We have already discussed in previous topics that market systems may not allocate resources efficiently for many reasons. This is known as market failure. Governments intervene in order to correct such market failures. Imposition of price controls is one of such interventions.
It is known as maximum price or price ceiling when the government sets a maximum legal limit of a price of a particular good or service. For this to have an effect on market, the price ceiling must be placed below the natural market price. This normally leads to a shortage – the quantity demanded will be greater than the quantity supplied.
If a government decides that the market clearing price of a good or service is too high and needs to be reduced, a price ceiling maybe imposed. The reasons for such an intervention could be:
- A monopoly which charges unreasonably high prices.
- The good or services is an essential or merit good.
Examples of maximum prices
- Maximum prices for train tickets. With monopoly power, train companies could increase the price of tickets, but governments may impose a maximum price (or maximum price increase on firms) to keep tickets affordable – even if it leads to over-crowding.
- Maximum price for rent. Governments have tried different types of rent control – keeping the cost of renting below a certain level.
- Maximum price for food. In some developing economies, there are maximum prices for certain food items to keep them affordable.
Problems of imposing a price ceiling
- It often leads to shortage: unless the item is very much price inelastic, the quantity supplied will be far less than the quantity demanded. This could mean that some system of rationing needs to be in place. This will also result in long queues.
- Emergence of black market: This can happen in many ways. People could buy at the low maximum price and resell at a much higher price to those who were not able to buy it before the supply runs out. It can also be that the declared price and the price actually paid could be different, in which case the whole idea of maximum price is offset.
- The market will become less profitable. In the long-term this may lead to less investment and also decrease supply in the long-term. For example, rent controls may be a way to deal with the short-term problem of expensive housing. But, reducing rents will discourage many land owners from letting out property. It may also discourage people from building houses.
How to solve these problems?
A more long-term solution to the problem will be to use supply side policies rather than to distort the markets by controlling the price.
If housing is too expensive, a long-term solution is to build more affordable housing – and not just rely on maximum prices.
Maximum prices may be most useful in the case of a monopoly who is both restricting supply and inflating prices. An alternative maybe to reduce the power of monopolies; though in some industries, this is not possible – so maximum prices will be the most effective.
It is known as minimum price or price floor when the government sets a minimum legal limit of a price of a particular good or service. For this to have an effect on market, the price ceiling must be placed above the natural market price. This normally leads to a surplus – the quantity supplied will be greater than the quantity demanded.
Price floors are set by the government for certain commodities and services that it believes are being sold in an unfair market with too low of a price and thus their producers deserve some assistance.
Some situations in which price floors are used:
- To attempt to raise incomes for producers of goods and services which are essential. e.g agricultural products — helped due to prices are subject to large fluctuations or due to large foreign competition.
- To protect workers by setting minimum wage — ensuring workers earn enough to lead a reasonable existence.
The Disadvantage of Minimum Prices
- Higher prices for consumers. We have to pay more for food.
- Higher tariffs necessary on imports. For example – The EU put tariffs on food to keep prices artificially high.
- May encourage oversupply and inefficient. The CAP(common agricultural policy in EU) encouraged farmers to produce food that no one actually wanted to eat.
- Over-supply (butter mountains, wine lakes)
Government can eliminate the surplus by buying the excess supply at the minimum price. This will result in the shifting of demand curve to the right, thus creating a new equilibrium at a higher price level.
The Government may store it or sell it abroad. However, both these options have consequences. Buying the surplus and storing it will cost an opportunity cost for the government as they have to divert funds from other important areas and exporting it other countries may be considered as dumping especially if they are sold at below cost prices.