What it is:
A price ceiling is the maximum price a seller can legally charge a buyer for a good or service. Regulators usually set price ceilings.
How it works (Example):
Price ceilings typically have four tenets:
1. The regulator (such as a local government) establishes the maximum acceptable prices for the service. The regulated company can sell its services at any price that is equal to or below the ceiling. The regulator may also set a price floor to discourage anticompetitive pricing, and it might require companies to refund excess profits.
2. The regulator may group services into baskets and set an overall price ceiling for them, or it might set a ceiling for each individual service. When the regulator caps prices for a basket, the producer might be able to raise the price of one item in the basket as long as it adjusts the prices of the other items in the basket to make the weighted average price equal or fall below the ceiling.
3. The regulator may adjust a ceiling based on changes in industry prices or productivity.
4. The regulator periodically reviews the price cap system. It may change the ceiling formula or review the profit conditions of a firm.
An example is a price ceiling on apartment rents, which some cities impose on landlords. Let's say Gotham City sets a price ceiling of $1,000 for a one bedroom apartment, where landlords cannot legally charge higher than that rate. But depending on the market demand for apartments, this price ceiling could hinder supply and create inefficiencies and shortages in the market.
Let's say Gotham becomes popular causing the demand for apartments in that area to skyrocket and the "natural" market price (if there wasn't a price ceiling) reaches $1,500. The demand would be so high that all of the landlord's apartments and the neighboring apartments would be rented out along with other apartments in the city for a bargain price of $1,000 each.
But there would be two tragedies caused by the price ceiling: 1.) There would be an apartment shortage because all the existing apartments would be rented out- leaving a lot of people without the ability to rent apartments in Gotham, and 2.) The landlords could have made $500 more dollars on each of those apartments – an inefficient "waste" of market demand. The landlords also have no incentive to make their apartments nicer than they currently are because they already know the apartments will sell out with the high demand and the limiting price ceiling.
Why it Matters:
The intended goal of price ceilings is to protect consumers from rapid price increases and price gouging. But its good intentions come with unintended consequences (as shown in the example earlier) of supply shortages and market inefficiencies.
Price ceilings also don't work if the natural market-clearing price is below the ceiling (for example, a $75,000 price ceiling for cars when most cars sell for $20,000). They can also force sellers to create unregulated black markets and high-priced required add-ons.
From a financial perspective, price ceilings can often send mixed messages to managers, because it also weakens the relationship between costs and prices. For example, a firm might be able to keep any profits obtained via cost reductions relative to the price ceiling, in theory increasing the firm's efficiency. Alternatively, if regulators allow producers to raise prices parallel to increases in production prices, companies have no incentive to improve the quality of service or cut costs.