Government Intervention
We have studied the way markets work under normal conditions. There are times where
government may intervene in the free market which changes the market equilibrium and cause
market disequilibrium. In this chapter we will discuss two types of such conditions which are
price ceilings and price floors. Let us begin with price ceilings.
Price Ceiling or maximum price: A price ceiling occurs when the price is artificially held
below the equilibrium price and is not allowed to rise. Thus maximum price < Pe ; For example,
in many cities, there are rent controls. This means that the maximum rent that can be charged is
set by a governmental agency. This rent is usually allowed to rise a certain percent each year to
keep up with inflation. However, the rent is below the equilibrium rent. Also, from 1973 to
1981, there was a price ceiling for gasoline. There was a maximum price allowed by law. Any
gas station owner charging more than this maximum price would be guilty of fraud. During
World War II, there were price ceilings on most products.
Maximum price: price ceiling
P
S
Pe
maximum
price
shortage
D
O
Qs
Qd
Q
This type of price control leads to shortages because the control price is below the market price
where demand will be more than supply. Total shortages = QCD – QCS.
Government may set a maximum price for reasons of fairness. In wartime, or times of famine,
the government may set maximum prices for basic goods so that poor people can afford to buy
them.
The resulting shortages, however, create further problems. If the government merely sets prices
and does not intervene further, the shortages will lead to the following:

Allocation on a ‘first come, first served’ basis. This is likely to lead to queues developing, or
firms adopting waiting lists. Queues were a common feature of life in the former communist
east European countries where governments kept prices below the level necessary to equate
demand and supply. In the 1990s, as part of their economic reforms, they lifted price
controls; this had the obvious benefit of reducing or eliminating queues. However, the
consequential sharp increase in food prices made life very hard for those on low incomes.

Firms deciding which customers should be allowed to buy: for example, giving preference to
regular customers.

Government may adopt a system of rationing. People could be issued with a set number of
coupons for each item rationed.
Further effects of Price Ceilings
It creates black markets, where customers, unable to buy enough in legal markets, may well be
prepared to pay very high prices: prices above the price ceiling. So, for example, tickets to
popular events are sold by scalpers at high prices.
A gray market is a way of getting around the price ceiling without actually doing anything
illegal. There are two forms of gray market. One form of gray market involves charging for
goods or services that were formerly provided free. If the rent cannot be raised on the apartment,
there is nothing preventing the landlord from charging for the parking space, charging for use of
the elevator, charging for gardening and cleaning services, forcing the tenants to pay for
electricity and water, and so forth. In New York, a rent-controlled apartment near Central Park
might rent for $300 to $400 per month; in a free market, the rent would probably be $2,000 per
month. To get in, one needs the key. This has been known to cost $1,000. This is not a
refundable deposit; this is a charge to have the key. It is obviously worth it to be able to rent the
apartment for $300 to $400 per month. A Berkeley apartment owner converted his apartment
into a church. To be able to live there, one had to pay church dues of $1,200 per year in addition
to the rent. Gasoline stations would commonly charge for washing the windows, checking the
tires, and so forth. The price of oil used in oil changes would be raised. (Those having oil
changes at the station were favored in access to gasoline during the years of the price ceiling. In
these years, Americans had the cleanest engines in history.) Some gas station owners ran the line
to the gasoline pump through the car wash. One San Diego station forced people to have a $7 car
wash to get to the gasoline pump. ($7 in these years is the equivalent of about $20 today.). This
practice was later declared illegal.
The second form of gray market is to provide less service for the same price. The apartment
owner would not repair, clean, paint, nor otherwise maintain the apartment building. Some
people argue that rent controls are one reason for the dilapidated state of many apartments in
New York and for the fact that nearly half of furnaces in New York apartment buildings do not
work. The gasoline companies would lower the octane rating. Unleaded gasoline, which was 91
octane, becomes 89 octane and then 87 octane. (For a while, Texaco even tried 85 octane.) If you
want 91 octane, you must now buy Super Unleaded, and pay $0.30 per gallon extra.
Price Floor or Minimum price The government sets the price floor above the equilibrium price
and stops the price from falling to a certain level. Minimum price > Pe. A minimum price creates
a surplus, since Supply will be more Demand (QS>QD).
Minimum price: price floor
P
S
surplus
minimum
price
Pe
D
O
Qd
Government may do this for many reasons:
Qs
Q

To protect producers’ incomes. If the industry is subject to supply fluctuations (e.g.
fluctuations in weather affecting crops), prices are likely to fluctuate severely. Minimum
prices will prevent the fall in producers’ incomes that would accompany periods of low
prices.

To create a surplus (e.g. of grains) – particularly in periods of glut – which can be stored in
preparation for possible future shortages.

In the case of wages (the price of labour), minimum wage legislation can be used to prevent
workers’ wage rates from falling below a certain level The government can use various
methods to deal with the surpluses associated with minimum prices. The government could
buy the surplus and store it, destroy it or sell it abroad in other markets.


Supply could be artificially lowered by restricting producers to particular quotas.
Demand could be raised by advertising, by finding alternative uses for the good, or by
reducing consumption of substitute goods (e.g. by imposing taxes or quotas on substitutes,
such as imports).