Price ceiling

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Definition

A price ceiling is an upper limit placed by a regulatory authority (such as a government, or regulatory authority with government sanction, or private party controlling a marketplace) on the price (per unit) of a good.

A price ceiling is a form of price control. Other forms of price control include minimum prices, price change ceilings, and profit ceilings.

At any given time, a price ceiling is one of these:

  • 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. Binding price ceilings cause a reduction in the price, and may increase or decrease the quantity traded depending on the market structure.

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.

Type of price ceilings based on how they apply

Uniform fixed price ceiling

The simplest kind of price ceiling is a price ceiling that is fixed (i.e., a fixed price per unit) and imposed uniformly across all transactions, i.e., for all buyers and sellers. The value of this fixed price ceiling may change over time but generally does so through discrete policy changes. Therefore, in the short run, and possibly even the medium-to-long run, the price ceiling can be considered fixed.

There are two other kinds of variants of price ceilings.

Price change ceiling

Further information: Price change ceiling

This is a ceiling on how rapidly a price is allowed to increase. Price change ceilings may be any of these:

  • Price change ceiling applied to the market as a whole: Here, no seller is allowed to sell at a price more than some percentage higher than the market price at some point in the recent past (e.g., no seller is allowed to sell at more than 10% of the average price in the market last week).
  • Price change ceiling specific to a seller: Here, the price a seller is currently selling at is compared to the price the seller sold at in the past.
  • Price change ceiling specific to a pair of buyer and seller: This makes sense in the context of a repeat transaction. Rent regulations of the "vacancy decontrol" form are like that -- the rent of a given housing unit is allowed to increase at some maximum annual rate for a given pair of landlord and tenant, but once the tenant moves out, the landlord may give the apartment out for rent at any price.

For static analysis at a single point in time, price change ceilings may seem to function effectively as price ceilings; however, the long-run analysis (across multiple time periods where price changes can be made) is quite different. In particular, the "expectation regarding future prices" by both buyers and sellers, that shapes both the demand and supply curves, is affected by the structure of the price change ceiling. Despite these differences, in the cases where unexpected demand or supply shocks cause price change ceilings to create binding price ceilings, they behave qualitatively like uniform fixed price ceilings.

Profit ceiling

Further information: Profit ceiling

Here, sellers are forbidden from selling a good at a price greater than some multiple of the cost of production, to prevent excessive profiteering, while taking into account the cost of production.

Profit ceilings are effectively fixed price ceilings in cases where the marginal cost of production is constant across quantities and between sellers. However, in most real-world cases, profit ceilings are reasonably different from fixed price ceilings. Please see the profit ceiling page for more detailed models of how profit ceilings work.

A note on "voluntary" price ceilings

In general, only sellers with market power (i.e., sellers who can influence the market price, either as monopoly sellers or part of a small oligopoly) can adhere to voluntary price ceilings. Small sellers in a competitive market who choose to adhere to voluntary price ceilings, not raising prices to the market equilibrium, will not be able to meet the huge amount of market demand directed at them.

In the face of huge demand shocks and supply shocks, it is possible for de facto price ceilings to take effect, not through a single regulatory authority or marketplace controller, but though all sellers deciding to not risk increasing prices, even if that means shortfalls and forgone profits. The two typical reasons are:

  • Potential regulation and litigation: Sellers may fear that if they raise prices, they will attract the ire of regulators, even if no current regulations forbid them raising prices.
  • Public opinion: Sellers may fear that negative public sentiment against price gouging may hurt their reputation more than any additional profits they will make by selling at a higher price, or any additional goodwill they will generate among actual customers who appreciate not having a shortfall. The idea here is that it's not just the actual buyers, but also others who are unable to buy, or even general spectators, who could create trouble for the seller. The more diversified the seller, the bigger this public opinion concern (so a seller who only sells the good affected by the price ceiling may be less concerned, but a seller who sells many other goods may be concerned about reputational impact on sales of those other goods).

It is worth keeping in mind that this sort of "voluntary" price ceiling can really be effective only if some sellers have market power, or if there is widespread agreement between sellers about the wisdom of adhering to the "voluntary" price ceilings.

The distinction between price ceiling-like policies and other similar market controls

Price ceilings versus sales taxes

As we'll discuss later on this page, price ceilings and sales taxes have similar effects -- they generally reduce quantity traded relative to an unrestricted market, and they cause a deadweight loss (which, in simple cases, is given by the Harberger triangle). Moreover, each approach has many real-world variants, so we should really think of a cluster of "price ceiling-like" policies versus a cluster of "sales tax-like" policies.

Conceptually, the main difference between the clusters is that sales tax-like policies aim to mimic the behavior of an unrestricted market -- just one where buyers and sellers see different prices (with the difference pocketed by the taxing authority). They therefore retain many of the dynamics of an unregulated market as far as the buyers and sellers individually are concerned. In contrast, price ceiling-like policies are qualitatively different from unrestricted markets to the point that buyers and sellers can see and feel the differences directly.

Price ceilings and sales taxes also work quite differently in non-competitive markets. In a monopoly market, it is possible for a price ceiling to increase the quantity traded. In contrast, a sales tax will reduce quantity traded, even in a monopoly market.

Price ceilings versus quantity ceilings

Both price ceilings and quantity ceilings effectively create a situation where the quantity traded is less than it would be without a ceiling. However, quantity ceilings favor sellers over buyers, and also shift the burden of non-price competition to sellers: sellers compete with each other for permission to produce a larger share of the quantity ceiling.

Basic theory: the effects of price ceilings in competitive markets

The simple analysis in this section assumes a fixed price ceiling and ignores some of the indirect effects of price ceilings:

  • Expectations regarding future prices: Price ceilings affect not just current prices but also expectations regarding future prices, on both the demand and supply side. This is particularly important for goods where buying now and buying later can substitute for each other, or where producing now and producing later are substitutes. In particular, the existence of the price ceiling affects the shape of the demand and supply curve. Moreover, the nature of the ceiling (whether it's a fixed price ceiling or a price change ceiling, and how people expect the price ceiling itself to evolve) plays a part in how this effect plays out. We will ignore these considerations.
  • Interaction with price ceilings on substitute goods and complementary goods

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 good has no direct short-run effect.

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 economic 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.

Since a price ceiling creates a shortfall, it is not immediately clear which of the buyers willing to buy the good at the lower price will succeed in buying it (i.e., there is non-price competition among buyers, as discussed later in this page). Under the efficient allocation assumption (i.e., perfect sorting among buyers, and no costs imposed by non-price competition), the deadweight loss equals that arising from the case when the same quantity traded is accomplished by means of a sales tax, and is described by the area of the Harberger triangle, bounded by a vertical line through A and the demand and supply curves (so that two of its vertices are A and C). For more discussion, see Effect of price ceiling on economic surplus.

Shortfallbelowmarketprice.png

Basic theory: the effects of price ceilings in monopolistic markets

This article or section could be in use of a graph or other visual aid. Relevant discussion may be found on the talk page.

As was the case with the competitive markets analysis, the simple analysis in this section assumes a fixed price ceiling and ignores:

  • Expectations regarding future prices
  • Interaction with price ceilings on substitute goods and complementary goods

The basic case of increasing marginal costs

We restrict attention to cases where the monopolist's marginal cost curve is increasing, to avoid issues related to multiple optima. Many of the conclusions we draw are not dependent on this assumption.

There are three key price points relative to which price ceilings can be compared. For more context, see determination of price and quantity supplied by monopolistic firm in the short run.

  • The free market price (without any price ceiling), chosen by the monopolist for profit maximization.
  • The optimal price, which is the price point for the intersection of the market demand curve and the monopolist's short-run marginal cost curve. We can also think of this as what the market price would be if the market were competitive. This is based on the determination of quantity supplied by firm in perfectly competitive market in the short run, where we find that the supply curve coincides with the short-run marginal cost curve if the latter is increasing.
  • The free market marginal cost, which is the marginal cost at the quantity being traded without any price ceiling. This is equal to the marginal revenue, since a monopolist optimizes at marginal cost equals marginal revenue.

There are two interesting values of quantity traded:

  • The market quantity traded, which is the quantity traded in the market without any price ceiling.
  • The optimal quantity traded, which is the maximum possible quantity traded, and is the quantity at the intersection of the market demand curve and the monopolist's short-run marginal cost curve. We can also think of this as what the market quantity traded would be if a competitive market were simulated with the same demand and supply structure.

We can now make cases based on the value of the price ceiling. We move the price ceiling down, so the earlier rows discuss larger price ceilings and the later rows discuss lower price ceilings.

For any given price ceiling, there are two possibilities:

  • It is a non-binding price ceiling, i.e., it is greater than or equal to the free market price. In this case, the market behavior remains the same as it would in a free market.
  • It is a binding price ceiling in the sense of price, i.e., it is less than the free market price. In this case, the market price equals the binding price (note that this is no longer true with more complicated market structures, such as the case when the marginal cost curve is not increasing).
Price ceiling Binding or non-binding (binding means that the market price equals the ceiling, non-binding means it continues to equal the free market price) Quantity traded (compared to free market) Directional change in quantity traded as price decreases Location of the (price, quantity) pair Is there a shortfall?
Greater than or equal to than the free market price Non-binding Same No change On the market demand curve, same as without any price ceiling No
Less than the free market price, but more than the optimal price Binding More Increasing On the market demand curve, moving down and right along the curve. The price being charged is the maximum possible price for the given quantity traded No
Equal to the optimal price Binding More Maximized At the intersection of the market demand curve and short-run marginal cost curve No
Less than the optimal price, but more than the free market marginal cost Binding More Decreasing On the short-run marginal cost curve, moving downward and leftward. The price being charged is the minimum possible price for the given quantity traded Yes
Equal to the free market marginal cost Binding Same Decreasing On the short-run marginal cost curve, moving downward and leftward. The price being charged is the minimum possible price for the given quantity traded Yes
Less than the free market marginal cost Binding Less Decreasing On the short-run marginal cost curve, moving downward and leftward. The price being charged is the minimum possible price for the given quantity traded Yes

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

Non-price competition mechanisms

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? There are two broad categories of approaches:

  • Queueing, rationing, and queue-rationing
  • Black markets

Queueing, rationing, and queue-rationing

Further information: Queueing, rationing, and queue-rationing

  • Queueing is an approach where buyers are served in some form of a queue. The simplest is a time-based queue (first-come-first-serve) though other forms of priority queue are also possible.
  • Rationing is an approach that limits the amount that each buyer can buy.
  • Queue-rationing refers to a mix of queueing and rationing. For instance, each buyer can buy only a fixed amount in each iteration of purchase, and a buyer can take only one other position in the queue at a time (or even within a time period, for instance, per day). For instance, if the ration is 5 units per purchase, and the buyer wants to buy 48 units, the buyer will have to stand in the queue 10 times.

A key idea to keep in mind when thinking about these policies (queueing, rationing, and queue-rationing) is that the policies are determined mainly by sellers, but sellers do not internalize most of the gains from selecting policies that improve the efficiency of allocation between buyers. Sellers may, however, gain indirectly through reputational benefits, or spillover benefits to other goods the seller is selling.

Black markets

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 good 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 economic surplus

Further information: effect of price ceiling on economic surplus

Under most sets of assumptions (in particular, assuming that there are no external costs or external benefits), price ceilings have a negative effect on economic surplus in competitive markets. In general, the following are true:

  • Non-binding price ceilings have no effect on economic surplus.
  • Binding price ceilings have negative effects on economic surplus as well as producer surplus, with the magnitude of the effect increasing as the ceiling price goes lower. The effect on consumer surplus is ambiguous. This is a deadweight loss.

Note that there are three components to the deadweight loss arising due to a binding price ceiling:

  • The inevitable deadweight loss, that is given by the area of the Harberger triangle.
  • The deadweight loss that arises due to imperfect sorting among buyers (i.e., buyers who value a good less get it). In other words, this occurs because non-price competition did not do its job well.
  • The deadweight loss arising from the transaction costs associated with non-price competition.

Short-run impact of binding price ceilings in monopolistic markets

Non-price competition mechanisms

Similar to the case of a competitive market, binding price ceilings can create shortfalls, leading to non-price competition among buyers. However, unlike the case of competitive markets, not every binding price ceiling leads to a shortfall and to non-price competition. More specifically, a binding price ceiling leads to shortfalls only if it is set to below the optimal price as defined in #Basic theory: the effects of price ceilings in monopolistic markets, i.e., the price at which the marginal cost curve and market demand curve intersect.

When the price ceiling is set to below the optimal price, the non-price competition mechanisms are similar to those in a competitive market, namely:

  • Queueing, rationing, and queue-rationing
  • Black markets

One difference is that since the monopolist has complete control over the supply of the market, it may be easier for the monopolist to choose the non-price competition strategy more freely.

Effect on economic surplus

Further information: effect of price ceiling on economic surplus

Here we assume that the good being sold has no external costs or external benefits.

The discussion here builds on that in #Basic theory: the effects of price ceilings in monopolistic markets. You may need to reference that for more context around some of the terminology used.

For some of the rows, we can draw definite conclusions only under the efficient allocation assumption: perfect sorting among buyers (the buyers who acquire the good are those who value it most highly), and the non-price competition imposes no extra costs on buyers and sellers. The caveats are noted in the corresponding cells where they apply.

The "optimal price" in the table below is obtained as the price point at the intersection of the marginal cost curve and the market demand curve. This is essentially what the price would be if the seller could be made to behave as if operating in perfect competition.

Price ceiling range economic surplus compared to no price ceiling Producer surplus compared to no price ceiling Consumer surplus compared to no price ceiling Direction of change of economic surplus with decreasing price ceiling Direction of change of producer surplus with decreasing price ceiling Direction of change of consumer surplus with decreasing price ceiling Qualitative comments
Greater than or equal to the free market price Same Same Same None None None Deadweight loss is intact as the price ceiling has no effect
Less than the free market price and greater than the optimal price More Less More Increasing Decreasing Increasing Deadweight loss due to monopoly is ameliorated by the price ceiling
Equal to the optimal price More Less More Maximized Decreasing Ambiguous Deadweight loss is eliminated as perfect competition is emulated
Less than the optimal price and greater than the free market marginal cost More (assuming efficient allocation), indeterminate otherwise Less More (assuming efficient allocation), indeterminate otherwise Decreasing Decreasing Ambiguous Deadweight loss is now no longer due to monopolistic pricing but rather due to price ceilings cutting off beneficial transactions
Equal to the free market marginal cost Same (assuming efficient allocation), less otherwise Less More (assuming efficient allocation), indeterminate otherwise Decreasing Decreasing Ambiguous The quantity traded mimics that in the no-ceiling case, but the price at which the trades occur is lower. Assuming efficient allocation (i.e., the goods go to the buyers valuing them most highly), the economic surplus is the same but it is distributed more to consumers. Without the efficient allocation assumption, total economic surplus is down, with producer surplus down and the effect on consumer surplus indeterminate.
Less than the free market marginal cost Less Less Starts out as more (assuming efficient allocation), may later becomes less. Without the efficient allocation assumption, indeterminate. Decreasing Decreasing Ambiguous Deadweight loss now exceeds that of monopoly, even under the efficient allocation assumption.

Long-run impact of price ceilings

The long-run impact of a price ceiling is a much more complicated matter than the short-run impact. There are, roughly speaking, three sources of complication:

  • Expectations regarding future demand and supply patterns: A price ceiling that is binding today may become non-binding in the future, and a price ceiling that is non-binding today may become binding in the future. Both the normal course of supply-and-demand changes as well as low-probability demand and supply shocks need to be examined in connection with the price ceiling.
  • Intertemporal substitution with the future: Buyers and sellers who can substitute buying or selling now against buying or selling in the future, have to consider the effect of the price ceiling on how they distribute their buying or selling behavior over time. Note that this long-run consideration can also change the present-day shape of the supply and demand curves, thereby causing a short-run effect.
  • The distinction between short-run and long-run supply, through reconfiguration: In the short run, sellers are generally constrained to a increasing short-run marginal cost curve. In the long run, the seller can change the mix of inputs, for instance, by acquiring more land and capital or hiring more people.

The type of impact a price ceiling has also depends on its structure. The analysis can differ quite a bit between uniform fixed price ceilings, price change ceilings, and profit ceilings. However, we can say a few broad things.

Price ceilings are more likely to cause firms to exit the market in the long run than in the short run, and have qualitatively different effects in increasing cost industries versus decreasing cost industries

In the short run, even in the face of a price ceiling, a firm may continue to produce as long as the minimum AVC value (at minimum efficient scale) is less than the price ceiling. That's because the firm has sunk its fixed costs. If the price ceiling is even lower than the firm's AVC, the firm may simply stay idle in the short run.

In the long run, however, firms are looking at their average total cost and comparing it with the minimum between what they expect the price to be (taking the minimum across the price ceiling and market price). There are two competing considerations here -- the ability to optimize better in the long run, and the ability to exit altogether in the long run. Here is how they interact for a firm in a large, competitive market:

  • On the one hand, the long-run knowledge of the price ceiling allows the firm to choose a configuration of fixed and variable costs that is optimized for that price ceiling, rather than its prediction for the unrestricted price.
    • For an increasing cost industry, the firm will do so by reducing its fixed costs and reducing overall production. This can make the shortfall even worse than in the short run.
    • For a constant cost industry or decreasing cost industry, the firm (since it is small relative to the market) will still keep producing at maximum capacity. So there is no change.
  • On the other hand, solving this problem might also show the firm that it does not have a configuration that allows for long-run profitability. Specifically, if the price ceiling is less than the minimum possible average total cost (ATC) for the firm, it will exit the market.
    • For a constant cost industry or decreasing cost industry, the minimum ATC is attained at the maximum level of production. In other words, in such cases, if even at the maximum level of production, the firm is unable to make its ATC drop to below the price ceiling, it will exit the market. Over time, this might reduce the number of firms in the market, causing larger shortfalls.

The situation is a little different in a monopolistic firm, but the underlying trade-off remains the same: the firm can optimize better in the long run, but it can also choose to exit altogether.

Generally, price ceilings reduce seller incentives to prepare for demand and supply shocks, but the story is a little more complicated

A price ceiling that is non-binding now could become binding in the face of a demand shock or supply shock that increases market prices, especially in the short run when firms cannot reconfigure their factors of production.

If the price mechanism is allowed to operate freely, the firm may have stronger incentives to prepare for such situations, because the better prepared it is, the more it can sell and the more it can profit from the increased prices. Specifically, the firm may do one or more of these:

  • Stockpile extra production that can be released into the market in the face of a demand or supply shock that raises price.
  • Develop better forecasting so that shocks can be anticipated, and prepared for a little bit in advance (this can be combined with the previous point to give the idea of "speculative production" -- if the forecast shows increased demand, then start stockpiling).
  • Configure their production process so that it is easier to reconfigure quickly (i.e., make the long run less long).

For instance, let's say a firm is one firm among many in a competitive market and an increasing cost industry (we'll assume an increasing cost industry because with a decreasing cost industry, firms are anyway maxed out on production capacity). The market price of a good under normal conditions is 1. The firm correctly forecasts a soon-to-happen demand shock that would cause the market price to go up to 3,. There is a price ceiling of 2.

  • If there were no price ceiling, the question before the firm is whether to reconfigure its production process to optimize the amount produced for a market price of 3.
  • Due to the price ceiling, the question before the firm is whether to reconfigure its production process to optimize the amount produced for a price of 2.

Comparing these two, we see that the price ceiling prevents the firm from capturing all the gains in market price. Therefore, even if the firm does increase its production, it will increase it to a lower level (enough for the price ceiling of 2) rather than to the higher level (enough for the market price of 3). Thus, although the firm's long-run planning will alleviate the shortfall a little bit compared to not being prepared at all, the shortfall is still not going to be eliminated.

The above assumes that the firm has definite knowledge of the demand shock. However, the situation gets more complicated when the demand shock is more probabilistic. For instance, suppose the firm believes that there is some probability that a demand shock will cause the market price to rise to 3. The firm has to choose to reconfigure its fixed costs to gear toward producing enough for the market price of 3, or stay with its current setup, or anything in between. Whatever choice the firm makes, it will have to compare the expected gain from that choice of both the options.

Even in this more complicated situation, the presence of the price ceiling reduces, overall, the extent to which the firm will increase its production, by reducing the upside. However, the specifics will depend on other questions such as whether the firm's production cycle, as well as its buyers, can engage in intertemporal substitution.

Note that this analysis is contingent on some assumptions:

  • The price ceiling is a uniform fixed price ceiling: More complicated price ceiling formulas, like price change ceilings and profit ceilings, share some qualitative characteristics but are also different in other ways.
  • The price ceiling is known in advance to the firm: A price ceiling imposed suddenly without warning after a demand shock will have a less detrimental effect on quantity; the firm that had ramped up production has now already invested the fixed costs (thinking it could profit more), and is therefore able to produce more.

Price ceilings can change the way buyers substitute intertemporally

For goods where present purchases can substitute for future purchases, buyers respond to expectations of future price increases by buying more now. In markets with price ceilings that may become binding, buyers have to factor in not just the future market prices but also future availability. This can change the buyers' decision of how much to buy now, but it's ambiguous in what direction the buyers' behavior will change. Specifically, the way the buyers' behavior changes depends partly on how much each buyer perceives as the costs of non-price competition and how much the buyer's individual reservation price compared with the market price.

For instance, let's say buyers expect a demand shock or supply shock in the future that would, in a free market, cause the price of toilet paper to rise. This might incentivize buyers to stock up on toilet paper right now. Now, if a price ceiling is implemented that prevents the price of toilet paper from rising, buyers' expectations will shift from an expectation of increased price to an expectation of reduced availability, and the possibility that the buyer may have to engage in non-price competition to get the good. This, too, might incentivize buyers to stock up on toilet paper right now. However, the relative strength of the incentive to stock up on toilet paper, between the free market and price ceiling case, is ambiguous.

This ambiguity is related to the idea that the effect of price ceilings on consumer surplus is ambiguous (though it's definitely negative for producer surplus and overall economic surplus).

Note that the possibility of black markets does increase the incentive to buy and hoard.

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.