Unit 2.

7(2): Governments in markets - price

controls

What you should know by the end of this chapter

• Price controls
• Maximum prices
• Reasons for the use of maximum prices
• Effects of a maximum price on a market using graphical analysis
• Consequences of maximum prices for different stakeholders and for welfare
• Minimum price
• Reasons for minimum prices
• Effects of minimum prices on a market using graphical analysis
• Consequences of minimum prices for different stakeholders and for welfare.

Price controls

In free markets where there is no government intervention the price and output in a market are
determined by demand and supply. Government often intervene in markets when market price
and output does 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 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.

© Alex Smith
InThinking [Link]/Economics 1
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 maximum price

One 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, quantity demanded increases from
30,000 units to 36,000 units because of the income and substitution affects (more people
can afford to rent and its cheaper to rent relative to buying a house).
• The decrease in price reduces quantity supplied when landlords withdraw from the market
because they make less profit and fewer landlords can cover their costs.
• Excess demand (shortages) for rented housing develop because quantity demanded is
greater than 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 the rent ceiling of $1300
but also agree 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.

© Alex Smith
InThinking [Link]/Economics 2
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

In theory producers lose 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 which is smaller than the producer surplus at the normal
market equilibrium price. 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.

© Alex Smith
InThinking [Link]/Economics 3
Welfare

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 (tax payers) 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 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 food supply. Producers in agricultural markets often struggle because of unstable prices
because of the impact of the weather on their output. The aim of a price floor is 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 at €8 per
bushel with 2 million units of output. A
minimum guaranteed price is put in
place at €11.

© Alex Smith
InThinking [Link]/Economics 4
Empirical evidence of the effects of a minimum price set at 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 quantity supplied is greater than 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 good that needs to 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.

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 price on 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.

© Alex Smith
InThinking [Link]/Economics 5
Government

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

Welfare

Minimum prices are not used very much anymore because they were expensive for 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.

© Alex Smith
InThinking [Link]/Economics 6