Price Ceiling Definition
Effects, Graph, and Examples
WRITTEN BY PAUL BOYCE | Updated 9 January 2021
What is a Price Ceiling
A price ceiling is the maximum amount a producer can sell their good or service for. This is usually mandated by government in order to ensure consumers can afford the relevant goods and services. Examples include, food, rent, and energy products which may become unaffordable to consumers.
A price ceiling is a form of price control that manipulates the equilibrium point between supply and demand. What price ceilings do is prevent the price of a good from increasing. In turn, this provides a disincentive to the producer to bring more supply to the market.
If we look at renting for example, price ceilings place a cap on the amount landlords can charge. So instead of making a return of investment of 10 percent, they may be limited to 2 percent. Inevitably, this disincentivizes not only new investors, but also construction firms, from supplying new rental units to the area.
- A price ceiling is a cap or limit on the amount producers and charge the customer for their goods or services.
- Price ceilings may potentially lead to excess demand in the market as it is left in disequilibrium.
Price Ceiling Effects
There aren’t many issues that economists tend to agree on, but price ceilings are one of them. According to the Center of the American Experiment, 81 percent of economists agree that price ceilings are bad economics. They lead to a number of negative effects which we will look at below.
1. Black Market
Price ceilings create excess demand when the ceiling falls beneath the true market value. That leaves consumers wanting goods, but unable to purchase them. To illustrate, imagine a doughnut store selling fresh doughnuts at $0.10 each. It would be incredibly difficult to purchase one as it is significantly below the normal market price. Some consumers will get there early and there might be some scuffles as well. The low prices will increase demand dramatically and as a result make the supply scarce – making doughnuts difficult to come by.
So what happens with this pent-up demand? Well it leads to black markets. Essentially, there is demand, but producers won’t supply this at the prices dictated by the ceiling. The solution is to buy these illegally at a price in excess of the price ceiling. That way, the customer is able to buy the good at a price they are willing to pay.
Price ceilings create black markets, which by themselves is illegal. Yet price ceilings can also contribute to increased crime in other ways. For example, rent controls have led to housing falling into a state of disrepair – which contributes to the ‘broken window’ theory whereby such housing attracts crime.
There is also the fact that landlords are not earning as much money from their properties. Instead of earning a 5 percent return, they may not even earn 1 percent. In turn, this has, on occasion, contributed to arson in a bid to get money back from the insurance.
3. Lack of Mobility
This effect is largely limited to rental price ceilings. To explain, price caps on rental units make it extraordinarily cheap – especially over time. What this does is lock people in who fear losing their cheap rent-capped accommodation. In New York, for example, many residents end up keeping rent-capped accommodation as a second home or refuse to move entirely – even if the accommodation is too large. Alternatively, it can result in overcrowding as families grow. .
The logic behind this is that renting becomes a cheaper option than owning, thereby incentivizing residents to rent. At the same time, there is an incentive to work locally in order to stay at the same rent-capped accommodation – after all, it can be extremely difficult to obtain a rent-controlled apartment.
4. Poor Quality
When prices are unable to react to demand, what normally happens is a reduction in supply. However, it can also lead to a decrease in the quality of the good or service. For example, a price ceiling may prevent businesses from making a profit as the ceiling is below the cost of production. In turn, the firm can either choose to go out of business, or try and cut costs in order to make a profit at the lower price.
If we take it to the extreme and look at a car for example. Most new cars cost well in excess of $15,000 in the US. Yet what would happen if a price ceiling of $5,000 was imposed? Inevitably, you would get a car that is worth that much. Most likely it will be made of cheap materials, unreliable, and of poor quality.
Shortages occur because prices are not able to react to demand. For example, a price ceiling is usually placed below the equilibrium point where supply and demand meet. This is in order to make the good or service affordable to the consumer. However, this is not a gain for both parties. There is a large amount of demand, but prices are not high enough to encourage producers to provide the goods.
This is not necessarily because producers are greedy. It can simply mean that they would make a loss to do so. This is particularly an issue when the price ceiling is in place for many years and not increasing in line with inflation. So whilst the price to produce the goods is increasing – the price the producers receive is not. Inevitably, this can push many businesses over the cliff edge as it becomes unaffordable to continue production.
6. Rationing and Queues
When prices are constricted by price ceilings, we see an excessive amount of demand. For example, the US imposed price restrictions on fuel in the 1970s following the OPEC crisis.
In this instance, prices were increasing as a result of a reduction in supply, which forced President Nixon to introduce a price cap. Demand remained the same, but because prices didn’t rise, producers kept output at lower levels. There was still a prolonged period of excess demand as supply was never able to increase. to the
As a result, there was a period of rationing whereby only cars with a certain number plate could get petrol on any one day. At the same time, queues were long and often people would wait hours to find there was no fuel left when they got there.
Price Ceiling Graph
When price ceilings are set, they are done in order to allow people who would otherwise be unable to purchase the relevant goods, to be able to purchase them. For example, rent caps are designed to ensure rent is affordable – especially to low-income workers. Similarly, price ceilings on fuel and gas are equally designed to make it more affordable. By making goods cheaper, more people can then afford them.
A price ceiling would never be implemented above the equilibrium – as highlighted at P and Q*. This is because it would not have the intended effect – i.e. make it affordable to consumers. What happens is the price ceiling is set BELOW the equilibrium point in order to reduce the producer surplus and make it affordable to the consumer.
To explain, let us take a MacBook as an example. It generally sells for around $1,000 in the US. As a policymaker, setting a price ceiling at $1,500 won’t have any effect as it’s already selling below that price. It’s a bit like having a 10-meter-high ceiling in your home – it’s just completely unnecessary. So in order for the ceiling to have any effect – it has to be below the existing equilibrium point.
When a price ceiling is put in place, it is set below the equilibrium. We can see this at point Pc on the graph above. At this point, both supply and demand are out of equilibrium.
When the price is at Pc, which is dictated by the price ceiling – quantity supplied is at Qs and the quantity demanded is at Qd. What we can see here is that there is a large differential between the amount supplied and the amount demanded. In turn, we define this as a shortage of supply.
What normally happens under such conditions is for prices to rise, which encourages producers to bring a greater supply to the market. However, as prices are capped, this does not occur and therefore the market is undersupplied
Price Ceiling Examples
1970s Oil Embargo
In 1973, the US and the world faced an oil crisis as the newly founded OPEC cartel worked together to stem the supply of oil and inflate prices. In part, this was in reaction to the perceived support of Israel during the Yom Kippur War.
The shortage of supply was met by a price ceiling, implemented by President Nixon in November of 1973. The price ceiling was based on prices as at March 1973 and allowed suppliers to increase prices, but only if profit margins were kept the same.
What resulted were long queues, strikes, and violent incidents due to the rationing of fuel. On top of that, the suppressed prices of oil prevented an acceleration in the development of US oil extraction. Had prices been allowed to increase, it would have provided US extractors an incentive to increase production and perhaps helped improve the efficiency of production at home.
New York City Rent Control
New York City has a long history of rent control which spans back as far as 1920. However, the cities regulation started to take off shortly after the Second World War. Since then, the details surrounding price ceilings has consistently changed. This has made it extremely complex as some buildings are regulated, whilst others are not – allowing people to take advantage of loopholes.
At the core of New Yorks price ceilings is the age by which the building was constructed. Depending on a number of other variables, this tends to include any buildings built before 1974 and some thereafter. Subsequently, the number of rental units has diminished over time, as old, rent-controlled apartments, make way for new builds.
As a result of these regulations, the number of rental units has declined as old apartments make way for newer buildings. It provides an incentive for the landlords to rebuild and gain exemption from the rent controls. These price controls have not only reduced the number of rental units available, but more importantly, the quality of rent-controlled units declined remarkably.
Rent control reduces investment in a property’s quality and causes a city’s housing stock to decay – which is exactly what happened in New York, especially throughout the 1980s.
Uber in India
First introduced in 2016, the Indian government implemented a price cap on Uber to prevent it from taking advantage of consumers in peak times. The issue was that during peak hours such as the weekend, after work, and at night. Known as price surging, this aggravated consumers and the government stepped in.
Customers are already experiencing poorer quality service – meaning longer waiting times as there is reduced supply. At the same time, drivers are receiving lower wages as a result of the cap – meaning many are leaving the job altogether as it doesn’t bring in the money they were expecting.
General FAQs on the Price Ceilings
Rent control is one of the most common examples of a price ceiling. It prevents landlords charging tenants a higher price than the ceiling set by government. In doing so, tenants benefit from lower prices, but it equally diminishes the rental stock as landlords sell their property to owners in order to obtain a fair market value. At the same time, it becomes unprofitable to continue to maintain the property at lower rents – so rental units tend to fall into disrepair. In short – those on the outside cannot get a property, whilst those on the inside have to endure poorer quality residences.
Price ceilings are bad because they artificially create shortages. As part of supply and demand, when demand increases, prices increase to attract a higher level of production by suppliers. However, when prices are set artificially below the equilibrium point, prices are low, demand is high, and producers are unable to meet supply.
Generally speaking, price ceilings intend on making it cheaper for consumers to participate in the market. For instance, rent ceilings are implemented to ensure everyone has an affordable place to live and rent.