Price ceilings and floors
What happens when the law caps or props up a price, with rent control, petrol queues and the minimum wage as Mankiw's examples.
FinanceA company's marketAbout 6 min: 3 reading, 3 practiceUpdated
General education, not financial advice.
- Tell a binding price control from a non-binding one
- Explain why a binding ceiling causes a shortage and a binding floor a surplus
- Describe Mankiw's examples and the alternatives economists prefer
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 5 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 6
What it is
- A price ceiling is a legal maximum price.
- A price floor is a legal minimum price.
A control only matters if it is binding: a ceiling below the equilibrium price, or a floor above it. A ceiling above the equilibrium price, or a floor below it, has no effect.
Mankiw's ice-cream market has an equilibrium of 3 dollars and 100 cones:
| Control | Binding? | Result |
|---|---|---|
| Ceiling at 4 | No | Price 3, 100 cones |
| Ceiling at 2 | Yes | 125 demanded, 75 supplied: shortage of 50 |
| Floor at 2 | No | Price 3, 100 cones |
| Floor at 4 | Yes | 120 supplied, 80 demanded: surplus of 40 |
Quick check
Tap an answer to check it.
The equilibrium rent is 900. The city caps rents at 1,000. What happens?
- A ceiling only causes a shortage when it is below the equilibrium
Show answer
Nothing: the ceiling is above the equilibrium, so it doesn't bind. Rents settle at 900, below the cap.
Why it matters
Binding ceilings cause shortages, and something other than price has to ration the good: queues, sellers' favouritism or under-the-table payments. Not every buyer benefits: some pay less, others get nothing.
- Petrol queues in the 1970s. When OPEC raised crude-oil prices, the supply of petrol fell. Mankiw notes that most people blamed OPEC for the long queues, but economists blamed US price regulations: the ceiling became binding, and the shortage showed up as queues.
- Rent control. In the short run, the supply of flats and the demand for them are inelastic, so the shortage is small. In the long run, landlords build less and maintain less, and more people look for their own flat, so supply and demand become more elastic and the shortage grows. Landlords then ration by waiting lists, preferences, discrimination or bribes, and quality can suffer.
Binding floors cause surpluses.
- The minimum wage is a price floor in the labour market. Where it binds, the quantity of labour supplied exceeds the quantity demanded: unemployment. It binds most for the least skilled and least experienced, so teenagers are most affected. Mankiw reports that the typical study finds a 10% rise in the minimum wage reduces teenage employment by between 1% and 3%, while noting there is some debate about the size of the effect. Supporters see it as a way to raise the incomes of the working poor; critics say it is poorly targeted, since many minimum-wage workers are teenagers from middle-class homes.
What economists usually prefer. Mankiw explains that economists usually oppose price controls because prices do the work of balancing supply and demand. Alternatives include rent subsidies for poor families and wage subsidies such as the earned income tax credit. These cost the government money, so they need taxes, which have costs of their own.
Text description
Supply and demand for ice-cream cones cross at the equilibrium E: a price of 3 and 100 cones. A price ceiling at 2, below the equilibrium, binds. At 2, buyers want 125 cones but sellers offer only 75, a shortage of 50 cones that must be rationed by queues or other means.
Text description
Supply and demand for ice-cream cones cross at the equilibrium E: a price of 3 and 100 cones. A price floor at 4, above the equilibrium, binds. At 4, sellers offer 120 cones but buyers want only 80, a surplus of 40 cones. The minimum wage works the same way in the labour market, where the surplus is unemployment.
Worked example
A market for taxi rides. Figures are made up.
| Fare | Rides demanded | Rides supplied |
|---|---|---|
| 8 | 700 | 300 |
| 10 | 600 | 400 |
| 12 | 500 | 500 |
| 14 | 400 | 600 |
- Equilibrium: 12, with 500 rides.
- A cap at 10 binds: 600 demanded, 400 supplied, a shortage of 200. Only 400 rides happen.
- A minimum fare of 14 binds: 600 supplied, 400 demanded, a surplus of 200 (idle taxis). Only 400 rides happen.
Either way, fewer rides take place than at the equilibrium: the control blocks some trades that buyers and sellers both wanted.
Common mistake
Thinking a ceiling always lowers prices and a floor always raises them. A ceiling above the equilibrium, or a floor below it, does nothing. And when they do bind, the quantity traded falls in both cases.
Key terms
- price ceiling
- a legal maximum on the price at which a good can be sold
- price floor
- a legal minimum on the price at which a good can be sold
- binding
- set so that it changes the market outcome (a ceiling below equilibrium, a floor above it)
- shortage
- quantity demanded greater than quantity supplied
- surplus
- quantity supplied greater than quantity demanded
- minimum wage
- a price floor on wages
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| price ceiling | a legal maximum on the price at which a good can be sold |
| price floor | a legal minimum on the price at which a good can be sold |
| binding | set so that it changes the market outcome (a ceiling below equilibrium, a floor above it) |
| shortage | quantity demanded greater than quantity supplied |
| surplus | quantity supplied greater than quantity demanded |
| minimum wage | a price floor on wages |
Practice
Work it through
Using the taxi table, the city caps fares at 8.
- From the table
- From the table
- 700 − 300
Quick quiz
Tap an answer to check it.
Why does rent control's shortage grow over time, in Mankiw's account?
- Under rent control they cannot
Show answer
Supply and demand for housing are more elastic in the long run. Landlords build and maintain less, and more people seek their own flats.
What does the typical study find, according to Mankiw, for a 10% rise in the minimum wage?
- The typical study finds it falls
- There is debate about the size, but the typical finding is a fall
Show answer
Teenage employment falls by between 1% and 3%. The minimum wage binds most for teenagers.
A floor is set below the equilibrium price. What happens?
- A floor only causes a surplus when it is above the equilibrium
Show answer
Nothing: it doesn't bind. The market price is already above the floor.
Sort it
Which group does this belong to?
A rent cap below the market rent
A binding ceilingShow answer
Shortage. A binding ceiling
A minimum wage above the market wage
A binding floor: unemploymentShow answer
Surplus. A binding floor: unemployment
A petrol price cap above the market price
The ceiling does not bindShow answer
No effect. The ceiling does not bind
A guaranteed minimum price for milk above the market price
A binding floorShow answer
Surplus. A binding floor
A minimum price for bread below the market price
The floor does not bindShow answer
No effect. The floor does not bind
In short
- Ceilings are maximums, floors minimums; they matter only when binding.
- Binding ceilings cause shortages and rationing; binding floors cause surpluses.
- Examples: petrol queues, rent control, the minimum wage.
- Economists usually prefer subsidies, which have costs of their own.
Mastery check
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Check yourself
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In Mankiw's example, what is the shortage under a ceiling of 2?
Show answer
50 cones (125 demanded, 75 supplied).
Which side of the labour market does a binding minimum wage leave with a surplus?
Show answer
The supply side: more people want to work than firms want to hire, so there is unemployment.
Name one alternative to rent control that Mankiw mentions.
Show answer
Rent subsidies for poor families (wage subsidies are the alternative to the minimum wage).
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 6.
- On this site: Supply, equilibrium and shifts and Who really pays a tax.
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