TheStreet

What Is a Price Ceiling?

A price ceiling is an accounting term, with different variations and meaning, that fixes the highest price a company or individual can charge for a product or service. Price controls are designated by government regulators, theoretically in order to shield consumers from fast and substantial prices.

The term sets out to establish fair business practices, and makes it difficult for sellers to engage in price-gouging against buyers. Historically, price ceilings are established in times of great economic calamity, like depressions, wars, and natural disasters.

When demand for bread rose dramatically in ancient Rome, Emperor Diocletian issued a price ceiling on bread and declared the offense punishable by death. When bread makers started getting out of the business in fear of getting ensnared in a price control issue with the Roman government, Diocletian had to repeal his price decree, as few people were selling bread.

Fast forward to the 20th century, in the aftermath of Pearl Harbor. After the U.S. declared war against Germany and Japan in 1941, the Roosevelt administration imposed prices controls on various industries, like agriculture, steel and oil, to support the U.S. effort in World War II.

State governments tried the same approach after Hurricane Sandy devastated much of the U.S. Northeast in 2012. Both New York and New Jersey imposed price controls to prevent price gouging, leading to shortages of much-needed supplies like water and gasoline.

Another example of price ceilings is rent control. Here, cities impose maximum limits on the price landlords owners can charge for rent - New York City has issued rent control and rent stabilization edicts for years.

In addition to price controls, governments can also set price floors, as well.

While price controls set maximum prices businesses can charge, price floors establish the lowest price a business can charge for a product or a service. While price ceilings are often linked to product shortages, price floors go the other way, often creating a surplus of goods if the price is set at a point where consumers can't afford to buy a product.

Even though price ceilings have been around for centuries, many economists doubt their effectiveness. Let's take a closer look at price ceilings and see where they fit, good or bad, in today's economy.

Digging into Price Ceilings

In the effort by a government to set price ceilings and try to keep business practices on the level, not everyone is on board with the notion that price controls are a good idea.

In fact, some economists say that price ceilings do more harm than good.

For example, back in 1973, in the midst of the Arab oil embargo, the government imposed price ceilings on gasoline, which helped hurt supply, as more and more Americans lined up to buy cheaper gasoline, which led to a nationwide gasoline shortage. The edict wound up hurting and not helping consumers looking to fuel their vehicles and heat their homes.

Economists point out that if government regulators had left prices where they stood, and didn't enact price controls, consumers would have likely been forced to conserve oil and gasoline instead of lining up to purchase cheap gasoline.

What happens when government stays out of the pricing equation?

Consider New Orleans and the Mississippi delta - areas decimated by Hurricane Katrina in 2005. Contractors were in high demand in the immediate aftermath of the hurricane, and those contractors placed a high demand for wood, plastic sheeting, nails, and other goods used for rebuilding.

While regulators kept a sharp eye on construction-related equipment, they did not impose price controls on things like plywood on nails.

That decision worked out for the area, as companies selling much-needed tools and lumber, among other construction supplies, were able to sell those products on the open market, and didn't pack up and go away over serious price controls on their goods.

Four Potential Outcomes of Price Ceiling Mandates

Price ceilings face limitations in other ways, as well. Let's examine a few ways where pricing controls can lead to outcomes not expected by government regulators.

  • An artificial imbalance. Price controls can upset the natural balance between supply and demand. In fact, pricing controls often lead directly to a reduction in supply of a particular product, leaving the market for such products dried up. This decline in a product's supply, in turn, leads to an imbalance between supply and demand which could lead to regulators stepping back from raising the maximum price of a product, to swing the supply and demand equation back into proper balance.
  • An unintentional black market. One other unintentional, but all-too real outcome from price controls is the emergence of black markets, where products are sold in the shadows for more money than regulators have mandated. (Again, that's what can happen when supply is diluted by the implementation of price controls.) Once a vendor or seller discovers there's a market for a good or service that pays higher than the mandated price control, that seller is more likely to avoid the price controls established and move over into the shadows and sell their product for a price that's higher than the one cited in the price control edict.
  • An end run around price. Sellers dealing with price ceilings may also make an "end run" around the edict by adding separate fees to the purchase price of their product, which boosts the price, stays in the technical parameters of the price ceiling edict, and puts more money in the seller's pocket - all against the wishes of government regulators. Sellers who go the "additional fee" route often charge specific fees (think of an administrative fee, a delivery fee, or a handling fee, for example.) In their minds, the seller believes he or she is operating safely within the lanes mandated by regulators, but still turning a good profit through the addition of fees.
  • Lower quality. If you take away profit potential from sellers, they may also respond by diminishing the quality of their product. For example, a blue jeans manufacturer may turn to cheaper material to keep prices down, or landlords may decide an apartment doesn't need a dishwasher, microwave, or Wi-Fi when ordinarily they would include those perks in an unencumbered pricing market.

More Problems Than Solutions?

While implemented with the best of intentions, price ceilings wind up doing more harm than good when applied in real-world scenarios.

Product sellers invariably will respond to price ceilings by reducing quality, shifting to black markets, or slapping separate fees and charges to their goods and services - all to avoid complying with they consider an unfair and intrusive government regulatory edict.

That's not the outcome intended by regulators, but it's one that invariably occurs when governments step in with price ceilings in markets better run when supply and demand are in optimal equilibrium.