[Microeconomics] Price Ceiling

How it works

- A price ceiling is the maximum legal market price set and allowed by the government.
- It is set at Pmax, below the free market equilibrium price P0.
- The market price is not allowed to rise above the maximum legislated price, thus ensuring greater affordability for consumers who previously may not be bale to fford it.

What to consider?

Presence of Shortage

- The fall in price will lead to an increase in QD and decrease in QS, ceteris paribus. This results in a shortage of QSQD units of [good/service].
- The demand for good is relatively price [elastic/inelastic] as [give 1-2 reasons.]
Eg. Medicine; Inelastic; High degree of necessity to patients and it is unlikely that there are close substitutes to medicine as remedies of illnesses.
- The supply is likely to be relatively price [elastic/inelastic] as [give 1-2 reasons.]
Eg. Elastic; Proportion of marginal cost of providing medicine is very small and modern technology is likely to manufacture medicine easily in a short period of time.
- As such, the fall in price will cause a more than proportionate decrease in QS, ceteris paribus.
- This results in a severe shortage of medicine with the implementation of a price ceiling. The government has to assess between the price and degree of shortage. The lower the price ceiling, the larger the shortage.

Black Market

- Given that medicine has a high degree of necessity to those that need them, they are likely to be willing to pay more than the legislated price to obtain the good. This causes a black market to emerge.
- Assuming that black market dealers are able to buy up all the available quantity (QS units) at Price Pmax, and have access to customers who are willing to purchase the medicine at a higher price and are unable to purchase medicine at the legal price, the black market dealers will be able to sell the medicine at price Pb.
- With the emergence of black markets, the government's objective of achieving a fairer distribution of medicine to ensure affordability will not be achieved.

DWL

- Before the implementation of the price ceiling, there is a consumer surplus of Area AP0E0 and producer surplus of Area FE0P0. With the implementation of a price ceiling, consumers enjoy a lower market price but have access to a smaller quantity of medicine. Their consumer surplus increases to Area PmaxBP, while producer surplus decreases to PmaxDF. Society thus incurs a DWL of Area DBE0.

Closure

- According to the law of supply, the fall in price will lead to a fall in QS, ceteris paribus. Given that revenue is a product of price and quantity, the price ceiling will cause a fall in revenue.
- If the fall in revenue results in subnormal profits in the LR and the price ceiling is below LRAC, there will be closure of medicine providers.

No equity

- The price ceiling may not necessarily lead to an equitable outcome. Those who need the medicine most may not be the ones who are first in line to gain access to the medicine.
- For example, firms may prioritize their regular customers in terms of who can obtain their goods first.

Cost of implementation

- The government is likely to conduct rationing through the use of coupons to achieve a more equitable outcome of the price ceiling. This however, is administrative expensive as mean testing will have to be conducted to assess which consumers are likely to be able to purchase the medicine.
- Given that India is a large country and has lack of accessibility in some area, admin costs will be very high.

Opportunity Cost

- While price is lowered, allocation of good is still on a first come first serve basis. This is likely to lead to queues developing or firms adopting waiting lists.
- Consumers incur additional OPP cost of spending more time searching for and waiting for the good or service.

Severity

- The government should consider whether a price ceiling is necessary. If the rising price of medicine is due to a sudden shock in supply which can be rectified in the SR, then there is no need to implement price ceiling. If the SS of medicine can be increased significantly in the LR, there will be a surplus of medicine at the current equilibrium price, putting downward pressure on price. This allays the rising prices.
- The government should consider the proportion of people who affected by the rising price of medicine. If it's a small group of people, they should provide direct subsidy to those who need it, so as to not negatively affect those who do not need price ceiling.
- The government can consider the average income and distribution of income in India. If a majority of Indians have low incomes, medicine may be considered to be unaffordable, hence price ceiling is necessary.