Price ceiling (also known as price cap) is an upper limit imposed by government or another statutory body on the price of a product or a service. A price ceiling legally prohibits sellers from charging a price higher than the upper limit.
A price ceiling is typically below equilibrium market price in which case it is known as binding price ceiling because it restricts price below equilibrium point. Binding price ceilings interrupt natural market equilibrium forces. Rarely, a price ceiling may be above market price in which case it is called non-binding price ceiling because it does not affect market equilibrium.
When price ceiling is below equilibrium market price, the quantity supplied by producers is below the equilibrium quantity, as governed by law of supply. But the quantity demanded by consumers is above the equilibrium quantity, as governed by law of demand. This results in excess of quantity demanded over quantity supplied thus creating shortage in the market.
Advantages and Disadvantages
Price ceilings increase the affordability of goods and services that are basic necessities allowing low-income consumers to fulfil their needs. Price ceilings allow a government to counter practices such as price collusion in which suppliers charge outrageously high prices.
One of the arguments against setting price ceilings is that the shortage created by price ceilings actually makes it difficult to find and purchase sufficient quantities of the product or service. Price ceilings reduce economy's output by discouraging suppliers thus reduces economy's growth rate.
Examples of price ceiling include price limits on gasoline, rents, insurance premium etc. in various countries.
Consider a hypothetical market the supply and demand schedules of which are given below:
In absence of any price ceiling, the equilibrium price is $3 per unit at a point where quantity supplied and quantity demand matches. When a price cap of $2 is enforced, the producers reduce the quantity supplied to 133 units but consumers increase the quantity demanded to 280 units. This results in a shortage of 147 units [=280–133] in the market as shown in the following chart. The price ceiling is represented by the red line in the chart.