Price controls

In free markets where there is no government intervention, the price and output in a market are determined by demand and supply. Governments often intervene in markets when the market price and output do not maximise welfare in society. This could be a high price that negatively affects households on lower incomes or a low price that forces firms out of business in a strategically important market.

Maximum prices (price ceiling)

Definition

A maximum price or price ceiling is a price set by a government or controlling authority to prevent the price of a good or service from rising above a fixed level. For example, rent controls in a housing market are a maximum price where market rents cannot rise above a certain price.

Reasons for maximum prices

Maximum prices are put in place to protect low-income consumers from prices rising in a market to a level they cannot afford. Maximum prices are normally put on goods that governments feel all people in society ought to be able to consume such as housing, basic food, healthcare and education.

Effects of a maximum price

One of the most famous maximum prices or price ceilings are rent controls in New York City. Rent controls have existed in the city since the 1940s to protect low-income families. The number of houses and apartments subject to rent controls is around 22,000 at present with an average rent of about $1,300 per month. The average market rent would be around $2,500 per month.

Diagram 2.33(1) illustrates the impact of a maximum price on rents in the New York housing market.

Empirical evidence of the effects of a maximum price set below the equilibrium price would be:

• If the price falls in the market from $2500 to $1300, the quantity demanded increases from 30,000 units to 36,000 units because of the income and substitution effects (more people can afford to rent and its cheaper to rent relative to buying a house).
• The decrease in price reduces the quantity supplied when landlords withdraw from the market because they make less profit and fewer landlords can cover their costs.   

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• Excess demand (shortages) for rented housing develops because the quantity demanded is greater than the quantity supplied of rented housing at the maximum price.
• The rationing function of price no longer works effectively. The price cannot rise to clear the market because of the price ceiling.
• Other methods of rationing develop such as: queueing (first come, first serve), preferential consumer selection (landlords rent to tenants they favour), regulations develop (landlords are forced to prioritise families) and lottery schemes develop (random selection of tenants).
• Parallel markets develop where consumers and producers try to find their way around the ceiling price controls.  A landlord and tenant might officially agree on the rent ceiling of $1300 but also agree on a payment of $1000 per month to be paid unofficially.
• The quality of rented housing declines because landlords do not have funds to make repairs and maintain their properties as well as they could do at the equilibrium price.
• In the long-term new investment in rented housing falls because the market is not as profitable as it would be without the maximum price.

Impact on stakeholders

Consumers

The consumers who buy the good or service at a maximum price benefit because they pay a lower price than the equilibrium price. The gain in consumer surplus these consumers receive is shown by the yellow shaded area in diagram 2.34. Some consumers who would have paid the market price and cannot buy the good at the maximum price because of a shortage lose out. Consumers may also lose out because of the time they might spend queueing for a good that is in short supply, or they might encounter extra regulations resulting from the price ceiling. Some consumers might enter the parallel market where they might have to pay a very inflated price and risk breaking the law.

Producers

Producers lose producer surplus when there is a maximum price because they receive less revenue and profit from selling their good or service. For the landlords in the rented housing market, the producer surplus is the green shaded in diagram 2.34 which is smaller than the producer surplus at the normal market equilibrium price. Some producers will leave the market when there is a maximum price and their producer surplus disappears.  It is, however, possible for some fringe producers to enter the parallel market and make high profits from selling their good illegally.

Governments

Governments have the cost of setting up and enforcing the maximum price, as well as the loss of tax revenue that might come from lower sales in the market (although the good may not be subject to tax). There are, however, some political benefits from setting a price ceiling because it looks like an effective policy that reduces prices. This is why governments are often tempted to use them.

Welfare

Maximum prices lead to a loss of welfare because of the loss of consumer surplus of consumers who no longer buy the good when the maximum price is imposed. This is shown by the brown shaded area in diagram 2.34. There is also a welfare loss of the producer surplus from producers who leave the market as a result of the maximum price. This is shown by the brown shaded area in diagram 2.34. 

Empirical evidence suggests maximum prices tend to lead to a loss of welfare because the benefits of the maximum price are concentrated amongst a relatively small number of consumers and there are wider dispersed costs on the rest of society. In New York, a relatively small number of tenants (sometimes wealthy) benefit from the maximum price, but many potential tenants lose out, landlords see a fall in profits and the government (taxpayers) have to pay for the system.

Minimum prices (price floors)

Definition

A minimum price or price floor is a lower limit set by the government or controlling authority to stop the price of a good or service from falling below a certain level. Minimum prices have been used in the past in agricultural markets, although they are not used as much today. There are, however, still examples of minimum prices in agriculture in India on Kharif (autumn) crops. These are crops such as maize and rice.

Reasons for minimum prices

Governments use minimum prices or guaranteed minimum prices to protect producers in markets. This is often the case in agricultural markets where governments look to support farmers and protect the food supply. Producers in agricultural markets often struggle because of unstable prices because of the impact of the weather on their output. A price floor aims to offer them a more stable income.

Effects of minimum price (price floor)

The European Union used minimum prices as part of their Common Agricultural Policy (CAP) in the 1970s and 80s. Diagram 2.35 is an example of how minimum prices might work in the market for wheat. In this example, the equilibrium price for wheat is €8 per bushel with 2 million units of output. A minimum guaranteed price is put in place at €11.

Empirical evidence of the effects of a minimum price set above the equilibrium price would be:

• As the price rises from €8 to €11 the quantity demand for wheat falls to 1.1m bushels. As the price increases quantity demanded decreases because of the income and substitution effects. Wheat is now less affordable, and buyers switch to cheaper alternatives.

• Quantity supplied increases to 2.7m bushels because the higher price increases producer profits and covers the costs of higher production.

• At the minimum price, the quantity supplied is greater than the quantity demanded and there is excess supply or surplus output. In diagram this is (2.7m – 1.1m = 1.6m units).

• To maintain the minimum price the government or buying authority needs to purchase the surplus and put it into storage. If the surplus is allowed onto the market the price will fall – hence the term guaranteed price. The cost of the government intervention is 1.6m x €11 = €17.6m

• The wheat needs to be stored and this is an additional cost of the scheme. This can be particularly expensive for goods that need to be refrigerated.

• Additional agricultural producers are attracted to the market by the minimum price which leads to an increase in excess supply in the long run and reduces supply in other markets.

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Impact on stakeholders

Consumers

Consumers lose out when a minimum price is set above the equilibrium price because they need to pay a higher price for the good and their consumer surplus falls. The loss of consumer surplus from the minimum price put on wheat is shown in diagram 2.36. The yellow shaded area shows the new consumer surplus following the increase in price from €8 to €11. The increase in the price of agricultural products affects poorer consumers badly because buying food is often a high proportion of their household expenditure.  

Producers

Producers gain when a guaranteed minimum price is above the equilibrium price because their producer surplus increases. This means they will receive higher revenues and profits. The increase in producer surplus is shown by the green shaded area in diagram 2.36.  In the wheat market, this may well fulfil the government’s aim of stabilising farming incomes and maintaining long-term food supply.

Government

Minimum prices represent an opportunity cost to the government. The government or the authority buys the excess supply and has the considerable cost of purchasing the good, as well as the cost of storing any excess supply and managing the system.

Welfare

Minimum prices are not used very much anymore because they were expensive for the government to manage and the benefits of the system were less than its costs. They often led to a misallocation of resources in agriculture markets with huge surpluses developing at the expense of reduced production in other markets. There was also considerable waste with excess supply being destroyed when it could not be sold. In some instances, the European Union sold excess supplies to developing countries with disastrous effects on their farmers when prices fell in their markets. Like maximum prices, the gains tended to be concentrated amongst a certain group of stakeholders - in this case, producers, with dispersed losses for consumers and taxpayers.