Maximum prices or similar forms of price controls are certainly topical once again! Until recently, housing rent controls were just about the only applied example of price capping in markets that made it into exam questions. But now we see instances of possible price ceilings in energy, telecommunications and calls for wage caps in the labour market. Once again, start with the basic analysis of where a maximum price must be set to have an impact on the market. Then analyse with reference to elasticity of demand and supply. Look to be able to critically evaluate price controls as a form of intervention – which stakeholders gain and which lose out? Are there better alternative policies?
3. Maximum Prices / Price Caps – Some Topical Issues
Housing Rent
Controls
Energy Price Caps
to control fuel bills
Caps on CEO Pay
/Bonuses
Cap on Mobile
Roaming Charges
Price capping for
water companies
Cap on interest
rates charged by
pay-day lenders
Cap on annual
charges to pension
plans
Currency peg e.g.
Hong Kong / US
dollar
The government or an industry regulator can set a maximum price
to prevent the market price from rising above a certain level
4. Maximum Price Analysis Diagram
Quantity supplied
P1
Q1
A maximum price must be set below the normal free market
equilibrium price to have any effect on price and output
Market
Demand
Max Price
Q2
Price
Q3
Market
Supply
Max Price (price ceiling)
Free Market
Equilibrium
An alternative to a
maximum rent is a rent
subsidy for housing which
is the equivalent of an
increase in income
5. Maximum Price Analysis – “Black Market” Prices
Quantity supplied
P1
Q1
If quantity is restricted to Q3, then some consumers will be
willing to pay a higher “unofficial price” at P2
Producers can extract extra consumer surplus at higher price
Market
Demand
Max Price
Q2
Price
Q3
Max Price
P2
Market
Supply
Extracted
consumer
surplus above
the official
price ceiling
Possible unofficial
price above the ceiling
Some
rationing or
auction
process may
be needed if
output = Q3
6. Applied Micro: Plans for an Energy Price Cap
Output
P1
Q1
D
Max
Price
Price
of gas
Q3
S
In 2013, Labour Leader Ed Milliband, announced that he would
consider capping fuel prices if elected into Government in 2015
• Milliband argues that rising fuel
prices benefit only the privately-
owned firms that sell the fuel.
• These firms benefit unfairly
because there is limited
competition in the fuel
generation and retail markets.
• Because demand for fuel is price
inelastic, an increase in fuel bills
reduces people’s real
purchasing power
• The main case for the energy
price cap proposal is to increase
fairness for families on low
incomes
Opponents of an
price cap argue
that competition
is a better long
term strategy
7. Evaluating Price Caps in Different Markets
A maximum price also involves a normative judgement on behalf of
the government about what that price should be
Benefits
• A useful surrogate
for competition
• Holds prices down
– consumer
welfare gains
• Incentives for
businesses to cut
costs to maintain
profits
Downsides
• Reduces profits –
less money for
capital investment
• May dissuade new
entrants
• Firms might raise
prices in other
ways
Alternatives
• Measures to
reduce entry
barriers in an
industry
• Higher taxes on
monopoly profits
e.g. a windfall tax
8. Get help from fellow
students, teachers and
tutor2u on Twitter:
@tutor2u_econ
Maximum prices or similar forms of price controls are certainly topical once again! Until recently, housing rent controls were just about the only applied example of price capping in markets that made it into exam questions. But now we see instances of possible price ceilings in energy, telecommunications and calls for wage caps in the labour market. Once again, start with the basic analysis of where a maximum price must be set to have an impact on the market. Then analyse with reference to elasticity of demand and supply. Look to be able to critically evaluate price controls as a form of intervention – which stakeholders gain and which lose out? Are there better alternative policies?