Price ceiling

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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. Other forms of price control include minimum prices and price change ceilings (such as rent control).

There are two types of price ceilings:

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 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.

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, 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
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
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.
Equal to the optimal price Binding More Maximized At the intersection of the market demand curve and short-run marginal cost curve.
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.
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.
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.

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.

Note that there are three components to the deadweight loss arising due to a 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.

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 economic surplus

Further information: effect of price ceiling on economic surplus

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

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 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 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.