Another way a market could be disturbed is through government intervention. If left alone, a market will settle at equilibrium through the rationing function of prices. However, the government sometimes thinks that the equilibrium price is unfair and will take it upon itself to influence the market through the establishment of price ceilings and price floors.
A price ceiling is a price that you cannot go above.
A price floor is a price that you cannot go below.
The easiest way to see the effects of a price ceiling or a price floor is to take a look at it graphically.
Sometimes students mix up the two when drawing and labeling them on a demand and supply graph. To help remedy this, conjure up the following image:
Imagine you are a giant in a really small room. If you tried to jump, your head would hit the ceiling. So the ceiling is a price you cannot go above. As you come tumbling back down, you would crash into the floor and come to a stop, so a price floor is a price you cannot go below. Keep that in mind.
Suppose we’re at the equilibrium point PE and QE when all of a sudden, the government decides that the market price is too high and institutes a price ceiling, PC. (Remember, a price ceiling is a price that we cannot go above, so it’s placed below the equilibrium point.) We can immediately tell from the graph that a shortage is created as a result.
The price ceiling prevents the rationing function of prices from taking place. So long as there’s a ceiling, there will be a shortage.
“So what,” you might think. “I don’t see what the big deal is.” Well, let’s think about the repercussions a little bit.
We have a constant shortage on our hands, which means there isn’t enough of this product to go around, so what do we do? Do we issue things on a first come, first serve basis? Do we try to ration out the product? How do we stop counterfeiters from flooding the market with an inferior, unregulated product? How do we stop black markets from arising where the good is sold above the market price?
Suppose we’re at equilibrium again at PE and QE when all of a sudden, the government decides that the market price is too low this time and decides to institute a price floor, PF. (Remember, a price floor is a price that we cannot go below, so it’s placed above the equilibrium point.) We can immediately tell from the graph that a surplus is created as a result.
The price floor prevents the rationing function of prices from taking place. So long as there’s a price floor, there will be a surplus.
Again, let’s think about the consequences of this price floor.
We have a constant surplus on our hands, which means that there’s too much of this product flooding the market, so what do we do? How will we get rid of the extra surplus? Who will pay to get rid of the extra surplus? Or will we just let the extra go to waste? How do we get the suppliers to innovate and attempt to be more efficient if they’re guaranteed a higher-than-market price? What do we do when people who would have normally been able to obtain this good that are no longer able to because of this higher price start to complain? Just a few things to think about.
Does the government actually help increase the efficiency of our economy by instituting these price ceilings and floors, or are they just good intentions with bad outcomes? We’ll look at a few case studies later to see the results.
-A price ceiling is a price that you cannot go above. It only has an effect when set below the equilibrium price. Price ceilings create shortages that wouldn’t otherwise be there.
-A price floor is a price that you cannot go below. It only has an effect when set above the equilibrium price. Price ceilings create surpluses that wouldn’t otherwise be there.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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