Governments can restrict prices from going too low or too high through use of price ceilings. This lesson explains these concepts, as well as problems that can arise from their use.
Exceptions to Equilibrium
Most of the time, equilibrium is a good thing. After all, it is nothing more than a point of agreement between producers and suppliers. However, sometimes it is for the greater good to impose limits on prices. This is most often done to protect the particularly vulnerable in society, but limits have also been used by a surprising number of firms. These limits come in the form of price ceilings and price floors. As you might expect, price ceilings act to limit prices from rising too high, whereas price floors act to limit prices from falling too low.
Maybe you or a friend lives in a place with incredibly high rent, like Manhattan, San Francisco, or (gasp!) London. Needless to say, not everyone can afford to live in these areas, because the rent is simply too high. As a result, some people campaign for a price ceiling on rent. This would prohibit landlords from charging more than a certain amount of money for an apartment of a given size. Now, this does some interesting things to the supply and demand graph. If imposed in a place like Panama or Vietnam, locations known for their low cost of living, chances are that the ceiling would be nonbinding.
Because the equilibrium is below the ceiling, it really has no effect. This is why we call it nonbinding. However, this does nothing for prices if the equilibrium point is too high. In those cases, we have binding price ceilings.
There's a lot of information to absorb on the graph above, so we'll take it one-step at a time. Oh, and don't get worried about the fact that the 'ceiling' is suddenly beneath all the action - that is exactly where it belongs.
First of all, notice that the market price is lower on the graph than the free market equilibrium. This is the ceiling having an effect on prices. Also, look at the surpluses. Notice that the consumer surplus is much larger than the producer surplus - this is because ceilings are largely designed to benefit consumers. This means that the consumers are getting a much better deal than the producers are. Also, for now, we're going to ignore the deadweight loss, but we'll come back to it later in this lesson. Just remember that it's there.
However, the most important thing on this graph is that chunk of excess demand. This is because there are suddenly many more people wanting to rent houses and many fewer landlords wanting to rent them. Because of this, there are often large waiting lists in areas with housing ceilings.
Just as some places have rent ceilings to help the poor, many more have wage floors to help them. However, you've probably never heard the term wage floor, but I guarantee you've heard the phrase 'minimum wage.' That said, a minimum wage is nothing more than a floor on the price of labor. In this instance, it's important to remember that the workers are the producers, whereas firms are consumers. After all, workers are producing the work, and the firms are consuming it. Wages are nothing more than a price of work. Like ceilings, price floors can be ineffective. After all, in many places, it's hard to find people to work for less than minimum wage, even if a company tried.
However, in many places, minimum wage laws do create an effective price floor. Again, don't be confused by the fact that the floor is suddenly above the equilibrium point. Now this graph doesn't have as much going on as the previous one, so let's see if you remember where everything is:
The most important aspect is already labeled as surplus, and this is the fact that by paying a wage above market equilibrium, suddenly more people are going to want to work than before.
But that's enough help from me. Where are the surpluses? If you guessed that the consumer surplus is between the price axis, the green dotted line, and the red demand line, you would be correct. Not that it is much smaller than the producer surplus, which is between the green dotted line, the price axis, the red dotted line, and the blue supply curve. Again, producers, in this case, people who provide work, benefit greatly from price floors. But what about that other term, deadweight loss? I know I told you to ignore it, but do you at least remember where to find it? If you said it's the triangle between the red dotted line, the blue supply line, and the red demand curve, you'd be right, and that's what we're going to talk about next.
Deadweight Loss and Interventions
Yes, price floors and price ceilings do have a role to play in the market. However, that doesn't mean that they are efficient. In fact, we can graph and measure the inefficiency that they create.
Deadweight loss is a measure of how much economic efficiency, in terms of goods produced and price paid for them, is lost through price ceilings and price floors. That's right - this economic produce is simply lost to the economy. Needless to say, sometimes this is necessary. However, governments recognize that to limit surpluses and shortages, it is sometimes necessary to intervene even further.
In the example about rent ceilings, some jurisdictions make payments directly to landlords to offset the difference between the ceiling price and the market equilibrium price. This costs the city or state money, but makes sure that landlords want to provide enough housing for everyone. Similarly, governments, especially larger ones, like the idea of price floors on foodstuffs. However, that means that suddenly farmers like to produce a lot more of it. Rather than have it flood the market and spoil there, the governments buy up much of this produce, using it especially for foreign aid.
In this lesson, we looked at the role of price floors and ceilings on market equilibrium. We saw how price ceilings act to limit prices, but often cause a shortage due to the market not being at equilibrium. Likewise, we saw how price floors act to ensure a minimum price, but often cause a surplus due to more producers wanting to make more goods. As a result, deadweight loss exists, unless the government steps in with a further set of interventions to soothe the market.
Upon completing this lesson, you should be able to:
- Explain the effects of price floors and ceilings on market equilibrium
- Describe what deadweight loss is
- Identify the purpose of government intervention in regards to shortages and surpluses