Study notes

Government Intervention - Maximum Prices

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Other, Pre-U

The government or an industry regulator can set a maximum price to prevent the market price from rising above a certain level.

  • One aim of this might be to prevent the monopolistic exploitation of consumers
  • To be effective, a maximum price has to be set below the free market price.
  • One example might be when shortage of foodstuffs threatens large rises in the free market price.
  • Other examples include rent controls on properties – for example the system of rent controls in Manhattan in the United States.
  • Price capping also happens when the competition authorities judge that consumers are being exploited by businesses using their monopoly power. For example, the EU has introduced price caps for roaming charges on consumers made by the mobile phone service providers
  • A maximum price seeks to control the price – but also involves a normative judgement on behalf of the government about what that price should be.

A price ceiling set above the free market equilibrium price would have no effect whatsoever on the market – because for a price floor to be effective, it must be set below the normal market-clearing price.

Black Markets

A black market (or shadow market) is an illegal market in which the market price is higher than a legally imposed price ceiling. Black markets develop where there is excess demand. Some consumers are prepared to pay higher prices in black markets in order to get the goods or services they want.

With a shortage, higher prices are a rationing device.

Good examples of black markets include tickets for major sporting events, rock concerts and black markets for children's toys and designer products that are in scarce supply.

There is also evidence of black markets in the illegal distribution and sale of computer software products where pirated copies can often dwarf sales of legally produced software.

Rationing when there is a market shortage

Rationing when there is a maximum price might also be achieved by allocating the good on a 'first come, first served' basis – e.g. queues of consumers. Suppliers might also allocate the scarce goods by distributing only to preferred customers. Both of these ways of rationing goods might be considered as inequitable (unfair) – because it is likely that eventually those who might have the greatest need for a commodity are unlikely to have their needs met.

Another problem arising from the maintenance of a maximum price is that in the long run, suppliers might respond to a maximum price by reducing their supply – the supply curve becomes more elastic in the long term. This is illustrated in the next diagram which looks at the effect of a maximum price for rented properties.

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