Price Ceilings, Price Floors, and Black Markets - Online Tutor, Practice Problems & Exam Prep

Price ceilings are government-imposed maximum prices, effective only when set below equilibrium, leading to shortages. For example, rent control can create a situation where demand exceeds supply. Conversely, price floors establish minimum prices, effective when above equilibrium, resulting in surpluses, as seen with minimum wage laws. Both mechanisms can lead to black markets, where transactions occur outside legal limits due to government regulations. Understanding these concepts is crucial for analyzing market dynamics and the implications of government intervention.

Price Ceilings

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.

Price Ceilings

All right, so we've got an example here. Consider the following graph. A price ceiling of $20 would cause a surplus of 500 units, a shortage of 500 units, surplus of 1,000, shortage of 1,000, or no effect. Alright. So we have to remember with price ceilings, they set a price too low if they're effective, right? And when the price is too low, the demand is going to outweigh the supply, so we're going to be in a situation where there's a shortage if there's this price ceiling if it's effective, right? So, off the bat, we can cancel these that say surplus. We know it's not going to be any of those answers, but even if we can't do that, remember that specific knowledge on the test, we do have the graph and let's go ahead and look at the graph and see if we can figure out, the surplus or the shortage or what effect we have here. So the first thing we want to check is is this an effective price ceiling? And my trick remembers is the house trick. So notice that at this price of $20, we do get a house, right? We get the house, so we can say that it is an effective price ceiling because we got the house there, so we know that it's going to affect the market and it's going to do something here. So let's see what happens here. The government says you can't charge a price more than 20 the market wants to trade at 25, so this is going to be effective. So what do we have here? This is going to be the supply curve, right? Because we have our downward demand, supply is the other one. Right? So what happens here at the price of $20, 500 is going to be our quantity supplied, right? That's where the $20 touches the supply curve and a 1,000 over here that's going to be the quantity demanded, right, that's where the $20 is touching the demand curve. So what do you have? We have a quantity supplied of 500, a quantity demanded of 1,000. There's a shortage, right? People want 1,000, but there's only 500 available. So that difference there between the 500,1,000 is the shortage. Right? So the shortage isn't a thousand. There's not a thousand shortage. There's still 500 units available. It's the other 500 that is missing that's the shortage. So the quantity demanded being a thousand minus the quantity supplied of 500. If we subtract those, we're going to get 500 which is the shortage. So we have a shortage of 500 units in this case. Alright? So let's go on let's go ahead and go to the next video.

When the government imposes a binding price ceiling, it causes

• A. The supply curve to shift to the right
• B. The demand curve to shift to the right
• C. A shortage of the good
• D. A surplus of the good

A price ceiling will have no impact on a market if it is set

• A. below last year's average price
• B. above the equilibrium price
• C. by knowledgeable government officials
• D. below the equilibrium price

All of the following are problems associated with price ceilings except:

• A. chronic excess demand
• B. an eventual decline in the number of suppliers
• C. the need to use ration coupons to purchase a good
• D. chronic excess supply
• E. landlords failing to maintain rent-controlled properties adequately

Price Floors and Black Markets

So just like the government can set legal maximum prices, they can also set legal minimum prices. We talked about price ceilings and how that was a maximum price that can be charged. Well, the price floor, what do you think? It's going to be the opposite. It's the legally determined minimum price that can be charged, right? Just like before, let's go ahead and head to the graph and discuss what makes an effective price floor. Then we'll go back and fill in our summary. If you think ahead, you can realize that this is going to be the opposite of a price ceiling, right? When we do our example here, we're going to talk about minimum wage. This is a very common topic when discussing price floors—a minimum price, so the minimum wage that must be met.

First, let's talk about this ineffective price floor on the left hand side. We've got our common price-quantity graph with our demand curve and our supply curve, right, and our equilibrium right here. Let's say that in this market, it's a labor market, right? We're going to have an equilibrium wage here of let's say $10, and then the government steps in and says, "Hey, you can't pay anybody less than $6; that's not okay." So when the government requires a minimum wage of $6, and the market's already at $10, the demand and supply at equilibrium are already at $10. They're going to keep trading at $10 just like we saw with the price ceiling. This will have no effect. The minimum price set at $6 an hour while everyone's already trading at $10 means they'll just keep doing what they're doing. They're already above the minimum; they're not breaking the law, so they're just going to keep doing what they're doing. The price floor has no effect on the market, making it ineffective.

Now, let's move to the effective price floor behind me. The same thing—our price and quantity axes with our demand and supply curves. Now, this time we've got the same equilibrium here in the middle. Quantity and price, right, and now the government steps in when people are trading at $10, and the government says, "Hey, everyone's been concerned about this. We've got the minimum wage at $15 now." Bernie Sanders is in office, and he sets that $15 minimum wage. Let's see what happens. The minimum wage comes into play, and everyone's really happy. "Hey, we're going to be making more money," but what is going to happen in this market? Remember, this is a labor market, so the supply of labor is the people who have labor and go to work. Compared with the demand, which is from the companies that hire you. So, at this high wage, companies are demanding less labor. They can't afford it, so they're going to demand less of it and use other things instead of labor to create their products, like robots or something similar. So we're going to have the quantity demanded over here, and at this $15 minimum wage, everyone wants a job now. Everyone who was just sitting around thinks, "Man, I could use $15 an hour, that sounds good." The quantity supplied of labor is going to be way up here, and we will find ourselves with too much labor on the market and not enough jobs. So there's not going to be enough jobs to fill this up; there’s going to be a surplus of labor. Everyone's looking for a job at this $15 an hour rate, but nobody wants to hire. This is what we can call an effective price floor and now it's because it's above equilibrium. For it to be effective, the price floor must be above equilibrium. And what did we see? An effective price floor causes a surplus in the market. The supply of labor in this case was much greater than the demand for labor at the price floor. Just like we saw with the price ceiling, right? Over here, the ineffective price floor would have been an effective price ceiling. Over here, we’ve got our effective price ceiling. If you noticed, that would be an effective price ceiling. If you remember the price ceiling is the one below equilibrium and you can remember because of the drawing, then the price floor has to be the opposite, the one that's above equilibrium.

Alright, one more thing I want to discuss in this video is the idea of black markets. I'm sure you've heard the term black market before where kind of shady transactions happen. Black markets occur when the government has stepped in and regulated the price or the quantity of a good and people want to exchange anyway. This inefficiency created by the government prompts the black market where transactions try to circumvent the law. Here are some examples of activities in black markets. The first one is hiring workers at less than the minimum wage. Sometimes you see people getting hired under the table, and they can be paid less than minimum wage. This is a very common one. Just like we saw in our price ceiling example, renting apartments above the rent-controlled limits. The government had stepped in and said you can't charge more than this for rent, but now people are going to try and charge higher rent anyway in sneaky ways. They might get a check for the government-regulated amount and then charge extra in cash. Another black market is the market for illegal drugs. In this market, the government hasn't set any price regulation but has set a quantity regulation. The quantity in this market is zero; there should be zero of these illegal drugs available, but because people still want the drugs, there becomes this black market where the trades happen anyway behind the eyes of the law. Black markets occur when the government regulates price or quantity because it creates inefficiencies and blocks trades that people want to happen. Now, that's about it here. Let's go ahead and move to the next video and do some examples and practice problems.

Price Floors

All right, let's try this example. Consider the following graph. A price floor of $20 would cause a surplus of 1,000 units, a shortage of 1,000 units, or no effect. The first thing we want to check when we get a price floor or price ceiling problem is whether or not the price floor or price ceiling is going to be effective, right? And I use my trick of that little house to figure out if it's effective or not, right? Because you're on the test and you're like, man, is price floor, price ceiling, which one's below equilibrium, which one's above equilibrium? Well, just remember that the ceiling is the one that makes the house with the ceiling price that's effective, right? We've got the house right here and this ceiling of the house is our ceiling price that makes an effective price ceiling, right? So boom, right there I remembered on the test that effective price ceilings are below equilibrium, right? That's what we see in this problem, an equilibrium of 25 and an effective price ceiling below equilibrium. So then now that I've figured out ceilings, I know that floors are the opposite, right? And in this question, we're talking about price floors, right? So now that I know that an effective price ceiling is below equilibrium from my house trick, I know that an effective price floor is above equilibrium, right? Above and I just figured this out just from the little house trick. So now I can go back to my graph. I'm going to erase all this, right? Well, I can leave the p star and so all of that was just to think was it effective or ineffective? Boom. We know that an effective price floor would be above equilibrium and what do we have here? A price floor of 20 which is below equilibrium, right? So this is an ineffective price floor and just like that, we know that the answer is going to be no effect, right? At this price floor the government set a minimum of $20 that could be charged but it doesn't matter to the market because they were trading at $25 which is above the minimum, right? And that's okay, that's within the law and they're just going to keep doing what they were doing and trading at $25. So the answer here is no effect. Let's go ahead and move on to the next video.

Which of the following statements regarding the expected effects of a price control imposed on a competitive market is false?

• A. A price floor above the competitive equilibrium price will result in a surplus.
• B. A price ceiling above the competitive equilibrium price will result in a surplus.
• C. A price ceiling below the competitive equilibrium price will result in a shortage.
• D. A nonbinding price floor will result in a quantity exchanged that is equal to the equilibrium quantity

Here’s what students ask on this topic:

What is a price ceiling and how does it affect the market?

A price ceiling is a government-imposed limit on how high a price can be charged for a product. It is effective only when set below the market equilibrium price. When a price ceiling is below equilibrium, it leads to a shortage because the quantity demanded exceeds the quantity supplied. For example, in the case of rent control, if the government sets a maximum rent that is lower than the market rate, more people will want to rent apartments at the lower price, but landlords may not be willing to rent out as many apartments, leading to a shortage.

What is a price floor and how does it impact the market?

A price floor is a government-imposed limit on how low a price can be charged for a product. It is effective only when set above the market equilibrium price. When a price floor is above equilibrium, it leads to a surplus because the quantity supplied exceeds the quantity demanded. A common example is the minimum wage law. If the minimum wage is set above the equilibrium wage, more workers will be willing to work at the higher wage, but employers may not be willing to hire as many workers, leading to a surplus of labor, or unemployment.

What are black markets and how do they relate to price ceilings and price floors?

Black markets are illegal markets where transactions occur outside of government regulations. They often arise when price ceilings or price floors create inefficiencies in the market. For instance, if a price ceiling on rent is set too low, landlords might illegally charge higher rents under the table. Similarly, if a price floor like a high minimum wage leads to unemployment, some workers might accept jobs for less than the legal minimum wage, creating an underground labor market. Black markets emerge as a way to circumvent the restrictions imposed by price controls.

How do price ceilings lead to shortages?

Price ceilings lead to shortages because they set a maximum price below the market equilibrium price. At this lower price, the quantity demanded by consumers increases, while the quantity supplied by producers decreases. This mismatch between high demand and low supply results in a shortage. For example, if the government imposes a rent ceiling below the equilibrium rent, more people will want to rent apartments at the lower price, but fewer landlords will be willing to rent out their properties, leading to a shortage of available apartments.

How do price floors cause surpluses?

Price floors cause surpluses because they set a minimum price above the market equilibrium price. At this higher price, the quantity supplied by producers increases, while the quantity demanded by consumers decreases. This mismatch between high supply and low demand results in a surplus. For example, if the government sets a minimum wage above the equilibrium wage, more workers will be willing to work at the higher wage, but employers will hire fewer workers, leading to a surplus of labor, or unemployment.