National and local governments sometimes implement price controls, legal minimum or maximum prices for specific goods or services, to attempt managing the economy by direct intervention. Price controls can be price ceilings or 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. The quantity supplied at the market price equals the quantity demanded at that price. So, the government imposition of price controls causes either excess supply or excess demand, since the legal price often differs greatly from the market price. Indeed, the government imposes price controls to solve a problem perceived to be created by the market price. For instance, rent control is imposed to make rent more affordable for tenants. This, of course, leads to new problems, such as a decline in the building of new housing, but governments often do not account for the future. Because politicians serve limited terms, they're more apt to solve current problems and not worry so much about future problems. As they say, politicians like to kick the can down the road, leading to future problems. But preventing future problems does not help politicians get re-elected. Thus, price controls are a political expediency to solve current social problems that will garner support, at least temporarily, for politicians managing the problem, even though price controls are often detrimental to the economy in the long run.
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 price. A price ceiling below the market price creates a shortage causing consumers to compete vigorously for the limited supply, limited because the quantity supplied declines with price.
Likewise, since supply is proportional to price, a price floor creates excess supply if the legal price exceeds 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 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 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: 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, unchanged since July 24, 2009. Other countries, such as France and Britain, have much higher minimum wages.
While the minimum wage increases the income of many workers who have traditionally low-paying jobs, it increases unemployment, since the demand for labor, as is the demand for other things, varies inversely to price. So while the employed earn higher wages, the unemployed earn nothing. Teenagers and minorities are particularly affected. People with specialized skills have a larger market demand, so they are unaffected by minimum wage laws because their pay already exceeds the minimum wage.
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 a 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.
Some Price Controls May Have Some Economic Benefit!
The usual argument against the minimum wage considers only the microeconomic perspective of the law of supply and demand for an employer: minimum wage laws increase unemployment by increasing the price of labor, thereby lowering demand for labor. However, from a macroeconomic perspective, minimum wage laws may actually increase employment! Why?
Because the marginal propensity to consume increases with lower incomes. By increasing wages for low-income workers, they will spend their increased disposable income to live, thus stimulating the economy. Additionally, as increases in technology make each worker more productive, the price of labor becomes a smaller part of the cost of products and services, so a higher minimum wage will only increase market prices minimally, if at all. Hence, the increase in aggregate demand caused by increases in the minimum wage, while minimizing increases in the prices of products and services produced by those laborers through technology, will more than offset any negative microeconomic effect of higher wages. Moreover, according to efficiency wage theory, better-paid workers will work harder and be more productive, thereby increasing output for the business and the economy. And a higher minimum wage will increase the labor participation rate, thereby increasing the total economic wealth of the economy!