Now let's discuss what happens when the government steps in and regulates prices of a product. The first topic we're going to talk about is a price ceiling. A price ceiling is when the government sets a legal maximum on the price that can be charged. Essentially, a ceiling you can't go above, so it's considered the maximum. Let's switch to the graph to discuss how a price ceiling can be effective or ineffective.
The government might intervene in a market to control escalating prices by setting a maximum price. Consider an ineffective price ceiling scenario using our standard graph with price and quantity axes, demand and supply curves, and an equilibrium point at \( P^* \) and \( Q^* \). A common example of this is rent control. When markets typically trade rent at $1,000 a month and the government sets a ceiling of $1,200 a month, the ceiling has no impact if the market continues trading at $1,000. Thus, the $1,200 price ceiling does not affect market behavior since it's above the current trading price.
Now, let's examine an effective price ceiling. Imagine the same setup, but this time the government limits the rent to $800 a month. Since the normal trading price is $1,000, imposing an $800 ceiling disrupts the market. At this new ceiling, the quantity supplied becomes less than the quantity demanded because landlords may choose not to rent at the lower price, resulting in a shortage. This shortage is characterized by a point on the graph where quantity supplied is less than quantity demanded at the imposed ceiling price.
This scenario illustrates that for a price ceiling to be effective, it must be set below the market equilibrium. Effective price ceilings result in shortages as the market supply does not meet the demand at the artificially low price.
To solidify our understanding, here's a mnemonic: imagine a diagram where we draw a little house with the price as the ceiling of the house, indicating that the effective price ceiling must lie below the equilibrium to form the roof of our house. This visual helps in remembering that a ceiling set above the equilibrium does not effectively alter market dynamics and is thus ineffective.
Before we proceed to our next video where we will explore price ceilings through examples, let me mention a related concept. When price ceilings create significant shortages, governments often introduce rationing coupons to manage the distribution of scarce resources, allowing holders to purchase limited quantities at the controlled price. This method aims to ensure some level of fairness in distribution during shortages caused by effective price ceilings.