What this lesson teaches
I can describe taxes, subsidies, price controls and quotas as ways a government intervenes in a market.
Syllabus 9570, 2.1.3(a). Government Intervention in Markets: Governments may intervene in markets in the form of taxes, subsidies, price controls (maximum and minimum prices) and quantity controls (quotas)
Make a guess
The government caps rents below the market level. What happens to the number of flats rented out?
- It rises, because more people can now afford to rent a flat.
- It falls, as landlords offer fewer flats at the lower rent.
- It stays the same, because flats are already built.
Show the answer
It falls, as landlords offer fewer flats at the lower rent.
A binding cap moves landlords down the supply curve. Fewer flats are offered, so fewer are rented, even though more people want one.
A maximum price below equilibrium creates a shortage, so some buyers go without.
A maximum price (price ceiling) is a legal limit on the price. It only has an effect if it is set below the equilibrium price.
At the lower price, buyers want more (Qd) but sellers offer less (Qs). The gap is a shortage. Because the price cannot rise, the shortage stays.
Only Qs units are sold. Buyers who get the good pay less, but many willing buyers get nothing. The good must be shared out some other way: queues, first-come-first-served, ballots or who you know.
Shortages can also lead to black markets, where the good is resold illegally above the legal price, and to lower quality as sellers cut costs.
- Binding
- Only if set below equilibrium.
- Result
- Shortage; only Qs is sold.
- Side effects
- Queues, black markets, lower quality.
Why maximum prices cause problems
Shortage
The price cannot rise, so the gap between Qd and Qs stays.
Non-price rationing
Queues, ballots or favouritism decide who buys.
Black markets
Some buyers pay above the legal price to get the good.
Quality and supply
Lower returns can lead to less upkeep and less investment.
| Control | Qd | Qs | Units sold |
|---|---|---|---|
| $4 maximum | 120 | 40 | 40 |
| $8 minimum | 40 | 120 | 40 |
Worked example: A $4 cap on meal prices
Without the cap, 80 meals a day sell at $6. At $4, buyers want 120 meals but stalls offer only 40.
- The cap is below $6, so it is binding.
- The shortage is 120 - 40 = 80 meals a day.
- Only 40 meals are sold. Spending falls from $480 to $4 x 40 = $160.
- The 40 buyers who get a meal gain. Another 80 buyers who want one at $4 go without.
Watch out for this
With a shortage of 80, 80 more units are sold.
The shortage is units people want but cannot get. Sales are limited to the smaller quantity, what sellers are willing to supply.
Check your understanding
The equilibrium rent is $2,000. The government sets a maximum rent of $2,500. What happens?
- Rents rise to $2,500.
- Nothing: the cap is above equilibrium, so it is not binding.
- A shortage of flats develops.
Show the answer
Nothing: the cap is above equilibrium, so it is not binding.
Right. The market rent of $2,000 is already allowed, so the cap has no effect.