Effective Price Floors, Price Ceilings, and Efficiency
For price floors to be effective, the legal minimum price must be higher than the equilibrium price, and for a price ceiling to be effective, it must be lower than the equilibrium price.
For example, the equilibrium price of a liter of milk is $1. This means that at $1 per liter the quantity buyers want to buy equals the quantity that sellers can and are willing to sell. When the government imposes a price floor that is higher than the equilibrium price, for example, $1.5 per liter, it follows that, as usual, the supply and demand concept will move the price in the direction of the equilibrium price. Still, once the market price hits the floor, it cannot fall any further. At this point, the price floor causes a surplus since sellers are willing to sell the milk at the price of $1.5 per liter, but some buyers cannot afford it.
On the other hand, let us say the government decided to set a price ceiling of $0.5 per liter of milk. The forces of demand and supply will try to move the price towards the equilibrium, but once the market price hits the ceiling, it cannot go any higher. At this point, the quantity of milk demanded exceeds the quantity of milk supplied, and as such, there will be a shortage of milk since sellers are not willing to sell the milk at the price at which buyers are willing to buy. Therefore, some people who are willing to buy milk will not be able to do so.
Non-binding Price Floors and Price Ceilings
In addition, taking the same case of milk above, the government might also induce a price floor, which will be lower compared to the equilibrium price of $1 per liter; for instance, $0.5. Since the equilibrium price is more than the price floor, the price floor is non-binding since market forces will naturally move the market price towards the equilibrium, and the floor will have no effect.
Still, the government might set the price ceiling higher than $1, say at $1.5. This price ceiling is not binding because market forces will move the market price towards the equilibrium, a situation that will not be affected by the price ceiling.
Rationing Mechanisms in Perfectly Competitive Markets
Rationing mechanisms that emerge due to price ceilings are not always desirable; customers may be forced to go to extra lengths to acquire the scarce resources. Price floors also mean that sellers are left with surplus goods and cannot sell them at the market price. Therefore, the best rationing mechanism in a competitive market would be a free market because buyers can buy all they want, and sellers can sell what they want.
Taxes on Buyers and Sellers and their Effect on Market Outcomes
Taxes reduce the amount of activity in the market. However, whether the tax is levied on buyers or sellers, the effect is the same because they share the burden under the new equilibrium.