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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Short-run impact of binding price ceilings

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.

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.

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.