A price ceiling can be set above or below the free-market equilibrium price. For a price ceiling to be effective, it must differ from the free market price. In the graph at right, the supply and demand curves intersect to determine the free-market quantity and price. The dashed line represents a price ceiling set above the free-market price, called a non-binding price ceiling. In this case, the ceiling has no practical effect. The government has mandated a maximum price, but the market price is established well below that. In contrast, the solid green line is a price ceiling set below the free market price, called a binding price ceiling. In this case, the price ceiling has a measurable impact on the market.
Consequences of Binding Price Ceilings
A price ceiling set below the free-market price has several effects. Suppliers find they can't charge what they had been. As a result, some suppliers drop out of the market. This reduces supply. Meanwhile, consumers find they can now buy the product for less, so quantity demanded increases. These two actions cause demand to exceed supply, which causes a shortage—unless rationing or other consumption controls are enforced. It can also lead to various forms of non-price competition so supply can meet demand.
How Do Tariffs Affect Prices?
Tariffs increase the prices of imported goods. Because of this, domestic producers are not forced to reduce their prices from increased competition, and domestic consumers are left paying higher prices as a result. Tariffs also reduce efficiencies by allowing companies that would not exist in a more competitive market to remain open.
Figure 1 illustrates the effects of world trade without the presence of a tariff. In the graph, DS means Domestic Supply and DD means Domestic Demand. The price of goods at home is found at price P, while the world price is found at P*. At a lower price, domestic consumers will consume Qw worth of goods, but because the home country can only produce up to Qd, it must import Qw-Qd worth of goods.
Figure 1. Price without the influence of a tariff
When a tariff or other price-increasing policy is put in place, the effect is to increase prices and limit the volume of imports. In Figure 2, price increases from the non-tariff P* to P'. Because price increases, more domestic companies are willing to produce the good, so Qd moves right. This also shifts Qw left. The overall effect is a reduction in imports, increased domestic production and higher consumer prices. (To learn more about the movement of equilibrium due to changes in supply and demand, read Understanding Supply-Side Economics.)
Figure 2. Price under the effects of a tariff
