Government Intervention: Price Controls & Externalities

Price Ceilings: Market Intervention

A price ceiling is a legal maximum on the price at which a good or service can be sold. It is imposed by the government to prevent prices from rising above a certain level.

Not Binding Price Ceiling

When the government imposes a price ceiling of 4€ per cornet, but the market equilibrium price is 3€, the ceiling has no effect on the market price or the quantity sold. The market naturally operates below the imposed maximum.

Binding Price Ceiling

When the government imposes a price ceiling of 2€ per cornet, and the equilibrium price is 3€, the price ceiling becomes a binding constraint on the market. Supply and demand naturally push the market price towards the equilibrium, but when the price hits the ceiling, it cannot rise further. This typically leads to a shortage where quantity demanded exceeds quantity supplied.

Rent Control: A Case of Price Ceilings

Rent control is a specific type of price ceiling applied to housing markets.

Short-Run Effects of Rent Control

In the short run, both supply and demand for housing tend to be relatively inelastic. The number of people searching for housing in a city may not be highly responsive to immediate changes in rent.

Long-Run Effects of Rent Control

In the long run, supply and demand become more elastic:

• Supply Side: Landlords respond to low rents by not building new housing and by failing to maintain existing properties, reducing the overall supply.
• Demand Side: Low rents encourage more people to seek their own housing and can induce more people to move into the city, increasing demand.

When a price ceiling like rent control is binding, it results in a shortage of the good (quantity demanded exceeds quantity supplied).

Price Floors: Setting Minimum Prices

A price floor is a legal minimum on the price at which a good or service can be sold. It is imposed by the government to prevent prices from falling below a certain level.

Not Binding Price Floor

When the government imposes a price floor of 2€ per cornet, but the equilibrium price is 3€, the floor has no effect. The market naturally operates above the imposed minimum.

Binding Price Floor

When the government imposes a price floor of 4€ per cornet, and the equilibrium price is only 3€, the price floor becomes a binding constraint on the market. Supply and demand tend to move the price towards the equilibrium, but when it hits the floor, it cannot fall further. This typically leads to a surplus where quantity supplied exceeds quantity demanded.

Labour Markets and Minimum Wage

In a free labour market, the wage adjusts to balance labour supply and labour demand. However, government intervention can occur through a minimum wage.

Impact of a Binding Minimum Wage

If the minimum wage is set above the equilibrium wage level, the quantity of labour supplied exceeds the quantity demanded. This situation, where the minimum wage is binding, results in a surplus of labour, which manifests as unemployment.

While a minimum wage can raise the incomes of those who retain their jobs, it simultaneously lowers the incomes of those who cannot find employment due to the reduced demand for labour.

Externalities: Unintended Market Effects

An externality is a cost or benefit that affects a third party who did not choose to incur that cost or benefit. Externalities represent a form of market failure.

Negative Externalities

If the impact on the third party is a cost, it is called a negative externality.

• Example: The operation of a factory may cause environmental pollution (air, water) for nearby residents, but the factory is not directly charged for this societal cost.

Positive Externalities

If the impact on the third party is a benefit, it is called a positive externality.

• Example: A private firm maintaining public parks and green spaces for free, benefiting the entire community.