Price Ceilings and Price Floors

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Price Ceilings and Price Floors

What It Means

Throughout history, governments have attempted to control prices through the use of price ceilings and price floors. A price ceiling is a maximum price that the seller of any good or service may charge. For example, if the U.S. government declared that no street vendor could charge more than $2.00 for a hot dog, a price ceiling would be in effect. A price floor, by contrast, is a minimum price that the seller may charge. If the government declared that hot dogs could not be sold for any less than $5, a price floor would be in effect. While price ceilings and price floors can be necessary in certain situations, most economists strongly disapprove of them because they interrupt the natural processes by which the economy regulates itself.

If the market for hot dogs is functioning properly and freely (a market is any place or system that brings buyers and sellers together to make exchanges), rising prices for hot dogs will encourage vendors to supply more hot dogs to buyers in the hope of maximizing their profits. These same rising prices, however, discourage more and more consumers from buying hot dogs, because consumers want to maximize their own economic well-being. Vendors must therefore balance their desire to maximize profits with what they know about consumer demand for hot dogs at various prices. The competing interests of sellers and buyers (in other words, of supply and demand) efficiently regulate the number of hot dogs produced and sold. Vendors show up to work with the correct number of hot dogs, and vendors and consumers both get what they want with a minimum of waste and inefficiency.

A price ceiling for hot dogs would reduce the supply of hot dogs, because the potential profit to be made on the sale of each hot dog would be diminished. At the same time, the lowered price of hot dogs would make more people willing and able to buy hot dogs. This imbalance between supply and demand (supply is falling while demand is rising) would likely lead to a shortage of hot dogs. On the other hand, a price floor would artificially raise the price of hot dogs, thereby encouraging vendors to supply more than consumers would be willing and able to buy. Supply will have risen while demand falls, a situation that is likely to lead to a surplus of hot dogs.

When Did It Begin

Price ceilings and floors have probably existed for as long as there have been organized governments. Ancient Hebraic law, as reflected in the Old Testament, forbade the collection of interest, a fee charged to someone who borrows money. Islamic law has had a similar rule for much of that religion’s history. Because interest can be thought of as the price that people pay for borrowed money, a prohibition on interest is a price ceiling, one that is set at zero.

In ancient Egypt, Babylon, and Greece, the government set prices for grains and other farm produce, sometimes enforcing these price controls with the threat of the death penalty. A crisis occurred in Rome under the emperor Diocletian (245–316 ad ) when, in the year 284, he created inflation (rising prices) by coining too much money. (More money in circulation results in more purchasing power per person and by extension increased demand for products, which forces up prices). In an attempt to stop the out-of-control rising of prices, Diocletian imposed price ceilings. Farmers and other suppliers of goods, unable to get reasonable prices, stopped bringing their products to market, and many people starved as a result.

More recently price controls have been common in times of war, when out-of-control inflation can be a problem. During World War I (1914–18), World War II (1939–45), and the Korean War (1950–53), for example, the U.S. government attempted to control inflation through price ceilings. High inflation in the early 1970s led to the much rarer phenomenon, under President Richard Nixon (in office 1969–74), of price controls on consumer products during peacetime.

More Detailed Information

Despite the consensus of economists on the generally negative impact of price controls, periods of economic difficulty and the needs of particular groups of people have often made specific forms of price ceilings and floors appealing to many. In New York City, for example, the local government in some cases imposes a price ceiling on rent, known as rent control. Rent control is intended to ensure that affordable housing remains available to people who cannot pay the extremely high prices that landlords in the city often ask for apartments. Without rent control poor and middle-class people would, in many cases, be unable to live in New York.

Most economists maintain, however, that rent control creates an imbalance between the supply and demand for housing in the city. Because prices are kept artificially low, demand increases while supply declines. People rush to find rent-controlled apartments, while landlords have little incentive to build new housing if their potential for profits is limited. A shortage of housing results. Additionally, rent control is believed to result in deterioration in the quality of housing. Because people are unlikely to move out of an apartment whose rent is artificially low, landlords do not have to make repairs or conduct routine maintenance to keep their apartments occupied.

An example of an existing price floor that has widespread public support in the United States is the federal minimum wage. If we think of labor as a good that a worker sells to a company, the minimum wage represents a price floor mandating that the price of labor cannot drop below a certain amount ($5.85 an hour as of 2007). The intent of this price floor is to create economic benefits for the poor, a vulnerable group of people for whom most voters have sympathy. If the government did not set price floors for wages, supporters argue, unskilled workers (people who lack special training or education) would have no guarantee of being able to pay for their basic necessities.

As with rent control, however, many economists oppose the minimum wage because of its effect on the balance between supply and demand. Theoretically, the minimum wage increases the supply of workers (because more people want the jobs) at the same time that it decreases businesses’ demand for these workers (because they are less willing to employ people at the higher wages). According to economists, the minimum wage actually increases the number of unskilled workers who want jobs but cannot find them.

Recent Trends

In the early years of the twenty-first century, many Americans were calling for various price controls, although most of them probably did not think of it in these terms. There was a widespread belief that two industries in particular, the oil industry and the pharmaceutical industry, were taking advantage of consumers by pricing their goods unfairly. Although Americans had long been accustomed to gas prices that were lower than those in other countries because of lower taxes on fuel, rising prices during this time were a serious economic blow to many U.S. households. At the same time, the corporations that drilled and refined oil, bringing it to consumers in the United States, were making record amounts of profit. A substantial portion of the country’s population believed that the government should intervene to make gas more affordable, even though nearly every economist disapproved of the idea.

Similarly, prescription-drug prices were increasingly high during this time, even as the pharmaceutical companies that developed and sold these drugs were among the most profitable of all businesses. As a result, calls for government limits on drug prices were common.

Although some politicians used these issues to gain the support of disgruntled voters, the likelihood that the federal government would impose price ceilings on these items was minimal. Since the 1970s the U.S. government has not seriously ventured into the arena of price controls for consumer goods.