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To this point, we have assumed that competitive markets are allowed to operate freely, without any government intervention. Economists refer to freely functioning markets as laissez-faire, a French term meaning “let it be.” The justification for this type of economic policy is that when competitive markets are left to determine equilibrium price and output, they clear. This means that businesses provide consumers with the quantity of goods they want to purchase at the established prices; there are no shortages or surpluses. Consumer and producer surplus together, or total surplus, is maximized.

However, as we saw at the end of the previous section, sometimes freely functioning markets fail to achieve the optimal quantity of goods and services. An example of this is when many people consider the equilibrium price to be unfair. Because of these economic (efficiency) or political (equity) reasons, governments will sometimes intervene in the market by setting limits on the prices of various goods and services. Governments use price ceilings and price floors to keep prices below or above market equilibrium. What really happens when government sets prices below or above market equilibrium? The previous section hinted at the answer. Let’s look at price ceilings and floors more closely.

When the government sets a price ceiling, it is legally mandating the maximum price that can be charged for a product or service. This is a legal maximum; regardless of market forces, price cannot exceed this level. An historical example of a price ceiling is the establishment of rent-controlled apartments in New York City during World War II, some of which still exist today. However, more common examples of price ceilings include limits on what insurance companies can charge customers, price caps on telecommunications and electric services to customers in rural or remote locations, and limits on tuition hikes at public universities.

Panel A in Figure 5 shows an effective price ceiling, or one in which the ceiling price is set below the equilibrium price. In this case, equilibrium price is P_e, but the government has set a price ceiling at P_c. Quantity supplied at the ceiling price is Q₁, whereas consumers want Q₂; therefore, the result is a shortage of Q₂ – Q₁ units of the product. As we saw in the previous section, setting a price below equilibrium alters consumer and producer surplus and results in a deadweight loss indicated by the shaded area. If the price ceiling is raised toward equilibrium, the shortage is reduced along with the deadweight loss. If the price ceiling is set above P_e (as shown in panel B), the market simply settles at P_e, and the price ceiling has no impact; it is nonbinding, and no deadweight loss occurs. A price ceiling can also become nonbinding if market factors cause supply to increase or demand to fall, pushing the equilibrium price below the ceiling.

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A common mistake when analyzing the effect of price ceilings is assuming that effective price ceilings appear above the market equilibrium, because the word “ceiling” refers to something above you. Instead, think of ceilings as something that keep you from moving higher. Suppose you build a makeshift skateboarding ramp in your apartment hallway, and tempt your friends to test it out. If the ceiling is too low, some of your friends might end up with a severe headache. In other words, an effective (binding) ceiling is one that is kept lower than normal. If the ceiling can be raised by 5 feet, then all of your friends would achieve their jumps without bumping their heads. In sum, price ceilings have their strongest effects when kept very low; as the ceiling is raised, the effect of the policy diminishes, and the ceiling becomes nonbinding once the equilibrium price is reached.

Given the price ceiling, one might argue that although shortages might exist, at least prices will be kept lower and therefore more “fair.” The question is, fairer to whom? Suppose your university places a new price ceiling on the rents of all existing apartments located on campus, one that is below the rents of similar apartments off campus. This might sound like a great idea, but often what sounds like a great idea comes with costs.

A price ceiling increases the quantity demanded for on-campus apartments, and without an increase in supply, a shortage results. Those lucky enough to obtain an on-campus apartment benefit from the lower rents. But what about those who couldn’t? Because some students who really could have benefited from lower rents (those with lower incomes or without cars) cannot find an on-campus apartment, while other students who could have easily afforded a higher-priced off-campus apartment managed to snatch one up, a misallocation of resources is created. Further, when on-campus apartments do open up, students eager to obtain one might spend a lot of time and resources trying. These resources (an opportunity cost) end up offsetting some or all of the savings from finding an on-campus apartment.

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Besides the misallocation of resources and potential opportunity costs of long waits and search costs, price ceilings also lead to some unintended long-term consequences. For example, if a landlord owns some apartments on campus (where rents are controlled) and some apartments off campus (where rents are higher), on which apartments is she likely to spend more money for upgrades and/or maintenance? The quality of goods and services subjected to price ceilings tends to deteriorate over time, as the incentives shift toward products with higher prices. Further, when it comes time to invest in new apartments, where do you think they are likely to be built—on campus or off?

The key point to remember here is that price ceilings are intended to keep the price of a product below its market or equilibrium level. When this happens, consumer surplus increases for those able to purchase the good, while producer surplus falls. The ultimate effect of a price ceiling, however, is that the quantity of the product demanded exceeds the quantity supplied, thereby producing a shortage of the product in the market. When shortages occur, deadweight losses are created because some mutually beneficial transactions do not take place, causing a reduction in total surplus.

A price floor is a government-mandated minimum price that can be charged for a product or service. Regardless of market forces, product price cannot legally fall below this level.

Figure 6 shows the economic impact of a price floor. In panel A, the price floor, P_f, is set above equilibrium, P_e, resulting in a surplus of Q₂ – Q₁ units. At price P_f, businesses want to supply more of the product (Q₂) than consumers are willing to buy (Q₁), thus generating a surplus. Depending on the government policy in place with the price floor, producers may end up having to store the excess supply if only Q₁ is transacted in the market, or in some cases the government may buy the surplus goods. Either way, inefficiency is created in the market. However, if the price floor is set below equilibrium (as shown in panel B), the equilibrium price, P_e, will prevail in the market. Therefore, a price floor set below P_e has no impact on the market and no deadweight loss occurs. Likewise, a price floor can become nonbinding if market factors push the equilibrium price above the price floor.

Throughout much of the past century, the U.S. government has used agricultural price supports (price floors) in order to smooth out the income of farmers, which often fluctuates due to wide annual variations in crop prices. This approach is not limited to the United States. Many developed countries, including members of the European Union and Japan, have long protected their agriculture industries by ensuring a minimum price level for many types of crops.

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These price supports act very much as they are intended. By ensuring a minimum price for a crop, farmers have an incentive to grow more of these crops relative to crops that aren’t protected by price supports. Further, because the price supports typically are above market equilibrium prices, resulting in higher prices for consumers, demand for such crops is less than what it would be without the supports.

Thus, with greater supply and smaller demand, price supports lead to surpluses of crops. What happens to these surpluses? Because the government guarantees the price levels of the crops, it must purchase the excess supply, which is typically stored for use in the event of future shortages. But agricultural surpluses eventually rot, which means government must find other ways to use the surplus before it goes bad. One common use of surplus foods is in public school lunches, leading to some criticism that the types of foods being provided (wheat, grains, and corn) are not the most nutritious foods for children to eat.

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Another criticism of agricultural price supports comes from developing countries that depend on agricultural exports for their economic output. These countries claim that price supports hamper their economic development by preventing them from selling goods in which they have a comparative advantage. In other words, agricultural price supports restrict gains from trade.

Despite their questionable economic justification, political pressures have ensured that agricultural price supports and related programs still command a sizable amount of the discretionary domestic federal budget.

Price floors are also used to analyze minimum wage policy. To the extent that the minimum wage is set above the equilibrium wage, unemployment—a surplus of labor—may result if jobs go uncreated when employers are forced to pay the higher minimum wage. However, the minimum wage offers a potential positive effect of reducing income inequality by raising earnings among low-wage workers. This effect is stronger if increasing the minimum wage subsequently leads to higher wages for workers who are already earning slightly more than the minimum wage.

In sum, price ceilings and price floors often are policies aimed at promoting equity or fairness in a society, such as preventing rapid price increases for consumers or ensuring fair wages for workers. Still, governments must be careful when setting price ceilings and price floors to avoid meddling with markets.