supplies evenly but reducing flexibility in purchasing.
Impact of price ceilings on stake holders (4+PB)
1) Consumers - Consumers partly gain and partly lose. If they were able to purchase the good despite the shortage, they benefit as they can purchase the good or service at a lower price. However, some consumers remain unsatisfied since they are not able to buy the goods or services at all. This is because, at the selling price, there isn’t enough to satisfy all consumers.
2) Producers - They are worse off - With the price ceiling they sell a smaller wty of goods at lower prices. Therefore, their revenue drops from (Pe x Qe) to (Pm x Qs). THis is clear from their loss of producer surplus. (ONLY THE BLACK MARKET WILL BENEFIT)
3) Workers - At lower prices, producers find it less profitable to produce the same qty of goods as they would at an equilibrium price. As a result, they cut back on products to avoid incurring loses.
Since labor demand is derived from demand, when output falls, so does demand for labours. In turn, labor gets unemployed, as companies no longer need as many employees to produce small quantities of goods.
4) Government - There will be no direct gain or loss for the govt budget. The govt can gain potential popularity among certain groups of consumers. Price max often makes neccesities cheaper and hence the public may show increased support.
Advantages (2)
1) Some consumers benefit as they purchase at lower prices. For these consumers their consumer surplus increases
2) Price ceilings can stabilise markets in the short-term during periods of intense disruption e.g. Covid supplies at the start of the pandemic
Disadvantages (4)
1) Some consumers are unable to purchase due to the shortage
2) Producers lose out as the price is below what they would usually receive: their producer surplus falls
3) The unmet demand usually encourages the creation of illegal markets (black/grey markets) as desperate buyers turn to illegal bidding
4) Maximum prices distort market forces and therefore can result in an inefficient allocation of scarce resources e.g. price ceilings of housing rentals in the property market create a shortage
5) When used in necessity markets, Governments may be forced to intervene further by supplying the good/service themselves in order to meet the excess demand
Short term impact
1) Consumer Surplus Increase: In the short run, consumers benefit from lower prices, leading to an increase in consumer surplus.
2) Shortage: A price ceiling below the market equilibrium creates a market shortage because the quantity demanded exceeds the quantity supplied at the artificially low price.
3) Non-Price Rationing: Due to the shortage, firms may implement non-price rationing mechanisms such as waiting lists, quotas, or favoritism to allocate limited goods or services.
4) Reduced Producer Surplus: Producers receive less revenue due to the lower price, leading to a reduction in producer surplus and potentially decreased willingness to supply the good.
Long term impact
1) Persistent Shortages: The price ceiling causes a long-term persistent shortage as the lower price reduces the incentive for firms to supply the good, while increasing the incentive for consumers to demand it.
2) Underproduction: Over time, producers may reduce output or exit the market due to lower profitability, leading to underproduction of the good or service.
3) Quality Reduction: To cut costs, producers may reduce the quality of the good or service, as they are no longer able to charge a price that reflects the true cost of production.
4) Black Markets: A persistent shortage can lead to the emergence of black markets, where goods are sold at prices higher than the ceiling, effectively bypassing the price control.
5) Inefficiency: The price ceiling distorts the allocation of resources, leading to allocative inefficiency, where the good or service is not distributed to those who value it most (i.e., consumers who are willing to pay more at the equilibrium price).
