How price ceiling and price floors work and why they cause a shortage or surplus in the market?

These are buyers and sellers whose interactions in the market decides at what price the demand and supply would meet each other. Price and quantity, at which the supplier fully meets the demanders demand this price and quantity is called equilibrium price and quantity. The next step is to decide either the price in the market always sets according to a simple formula of market equilibrium or not. Actually, in the real market price setting phenomena is flexible, prices are free to rise or fall through its equilibrium position. Sometimes, it happens that things become unfair due to the flexibility of the pricing decisions in the market system. To prevent those unfair actions that are happening either with buyers that they have to pay a large sum of money or with suppliers that they have to sell the goods at such prices that even not cover their production expenses or not create enough income for them. So, the government interferes is important in these matters to protect it from happening. The government actually could set how high or low the prices should be through the price ceiling and price floor.

Price Ceiling: 

The price ceiling is the maximum price the seller could charger for the product. Charging above the ceiling price is not legal and charging below or exact the ceiling price is acceptable. The purpose of this restriction by the government to make some necessities of life available for every person. Like in the case of house rents if the government set some ceiling that owner could not charge above a certain limit it makes it more comfortable for people to afford their own places. 

A price ceiling is always set below the equilibrium price because setting above the ceiling price would of no use. The maximum price that seller sets are up to the equilibrium price because above that demand would decreases and supply would increase and it results in surplus in the market. Therefore, no seller prefers to charge more than the equilibrium price. 

Analyzing through Graphical point of view:

The effect of the price ceiling in the market will be more clear if we understand it graphically. Let’s consider that the demand in the market for hand sanitizer increases rapidly due to COVID-19 so that the demand curve shifts toward right and equilibrium gets settled at the higher price i.e. Rs. 100 per bottle. A rapid increase in price from Rs.30 per bottle to Rs.100 per bottle results in people from a low-income background unable to afford the basic necessity of the time. Due to the prevailing situation, the government decided to impose a price ceiling to make it available for every person and make the fight against this deadly virus easy. As a result of the price ceiling, the seller now could not sell the bottle of hand sanitizer more than Rs. 55. 

The consequence of this price ceiling result is a shortage in the market. This happened because the sellers don’t want to produce more on this price because this price does not cover their production cost fully and their profit decreases. As shown in the graph at the price ceiling the quantity demanded is Qd and the quantity supplied is Qs which is less than quantity demanded Qd. So the price ceiling brings with it the problem of shortage in the market while the government tries to protect the consumer from inflation. 

Price Flooring:

The price flooring is the minimum price the seller could charger for the product. Selling the goods and services below the price floor is not legal but sellers could sell the items above or at the exact same amount. The purpose of this restriction is that when the government found that the free-market system unable to compensate for some group in the market. Like some groups, not earring enough money to make both ends meet. For example, if the price of a bushel of wheat is $4 that results in the low income for farmers so the government sets the price floor at $6 per bushel of wheat. 

A price floor is always set above the equilibrium price because setting below the price floor would of no use. The maximum price that seller sets are up to the equilibrium price because above that demand would decreases and supply would increase and it results in surplus in the market. Therefore, no seller prefers to charge more than the equilibrium price but it results in low revenue and hences the low income for some groups. So to protect those group government sets the price floor above the equilibrium price. 

Analyzing through Graphical point of view:

As the government imposes the price floor at $6 no seller in the market could sell at the market equilibrium price i.e. $4. But the problem with this price floor is that there would be a surplus in the market as shown in the graph below. We can see the quantity demanded Qd is less than the quantity supplied Qs at $6. 

Also Read: How does the market equilibrium change as the supply and demand shifts?