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Mixed Economic System » Maximum and Minimum Prices

What you'll learn this session

Study time: 30 minutes

Cambridge spec: 2.10.3

What maximum and minimum prices are
How to draw and read a diagram for each one
The advantages and disadvantages of maximum prices
The advantages and disadvantages of minimum prices

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When the government sets the price

In a market, demand and supply usually settle on an equilibrium price. Sometimes a government thinks that price is unfair. It might be too high for poor families, or too low for farmers. So it steps in and sets a limit by law.

This is one way a government can act in product markets to deal with market failure.

Key terms:

Maximum price: a legal limit above which the price of a good cannot be charged. It is also called a price ceiling.
Minimum price: a legal limit below which the price of a good cannot fall. It is also called a price floor.
Black market: illegal trade in which a good is sold above the legal maximum price.

Maximum prices

A government usually sets a maximum price on something people need, such as basic food or medicine. The aim is to keep it affordable. For the limit to matter, it must be set below the equilibrium price. A limit above the equilibrium price changes nothing, because the market price is already lower.

Here is a made-up market for 10 kg bags of rice in the country of Marovia.

Price per bag ($)	Quantity demanded (thousand bags)	Quantity supplied (thousand bags)
2	100	20
4	80	40
6	60	60
8	40	80
10	20	100

The equilibrium price is $6 and the equilibrium quantity is 60 thousand bags. The government sets a maximum price of $4.

Worked example

At $4, quantity demanded is 80 thousand bags and quantity supplied is 40 thousand bags.

Demand is bigger than supply, so there is a shortage of 80 − 40 = 40 thousand bags.

The price cannot rise to clear the shortage, because the law stops it.

Only 40 thousand bags are actually sold, because producers will not supply more. That is fewer than the 60 thousand sold at equilibrium.

Remember from the lesson on disequilibrium that a shortage means quantity demanded is greater than quantity supplied. Normally a rising price would fix it. A maximum price blocks that signal, so the shortage stays.

Drawing the maximum price diagram

Follow these steps in the exam.

Draw the axes. Put Price on the vertical axis and Quantity on the horizontal axis.
Draw a downward sloping demand curve and label it D.
Draw an upward sloping supply curve and label it S.
Mark where they cross. Label the equilibrium price P and the equilibrium quantity Q.
Draw a horizontal line across the diagram at a price below P. Label it "Maximum price".
Where the line meets the supply curve, drop down to the quantity axis and label it Q_S. Where it meets the demand curve, drop down and label it Q_D.
Q_D is to the right of Q_S. The gap between them is the shortage.

Advantages and disadvantages of maximum prices

✅ Advantages

Goods that people need stay affordable, which helps low-income households.

Buyers are protected from sudden, very high prices, for example after a poor harvest.

❌ Disadvantages

It creates a shortage, so some people who want the good cannot get it.

Sellers may share the good out unfairly, or buyers queue for hours.

A black market may appear, where the good sells at a much higher price.

Producers earn less, so some may cut supply or lower the quality.

Minimum prices

A government usually sets a minimum price to help producers or to discourage a harmful good. Some governments set a guaranteed price for farm crops. Some set a minimum price for alcohol to cut drinking. For the limit to matter, it must be set above the equilibrium price.

Here is a made-up market for wheat in the country of Tarsala.

Price per tonne ($)	Quantity demanded (thousand tonnes)	Quantity supplied (thousand tonnes)
200	90	50
250	80	60
300	70	70
350	60	80
400	50	90

The equilibrium price is $300. The government sets a guaranteed minimum price of $350.

Worked example

At $350, quantity demanded is 60 thousand tonnes and quantity supplied is 80 thousand tonnes.

Supply is bigger than demand, so there is a surplus of 80 − 60 = 20 thousand tonnes.

If the government buys the surplus at $350 a tonne, it spends 20,000 × $350 = $7 million.

Consumers buy only 60 thousand tonnes at $350, which is fewer than the 70 thousand bought at equilibrium.

Drawing the minimum price diagram

Draw the same axes, with D, S, P and Q as before.
Draw a horizontal line at a price above P. Label it "Minimum price".
Where the line meets the demand curve, drop down and label Q_D. Where it meets the supply curve, drop down and label Q_S.
Now Q_S is to the right of Q_D. The gap between them is the surplus.

Advantages and disadvantages of minimum prices

✅ Advantages

Producers such as farmers get a higher and more stable income.

Higher prices can cut consumption of harmful goods such as alcohol.

The extra income may encourage producers to keep supplying.

❌ Disadvantages

It creates a surplus, which may be wasted or have to be stored.

If the government buys the surplus, taxpayers pay for it.

Consumers pay higher prices, which hurts low-income households.

Resources may stay in an activity that makes more than people want.

Common mistakes

Drawing a maximum price above the equilibrium price. It must be below, or it has no effect.
Drawing a minimum price below the equilibrium price. It must be above, or it has no effect.
Forgetting to name what happens at the limit: a maximum price gives a shortage and a minimum price gives a surplus.
Saying a maximum price makes goods "cheaper" with no downside. Always mention the shortage.

Exam-style question

The government of the made-up country of Brelmar sets a maximum price for bread after a poor wheat harvest. It also sets a minimum price for milk to help dairy farmers.

(a) Define "maximum price". [2 marks]

(b) Explain why a maximum price set below the equilibrium price causes a shortage. [4 marks]

Model answer

(a) A maximum price is a legal limit (1) above which the price of a good cannot be charged (1).

(b) A maximum price below the equilibrium price makes the good cheaper (1). More people want to buy at the lower price, so quantity demanded rises (1). At the same time, producers earn less, so quantity supplied falls (1). Demand is now greater than supply, which is a shortage, and the price cannot rise to remove it (1).

(c) A minimum price above the equilibrium price raises the price farmers receive (1), so their income rises and is more stable (1). However, it also creates a surplus of milk because consumers buy less and farmers supply more (1). If the government buys the surplus, taxpayers pay the cost (1). Higher milk prices also hurt poorer households (1). It helps farmers, but it is costly and wasteful unless the surplus is dealt with, so it is a good way only if the cost is accepted (1).

Exam tip

In a "discuss" answer, give a point for each side, then end with a judgement that uses the context, such as milk and dairy farmers.

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