Price controls are one of the most hotly debated topics in economics. Many people believe that price controls are a good way to balance supply and demand, but price controls have been shown to have many negative effects on the market.
Price controls refer to the setting of a minimum or maximum price for a good or service. These can be binding, meaning they are enforced by the government, or non-binding guidelines that businesses follow because they know that consumers will not pay more for a good or service.
Binding price floors are very common in industries like housing. Governments often put in laws that say that the minimum rent for a apartment is $1000 per month, for example. This limit keeps down supply and demand, only allowing five people to rent an apartment at that price.
Non-binding guidelines like this can also backfire and increase supply and demand at the same time. If businesses know that consumers will not pay less than a certain price for a good or service, then they will produce as many as they can at that level to make profits- which could lead to surplus inventory.
Increase to a new, market-determined price
When the government removes a binding price floor from a market, buyers will pay a new, higher price for the good. This new price is determined by the balance between supply and demand in the market.
If there is a lot of supply and little demand, then the price will drop as sellers try to get rid of their goods. On the other hand, if there is little supply and lots of demand, then the price will increase as buyers have to compete with each other to acquire the good.
A great example of this is oil markets following international sanctions being lifted. Since oil was selling for a low price due to lack of buyers, buyers had no incentive to buy at a lower price than they could get elsewhere. This caused the overall supply to decrease, raising the market price.
Similarly, since there was high demand for oil, suppliers had incentive to raise their prices in order to earn more profits.
Decrease to a new, market-determined price
If a government removes a price floor, the market-determined price will decrease to a new, lower price. This is because the amount buyers are willing to pay will decrease.
For example, if the government removed the minimum wage, then employers would be willing to pay less than the current minimum wage for each hour of work.
The same would be true for markets with binding price ceilings. If the government removed a binding price ceiling, then the quantity demanded would decrease and buyers would pay less than what they were previously forced to pay.
The effect of removing a binding price floor or ceiling is not unanimous among buyers and sellers. Some may benefit, while others may not. Ultimately, however, the removal of a binding price floor or ceiling will result in a new market-determined price.
Run out immediately because of high demand
Fortunately, this has never happened in the real world, but it has happened in a virtual world. In 2013, the biggest item in the online game called Second Life was a rug called The Gnomefather.
It cost 100 Second Life dollars, which at the time was about US $1. That may not sound like much, but it was quite a lot in Second Life where everything is priced in terms of that currency.
The Gnomefather was sold by a vendor who bought it for 100 Second Life dollars and then put it up for sale for 100,000 Second Life dollars. This created what’s called a binding price floor of 100 Second Life dollars.
In 2017, one buyer bought The Gnomefather for 1 Bitcoin, or about US $6,100 at the time. At that point, The Gnomefather’s binding price floor had been removed and its market value had shifted to 1 Bitcoin.
Be uncertain, depending on many factors
When the government removes a binding price floor from a market, the price paid by buyers will be uncertain. This is because prices can fluctuate due to supply and demand, as well as other factors like speculation.
For example, if the government were to remove the minimum wage, then employers could choose to pay any amount they wanted for a worker.
However, in reality, employers tend to pay workers close to the minimum wage because they need enough incentive to work for them.
Too low of a wage would simply cause employees to find another job that pays better, so most employers keep this in mind when deciding how much to pay workers.
Similarly, if the government were to remove rent control laws, then landlords could charge any amount for rent. In reality, landlords tend to keep their rents close to what the market average is for similar apartments due to supply and demand.
Ensure that suppliers do not engage in predatory pricing practices
When the government removes a binding price floor from a market, buyers should be assured that suppliers do not engage in predatory pricing practices.
Predatory pricing is when a seller drops their price to a point where they are not making a profit, or are losing money, with the intention of driving out their competitors and gaining market share.
This is illegal in most cases, and can be very damaging to the business as they may have to cut costs elsewhere to make up for the losses due to low prices.
Since this is an issue that can arise after removing price floors, legislation should ensure that suppliers do not engage in predatory pricing practices. Legislators should also ensure that buyers have protections against sellers dropping prices below cost.
Encourage more competition in the market
If the government removes a binding price floor from a market, then the price paid by buyers will be determined by the equilibrium point of the market.
As we’ve discussed before, this means that the price paid will be what’s necessary to prompt the amount of supply and demand needed to match each other.
More suppliers will decide to offer their product for sale at this price since there is no legal limit on how low they can set their prices. This means there will be more supply than demand, which will push the price down.
Consumers will not pay more than what the item is worth to them, so they will not buy it if it is too expensive for them. This will reduce the demand, which will push the price down further.
Allow buyers and sellers to adjust their strategies and behaviors accordingly
When the government removes a binding price floor from a market, buyers will pay the market-determined price for the good.
However, sellers may have difficulty finding buyers at that price. Sellers may have to find other ways to sell their product, such as selling it at a lower price or offering other incentives.
This is because buyers may think the good is not worth much and try to get it at a low price. Or, they may decide not to buy it at all because they think it is not worth much.
Sellers may also have trouble finding buyers who are willing to pay their asking price. They may have to lower their asking price in order to find a buyer, which makes the problem worse. More and more sellers may have difficulty selling their product at this point.
Maximize consumer welfare
When the government removes a price floor from a market, the price paid by buyers will maximize consumer welfare. This is because the market will return to its natural level of supply and demand, which is what consumers want.
In this situation, sellers cannot ask for more than the market value of their good or service. If they do, no one will buy their good or service at that price. As a result, buyers get the best value out of a price floor removal.
Consumers can be confused by sudden drops in prices, but this is a good thing. It means that people are getting more for their money, and there is more supply to go around. More supply means that there are maybe other options if this one runs out.
However, there may be cases where people are stuck with products that have lost value. There needs to be some education on how to handle this situation in an emergency removal of a price floor.