A maximum price

A maximum price is a cap on the price of a good or service, and is a limit on the level that a price can reach. Maximum prices may be set by governments or other agencies

The effect of the lower price for some consumers is to encourage more consumption. Graphically, demand extends, to ‘e’. However, producers will be less inclined to supply at the lower price. Graphically, supply contracts, to ‘f’.

The effect of this is to create a shortage of the good. However, this only happens if the maximum price is set below the market rate. If set above, the market rate prevails.

Example

If we consider this simple example, market equilibrium would be at a price of '4'. Setting a maximum price of three would create a shortage of 400 units.

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When is a maximum price set?

A maximum price might be set in certain circumstances, including:

1. As a cap on the prices of firms who are exploiting their monopoly power by setting high prices
2. On food prices during times of war to ensure that individuals can afford food - however, this would only work if the government also takes charge of supplying food, and possibly operates a rationing system.
3. To cap the prices of merit goods so that consumption is not deterred, such as setting university fees at a level which encourages students to attend university.
   To cap rental prices for accommodation so that the less well off can afford a home.

The major criticism of setting maximum prices is that it can create shortages. Supply is likely to contract and demand extend so that demand exceeds supply. This is likely to lead to queuing, waiting lists and even 'black' markets.