All Economics Terms A-Z

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Economics Terms A-Z

Price Ceiling

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A price ceiling, also called price cap, is the maximum price that a seller is allowed to charge for a particular good or service by law. It is an instrument of market regulation that governments may use to ensure that firms do not abuse their market power by charging consumers excessively high prices. Particularly, for goods which are considered a necessity such as water, electricity, or food, the government may establish price ceilings to protect consumers. Often price ceilings are only used temporarily in exceptional situations such as during times of war, famine or after natural catastrophes. For example, during the COVID-19 pandemic some countries established price ceilings for hand sanitizer after observing extreme increases in the price for this product.

What is the impact of a price ceiling on consumers and producers? Let us consider a perfectly competitive market where market demand is given by \(q_{D}=10-p\) and market supply is \(q_{S}=2p-2\). If the government establishes a price ceiling below the market price, then the firms will not be able to charge the market price and sell their goods at the price established by the government. For the example considered, the market price in an unregulated market is equal to 4. Suppose the government fixes a price ceiling at \(\bar{p}\). As this price is lower than the market price, some customers who were not able to buy at the market price would now likely buy the good. The quantity demanded is equal to 8. The quantity supplied, on the other hand, decreases, because at a price of 2 it is less profitable to sell the good, and quantity supplied decreases to 2 units. As the quantity demanded exceeds the quantity supplied there is excess demand.

The figure below shows the effect of a price ceiling, in a perfectly competitive market, for linear demand and supply curves (the ones used as example). In the case of a price ceiling, producer surplus decreases. (It is the triangle described by the area below \(\bar{p}\) and above the supply curve.) Consumer surplus may increase or decrease depending on the demand function and the height of the price ceiling. Total welfare decreases, due to the decrease in the quantity exchanged. The shaded orange area is the efficiency loss that can be attributed to the price ceiling.

 

price ceiling

Price floor

A price floor is the lowest price possible price that buyers can pay for a good. The most well-known example of a price floor is the minimum wage. A price floor or minimum price is another instrument of market regulation that governments may use in markets where the demand-side has market power and as a consequence can force the supply-side to offer their good or service at extremely low prices.

Many countries have a minimum wage to protect workers and employees from having to work at unacceptably low wages. In the labour market the workers determine the supply (they supply more labor at a higher wage), while the firms determine the demand (they are interested in hiring more workers at a lower wage) and the wage is the price of labour.

The intention of a minimum wage is clear: The government is trying to prevent firms from exploiting the workforce by offering low wages. But why are some economists skeptical about the benefits of minimum wages? To answer this question, we can again use our graphs of supply and demand to analyse how a minimum wage affects the labour market. Suppose supply is given by \(q_{S}=2p-2\) and demand is \(q_{D}=10-p\). The equilibrium allocation in this market (without government intervention) will be a price of 4 and a quantity of 6. If we interpret our market as the labour market, we could say that 4 is the hourly wage in equilibrium.

Now suppose the government decides to fix a minimum wage. If this wage is below 4, the market allocation will not change (firms are anyway paying a wage above the minimum wage in equilibrium). But what will happen if the government sets a minimum wage equal to 5? Firms will want to hire 5 workers at this minimum wage, while in total 8 workers would like to work at this wage. The difference between the quantity supplied and demanded (the excess supply) are the workers who do not get a job, and are therefore unemployed. That is why some economists argue that we have to be careful when setting a minimum wage as this may increase unemployment. In general, a price floor above the market price will harm the demand side, that is, consumer surplus decreases. (In the figure it is the area that corresponds to the triangle above \(\underline{p}\) and below the demand curve.) Producer surplus may increase or decrease depending on the supply function and the price floor. Total surplus decreases, because the quantity exchanged decreases and there is a welfare loss, also called dead-weight-loss (DWL) described by the shaded orange area in the figure below.

 

price floor

In a perfectly competitive market, total surplus is maximal and any price regulation will cause efficiency to decrease. Perfectly competitive markets do not need to be regulated, but if one side of the market has market power (e.g. if the seller is a monopolist), price regulations may improve efficiency and decrease welfare loss.

Further reading

In the simple model of a perfectly competitive labour market, a minimum wage causes unemployment to rise and decreases efficiency. Many markets are not perfectly competitive and government interventions such as price regulations may improve efficiency. Cahuc and Michel (European Economic Review, 1996) show that minimum wage legislation may foster economic growth, because low demand for unskilled labour may create incentives for workers to build up more human capital.

Good to know

During the COVID-19 pandemic in 2020 various countries set price ceilings for different goods. The International Monetary Fund advises all countries to use price controls if this helps to “guarantee the functioning of essential sectors.” Different countries established price caps for different types of goods such as masks, hand sanitizer or toilet paper. Price ceilings during “normal” times are sometimes used to regulate markets for goods such as medication or utilities.