Binding price ceiling

What is a price ceiling?

A price ceiling is when the government sets a maximum price that firms are allowed to charge for a good or service. It is called a price ceiling because the firm is not allowed to charge a price higher than the stipulated price. The opposite of a price ceiling is a price floor which is when the government sets the minimum price for a good or service.

The idea behind a price ceiling is to ensure consumers are not paying exorbitant prices for goods which are deemed a necessity.

Examples of price ceilings?

  • Rent control on how much a landlord can charge for rent
  • Venezualian price controls on food
  • Rice prices in Thailand

Effective v ineffective price ceilings

An effective price ceiling is called a binding price ceiling. A binding price ceiling is when the price ceiling that is set by the government is below the prevailing equilibrium price. For example, if the equilibrium price for rent was $100 per month and the government set the price ceiling of $80, then this would be called a binding price ceiling because it would force landlords to lower their price from $100 to $80. This can be depicted in a supply and demand diagram, as such:

Bilding price ceiling

Because the price P_C is less than P_E the price ceiling is binding.

If the equilibrium price is already lower than the price ceiling, the price ceiling is ineffective and called a non-binding price ceiling. For example, suppose that the prevailing equilibrium price was $100 still and the government set the price ceiling to be $130 the price would still be $100 NOT $130. Remember, the price ceiling is a maximum price for which firms can sell their goods and services. The government setting a maximum price should not affect their pricing decisions as if they were able to charge a price of $130, they would already do it, as it would earn them more profit!

An example of a non-binding price ceiling in the supply and demand diagram looks as follows:

Non-binding price ceiling

Because the price is set above the equilibrium level, it will have no impact on the price that is charged and the equilibrium price will prevail.

How do binding price ceilings cause shortages?

To see why a binding price ceiling causes shortages, we need to see how much firms will be willing to sell at the given price and how much consumers are going to demand at the given price.

At the price P_C supplies will only be willing to supply the quantity Q_1.

At the price P_C consumers will demand the quantity Q_2.

Since Q_2 > Q_1 this would typically lead to the price increasing, fewer people demanding the good and more people supplying the good until we returned to equilibrium. However, since the government has mandated that the price cannot increase above P_C this adjustment process cannot take place and there will be shortages as there are more people who demand the good than there are suppliers willing to supply the good.

Thus the government faces a trade-off between lowering the price of a good and causing shortages or having a higher equilibrium price but more people purchasing the good.

For an example where price controls do not cause shortages, see this post  about consumer and producer surplus with perfectly inelastic supply.