Maximum & Minimum Prices

A-level Economics

how governments intervene

Maximum and minimum pricing (also known as price ceilings and price floors) can be used to intervene in markets which are failing to allocate resources efficiently.  Below, we will examine the effect these have on the market.

Maximum Pricing

A maximum price law (also known as a price ceiling) is a price intervention policy that is used to increase the allocation of resources in a market. The market will therefore be failing in the first place because too little of the good/service is being made.

The government enforces a maximum price which legally prohibits a firm from selling beyond the maximum price. For example, a government could use a maximum price policy in the market for rented housing. The government could issue a maximum price of 40p for a piece of fruit. If a firm is currently selling fruit at 50p per piece, then the firm will legally have to lower its price to the maximum legal level of 40p.

It is important to know that in order for a maximum price to work, it must be set below the current market price.

What are the benefits of maximum pricing?

1. Consumers demand more - if maximum prices are set below the current equilibrium price, the market price will have to fall to a new level. Consumers will likely increase their demand for the good/service.

2. The rules are simple for firms to follow - the policy is law and therefore has to be followed. The maximum price is very clear to the seller.

What are the disadvantages of maximum pricing?

1. Leads to imbalance in the market - maximum pricing will cause demand to outweigh supply. Even though consumers want to buy more at the lower market price, firms do not want to supply more because the price is lower than it used to be.

2. Emergence of black markets - if the maximum pricing laws are extreme enough, it can lead to an increase in black market activity which is costly for society due to the increase in criminal activity. It can cost the government (therefore, the taxpayer) to police.

3. Depends on elasticity - the elasticity of demand/supply can have an effect on the effectiveness of the policy.

4. What is the socially optimal level? - any error in calculating the socially efficient level of output will mean the maximum pricing policy can be wrongly implemented by the government. It may be too low or may not be low enough.

Minimum Pricing

A minimum price law (also known as a price floor) is a price intervention policy that is used to decrease the allocation of resources in a market. The market will therefore be failing in the first place because too much of the good/service is being made. An example of minimum price being enforced is the market for alcohol.

The government enforces a minimum price which legally prohibits a firm from selling below the minimum price. For example, a government could use a minimum price policy in the market for a unit of alcohol in drinks. The government could issue a minimum price of 50p a unit of alcohol. Therefore, if an alcoholic drink had 2 units of alcohol, then the drink would carry a minimum price of £1. This is currently a point of debate in the United Kingdom. The argument for this is that it could discourage and make it more difficult for alcoholics to fund their addiction and cause harm to themselves. The argument against is from the casual drinkers, who consume alcohol to chill out with friends or to drink on special occasions.

It is important to know that in order for a minimum price to work, it must be set above the current market price.

What are the benefits of minimum pricing?

1. Consumers demand less- if minimum prices are set above the current equilibrium price, the market price will have to increase to a new level. Consumers will likely decrease their demand for the good/service.

2. The rules are simple for firms to follow - the policy is law and therefore has to be followed. The minimum price is very clear to the seller.

What are the disadvantages of minimum pricing?

1. Leads to imbalance in the market - minimum pricing will cause supply to outweigh demand. Even though consumers want to buy less at the lower market price, firms are encouraged to want to sell more due to the price being higher.

2. Emergence of black markets - if the minimum pricing laws are extreme enough, it can lead to an increase in black market activity which is costly for society due to the increase in criminal activity. It can cost the government (therefore, the taxpayer) to police. For example, there could be a rise in illegal smuggling into the country and sales of alcohol that are kept off the books.

3. Depends on elasticity - the elasticity of demand/supply can have an effect on the effectiveness of the policy.

4. It won't affect the rich so much - a minimum price and inflated prices is unlikely to deter the richer in society from consuming the product. This might not decrease the consumption of the good/service by as much as desired.

5. What is the socially optimal level? - any error in calculating the socially efficient level of output will mean the minimum pricing policy can be wrongly implemented by the government. It may be too high or may not be high enough.

What have we learned?

1. What is a maximum/minimum price law?

2. When they are used

3. Advantages and disadvantages of the policies

4. Diagrams

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