A Price Control occurs when the government feels the current equilibrium price is unfair and intervenes and adjusts the market price. A maximum price or price ceiling is basically when the government believes the price is too high and sets a maximum price that producers can charge; this lies below the equilibrium price.
Price ceilings often cause shortages. For examples: In agriculture, medicine and education many governments set maximum prices to make the goods or services more affordable.
A Price Ceiling Diagram
The below diagram shows a price ceiling in equilibrium where the government has forced the maximum price to be Pmax. Thus the actual equilibrium ends up below market equilibrium.
The original price is P*, but with the price ceiling the price falls to Pmax and quantity supplied is Qs and quantity demanded is Qd. The distance between Quantity Demand (Qd) and Quantity Supplied (Qs) is a shortage. There is a fall in producer surplus, but a significant jump in consumer surplus.
Real World Example of Price Ceilings
The concept of rent control is a form of price ceiling. The local government can limit how much a landlord can charge a tenant or by how much the landlord can increase prices annually. Rent control aims to ensure the quality and affordability of housing on the rental market. New York and San Francisco have famous rent control laws.
Over the long-run, however, rent control decreases the availability of apartments, since suppliers do not wish to spend the money to build more apartments when they cannot charge a profitable rent. Landlords not only do not develop any more apartments, but they also do not maintain the ones that they have, not just to save costs but also because they do not have to worry about market demand since there is excessive demand for rent-controlled apartments. Hence, excess demand and limited supply lead to a massive shortage.
However, according to survey data, a majority of economists would argue that “a ceiling on rents reduces the quantity and quality of housing available.”
Effects of a Price Ceiling
The distance Qd-Qs represents a shortage as consumers will demand a higher quantity at the lower price Pmax than producers are willing to supply at that price. This leads to a distortion in the market.
Since there is a shortage, lines will form and/or black markets will emerge. The effect of a black market is that the government will face losses regarding revenues received from taxation. Goods traded on the black market are not registered; hence no records will be available for tax collection.
The quality of products, in the long run, might worsen as producers are tempted to use cheaper factors or cut corners. Similarly, in the rental market, landlords may not want to maintain their apartments when the apartments are under rent control.
The government could increase supply by subsidizing the product or releasing previous stock (if any).