What Are Price Ceilings and Price Floors?
By: Anish Agarwal
A country’s economy would be unstable if there is no government interference. Although every country has their own policy regarding how much power the government has in the economy, all countries have some sort of government interference.
A country with no government interference is known to have a free-market economy. In today’s world, Hong Kong’s economy is considered the most free.
One way a government intervenes in the economy is by setting price controls: price floors and price ceilings.
A country with no government interference is known to have a free-market economy. In today’s world, Hong Kong’s economy is considered the most free.
One way a government intervenes in the economy is by setting price controls: price floors and price ceilings.
Price Floors
What Do Price Floors Do?
A price floor is a minimum price set by the government that is above the equilibrium price. In other words, it increases the price of a certain product.
It is called a price floor because it sets a requirement for the amount consumers must pay to purchase a certain product. Producers benefit from price floors because the prices for certain products escalate.
Oftentimes people get confused between price floors and price ceilings; as a result, we have developed a method for you to easily distinguish between the two. Just like a floor requires people to stay at/above a certain level, a price floor requires the price to stay at/above a certain price mark.
Furthermore, a common misconception is that the government puts a price floor on a business. A government enforces a price floor on a product rather than a business.
It is called a price floor because it sets a requirement for the amount consumers must pay to purchase a certain product. Producers benefit from price floors because the prices for certain products escalate.
Oftentimes people get confused between price floors and price ceilings; as a result, we have developed a method for you to easily distinguish between the two. Just like a floor requires people to stay at/above a certain level, a price floor requires the price to stay at/above a certain price mark.
Furthermore, a common misconception is that the government puts a price floor on a business. A government enforces a price floor on a product rather than a business.
Why Are Price Floors Used?
Price floors are used by governments to establish minimum wages and keep people in business.
Minimum Wage
Price floors are necessary for minimum wages because if wages are unprotected, other societal problems will occur, such as a vast homeless population.
When enforcing a price floor, the government usually sacrifices some other aspect. For instance, when the government decides to put a price floor on the minimum wage (which increases the minimum wage), some jobs will most likely be lost. The government has to decide whether this tradeoff is worth it. Democratic states tend to want to increase the minimum wage, while republican states do not. To learn more about minimum wage, click here.
Keeping Businesses Thriving
The majority of the time, price floors are used for agricultural businesses. This is because food is a necessity and we need farmers to grow our food. Therefore, if the government raises the price at which food is bought, farmers will see more profit in growing food. A higher profit incentivizes farmers to grow more food, allowing people to have access to more food.
Meanwhile, if a product was cheap, producers would not want to produce that product because they would not earn as much profit from it. For instance, if watermelons were exceedingly inexpensive to purchase, then farmers would not produce watermelons.
Similar to minimum wages, putting a price floor on products also has a tradeoff. A price floor creates a surplus because producers produce more, while consumers purchase less. The government must decide whether the situation is bad enough to impose a price floor and hence, create a surplus.
To better visualize this concept, click below to view an expository graph of how surpluses are created by price floors.
Minimum Wage
Price floors are necessary for minimum wages because if wages are unprotected, other societal problems will occur, such as a vast homeless population.
When enforcing a price floor, the government usually sacrifices some other aspect. For instance, when the government decides to put a price floor on the minimum wage (which increases the minimum wage), some jobs will most likely be lost. The government has to decide whether this tradeoff is worth it. Democratic states tend to want to increase the minimum wage, while republican states do not. To learn more about minimum wage, click here.
Keeping Businesses Thriving
The majority of the time, price floors are used for agricultural businesses. This is because food is a necessity and we need farmers to grow our food. Therefore, if the government raises the price at which food is bought, farmers will see more profit in growing food. A higher profit incentivizes farmers to grow more food, allowing people to have access to more food.
Meanwhile, if a product was cheap, producers would not want to produce that product because they would not earn as much profit from it. For instance, if watermelons were exceedingly inexpensive to purchase, then farmers would not produce watermelons.
Similar to minimum wages, putting a price floor on products also has a tradeoff. A price floor creates a surplus because producers produce more, while consumers purchase less. The government must decide whether the situation is bad enough to impose a price floor and hence, create a surplus.
To better visualize this concept, click below to view an expository graph of how surpluses are created by price floors.
What Happens to the Surpluses Caused by Price Floors?
The government can do 2 things with surpluses.
Dealing with surpluses can sometimes prove to be onerous; therefore, a government sets production quotas to limit surpluses. Production quotas are a limit to how much producers are permitted to produce a certain product. If they exceed the maximum quantity allowed, then they will be fined.
Production quotas are beneficial because they prevent abundant surpluses from being created while keeping people in business. Although you may think that businesses would not make a greater profit if they cannot sell more products, simple economics allows them to make a lot more profit. Since they produce less products, their expenses are lower; however, due to the price floor, they make more revenue on each product they sell. Low expenses but high revenue indicates an increased profit.
- Government buys the surpluses and sells them to foregin countries.
- Government buys the surpluses and uses them to provide foreign aid.
Dealing with surpluses can sometimes prove to be onerous; therefore, a government sets production quotas to limit surpluses. Production quotas are a limit to how much producers are permitted to produce a certain product. If they exceed the maximum quantity allowed, then they will be fined.
Production quotas are beneficial because they prevent abundant surpluses from being created while keeping people in business. Although you may think that businesses would not make a greater profit if they cannot sell more products, simple economics allows them to make a lot more profit. Since they produce less products, their expenses are lower; however, due to the price floor, they make more revenue on each product they sell. Low expenses but high revenue indicates an increased profit.
How Do Price Floors Affect Supply and Demand?
Consumers tend to buy less when price floors are implemented because prices are higher than equilibrium. As the price goes up, the demand to purchase goes down.
Considering the law of demand, people tend to buy less if the prices are higher than equilibrium; however, if it is a necessity (inelastic demand), you may not have to deal with excess surpluses and a huge decline in demand.
Meanwhile, supply will go up because producers will earn a lucrative profit from selling that product.
Both the supply and demand changes can easily be seen from the following graph.
Considering the law of demand, people tend to buy less if the prices are higher than equilibrium; however, if it is a necessity (inelastic demand), you may not have to deal with excess surpluses and a huge decline in demand.
Meanwhile, supply will go up because producers will earn a lucrative profit from selling that product.
Both the supply and demand changes can easily be seen from the following graph.
To learn more about how demand and supply change along a graph (determinants of supply and demand), click below.
Price Ceilings
What Do Price Ceilings Do?
A price ceiling is a maximum price set by the government that is below the equilibrium price. In other words, a price ceiling reduces the price of a product.
Although it is placed below the equilibrium price, it is known as a price ceiling because it limits the price producers can charge consumers for a certain product. Consumers benefit from price ceilings because they can purchase the same product for a lower price.
Oftentimes people get confused between price floors and price ceilings; as a result, we have developed a method for you to easily distinguish between the two. Just like a ceiling doesn’t allow anything to go above it, a price ceiling doesn’t allow the price to exceed the set price mark.
Although it is placed below the equilibrium price, it is known as a price ceiling because it limits the price producers can charge consumers for a certain product. Consumers benefit from price ceilings because they can purchase the same product for a lower price.
Oftentimes people get confused between price floors and price ceilings; as a result, we have developed a method for you to easily distinguish between the two. Just like a ceiling doesn’t allow anything to go above it, a price ceiling doesn’t allow the price to exceed the set price mark.
Why Are Price Ceilings Used?
Price ceilings are used to ration scarce/over-priced goods and services, such as a significant increase in the price of an inelastic product, apartment rents, and credit card interest rates.
When the price for a good/service surge, many people can not afford to purchase that product. If this product is essential to life (inelastic product), then the government will most likely intervene and enforce a price ceiling.
For instance, if the price of purified water was to suddenly go up to $5 a gallon, millions of people would not be able to afford it, causing them to die. A possible reason behind this sudden increase in price could be a lack of water. To prevent this, the government will impose a price ceiling that limits the price to $1 a gallon, which is a reasonable price. As a result, everyone will be able to purchase purified water.
Although they may seem like a perfect solution, price ceilings have plenty of flaws and induce 2 crucial problems: shortages and black market transactions.
For instance, if the price of purified water was to suddenly go up to $5 a gallon, millions of people would not be able to afford it, causing them to die. A possible reason behind this sudden increase in price could be a lack of water. To prevent this, the government will impose a price ceiling that limits the price to $1 a gallon, which is a reasonable price. As a result, everyone will be able to purchase purified water.
Although they may seem like a perfect solution, price ceilings have plenty of flaws and induce 2 crucial problems: shortages and black market transactions.
Shortages
Since a price ceiling brings the price down, producers would be more hesitant to produce that product because they would not earn a high profit. In fact, if the situation is really bad, it is possible that producers might be spending more money in the production than they earn by selling the product. In other words, they lose money by selling the product.
While producers will produce less, consumers will buy more, creating a shortage.
To control the shortage, the government/individual retailers may set a limit on how much of a product each customer can purchase. To better visualize this concept, click below to view an expository graph of how shortages are created by price ceilings.
While producers will produce less, consumers will buy more, creating a shortage.
To control the shortage, the government/individual retailers may set a limit on how much of a product each customer can purchase. To better visualize this concept, click below to view an expository graph of how shortages are created by price ceilings.
If the shortage is severe, black market transactions will form. In an attempt to possess more of that product, people will desperately seek other methods to buy it.
We all know that black markets are when producers sell scarce items at a higher price. These methods are illegal because people exceed the amount they are legally allowed to purchase and they are purchasing the product at a price that is above the price ceiling.
We all know that black markets are when producers sell scarce items at a higher price. These methods are illegal because people exceed the amount they are legally allowed to purchase and they are purchasing the product at a price that is above the price ceiling.
Price Gouging
A common reason as to why an increase in certain products may occur is price gouging. Price gouging is when businesses drastically increase the price of a certain product to an unreasonably high amount.
This usually happens due to a sudden shock in supply and demand. For instance, during the Covid-19 pandemic, businesses raised the price of masks and hand sanitizers significantly.
This usually happens due to a sudden shock in supply and demand. For instance, during the Covid-19 pandemic, businesses raised the price of masks and hand sanitizers significantly.
How Do Price Ceilings Affect Supply and Demand?
Considering the law of demand, consumers tend to buy more when price ceilings are implemented because prices are lower than equilibrium. As the price goes down, the demand to purchase goes up.
Meanwhile, supply will plummet because producers will notice that they will not earn a high profit from selling that product, causing them to supply less.
Both the supply and demand changes can easily be seen from the following graph.
Meanwhile, supply will plummet because producers will notice that they will not earn a high profit from selling that product, causing them to supply less.
Both the supply and demand changes can easily be seen from the following graph.
Recent Scenario of the Use of Price Ceilings
Recently, when Covid-19 was declared as a pandemic, people panicked and thought that they needed to purchase copious masks, hand sanitizers, paper towels, wipes, etc. (To learn more about the determinants of demand, click here). Taking advantage of the situation, businesses raised the price of all these supplies so that they could maximize profit. This was an example of price gouging.
The exorbitant prices proved to be too expensive for many people; consequently, many people were left without these essential supplies.
The government realized how crucial this situation was and therefore, imposed a price ceiling, making it illegal to charge excessively for these supplies.
With this rule enforced, businesses decided to limit the amount customers were allowed to purchase.
Chronologically, as expected, black markets started to form, where people purchased these supplies at a much higher price.
Soon, however, the market for these supplies returned to normal and black markets and shortages were eliminated.
The exorbitant prices proved to be too expensive for many people; consequently, many people were left without these essential supplies.
The government realized how crucial this situation was and therefore, imposed a price ceiling, making it illegal to charge excessively for these supplies.
With this rule enforced, businesses decided to limit the amount customers were allowed to purchase.
Chronologically, as expected, black markets started to form, where people purchased these supplies at a much higher price.
Soon, however, the market for these supplies returned to normal and black markets and shortages were eliminated.
Contact Us With Any Questions or Comments
Continue learning by reading our other articles.