Test Your Understanding 4.

1: Price Ceilings
1. Define a price ceiling and, providing examples, outline some reasons why governments
impose them.
Price ceilings refer to a maximum price set by governments on goods or services. This means that
sellers cannot charge a price higher than this price ceiling. The primary reason governments impose
price ceilings is to provide certain consumers, that are only willing and able to buy the good/service
at a lower price, with the ability to interact with the market.

2. Using a diagram, explain why price controls lead to disequilibrium market outcomes.

3. Draw a diagram illustrating a price ceiling, and analyse its effects on market outcomes
(price, quantity demanded, quantity supplied, market disequilibrium) and consequences
for the economy (shortages, non-price rationing, allocative inefficiency, welfare loss)
A price ceiling limits a price at Pc as opposed to Pe. As a result, quantity demanded increases from
Qe to Qd. This is because more consumers will be able to access the good at a lower price. However,
quantity supplied decreases from Qe to Qs. This is because producers make less revenue as a result
of the price drop from Pe to Pc, and the drop in supply from Qe to Qs. This therefore results in
excess demand, meaning a shortage is created. Overall, this is representative of market
disequilibrium, as the price mechanism (price is determined by supply and demand) is unable to
function properly as a result of government intervention. This is also representative of allocative
inefficiency, as the under allocation of resources results in the shortage. Additionally, we can see the
loss graphically through areas c and e, indicating welfare or deadweight loss. To combat this, non-
price rationing mechanisms have to be used. Non-price rationing mechanisms attempt to solve the
problem of how to distribute limited supply given a shortage. For example, queueing is an example
of a non-price rationing mechanism as it meets demand based on a first-come-first-served basis as
opposed to using price

4. a) Explain the difference between price rationing and non-price rationing.

b) Describe the circumstances under which non-price rationing arises.

c) Identify some forms of non-price rationing.

d) Outline why underground markets are a form of price rationing.

5. a) Draw a diagram showing producer and consumer surplus in a free market

competitive equilibrium.

b) Assuming a price ceiling is imposed in this market, draw a new diagram showing the
new consumer surplus, producer surplus and welfare loss.

c) Comparing your diagrams for parts (a) and (b), what can you conclude about consumer
surplus, producer surplus and welfare loss?

d) Describe the relationship between marginal benefits and marginal costs at the new
equilibrium. Outline what this reveals about allocative efficiency (or inefficiency).

6. Examine the consequences of price ceilings for different stakeholders in the case of:
a) rent controls, and

b) food price controls.