A price ceiling is a government-imposed limit on how high a price can be charged on a product. For a price ceiling to be effective, it must differ from the free market price. In the graph at right, the supply and demand curves intersect to determine the free-market quantity and price.
A price ceiling can be set above or below the free-market equilibrium price. In the graph at right, the dashed line represents a price ceiling set above the free-market price, called a non-binding price ceiling. In this case, the ceiling has no practical effect. The government has mandated a maximum price, but the market price is established well below that.
In contrast, the solid green line is a price ceiling set below the free-market price, called a binding price-ceiling. In this case, the price ceiling has a measurable impact on the market.
A price ceiling set below the free-market price has several effects. Suppliers find they can no longer charge what they had been charging for their products. As a result, some suppliers drop out of the market. This represents a reduction in the quantity supplied. Meanwhile, demanders find that they can now buy the same product at a lower price. As a result quantity demanded increases.
As a result of these two actions, quantity demanded exceeds quantity supplied and a shortage emerges. This leads to various forms of non-price competition.
Price ceilings are often intended to protect consumers from certain conditions that could make necessities unattainable. But they can also cause problems if they are used for a prolonged period of time without controlled rationing. A good example is rent control in New York City (rent control is a price ceiling on rent). When soldiers were coming back from World War II and starting families (causing a large demand for apartments), but stopped receiving pay (there was no longer a war), many could not deal with the jumping rent. The government put in price controls, so the soldiers and their families were able to pay their rent and keep their homes. However, this increased the demand for apartments and lowered the supply, meaning that all available apartments were rapidly taken, until there were none left for any late-comers.
Producer Surplus is the difference between the price for which a producer would be willing to provide a good or service and the actual price at which the good or service is sold.
Consumer Surplus is the amount that consumers benefit by being able to purchase a product for a price that is less than they would be willing to pay.
Students may often incorrectly attribute a price ceiling as being on top of a supply and demand curve when in fact, an effective price floor is positioned at the top of a supply and demand graph.
N. Gregory Mankiw, Principles of Economics