Download The Effects of Price Ceilings

5.b The Effects of Price Ceilings
A price ceiling is a maximum price placed on a particular good by the government. In other words, it is a
limit to the price at which an item can be sold. If the price ceiling is set above the natural equilibrium price of the
good, it is said to be not binding. However, if the ceiling is placed below the free-market price, it produces a
binding price constraint and a shortage occurs.
Price ceilings are placed on certain items for the general purpose of establishing equity (dividing the wealth
equally). The intended goal of price ceilings is to help out the poor by making these goods available at a price they
can afford. Despite these good intentions, binding price ceilings actually make the poor, and everybody else, worse
off. Because of the resulting shortages, valuable resources, like time, will be wasted by waiting in lines for an item.
Producers of the item in demand find some way of dividing the good among the people who want it. It is sometimes
based on race, sex, or wealth status. This method is usually unfair because the item might not get to the person who
values it the most.
Binding price ceilings and shortages lead to the illegal practice of the black market. Black markets exist
because some people are willing to pay a higher price for a good to avoid waiting in line. To the people who have a
lot of money, the black market is a good thing. But to the people who don’t have enough money to skip the lines,
the black market is a bad thing because it is taking the item away from those waiting. So, when deciding if the black
market is good or bad, one must examine the morals at stake. Refer to Figure 5.b.1 to see how the black market
springs from price ceilings.
P
Black Market
Price
S
Pb =$0.85
$0.65
40 cent
waiting
time
Pc =$0.45
45 cent cash
10u shortage
D
8
12
18
Q-oil
Figure 5.b.1 There was an oil shortage because there was a price ceiling $0.25 less than the natural market price,
which means it was binding. People who want gas are going to pay $0.45 in hard cash and they are going to pay
$0.40 in waiting time. So when the scalper comes along, he or she is charging the customer $0.85 (found by tracing
a line from the quantity supplied up to the demand curve), which is the price that customer is paying while waiting
in line.
Example: Rent Control
When considering rent control, in order to compare the importance of different pros and cons, the economist assigns
dollar values, resulting in cost-benefit analysis. Rent control is an interference to free trade because it places a legal
maximum price for rent. In most cases, the price ceiling is set below the natural equilibrium price in order to make
the apartment or house more affordable to poorer people. Because of the binding price constraint, a shortage occurs.
Take a look at Figure 5.b.2.
P
S
$600
Pc=$500
150 u
shortage
500
D
650
Q- Houses
Figure 5.b.2 With a vertical supply of houses curve at 500, the natural equilibrium price of each house is $600.
However, when the government imposes a price ceiling (P c) of $500, it is a binding constraint. At $500, the
quantity demanded is 650. The supply is only 500. Since the quantity demanded exceeds the quantity supplied,
there is a shortage of 150 units.
This shortage triggers a series of unintended consequences. Normally, the landlord would water the grass,
paint the walls, and take care of the house because he or she wants people to rent the house. Since the price ceiling
causes excess in the quantity demand, the landlord does not have to try hard to get the house rented out. Therefore,
the grass is not watered and the appearance withers. Eventually, the neighborhood may become poorer and poorer
until it becomes unhealthy and the government takes over the land. So the price control was set up to help the poor,
but it might have taken them off their property. Figure 5.b.3 illustrates surpluses.
Figure 5.b.3 The consumer surplus (CS) before the price ceiling can be found as the area below the demand curve, above the price,
and left of the quantity bought (A) [(200*500)/2=$50,000]. After the price ceiling was imposed, CS rose by area B
[50,000+(100*500)=$100,000]. The producer surplus (PS) before the price ceiling can be found as the area above the supply curve,
below the price, and left of the quantity sold (B+C) (600*500=$300,000). After the price ceiling, PS shrunk by area B [300,000(100*500)=$250,000].
Since rent control causes shortages of houses, why then does the government impose it? If you live in a place where
the natural market price is higher than the ceiling price, you are definitely going to vote for the ceiling so that you can pay a
lesser price. Also, it is very politically unpopular to allow the price of houses to go up to fix the shortage problem.