Chapter 4: The impact of price controls
Impact of Price Controls:
Price controls are restrictions on how high or how low a price can be allowed to move. Price controls almost always refer to some sort of government policy. In fact, we reserve the term price control for exactly when a government has made a law that stipulates legal minimum or maximum prices. It’s basically a legally enforced upper bound or lower bound on prices. A price ceiling creates an upper bound, a legal maximum, and a price floor creates a lower bound or legal minimum for the market price.
It’s not a price control if a company has some sort of policy against raising or lowering the price (resale price maintenance is a particular pricing policy with some features similar to a price floor but we still don’t call this a price control).
Since price controls only limit where prices can move to and don’t necessarily stipulate a specific price, the price control is only relevant if the bound prevents the price from adjusting to the equilibrium. Take for example the market given by demand represented by P=10 - Q and supply represented by P = 2 + Q. We can solve for the market equilibrium by substituting for P to set the two equal: 10 - Q = 2 + Q. Solving algebraically we get: 8 = 2Q and finally Q* = 4. The corresponding equilibrium price is therefore P* = 6. A price floor would be if the government makes it illegal to sell the product for less than $7; a price ceiling would be present if it is illegal to sell the product for more than $3.
As in this example if a price ceiling (of P=3) is too low relative to the market equilibrium (of P = 6), the price is prevented from adjusting upward. As a result there will be a shortage. That’s because at the artificially low price the quantity demanded is greater than the quantity supplied, the definition of a shortage. Commonly cited examples of price ceilings are rent controls.
In the example with demand of P = 10 - Q and supply of P = 2 + Q we can identify the size of the shortage that would exist at the price ceiling of $3. If we’re doing this algebraically it helps to first solve each equation for Q. So we get demand of Q = 10 - P and supply of Q = P - 2. Now we find that Qd at the price of 3 is Qd = 10 - (3) = 7 and Qs at the price of 3 is Qs = (3) - 2 = 1. So at the price of $3, the quantity demanded is 7 and the quantity supplied is 1 so there’s a shortage equal to Qd - Qs = 7 - 1 = 6 units.
As in this example if a price floor (of P = 7) is too high relative to the market equilibrium (of P = 6) the price is prevented from adjusting downward and there will be a surplus. At the artificially high price the quantity supplied exceeds the quantity demanded, the definition of a surplus. The most commonly cited example of a price floor is the minimum wage. In the labor market we have a special name for surplus, unemployment.
In the example with demand of P = 10 - Q (or equivalently Q = 10 - P) and supply of P = 2 + Q (or equivalently Q = P - 2), we can identify the size of the surplus that exists at the price of 7. At the price of 7 the quantity demanded is: Qd = 10 - (7) = 3 and quantity supplied is: Qs = 2 + (7) = 9, which yields a surplus of 9 - 3 = 6 units.
Price controls that prevent the market price from reaching its equilibrium are said to be binding. This is what happened in the above example. By contrast, price controls that don’t prevent the market price from reaching equilibrium are non-binding. In the context of our example any price above the equilibrium of P=6 would be a non-binding price ceiling, such as P=9. Any price below the equilibrium of P=6 would be a non-binding price floor, such as P = 4. That’s because neither would obstruct the market from reaching the equilibrium. The price ceiling of P = 9 only prevents the price from rising any higher than 9 but the equilibrium is lower. Barring a significant change to demand or supply the price won’t rise above 6 anyway. Similarly the price floor of P = 4 only prevents the price from going lower than 4. But the equilibrium of P = 6 tells us the market doesn’t want the price that low in the first place!! Barring a significant change to demand or supply, the price won’t go below 6.
Generally speaking policy makers have some sort of purpose in mind when they intend to impose binding price controls. For instance, they might believe that in the absence of price control regulations, workers will be hired at too low a wage. To answer to this interest, they impose a minimum wage to make sure that everyone working earns at least some minimum amount. In the case of rent controls, the government might argue that rents are simply too high and so they require landlords to lease their rental units at a lower one.
There are other times where price controls are designed to be mostly non-binding. An example of this is an anti-price gouging law. Many states have laws that limit the magnitude of price increases for (1) items deemed a necessity when (2) a state of emergency has been declared. A typical law might not allow prices to rise more than 10% above its two-week average. This effectively creates a price control, a price ceiling.
Of course if demand or supply changes, a price control can change from being binding to non-binding. A binding price floor like the minimum wage will become non-binding with a sufficiently large decrease in demand (a recipe for a lower equilibrium wage and quantity hired) or decrease in supply (a recipe for a higher equilibrium wage and lower quantity hired). A binding rent control can become non-binding with a sufficiently large decrease in demand (a recipe for a lower price and lower quantity) or sufficiently large increase in supply (a recipe for a lower price and higher quantity).
If the market is perfectly competitive, price controls will harm market efficiency and lead to an overall distortion in the market. Economists generally oppose price controls on these grounds. However, if the market is not perfectly competitive, price controls can potentially restore market efficiency and lead to an overall improvement in market outcomes. An example would be government price ceilings placed on energy prices where the government protects the monopoly of a single power company by disallowing competitors to operate but at the same time places limits on what the company can charge (since they’re operating without any competition and would have no other reason not to raise prices as much as possible).
In any case the ‘Econ 101 takeaway’ should not be that government action in general or price controls in particular are always bad. Instead, the takeaway is that there’s important nuance that needs to be appreciated in order to best evaluate the outcomes of the specific policy!