Price ceiling

A regulation that prohibits the payment for a good or service that is higher than an alloted price. Similar to price floors, it is used by government and other governing bodies.

The alloted price must be below the equilibrium price as otherwise, it would not cause an effect on the markets in question. What this causes is a shortage in the good or service and creates inefficiency. It does it in two ways:
1) Through search activity
2) Deadweight Loss

1) Due to a shortage, people will be spending their time and resources looking for the good or service. For example, if there is a shortage for quality housing, people will be using their resources like gas, and time to look for housing. In turn, the opportunity cost increases by this time factor and other resource factors. This creates a loss of consumer surplus and producer surplus.

2) Since the set point is below the equilibrium price, there is an inefficiency in the market as the demand is much higher than the supply, there is a shortage. This creates a situation where there is a deadweight loss which in turn, like search activity, generates a loss in both consumer surplus and producer surplus.

Economics, like everything else, is a balancing act. Outside of the mechanical forces of supply and demand, human motivations and actions will affect the market. These must also be balanced with each other.

A basic force built into most corporations today is the necessity to maximize short-term profit at the expense of long-term financial health. If an executive's quarterly balance sheet doesn't please stockholders, bonuses will be cut back, or people will be passed over for promotion, or people will be fired.

Some goods and services are necessities to consumers; if their price increases, they will cut back on the consumption of other goods and services that may not be immediately necessary, but make their lives more efficient.

Producers have the power to cut back production at any time and create an artificial shortage. The 'equlibrium point' for the product's price will increase to meet the shortage if the need for the good is great enough, but since the producer's costs are the same, any price increase is pure profit. Any market inefficiency comes at the expense of the consumer, and any deadweight loss at the expense of consumers and other producers.

In the long term, of course, the producer may lose. But the market does not act immediately, and by the time the balance comes due, the executive will have his or her bonus, and may even have left the company for greener pastures.

In such cases, it may be prudent for a government to step in and set a price ceiling, in order to force the producer's unit profit down, and induce the producer to increase production to a reasonable level. Sometimes, more punitive measures may be called for. Other times, a price ceiling may be the worst possible action.

Any conclusion that a government-induced price ceiling will create market inefficiency is founded on a basic assumption, that a shortage in the supply of a good or service is created by the market, and not by a producer manipulating the market. This assumption is founded on a further assumption, that producers always act in good faith, that their profit always contributes to market efficiency. This is often a bad assumption.