Source: Image of Apartment Market Graph with and without Price Ceiling created by Kate Eskra, Image of Labor Market Graph with and without Price Floor
Hi. Welcome to macroeconomics. This is Kate. This tutorial is on binding and non-binding constraints. As always, my key terms are in red, and my examples are in green. In this tutorial, we'll talk about how government policies can alter market outcomes. You'll see that binding constraints-- price ceilings and floors-- actually don't allow equilibrium to be reached. Ceilings are going to create shortages in the marketplace, and floors will create surpluses. You'll also see that non-binding constraints actually have no market impact at all.
So we know that in most cases, the free market functions really nicely. And that's because producers have this profit motive to get us as consumers what we want at prices that we are willing to pay. And so generally speaking, unregulated free markets, or what sometimes are referred to as laissez-faire markets, produce the best outcome. And by the best outcome, we mean that the market clears when it reaches equilibrium.
At equilibrium, the market's allowing for trade to occur between buyers and sellers. And at equilibrium, every buyer has a seller, every seller has a buyer. So that means that the quantity being demanded by consumers is the same as the quantity being supplied by producers. And so there's no surplus, or shortage, of goods or services. So equilibrium is defined, then, as the price and quantity pair where supply and demand meet. It's the price and quantity where the market clears.
So here's one example of a market in equilibrium. If we were to allow this apartment market to reach equilibrium, the market would clear where 1,000 apartments are being rented out a month and landlords are receiving $2,000 per month for each of those 1,000 apartments. Now that's a really expensive rent. And we know in some cities in our country, rent prices are that high, if not even higher.
And so some people are unable to afford, obviously, this kind of high rent. So what the government will often do is control rent in a certain area. And when they do that, they're imposing a maximum price that landlords can charge. What, though, would happen if the government, let's say, set a maximum price up above where the equilibrium currently is? Let's say they set a maximum price at $2,500 per month. Saying landlords, you cannot charge more than $2,500 per month. That would mean setting a ceiling, or imposing a maximum price, up above equilibrium.
If you think about it, it actually would have no market impact at all. Because landlords only want to charge $2,000, because they know that that's when they'll be able to rent out their apartments. They know that a certain number of consumers are willing to pay $2,000, and that will clear the market. So they won't want to charge anything more than $2,000. So if they set the maximum price up above equilibrium, equilibrium price will just be allowed to be reached.
And that would be an example of a non-binding constraint. This is where we have a price level bounding that's really ineffective relative to the existing market clearing price and quantity combination. So in that previous example, the market would just reach equilibrium if they set a price up above equilibrium that was a maximum.
But a binding constraint is different. A binding constraint is one, a price level bounding that does preempt market clearing. And so let's talk about a price ceiling. A price ceiling is a set price level bounding the highest price where a good or service can be sold. It's typically initiated by some kind of government or regulatory body. And so rent control policy is a really good example of a price ceiling.
So remember, here's our example where the market was clearing at $2,000 per month in rent. Now if landlords went in-- I'm sorry, if the government intervened and told landmarks, no, no, no, no, you can't charge actually more than $1,200 per month, now this is a binding constraint. This is the ceiling. And I know it's a little confusing at first. You would think a ceiling would be above equilibrium. But think about it. To be effective as a maximum price, it has to be dropped down below equilibrium.
So now landlords cannot charge any higher than 1,200. They could charge lower than it, but they can't charge higher. You would think initially this is all good. It'll make apartments more affordable. And it will. But the thing is, this means that equilibrium now can't be reached. As we lower price, we know our law of demand says that more people will want to rent apartments at this price. So the quantity demanded now increases to $2,000 being demanded.
At the same time, sure, you can force landlords to charge a lower price, but you can't force them to rent out all of their apartments. Now landlords are less willing to rent at this price. So the quantity supplied falls. And we know that the law of supply states as prices fall, the quantity supplied falls. So now the quantity supplied is only 600.
Notice here the market is no longer clearing. The quantity demanded exceeds the quantity supplied. And what we have is a shortage of 1,400 apartments in this example. And so this rent control is an example of a price ceiling, and that is a binding constraint.
So the shortage that I was talking about-- here's your definition of it. It's the opposite to a surplus, we'll talk about a surplus in a little bit. This is a situation often caused by an imposed constraint, like we were talking about here, that results in a shortage of supply or an excess of demand. You could look at it either way. And that's occurring at the market price due to the inability of the market to adjust to market clearing price and quantity.
Now let's look at an opposite example. Let's look at a price floor. So a price floor is going to be a set price level bounding the lowest price at which a good or service can be sold. And again, this will be initiated usually by government or regulatory body. Let's talk about minimum wage. Because minimum wage is an example of a price floor. So now, when we're looking at a market, we're looking at the labor market. So supply and demand are a little bit different.
Supply of labor is what people want to work. So this is the supply of laborers. The demand are really employers-- people demanding labor. If we were allowing the market to reach equilibrium, we're suggesting here that would be at $6 per hour, a wage rate of $6. But we know that the government does not allow companies, legally, to pay workers $6 per hour. We have minimum wage law in our country. And so that will prevent this market from establishing equilibrium.
Notice before I move on that there is no dead weight loss at equilibrium, that we have consumer and producer surplus here maximized. Now, if we do impose a price floor, notice how a price floor, to be effective, actually has to be up above equilibrium. Remember, this is the minimum that the government will allow employers to pay their workers. So certainly, you can pay people more than $7.25, but now we're saying no, no, no, you can't pay people what's clearing the market at $6. The minimum you can pay is $7.25.
Most people in our country would agree that we do need minimum wage law. But what this is going to do is create another issue. Because the market will not be allowed to clear here. So we know as prices rise, now the quantity supplied will increase. So more workers are willing to supply their labor at the higher wage, but again, you can force employers to pay minimum wage, but you cannot force employers to hire as many workers or to keep people at full time.
So employers are less willing to hire and the quantity demanded for labor falls. And again, now we have a gap between the quantity supplied and the quantity demanded. This time, we have quantity supplied greater than the quantity demanded, and that creates a surplus of labor.
And so minimum wage, as I said, is an example of a price floor. So a surplus is a situation often caused by an imposed constraint like this that results in excessive supply, or a shortage of demand, either way, occurring at the market price due to the inability of the market to adjust to the market clearing price and quantity.
So in this tutorial, we looked at how these government policies can definitely alter market outcomes. Binding constraings like price ceilings and floors don't allow us to reach equilibrium. And so ceilings are going to create shortages. And remember, a shortage is where your quantity demanded is greater than the quantity supplied. Floors will create surpluses where the quantity supplied is greater than the quantity demanded, and both of them don't allow equilibrium. Equilibrium is that only price and quantity combination where the quantity demanded and supplied are equal, or the market clears. And remember, a non-binding constraint is one that has no market impact at all.
Thanks so much for listening. Have a great day.
Terms to Know
The price and quantity pair at which supply and demand intersect; price and quantity at which the market clears.
A set price level bounding the highest price at which a good or service may be sold; typically initiated by a government or regulatory body—ex. rent control policy.
A set price level bounding the lowest price at which a good or service may be sold; typically initiated by a government or regulatory body—ex. Minimum wage.
A price level bounding that pre-empts market clearing.
A price level bounding that is ineffective relative to the existing market clearing price and quantity combination.
The opposite side to a surplus. A situation, often caused by an imposed constraint, that results in a shortage of supply occurring at the market price due to the inability of the market to adjust to market clearing price and quantity.
A situation, often caused by an imposed constraint, that results in an excess of supply occurring at the market price due to the inability of the market to adjust to market clearing price and quantity.