National and local governments sometimes implement price controls, which are legal minimum or maximum prices for specific goods or services, in an attempt to manage the economy by direct intervention. There are 2 types of price controls: price ceilings and price floors. A price ceiling is the legal maximum price for a good or service, while a price floor is the legal minimum price. Although both a price ceiling and a price floor can be imposed, the government usually only selects either a ceiling or a floor for particular goods or services.
When prices are established by a free market, then there is a balance between supply and demand. When the government imposes price controls, then there will be either excess supply or excess demand, since the legal price is often very different from the market price. Indeed, the government imposes price controls for the very reason that it is not satisfied with the market price.
A price ceiling creates a shortage when the legal price is below the market equilibrium price, but has no effect on the quantity supplied if the legal price is above the market equilibrium price. A price ceiling below the market equilibrium price creates a shortage that causes consumers to compete vigorously for the limited supply. Supply is limited because suppliers are not getting the prices that would allow them to earn a profit.
Likewise, since supply is proportional to price, a price floor creates excess supply if the legal price is above the market price. Suppliers are willing to supply more at the price floor than the market wants at that price.
Example of a Price Ceiling: Rent Control
Rent control is a common type of price ceiling that large municipalities, such as New York City, often impose to make housing more affordable for low-income tenants. Over the short run, the supply for apartments is inelastic, since the quantity of buildings already supplied is constant, and those that are being constructed will continue to be constructed because of sunk costs.
Over the long-run however, rent control decreases the availability of apartments, since suppliers do not wish to spend money to build more apartments when they cannot charge a profitable rent. Landlords not only do not build any more apartments, but they also do not maintain the ones that they have, not only to save costs, but also because they do not have to worry about market demand, since there is excessive demand for rent-controlled apartments. Hence, excess demand and limited supply leads to a large shortage.
Example of A Price Floor: the Minimum Wage
Minimum wage laws require employers to pay all employees at least the minimum wage. First enacted during the Great Depression in 1938, under the Fair Labor Standards Act, the purpose was to ensure workers a minimum standard of living. Currently, the minimum wage is $7.25 an hour in the United States. Other countries, such as France and Britain, have much higher minimums wages.
While the minimum wage increases the income of many workers who have jobs that are traditionally low-paying, it increases unemployment, since the demand for labor, as is the demand for other things, is inversely related to price. So while the employed are earning higher wages, the unemployed are earning nothing. Teenagers and minorities are particularly affected. People who have specialized skills with a large market demand are unaffected by the minimum wage laws because they are already earning higher pay.
Sometimes governments use wage subsidies, such as the earned income tax credit in the United States, for people whose earnings are considered inadequate for even a bare living, to improve their standard of living.
Since the minimum wage lowers demand by increasing the cost of labor, it is obvious that unions have the same effect. However, union jobs pay much more than the minimum wage, so employers compensate by not hiring as many workers. Indeed, considering the lofty pay and benefits that public employees in the United States are receiving nowadays, there is tremendous pressure by taxpayers to greatly reduce the number of state workers, to offset the higher cost of their labor.