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Chapter 8 (Chapter 5)
Price Ceilings and
Floors
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
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Price Ceilings
Rent Controls (Optional Section)
Arguments for Price Ceilings
Universal Price Controls
Price Floors
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Introduction
 Price controls are laws making it illegal for
prices to move above a maximum price (price
ceilings) or below a minimum price (price floors)
 Price controls interfere with market signals.
 Price controls delink some markets and link
others in ways that are counterproductive.
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Definition
Price Ceiling:
a maximum price allowed by law.
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Price Ceilings
Price ceilings create five important effects:
1. Shortages.
2. Reductions in product quality.
3. Wasteful lines and other search costs.
4. A loss of gains from trade.
5. A misallocation of resources.
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Price Ceilings
1. Shortages
 When the price ceiling is below market price,
Qd > Qs which leads to a shortage.
 The shortage is measured by the difference
between Qd and Qs at the controlled price.
 The lower the controlled price is relative to the
market equilibrium price, the larger the
shortage.
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Price Ceilings
Price of
gasoline
per gallon
Supply
Market Equilibrium
Controlled
Price
(ceiling)
Shortage
Qs
Demand
Qd
Quantity
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Self-Check
Price ceilings create shortages because when
the controlled price is lower than market price:
a. Qd = Qs.
b. Qd < Qs.
c. Qd > Qs.
Answer: c – The quantity demanded is greater
than the quantity supplied.
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Price Ceilings
2. Reductions in Quality
 At the controlled price, sellers find there is an
excess of demand.
 Sellers can evade the law by cutting quality
rather
than raising price.
 Another way quality can fall is with reductions
in service.
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Price Ceilings
3. Wasteful Lines
 At the controlled price, demanders are willing
to pay more.
 The price controls make a higher price illegal.
 Other ways to pay:
• Bribes
• Waiting in line (includes value of time)
 Bribe goes to supplier, while time in line goes
to no one.
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Price Ceilings
Price
Supply
Willingness
to pay $3
Controlled
Price $1
(ceiling)
At the controlled
price
Total
value of
wasted
time
 Buyers are willing to
pay $3/gallon
 Line will grow until
total cost is price +
time, or $3
Shortage
Demand
Qs
Qd
Quantity
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Price Ceilings
4. Lost Gains From Trade
 As long as Pconsumers  Psellers are there are
are willing
to pay
willing to
accept
mutually profitable trades that can be made.
 With price controls, some profitable trades will
not be made.
 This creates a deadweight loss.
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Definition
Deadweight Loss:
the total of lost consumer and producer
surplus when not all mutually profitable
gains from trade are exploited.
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Price Ceilings
Price
Supply
Willingness
to pay $3
Controlled
Price $1
(ceiling)
Total
value of
wasted
time
A
B
A – consumer surplus
B – producer surplus
A + B = Lost gains
from trade
Shortage
Demand
Qs
Qd
Quantity
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Price Ceilings
5. Misallocation of Resources
 When prices are controlled, resources do not
flow to their highest valued uses.
 Example: on the East Coast a cold winter
increases the demand for heating oil.
• The demanders of heating oil are prevented
from bidding up the price of oil.
• There’s no signal and no incentive to ship oil
to where it is needed most.
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Price Ceilings
Price
Price controls prevent
highest valued
uses
Supply
from outbidding lower
valued uses.
Willingness
to pay $3
Result: some oil
flows to lower
valued uses
Controlled
Price $1
(ceiling)
Shortage
Demand
Qs
Qd
Quantity
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Self-Check
Under a price ceiling, resources are misallocated
because:
a. Price can’t signal that there is a shortage.
b. Quantity can’t respond to changing prices.
c. Neither price nor quantity can increase or
decrease.
Answer: a – The price is not allowed to increase,
which would signal that there is a shortage.
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Random Allocation
 Under a price control, a good is not necessarily
allocated to its highest-valued uses.
 Consumer surplus will be less than under market
allocation.
 In the worst-case scenario all the goods are
allocated to the lower-valued uses.
 More likely, goods are allocated randomly so that
a high-valued use is as likely as a low-valued
use.
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Best Case Scenario
Price
$30
Highest-valued
uses
Supply
Best case scenario: goods
go to the highest valued
uses, consumer surplus is
the green area
Controlled
Price $6
Shortage
Demand
Qs
Qd
Quantity
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Random Allocation
Price
$30
Average
Price $18
Controlled
Price $6
Highest-valued
uses
Lost
consumer
surplus
If goods are allocated randomly,
average value Supply
will be $18.
Resources are misallocated,
reducing consumer surplus to
green area.
Consumer
surplus
(random
allocation)
Shortage
Demand
Qs
Qd
Quantity
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Price Controls and Production
 Shortages in one market create breakdowns and
shortages in other markets.
 Effect of price controls expands into markets
without price controls.
 In an economy with many price controls,
shortages can appear at any time.
• Shortages of steel drilling equipment made it difficult
to expand oil production even as the United States
was undergoing the worst energy crisis in its history.
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Self-Check
The effects of price controls:
a. Are restricted to one market.
b. Disappear over time.
c. Can spread to other markets without price
controls.
Answer: c – The effects of price controls can
spread to markets without price controls.
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Definition
Rent Control:
a price ceiling on rental housing.
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Rent Controls
 Usually begin with a rent freeze, prohibiting
landlords from raising rents.
 As overall rents rise, controlled rents fall below
the market equilibrium rent.
 The short-run supply curve for apartments is
inelastic.
 Landlords have few options other than to absorb
lower price.
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Rent Controls
Price
(rent)
Short-run
supply
Market
equilibrium
Long-run
supply
Long-run
shortage
Short-run shortage
Controlled
rent
Demand
Qs
Long
run
Qs
Short
run
Qd
Quantity
(rental apartments
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Rent Controls
Rent control reduces the building of new apartments.
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Shortages
 The long-run supply curve is much more elastic
than the short-run supply curve.
 The shortage grows over time:
• Fewer new apartment units are built.
• Older units are turned into condominiums.
• Units are torn down to make way for other uses.
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Self-Check
Shortages caused by rent controls:
a. Become more severe over time.
b. Become less severe over time.
c. Remain constant over time.
Answer: a – Since long-run supply is more
elastic than short-run supply, shortages caused by
rent controls become more severe over time.
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Reductions in Quality
 Rent controls reduce housing quality.
• Maintenance costs rise.
• Owners respond by cutting costs.
 When rent controls are strong:
• Apartment buildings turn into slums.
• Slums turn into abandoned and hollowed-out
buildings.
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Wasteful Lines, Search Costs, Lost Gains
 Finding an apartment often involves a costly
search.
 At controlled price, landlords have more renters
than apartments so they can
discriminate.
 Bribes are illegal but can be
disguised:
 “Key money”.
 Charged for a
“furnished” apartment.
JG PHOTOGRAPHY/ALAMY
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Misallocation of Resources
 Apartments are not allocated to the renters who
value them the most.
 Some people with a high willingness to pay can’t
buy as much housing as they want.
 Others with a low willingness to pay consume
more housing than they would purchase at the
market rate.
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Rent Regulation
 In the 1990s many American cities eliminated or
eased rent controls.
 Some changed to “rent regulation”.
• Limits are placed on the amount that rent can
be increased e.g., 10% per year.
• Usually allow landlords to pass along cost
increases so the incentive to cut back on
maintenance is reduced.
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Arguments for Price Controls
 Rent controls help the poor.
 Controls are not the only way, and often not the
best way.
 Vouchers are a better way to help the poor:
 Do not create a shortage.
 Can be targeted to the poor.
 The best case for price controls is to discipline
monopolies.
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Definition
Price Floor:
a minimum price allowed by law.
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Price Floors
Price floors create:
1. Surpluses
2. Lost gains from trade
(deadweight loss)
3. Wasteful increases in quality
4. A misallocation of resources
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Surpluses
 A good example of a price floor is the minimum
wage.
 A minimum wage above the market price creates
a surplus - the quantity of labor supplied exceeds
the quantity demanded.
 A surplus of labor is called unemployment.
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Minimum Wage Creates a Surplus
Wage
($/hr)
Supply
of labor
Labor surplus
(unemployment)
Minimum
wage
Market
wage
Demand
for labor
Qd
Market
employment
Qs
Quantity
of labor
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Self-Check
Price floors result in:
a. Higher prices in future.
b. A shortage.
c. A surplus.
Answer: c – Price floors result in a surplus.
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Lost Gains From Trade
Wage
($/hr)
Supply
of labor
Labor surplus
(unemployment)
Minimum
wage
A
Market
wage
B
Demand
for labor
Qd
Market
employment
Qs
Quantity
of labor
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Wasteful Increases in Quality
 US airlines were extensively regulated from
1938 to 1978.
 Unregulated fares were half the price of similarlength regulated flights.
 The regulated prices were above the airlines’
willingness to sell.
 Airlines couldn’t drop prices to compete for
customers.
 They competed by offering higher quality that
buyers would otherwise not be willing to pay for.
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Wasteful Increases in Quality
Price
(fare)
Supply
Deadweight
loss
Regulated
fare (floor)
“Quality”
waste
Market
equilibrium
Willingness
to sell
Demand
Quantity
demanded
Quantity of
flights
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Misallocation of Resources
 Entry of new firms was also regulated in the
airline industry.
 Restrictions on entry misallocated resources
because low-cost airlines were kept out of the
industry.
 Also kept out innovations, new ideas, and
experiments that are part of the market process.
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Takeaway
 Price ceilings create:
• Shortages
• Reductions in quality
• Wasteful lines and other search costs
• A loss of gains from trade
• A misallocation of resources.
 This affects not just the market with the price
ceiling but potentially the whole economy.
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Takeaway
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Price floors create:
Surpluses.
A loss of gains from trade.
Wasteful increases in quality
A misallocation of resources.
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