Price controls − maximum price

Introduction

This lesson focuses on the impact of a maximum price on the market for a good or service.  At first glance many of your students may be supportive of a maximum price on certain goods and services.  This is because the benefits of price controls for certain products seem obvious − who wouldn't want to pay less for the goods and services that they purchase?  However, an important lesson which your classes need to take out of the next few pages is that price controls also have disadvantages.  When considering the benefits and costs of price controls your classes must consider the impact on a range of stakeholders as well as the opportunity costs of such a decision.

Enquiry question

The impact of price ceilings on the market for a good or service?  Why do governments provide a maximum price for certain products and not others?

Teacher notes

Lesson time: 70 minutes

Lesson objectives:

Understand why governments impose price ceilings, and describe examples of price ceilings, including food price controls and rent controls.

Illustrate using a diagram the impacts of a price ceiling on market outcomes.

Examine the possible consequences of a price ceiling, including shortages, inefficient resource allocation, welfare impacts, underground parallel markets and non-price rationing mechanisms.

Discuss the consequences of imposing a price ceiling on the stakeholders in a market, including consumers, producers and the government.

Calculate the possible effects of the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue) - HL only.

Teacher notes:

1. Beginning activity, start with the opening question, which you might need to guide your students with.  For the prezi and opening question allow 10 minutes.

2. Processes - technical vocabulary - The students learn the content reading the class handout, which you can print off and handout to your class.  Allow 10 minutes for an original discussion and activity 1.

3. Reinforcement processes - the handout includes 7 reinforcement activities, which will test a range of skills.  The activities focus on markets which are often subject to price controls.  Activity 8 is a HL activity and includes mathematical tasks while there are also a number of video activities suitable for a whole school discussion. (40 minutes)

4. Reflection activity -  link to the assessment - this page contains a relevant paper one style question on this topic, which your students can read and draw a plan for completion.  Time allowed for this activity should be between 10 and 15 minutes.

Beginning activity

1. Draw two demand and supply diagrams on the whiteboard.  Draw the equilibrium price and quantity and then on the first diagram, shade in the area of consumer and producer surplus.  Then on the second draw a maximum price, below the equilibrium price and again draw the consumer and producer surplus.  What do your students notice about the difference between the two diagrams?  Who benefits from the price ceiling?

Price controls

While the free market will generally lead to the most efficient allocation of any product there will be occasions when the market does not necessarily produce the best outcome for either consumers or producers.  In this situation price controls maybe applied by governments.  Price controls come in two types - maximum price controls and minimum price controls.

Watch the following power point presentation which compares both maximum and minimum prices.  Price controls

Key terms:

Price controls - a price intervention applied by governments.  Price controls come in two types - maximum price controls and minimum price controls.

Maximum price / price ceiling - when a government sets a maximum price, below the equilibrium price.  This forms a price ceiling for the good or service.  Firms cannot charge beyond this price and the policy is designed to protect consumers from exploitation.

Shortage - when the market for a good or service is not in equilibrium because demand for the product is greater than supply.

Rent controls - a price ceiling applied to the rental housing market.

 The activities are available as an PDF worksheet at: Maximum price  

Activity 1

The diagram to the right illustrates the market for bread in a middle income nation.  The government decides to place a maximum price on the product.

(a) Illustrate the effect of the price ceiling on the market for bread.

(b) Indicate the size of the bread shortage resulting from the price ceiling.

Qs - Qd

(c) One solution to the shortage is for the government to provide a subsidy for the product.  Illustrate this on your diagram.

(d) What is the opportunity cost of the decision to make a direct payment to the bread companies?

The money that the government allocates for the subsidy will either have to be raised from increased taxes or from cuts to other public services.

(e) Why might a government impose a price ceiling on certain public services e.g. public transport, internet, power or water supplies.

Governments will often use price ceilings in situations where consumers maybe at risk of exploitation from monopoly exploitation.  If firms have monopoly power, they can charge high prices to consumers – much higher than the marginal cost of production. 

Activity 2

Watch the first half of this short video (up to 1.50 minutes) and then complete the activity which follows:

(a) How does a price ceiling effect both producer and consumer surplus?

A price ceiling, placed below the equilibrium price, will reduce producer surplus but potentially increase consumer surplus, though by a smaller quantity than the loss os producer surplus.  This results in a net loss of community surplus and welfare loss.

(b) Why must the price ceiling be drawn below the equilibrium price level?

A price ceiling either on (or below) the equilibrium level will have no function, changing neither equilibrium price or output.

Activity 3: Rental controls

A government wishes to impose rent controls on housing in its capital city. This is an attempt to increase the quantity of low cost housing available for rent.

(a) Illustrate the effect of the maximum rental price on a supply and demand diagram, illustrating the area of shortage, following the rent control.

(b) Outline the impact of the rent controls on the following stakeholders:

i. Home owners who wish to rent out their properties

Homeowners will see rental prices fall reducing their income levels.  It may also dissuade some homeowners from renting out their properties.

ii. Low income tenants

This policy will be popular with low income tenants as they will have greater opportunities to live in the centre of the city, where housing would normally too expensive for them to purchase.

iii. Wealthy tenants wishing to locate a new house in a popular district within the city

Wealthy tenants will face stiffer competition from poorer residents in trying to locate property in the city.  Those that do obtain a premium apartment however will benefit from lower rents.

iv. House builders based in the city

House builders may see a fall in demand for new properties as well as lower demand for new renovations.  This will reduce demand for their services.

Activity 4

(a) Watch the following two short videos and then decide whether rental controls, in areas of high demand for housing are effective or not?  

Firstly, the argument in favour of rent controls:

And now for the alternative view:

(b) Are there other policies that might be effective in improving the affordability of housing in high demand areas?

Regardless of whether a city has rental controls or not, the problem in many cities is a lack of housing overall and space to build more properties limited by the confines of the city.  Local governments could of course build more houses themselves or invest in public transport links so that more people working in the city can afford to live outside of the city and then commute in to work.

Cities where renting a place to live absorbs half of the average salary

Available as a  Prezi at: City housing

Activity 5: Price ceilings for premier events

During the 2012 Olympics tickets to the premium events were heavily over subscribed. This was particularly true for the main athletic events, where tickets were sold on the black market for three or four times their face value. The government response was to impose strict limits on ticket sales, with customers limited to a maximum of two tickets per customer.

(a) Draw a supply and demand diagram for the premier athletic events, illustrating the impact of the maximum 2 ticket per customer policy.

The supply curve should be perfectly inelastic and the demand curve highly inelastic.  The impact of the 2 ticket policy can be shown by a second demand curve, drawn to the left of the original.

(b) Analyse the benefits and costs of the above policy. Who benefits and who loses out from restricting sales to 2 tickets per person?

The main beneficiaries include those sports fans who might not otherwise have obtained a ticket for a premium event.  The main losers from the policy are those sports fans who were unable to purchase as many tickets as they wished.  This would have impacted on families with children for instance.

(c) What other policies could the Olympic organisers have implemented to reduce the excess demand for certain events?

Besides a 2 ticket per customer policy the government could have introduced a first come first serve ticket policy.  Alternatively they could have issued tickets via a raffle system, restricted ticket sales to UK residents only or simply allowed the free market to drive up prices until the equilibrium price was reached.

Activity 6

Watch the following short video and then answer the questions that follow:

(a) Draw a price ceiling on the diagram and illustrate the change in consumer and producer surplus.

(b) Illustrate the size of the deadweight loss as a result of the price ceiling.

(c) Explain why the price ceiling has created deadweight loss.

As the video identifies a price ceiling will reduce the size of the consumer and producer surplus, thus creating a loss to the size of the community surplus.

Activity 7

Watch the following video on the impact of price controls on a macro economy and then decide whether or not price controls can ever be effective in a modern economy?

Activity 8: HL only (linear equations are the old syllabus only)

Demand and supply for bread in a middle income country is represented by the following functions: QS = - 2 + (5P), QD = 23 - (5P)

Price ($)

Demand (million loaves)

Supply (million loaves)

1

18.0

3.0

1.5

15.5

5.5

2

13.0

8.0

2.5

10.5

10.5

3

8.0

13.0

3.5

5.5

15.5

4

3.0

18.0

(a) Complete the table by adding in the missing blank spaces and highlight the equilibrium price.

(b) Illustrate the above information on a demand and supply diagram, using the graph paper included.

(c) The government decides to impose a price ceiling of $ 1.5, on the product, in an attempt to make the good affordable for more households.  Illustrate this on the diagram, indicating the area of shortage and the size of the deadweight loss.

(d) To correct the deadweight loss the government decides to place a subsidy on the good.  Illustrate this on the diagram and calculate the cost of the subsidy.

15.5m x $2 = $ 31 m

(e) Describe the opportunity cost of the government subsidy?

The other areas of public spending that could have benefitted from the $ 31m of additional spending

Activity 9: Link to the assessment

Typical paper one question:

Part (a)

Explain using a diagram how the introduction of a maximum price may impact on the market for food. [10 marks]

Command term: Explain

Meaning explain the consequences (both positive and negative) of a government decision to impose a price ceiling on the market for food.

Key term: price ceiling

Governments may introduce a maximum price in order to make basic food items more affordable for families on low incomes.  Low income households will also see a rise in real incomes and consumption of the product will rise from Qe to Qd.

However, disadvantages of the policy include food shortages, markets operating not at the socially optimum level, an increase in products sold in parallel / unofficial markets and rationing of the good.

Producers will also lose out as their average revenue falls from Pe to Pm.  While many consumers will benefit from the maximum price, providing they can still purchase the product in sufficient quantities.

Part (b)

Using real life examples, evaluate the advantages and disadvantages of a government decision to impose a price ceiling on rental property within a city. [15 marks]

Command term: Evaluate

In this instance the command term means in addition to explaining the consequences of a government decision to impose a price ceiling on rental property but will also consider should they do so?

Key term: price ceiling

Real world examples might be taken from the student's own experience in the city or country where they live.  A comparison should be made between two cities e.g. London which does not operate a rent ceiling and parts of US cities which do.  Alternatively a response might focus on one city, which has a mix of rent controls and free market determined rents as a way of comparing the effectiveness of the policy.

Arguments in support of this policy are that it might protect low income families from excessive profiteering amongst some landlords. City governments may also use the policy as part of a series of measures to attract key workers such as nurses, teachers and other public servants to the city. 

Arguments against this policy include a recognition that the ceiling might create a  shortage of housing, represented on the diagram by Qd - Qs.  The policy also risks the establishment of a parallel market.

In reaching a conclusion responses must consider the impact on a range of different stakeholders - existing tenants, new tenants, landlords, building firms as well as the short-term and long-term consequences of the price control.  Real life examples might include a city with rent controls such as Manhattan or Vienna.

Further reading on this subject can be accessed at:  Uber

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