A price control (maximum or minimum price) is imposed by government so that price cannot automatically move back to the equilibrium as it would in the free market because laws or regulations prohibit this.
A maximum price (or ceiling price) is a price control set by government prohibiting the charging of a price higher than a certain level. A maximum price is set in the interests of consumers to protect them from paying unreasonably high prices for essential goods and services, for example housing, petrol or certain food items.
By imposing maximum price, producers receive less profit. This encourages producers to be more efficient in other areas of production in order to reduce costs and restore their profit margin. Maximum price also lowers the price of good or service and making it available and affordable for consumers. Another merit of maximum price is that helps curtail the power of pricing with monopolist.
Before the introduction of maximum price ceiling the market equilibrium has already been determined. With the introduction of a maximum price ceiling caps the quantity that producers are willing to supply falls to Q3 whilst quantity demanded increases to Q2.
When a price ceiling is set, a shortage occurs. For the price that the ceiling is set at, there is more demand than there is at the equilibrium price. There is also less supply than there is at the equilibrium price, thus there is more quantity demanded than quantity supplied. An inefficiency occurs since at the price ceiling quantity supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss. This is illustrated with the diagram below:
If a price ceiling is set, then there must be a way to assign who gets the low supply of the product. Of course, since there is a legal limit on the price, the price can’t simply be raised. There are several ways this is done without raising the price:
- Black market
- First come First Serve
A minimum price is a form of government intervention that prevents the price of a good or service from falling to low thus being unfair.
The most common minimum price is the minimum wage–the minimum price that can be paid for labor. Minimum price or Price floors are also used often in agriculture to try to protect farmers.
For a price floor to be effective, it must be set above the equilibrium price. If it’s not above equilibrium, then the market won’t sell below equilibrium and the price floor will be irrelevant.
Since the price is set above equilibrium this creates an extension of supply (Q2) and a contraction of demand (Q3). Excess supply is created and disequilibrium sets in.
If the surplus is allowed to be in the market then the price would actually drop below the equilibrium. In order to prevent this the government must step in. The government has a few options:
- They can strictly enforce the price floor and let the surplus go to waste. This means that the suppliers that are able to sell their goods are better off while those who can’t sell theirs (because of lack of demand) will be worse off.
- The government can control how much is produced. To prevent too many suppliers from producing, the government can give out production rights or pay people not to produce which can lead to bribery on the long run.
- They can also subsidize consumption.
Price floors causes a deadweight welfare loss.
A deadweight welfare loss occurs whenever there is a difference between the price the marginal demander is willing to pay and the equilibrium price. The deadweight welfare loss is the loss of consumer and producer surplus. In other words, any time a regulation is put into place that moves the market away from equilibrium, beneficial transactions that would have occured can no longer take place.