Price Ceilings and Price Floors - Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Title : Price Ceilings and Price Floors Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2010 Introduction The government through some impositions on the prices for some goods and services can control the market prices. This is important in maintaining affordable prices for the staple goods to prevent rise in price when there is shortage of some goods. Price control by the government can be in form of price ceilings and price floors. Price controls have been in the past common in the developing nations but have been of late taken up by other developed countries such as the United States due to threats of inflation. Price controls have also been used by the governments to control the living standards so that the poor may not get oppressed by the sellers. The government set up prices that can be affordable to citizens of all economic levels. Price ceilings and price floors have been used by the government in controlling prices and ensuring affordability of all commodities. However, the price ceilings and price floors may have undesirable impacts in the market that affects both the buyers and the sellers. The two are commonly used in controlling prices of basic commodities such as food, house rent, and labour (Walras 2006). Price ceilings Price ceilings are limits imposed by the government on the prices that the sellers charge for certain products. Price ceiling can be a non-binding price ceiling or a binding price ceiling. The non-binding price ceiling is set above the free market price. This is price ceiling that has no practical effect. In this case, the government has set a maximum price that is so high such that the market cannot achieve them. Binding price ceilings are the ones set below the free market price in which the market prices must achieve. This has a significant impact in the market and must therefore be observed. (Government Intervention, 2010). The graph below shows the equilibrium price from which the price ceiling can be set below or above. Equilibrium price is the price in which the quantity and the demand for goods become equal. The equilibrium is never affected by the market forces. An example of price ceiling is where the government sets maximum rent increase that can be imposed to the tenants. This aims at controlling the low income tenants from rent increase that may be caused by house shortages. (Government Intervention, 2010) Price floors These are price limits set by the government that indicates the minimum prices that can be set for a product. It indicates the lowest legal price that a certain product can be sold at. The government sets price floors to prevent the prices falling too low. The most commonly set price floor is the minimum wage that indicates the minimum amount that can be given to labourers. According to the economies theory of demand and supply, the price floor should be set higher than the equilibrium for it to be effective and for demand to equal the supply. This is also evidenced in the graph below. Examples of price floor include an intervention by the government to raise the price of whet due to very low income of the wheat farmers (Arrow & Debreu 2004). (Government Intervention, 2010). Why the Government Uses Price Ceilings and Price Floors In Markets Price ceilings are imposed by the government in the market to protect the consumers form market conditions that may pose them difficulties in obtaining some commodities. For example, in case of shortage of some commodities in the market, the suppliers may raise the prices to take advantage of the conditions. This may have a negative impact to the low income citizens since that may not be able to obtain the commodities in such prices. It therefore protects the consumers from exploitation by the suppliers. On the other hand, price floors are set by the government to limit the minimum price for a commodity in the market. However, this must be set above the equilibrium price to avoid exploitation of the suppliers by both the government and the consumers. Price floors can also protect the consumers in cases such as wage control. The government sets the minimum price that can be paid for labour in a certain number of hours. Therefore, both the price ceiling and price floor are set by the government to control market prices and to protect the market players from exploiting each other. However the intentions of the government are to have a market situation that follows the economic theories of demand and supply as shown in the graph below. (Government Intervention, 2010). Effects of price ceilings and price floors on resource allocation According to Richard, (2005) the binding price ceilings that have been set below the free market price may have several impacts on market resource allocation. This is because the suppliers find themselves in a state where they cannot charge their usual price for commodities. This may result in a decrease in supply of goods since they do not wish to sell more at their undesired price. On the other hand, the buyers enjoy lower prices than what the suppliers intended to give. The consumer’s demand for the commodities therefore increases exceeding the supply. This therefore results in shortage of the commodities. Another impact of price ceilings is on the quality of the commodities regulated. This is because for the suppliers to meet the demand that increases following price ceiling, the suppliers must lower the quality. For example during the in the food industry, the suppliers may reduce the portion sizes, or use cheap ingredients to meet the demand at the set price. In the rent controlled buildings, the house owners may reduce the quality maintenance of those houses. This can only be prevented where there is oligopoly. This is because the few firms that are competing in the market will have to maintain quality to win the consumers. Price ceiling may also lead to black markets. Where certain consumers fails to get their desired goods because low quality foods in the market, they may get them in the black market. This is for those who are lucky to get goods during the shortage. They will therefore illegally sell them at a higher price to those in need of quality goods. The prices are higher in the black market than in the free market because the quantity of goods being trade with is low. Another impact of price ceiling is discrimination of the buyers. Where there is shortage of goods among the suppliers, they may discriminate the buyers and sell to their friends and relatives. In cases of controlled house rent for example in New York, the landlords resulted to giving the rent controlled buildings to the more wealthy celebrities over the poor and the less famous people. Price floors also have some impact on resource allocation. Where they are set above the equilibrium price in the market, the consumers found themselves in a situation where they are purchasing goods at a price higher than the one they are used to. In response to this, they lower their purchasing level or they completely stop purchasing the item. This may result to low demand for the commodities. On the other hand, the suppliers take advantage of the high prices and they tend to produce more goods. But since the buyers are not able to purchase their goods at that price, this results in excess supply. The resulting situation is low demand and high supply of goods. However, this does not apply when it comes to minimum wage. When the government sets minimum wage above the equilibrium price for the unskilled workers, the employers, who are the suppliers in this case, stop taking the workers due to the high wage price. This then results in unemployment. A minimum wage that is above the equilibrium forces the employers to take few workers than the number of those looking for the jobs. To avoid such a situation, the equilibrium wage should be set according to qualifications of a certain class of workers. Price floors can also lead to black markets same as the price ceilings. For example, price floors are mostly set in the hospitality industries. Sometimes the government may set the price of alcoholic drinks higher than the equilibrium price in the licensed bars to reduce overconsumption. If the prices are not affordable to low income drinkers, they may turn to the unlicensed bars that do not follow the legal prices and where there is no control on the consumption. However, for the price floor to have an impact on resource allocation in the market it must be set above the equilibrium market price. This ensures that the prices of the required commodities remain high so that there is no shortage in the production. On the other hand, for price ceilings to be effective, they must be set below the market price. This is the binding price ceiling which results in significant impacts in the market. Conclusion The difference between price ceiling and price floor is that the price ceilings prevent the prices from going too high and this helps the consumers to afford the commodities but it can result in shortages in supply. While price floors prevent the prices from going too low thus protecting the suppliers but can also lead to excess supply. Even though the government has a duty to protect both the suppliers and the consumers, this should be done considering the economies theories to prevent the resulting negative consequences. Georgescu-Roegen (2007) explains that to meet the demand that comes with price ceilings, the government can give subsidies to the commodity producers to enable them meet the demand and prevent them from giving low quality goods. This will enable them to meet the Qd at the set price ceiling. To prevent the negative impacts of price floors, the government can set price supports where the government buys the resulting excess supply, or production quotas that regulate the amount that is being produced. For effective consumer and supplier protection, the government should therefore take measures on both sides to avoid exploitation of one side at the expense of the other. Bibliography Richard A., 2005, Time for Revisionism on Rent Control, Journal of Economic Perspectives 9(1): 99–120. Georgescu-Roegen, N., 2007, Methods in Economic Science, Journal of Economic Issues, 13,(2): 317-328. Arrow, K., & Debreu, G., 2004, The Existence of an Equilibrium for a Competitive Economy, Econometrica, 26, 265-90. Walras, L., 2006, Elements of Pure Economics, Harvard University Press, Harvard. Government Intervention, 2010, Price Floor, Retrieved Sep 4, 2010 from . Government Intervention, 2010, Price Ceiling, Retrieved September 4, 2010 from . Read More