The price ceiling is the maximum price set by the government for certain goods. Sellers are not permitted to sell higher than that price.
The government sets a maximum price to protect consumers from conditions that can make goods very expensive. High prices can occur because of a monopoly on a product, an investment bubble, or during periods of high inflation.
The government feels that the market price for goods or services is too high. To keep products affordable for the people, the government sets a price ceiling.
An example of such a ceiling is rent control. Other examples are the price of fuel oil and agricultural insurance premiums.
Limiting prices to more affordable levels seems like a noble idea. However, that also creates another consequence, namely shortage.
When is the price ceiling effective?
Price ceilings limit the maximum selling price of goods or services. The seller or manufacturer cannot set a price above that rate.
A price ceiling is effective and can disrupt market equilibrium if the government sets it below market equilibrium. As lower than the equilibrium, the price will tend to rise due to excess demand.
On the contrary, the price ceiling is ineffective if the government sets it above the equilibrium price. The price is higher for consumers. Because of higher than equilibrium, the price tends to decline due to excess supply. Thus, a ceiled price above equilibrium is not in line with the initial objectives of the government, maintaining the affordability of goods.
Impacts of the price ceiling
Because the government sets a maximum price below the equilibrium price, the market experiences a shortage because the quantity demanded is greater than the quantity supplied. A shortage occurs as the lower price stimulating higher demand, and at the same time, it encourages producers to provide less.
Say, the equilibrium price is at Rp10. At this price, the quantity supplied is equivalent to the quantity demanded, which is 210 units. When the government sets a price ceiling of Rp5, the producers reduce the quantity supplied to 120 units. At the same time, because the price is lower, consumers increase the quantity demanded to 280 units. As a result, it produced a shortage of 160 units (280-120).
Although the shortage occurs in the market, the price does not move up. The market mechanism does not work to return it to equilibrium because there is government control.
Shortage requires rationing and can give rise to the black market. The black market occurs because some people are willing to pay higher prices for goods, so they don’t queue up.
Realizing the benefits of the black market, some producers may reduce their sales in the market. They diverted it on the black market. This diversion results in a far greater scarcity.
In addition to selling options on the black market, producers try to avoid the maximum price by charging additional costs or reducing the quality of the goods. The goal is, of course, to maintain profits.
The price ceiling creates a deadweight loss. Consumers get more benefits from receiving a lower price than they should (the equilibrium price). As for producers, it is a loss. In terms of price ceilings, some parts of producer surplus are converted to consumer surplus.
Advantages and disadvantages
Price ceilings discourage producers from producing products and services. Companies are reluctant to supply because they have to accept lower prices than they should. If the government sets it too low below the equilibrium price, it can force producers to reduce economic output.
To reduce these negative impacts, the government usually provides other incentives for producers, such as subsidies. By doing so, the producer receives compensation for losses incurred.
Meanwhile, for consumers, lower prices allow them to buy. It is essential during high inflation because it makes the cost of living affordable and prevents a sharp rise in prices.