Maximum and minimum prices

Overview

Whether a cap on domestic energy prices protects households effectively.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   The market rent for a one-bedroom flat in a city clears at £900 a month with 20,000 flats let. Draw and describe in words the effect of a legal maximum rent of £700 a month.

   Model answer

   Put rent in £ per month on the vertical axis and the number of flats per period on the horizontal. Demand slopes down, supply slopes up and they cross at £900 and 20,000 flats. The maximum price is a horizontal line drawn at £700, below the market-clearing rent. At £700, quantity supplied contracts back along the supply curve to 17,000 flats and quantity demanded extends along the demand curve to 24,000. The horizontal distance between the two curves at £700 is excess demand of 7,000 flats: a shortage. Only 17,000 flats are actually let, so 3,000 fewer households are housed than before.

2. 2

   A rent cap of £700 a month cuts quantity supplied to 17,000 flats and raises quantity demanded to 24,000. Calculate the shortage and state how many households lose a flat compared with the free market.

   Model answer

   The shortage is quantity demanded minus quantity supplied, which is 24,000 minus 17,000, giving 7,000 flats. Compared with the free market, where 20,000 flats were let at £900, the number actually let falls to 17,000, so 3,000 households that previously had a flat no longer do. The 17,000 who keep a flat pay £200 a month less than before. The policy therefore redistributes towards the sitting tenants who remain and away from landlords and from the households pushed out of the market altogether.

3. 3

   Why does a maximum price set above the current equilibrium price have no effect on a market?

   Model answer

   A maximum price is a legal ceiling, meaning the price may not go above it. If the ceiling is above the market-clearing price, the price the market would have chosen is already legal, so nothing prevents it. Supply and demand still cross below the ceiling, quantity traded is unchanged and no shortage appears. The line drawn on the diagram simply sits above the equilibrium point and never binds. A ceiling changes a market only when it is set below the equilibrium price, which is why such a control is described as binding.

4. 4

   Beyond the shortage itself, what consequences follow from a binding maximum price?

   Model answer

   Because price can no longer ration the good, something else must. Queues and waiting lists form, and sellers may allocate by favouritism or by charging for something else. Quality falls, since a landlord who cannot raise the rent has no incentive to maintain the property and no shortage of tenants if it deteriorates. An illegal secondary market appears, with the good changing hands above the cap, so the households the policy meant to protect can end up paying more than the free-market price. Investment in new supply also dries up, making the shortage worse over time.

5. 5

   Should a city where housing is unaffordable impose a cap on rents?

   Model answer

   For: rents take a very large share of low incomes, sitting tenants pay less immediately, and in the short run the supply of dwellings is almost fixed, so a modest cap transfers income from landlords to tenants with little loss of quantity. Against: over time supply is elastic because landlords sell up and developers build elsewhere, so the shortage widens; the cap rations by queue and connection rather than need; quality deteriorates; and a black market emerges. The conclusion turns on the elasticity of supply over the relevant period, and on whether the cap is paired with measures to build more housing, without which it treats the symptom.

6. 6

   A market for alcohol clears at £0.40 per unit with 500 million units sold. Draw and describe in words the effect of a minimum price of £0.55 per unit.

   Model answer

   Put price in £ per unit on the vertical axis and units per period on the horizontal. Demand slopes down, supply slopes up and they cross at £0.40 and 500 million units. The minimum price is a horizontal line at £0.55, above the market-clearing price. At £0.55, quantity demanded contracts along the demand curve to 430 million units while quantity supplied extends along the supply curve to 560 million. The horizontal gap between them is excess supply of 130 million units. Since the government does not buy the surplus, the quantity actually traded is the lower figure, 430 million units.

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