Price ceiling

Definition

A price ceiling is an upper limit placed by the government or a regulatory authority with government sanction on the price (per unit) of a commodity.

A price ceiling is a form of price control. The other form of price control is a minimum price.

There are two types of price ceilings:

• Non-binding price ceiling: This is a price ceiling that is greater than the current market price.
• Binding price ceiling: This is a price ceiling that is less than the current market price.

A particularly extreme form of price ceiling, which is not usually thought of that way, is a price ceiling of zero. This refers to situations where it is legal to give a good or service for free but it is illegal to offer the good or service in exchange for money. Price ceilings of zero are usually justified on aesthetic and ethical grounds as it is believed that the exchange of money sullies certain types of transaction. Since the market price for most forms of exchange is positive, price ceilings of zero are typically binding price ceilings. Examples include:

• Prostitution (the sale of sexual services), which is illegal, though not often rigorously prosecuted, in many countries
• Organ trade, i.e., there are often jurisdictions where it is legal to donate an organ such as a kidney but illegal to buy or sell it.
• Adoption: In many places, it is not legal for a pregnant mother to sell her baby for adoption to a couple willing to adopt the kid, though it is legal to put the baby up for adoption.

Basic theory: the effects of price ceilings in competitive markets

Non-binding price ceiling: price ceilings have no effect when they are above the market-clearing price

A price ceiling that is set above the market price of the commodity has no direct effect. Such price ceilings may be put in place to prevent price gouging in the event of an emergency (not currently happening) or to prevent rapid fluctuations in prices due to other unforeseen circumstances. A price ceiling that is above the market price is termed a non-binding price ceiling.

Binding price ceiling: price ceilings create excess demand when they are below the market-clearing price

If the price ceiling is below the market price, the quantity demand for the good exceeds the quantity supplied for the good, resulting in a situation of scarcity or excess demand. This results in a loss of social surplus compared to the situation of a market-clearing price.

For instance, in the figure below, if the price ceiling is set at the price level of the horizontal line AB, then there is a shortfall equal to the length of the segment AB. The loss in social surplus relative to the market price situation is given by the area of the triangle ABC.

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Basic theory: the effects of price ceilings in monopolistic markets

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Non-binding price ceilings: price ceilings have no effect when they are above the market-clearing price

This is essentially the same situation as in the competitive market case.

Binding price ceilings above marginal cost at the pre-ceiling level of production

Before a price ceiling is imposed, the monopolist will produce at a point where the monopolist's marginal revenue from selling a unit equals its marginal cost of producing a unit. (The price charged will be higher than this point). In this section, we are considering the impact of a price ceiling above this point described. (Since the price ceiling is binding, by definition it must be below the price charged by the monopolist.)

Effects on the market price: Price ceilings in this range will reduce the market price of the good sold.

Effects on the quantity traded: Price ceilings in this range will actually raise the quantity of the good sold (not lower it as in the competitive case).

The reason why is that the marginal revenue function for the monopolist effectively changes. The marginal revenue from selling the first unit is the price paid for that unit (which is fixed at the price ceiling). If it chooses to sell another unit, the price of the first unit does not change, as both units are sold at the maximum price allowed. So the marginal revenue is still equal to the price charged. This is true until the point at which consumers are willing to pay less than the price ceiling, at which point the marginal revenue of selling units falls below the price sold.

The monopolist will then maximize its profits in the short run by producing more than it previously was, because the marginal revenue gained from selling an additional unit is greater. This raises total surplus by removing part of the deadweight loss associated with the monopoly. In particular, if the price ceiling is set at the point that would prevail in a competitive market (that is, the point where the demand curve intersects the marginal cost curve), total surplus will be maximized and the deadweight loss from the monopoly will be completely eliminated.

An exception to this is discussed below. Namely, there are some cases in which a price control in this range will make a monopoly firm unprofitable, causing it to exit. In this situation, it may be necessary to allow price discrimination or subsidize the monopoly firm in order to increase total surplus.

Binding price ceilings below marginal cost at the pre-ceiling level of production

Price ceilings in this range will reduce the market price of the good sold, and will lower the quantity of the good sold. This is the same as the competitive case. The basic reasoning behind this is that the price ceiling reduces the marginal revenue from selling an additional unit at the current point of production, and thereby causes the monopolist to reduce the quantity it sells.

Short-run impact of binding price ceilings in perfectly competitive markets

Non-price competition among buyers

The key problem that needs to be solved in case of a binding price ceiling is the problem: given that the quantity supplied is less than the quantity demanded, who among the different potential buyers of the good gets how much of it? Note that this problem does not arise in case there is a single buyer.

One solution to this problem is non-price competition among potential buyers. An example of non-price competition is queueing -- the buyers stand in line to buy the good, and those who are too far behind in line end up not getting any of the good. There are other mechanisms of non-price competition.

The chief drawback of non-price competition is that it results in a deadweight loss because the buyers spend effort competing with each other but there are no net gains to society from this effort.

Black market

A black market, or an illegal market in the good, is one way around the problem of a price ceiling. In this scenario, a small quantity of the good is sold in the legal market at a price equal to the price ceiling, whereas the rest of the commodity is sold in the black market at the true equilibrium price. In fact, the black market price may well be higher than the market price would be in the absence of a price ceiling, because of the added costs incurred by sellers to evade the law.

Effect on social surplus

Further information: effect of price ceiling on social surplus

Under most sets of assumptions, price ceilings have a negative effect on social surplus. There are, however, some theoretical exceptions, whose incidence in practice is debated.

Short-run impact of binding price ceilings in monopolistic markets

Reduction of monopoly profits

A monopolist enjoys an economic profit that firms in perfect competition do not receive, because they are able to set the price and quantity sold in the whole market to maximize their profits. This excess profit is reduced when a price control is imposed, as it constrains the monopolist and requires them to offer the good at a price and quantity which does not maximize their profits (or else they would have chosen that price and quantity in the first place).

Effect on social surplus

Further information: effect of price ceiling on social surplus

Note: here we assume that the good being sold has no external costs or external benefits.

In the case in which the price control actually raises the quantity of the good sold in the short run, the effect on social surplus is positive, as it removes some of the deadweight loss of the monopoly and moves the price and quantity closer to what they would be in a perfectly competitive market.

Conversely, in the case in which the price control reduces the quantity of the good sold in the short run, the effect on social surplus is negative, as it prevents some mutually beneficial exchanges from occurring.

Long-run impact of price ceiling

Innovation and substitution between product lines

Price ceilings, both binding and non-binding, can have important long-run effects, including:

• Sellers may choose to rebrand or redefine their products so as to make cheaper or lower quality products that fit in the same category as the original product, or to shift the costs on to auxiliary products. For instance, if a price ceiling is imposed on the sale of cellphones, but what a "cellphone" is is not clearly specified, sellers may shift to stocking more of the cheaper and low cost cellphones. Alternatively, sellers may choose to shift costs from the cellphone to the payment plans so they end up selling the cellphones cheap but raise the price of the payment plans.
• Conversely, sellers may be reluctant to create new products in the category for fear that they will not be able to charge a higher price for the new product to recoup the cost of creation. This concern applies even in the case of non-binding price ceilings. Goods with high upfront investment costs command a high price at the beginning, and sellers then engage in price skimming as competitors catch up, and eventually the new products become as cheap as the older products used to be, and perhaps even cheaper. It is thus possible that the existence of a price ceiling scares away innovation that would ultimately have a more beneficial long run impact in terms of reducing cost and improving quality.

To avoid these, the following are usually done:

• Price ceilings are typically applied for commodities like oil or grain where the unit measurements are reasonably clear and the problem above of a new technology does not arise.
• Sometimes, price ceilings are applied only to certain brands and products and the same sellers are allowed to sell alternate or new products at unrestricted prices.

Disaster planning

Non-binding price ceilings are sometimes put in place to prevent price gouging in the event of natural disasters. This may reduce incentives for sellers to be well stocked with goods for natural disasters as they will be unable to command the full market price for the good in the event of a disaster.

Firms in declining-cost industries may leave the market

There are some industries where the average cost of producing a unit of the good actually declines as more units are produced. This often happens if there are fixed costs of production. The result is that the average cost of producing a unit will exceed the marginal cost of producing a unit, and generally only one firm will supply the market. This is often called a case of natural monopoly. The problem is that when a price control is established that would otherwise raise the quantity sold (as described above), the new price will be below the average cost of producing a unit, and so the monopolist firm will no longer be profitable.

In order to raise total surplus in this sort of monopoly situation, a price control set at the marginal cost of production will be insufficient. The firm will either have to be allowed to engage in price discrimination so that the profit-maximizing level of production will be closer to the socially optimal level of production, will have to be subsidized by the government so that it can sell units closer to marginal cost, or will have to be allowed to sell units at or above the average cost of production. This last option has less potential to raise total surplus, as it cannot allow the socially optimal level of production to prevail. However, the other options can also present difficulties, including distributional issues with price discrimination (more of the total surplus is taken up by the monopolist) and funding issues with subsidies (funding subsidies via distortionary taxes can actually create another deadweight loss).

Related notions

• Maximum retail price is an upper limit that the producer or wholesale distributor puts on the price at which retailers can sell the commodity to customers. Maximum retail prices do not usually have the inefficiencies associated with price ceilings, because producers of the goods can vary maximum retail prices according to demand trends over the somewhat longer term.