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Price Ceilings and Price Floors in Microeconomics

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  • 0:01 Exceptions to Equilibrium
  • 0:40 Price Ceilings
  • 2:45 Price Floors
  • 4:54 Deadweight Loss &…
  • 6:14 Lesson Summary
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Lesson Transcript
Instructor
Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Expert Contributor
Joseph Shinn

Joe has a PhD in Economics from Temple University and has been teaching college-level courses for 10 years.

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.

Ceilings

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.

price versus quantity

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.

Floors

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:

price floor graph

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.

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Additional Activities

Additional Questions:

  1. Think of a real-world example of a price floor (other than minimum wage). Describe the floor and explain how it is enforced by the government. Who benefits from the floor? Why? Who is made worse off by the floor? Why? Do you think society as a whole is better off, worse off, or no better or worse off?
  2. Think of a real-world example of a price ceiling. Describe the ceiling and explain how it is enforced by the government. Who benefits from the ceiling? Why? Who is made worse off by the ceiling? Why? Do you think society as a whole is better off, worse off, or no better or worse off?
  3. Based on the theory of price floors, the minimum wage should make society as a whole worse off because it creates a dead-weight loss. What is the main flaw with the assumption? Specifically, what are the secondary impacts that are not directly observed in the basic demand/supply model?
  4. Another basic problem with the theory of price ceilings and price floors is that it is generally assumed that the market will reach equilibrium without price control. Explain how markets, where at least some firms have market power, could actually see an increase in total surplus as a result of price control.

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