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Price floors and ceilings
Maximum prices (ceilings)
The Government can set a legally imposed maximum price in a market that suppliers cannot exceed –
in an attempt to prevent the market price from rising above a certain level. To be effective a maximum
price has to be set below the free market price.
One example of a maximum price might when shortage of essential foodstuffs threatens large rises in the
free market price. Other examples include rent controls on properties – for example the system of rent
controls still in place in Manhattan in the United States.
A maximum price seeks to control the price – but also involves a normative judgement on behalf of the
government about what that price should be. An example of a maximum price is shown in the next diagram.
The normal free market equilibrium price is shown at Pe – but the government decides to introduce a
maximum price of Pmax. This price ceiling creates excess demand for the product equal to quantity Q2-Q2
because the price has been held below the normal equilibrium.
It is worth noting that a price ceiling set above the free market equilibrium price would have no effect
whatsoever on the market – because for a price floor to be effective, it must be set below the normal
market-clearing price.
Maximum prices and consumer and producer welfare
How does the introduction of a price ceiling affect consumer and producer surplus. This is shown in the next
diagram. At the original equilibrium price consumer surplus = triangle ABPe and producer surplus equals the
triangle PeBC.
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Because of the maximum price ceiling, the quantity supplied contracts to output Q2. Consumers gain from
the price being set artificially lower than the equilibrium, but there is a loss of consumer welfare because of
the reduction in the quantity traded. At P max the new level of consumer surplus = the trapezium
ADEPmax. Producer surplus is reduced to a lower level Pmax EC. There has been a net reduction in
economic welfare shown by the triangle DBE.
Black Markets
A black market (or shadow market) is an illegal market in which the normal market price is higher than a
legally imposed price ceiling (or maximum price). Black markets develop where there is excess demand (or
a shortage) for a commodity. Some consumers are prepared to pay higher prices in black markets in order
to get the goods or services they want.
When there is a shortage, higher prices act as a rationing device.
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Good examples of black markets include tickets for major sporting events, rock concerts and black
markets for children’s toys and designer products that are in scarce supply.
Another example is the black market for the anti-impotence drug Viagra and its new rival products
now coming onto the market
There is also evidence of black markets in the illegal distribution and sale of computer software
products where pirated copies can often dwarf sales of legally produced software.
Rationing when there is a market shortage
Rationing when there is a maximum price might also be achieved by allocating the good on a ‘first come,
first served’ basis – e.g. queues of consumers. Suppliers might also allocate the scarce goods by distributing
only to preferred customers. Both of these ways of rationing goods might be considered as inequitable
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(unfair) – because it is likely that eventually those who might have the greatest need for a commodity are
unlikely to have their needs met.
Another problem arising from the maintenance of a maximum price is that in the long run, suppliers might
respond to a maximum price by reducing their supply – the supply curve becomes more elastic in the long
term. This is illustrated in the next diagram
If landlords decide that they cannot make a satisfactory rate of return by selling rented properties in the
market because of the maximum price, they might decide to withdraw some properties from the market. At
the prevailing maximum rent, the long run supply curve shows a smaller quantity of rented properties
available for tenants – which with a given level of market demand cause the excess demand (shortage) in
the market to increase.
The quality of rented properties might also deteriorate over time because landlords decide to cut spending
on routine maintenance and property improvements. The end result would be a loss of allocative efficiency
because there are fewer properties on the market and the quality of accommodation is getting worse –
fewer people’s needs and wants are being met at the prevailing market price.
Although maximum prices such as rent controls are still in place in many countries, in the UK, rent controls
were essentially abolished in the late 1980s. And, over the last fifteen years the government has actively
sought to encourage an expansion in the total supply of rented properties provided by both private sector
landlords and also registered social landlords such as housing associations. The rapid growth in the buy-tolet property market has also contributed to a huge increase in the supply of properties available for letting in
the majority of towns and cities in the UK.
European Union proposes a maximum price for mobile phone call charges
The European Union telecommunications commissioner has proposed imposing a maximum price for the
mobile phone operators. The EU is proposing to introduce a price-cap (i.e. a maximum price) on the soIB Economics notes
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called “roaming charges” imposed by companies such as Vodafone and T-Mobile. The roaming charges are
imposed when customers on one mobile phone network access the network infrastructure of other providers
when they are making calls to subscribers to competing networks and the charges are estimated to be
worth nearly £6 billion per year to the European mobile telecommunications industry. But these roaming
charges make the cost of using a mobile phone abroad way higher than the prices charged for national
calls. The EU believes that there is market failure here with prices of Euro1.15 per minute leading to a loss
of allocative efficiency and consumer welfare.
Many of the mobile phone operators make high profits from roaming charges which, in some cases, can
generate over 5 per cent of their total revenues. Under the plans, the EU has set a maximum price of 11
pence a minute for receiving calls, 35 pence a minute for calling home and 23 pence a minute for calls
within a country. At present, consumers in Britain pay an average of 42 pence a minute to receive calls
while on the Continent and up to 1.20 pounds a minute to make calls, depending on the service providers. A
four-minute call home on a UK phone used in France typically costs £2.38. The same call from Malta costs
£4.83, according to EU commission statistics.
Adapted from BBC news online and the EU internal market commission website
Definition of a minimum price (Price floor)
A minimum price is a legally imposed price floor below which the normal market price cannot fall. To be
effective the minimum price has to be set above the normal equilibrium price. Perhaps the best example of
a minimum price is the minimum wage. The national minimum wage was introduced into the UK in
1999. It is an intervention in the labour market designed to increase the pay of lower-paid workers and
thereby influence the distribution of income in society. In October 2005, the value of the minimum wage for
adults was £5.05 – following a series of small increases over recent years.
The main aims of the minimum wage
1. The equity justification: That every job should offer a fair rate of pay commensurate with the
skills and experience of an employee
2. Labour market incentives: The NMW is designed to improve the incentives for people to start
looking for work – thereby boosting the economy’s available labour supply
3. Labour market discrimination: The NMW is a tool designed to offset some of the effects of
persistent discrimination of many low-paid female workers and younger employees
Adult Rate
(for workers aged
1 Apr 1999
1 Oct 2000
1 Oct 2001
1 Oct 2002
1 Oct 2003
1 Oct 2004
1 Oct 2005
1 Oct 2006
22+)
£3.60
£3.70
£4.10
£4.20
£4.50
£4.85
£5.05
£5.35
Development Rate
(for workers aged 18-21)
1 Apr 1999
£3.00
1 Oct 2000
£3.20
1 Oct 2001
£3.50
1 Oct 2002
£3.60
1 Oct 2003
£3.80
1 Oct 2004
£4.10
1 Oct 2005
£4.25
1 Oct 2006
£4.45
16-17 Year Olds Rate
1 Oct 2004
1 Oct 2005
1 Oct 2006
£3.00
£3.00
To be announced
How does a minimum wage work?
The minimum wage is a price floor – employers cannot legally undercut the current minimum wage rate
per hour. This applies both to full-time and part-time workers. Labour supply and demand curve analysis
can be used to show the effects.
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A diagram showing the possible effects of a minimum wage is shown above. The market equilibrium wage
for this particular labour market is at W1 (where demand = supply). If the minimum wage is set at Wmin,
there will be an excess supply of labour equal to E3 – E2 because the supply of labour will expand (more
workers will be willing and able to offer themselves for work at the higher wage than before) but there is a
risk that the demand for workers from employers (businesses) will contract if the minimum wage is
introduced.
Possible disadvantages of a minimum wage
Although all political parties are now committed to keeping the minimum wage, there are still plenty of
economists who believe that setting a pay floor represents a distortion to the way the labour market works
because it reduces the flexibility of the labour market
1. Competitiveness and Jobs: Firstly a minimum wage may cost jobs because a rise in labour costs
makes it more expensive to employ people and higher labour costs might damage the international
competitiveness of British producers. To the extent that rising unemployment worsens the living
standards of those affected it has a negative impact on poverty.
2. Effect on relative poverty: Is the minimum wage the most effective policy to reduce relative
poverty? There is evidence that it tends to boost the incomes of middle-income households where
more than one household member is already in work whereas the greatest risk of relative poverty is
among the unemployed, elderly and single parent families where the parent is not employed.
Can a minimum wage actually increase employment?
The answer is yes – depending on the circumstances in the labour market when a pay floor is introduced
and also on what happens to the productivity of labour when a high (statutory) rate of pay is introduced.
There are two main explanations for the possibility of higher employment
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1. The Keynesian argument that higher wage rates will increase the real disposable incomes of
lower-paid workers many of whom have a high marginal propensity to consume. Thus they will
increase their own spending and this will feed through the circular flow of income and
spending
2. The efficiency wage argument that raising pay levels for low-paid employees may have a
positive effect on their productivity and efficiency. In addition to the psychological benefits of being
paid more, businesses may take steps to improve production processes, workplace training etc if
they know that they must pay at least the statutory pay floor.
The importance of elasticity of demand and supply of labour
The impact of a minimum wage on employment levels depends in part on the elasticity of demand and
elasticity of supply of labour in different industries. If labour demand is relatively inelastic then the
contraction in employment is likely to be less severe than if employers’ demand for labour is elastic with
respect to changes in the wage level.
In the next diagram we see the possible effects of a minimum wage when both labour demand and labour
supply are elastic in response to a change in the market wage rate. The excess supply created is much
higher than in the previous diagram.
Evidence on the minimum wage – has it worked?
1. Employment: Since the minimum wage was introduced, unemployment in Britain has continued to
fall and the level of employment in the British economy is now at a record high. It should be
remembered that the National Minimum Wage was introduced in a tight labour market, with
employment rising and unemployment falling. The true test of a pay floor is probably when the
economy experiences recession.
a. The sectors most directly affected by the minimum wage are in hospitality, leisure, textiles
and social care. Even here, the employment effects are small – and they might easily be
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2.
3.
4.
5.
explained by changes in competition (e.g. from overseas) and from the effects of
technological change on labour demand
Inflation: There have been negligible adverse effects on wage and price inflation. Other factors
affecting inflationary pressure have been broadly favourable for the UK in recent years. In many
sectors firms find it hard to pass on higher wage costs to final consumers – again limiting the
inflationary effect of the minimum wage
Wage costs: The minimum wage affects only a small proportion of workers and the effects on the
wage bills of most businesses is not a significant factor in their employment decisions. In the short
term, the demand for labour tends to be inelastic with respect to changes in wages
Discrimination: The minimum wage has had a significant impact on the earnings of part-time
female workers.
Productivity: It is hard to identify any strong positive effect on labour productivity - but
productivity gains have been made in most low-paying industries, a trend which started before the
minimum wage was introduced.
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