governments can interfere with the market mechanism by… setting maximum prices (price ceilings)...

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Intervention : Minimum and Maximum Prices

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Page 1: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Government Intervention

:Minimum

and Maximum

Prices

Page 2: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Governments can interfere with the market mechanism by…• setting maximum prices (price ceilings)• setting minimum prices (price floors)• subsidising certain products or activities• taxing certain products or activities.

Page 3: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Maximum prices (price ceilings, price control)

Governments set maximum prices to…• keep prices of basic foodstuffs low• avoid exploitation of consumers by producers• combat inflation

Maximum Price above Pe???Maximum Price below Pe???

Page 4: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Government sets a maximum price (Pm) below equilibrium price (P0). At (Pm) consumers demand Q2 > equilibrium quantity Q0 Supply falls to Q1, < than equilibrium quantity Q0 Causes market shortage (excess demand)

Q2 - Q1 (ab)Without price control, excess demand raises price until equilibrium is re-

established. With price control something else must do the job.

How to allocate quantity supplied (Q1) between consumers Q2?

Page 5: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

This can be done in various ways…• “First come first served” – queues/waiting lists.• Informal rationing systems (eg limiting quantity sold to each

consumer).• Government introduce official rationing system by issuing ration

tickets.

Page 6: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Emergence of Black Markets

• Some consumers willing/able to pay P1 • Tickets purchased at Pm can make a profit of P1 - Pm

Page 7: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Summary…Fixing prices below the equilibrium (or market-clearing) price thus…• creates shortages (or excess demand)• prevents market mechanism from allocating available quantity among

consumers• stimulates black market activity

Page 8: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

The welfare costs of maximum price fixingMaximum price (Pm) set below market-clearing price (P1)

Quantity: Q1 - Qm. At P1 - consumer surplus = P1DE

At Pm - consumer surplus = PmDRUGain B but lose A

At P1 - producer surplus = 0P1E.At Pm - producer surplus = 0PmU.

B transferred to consumer surplus. C disappears, since only Qm is produced and exchanged.

Total welfare loss to society = A + CDeadweight loss

Page 9: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Minimum prices (price supports, price floors)• Usually found in agricultural markets for agricultural • Stable demand, but supply subject to large fluctuations. • Prices fluctuate and income unstable and uncertain.

Minimum price below Pe???Minimum price above Pe???

Page 10: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Government sets a minimum price of R40/kg. Qd now = 4 million kg

Qs = 9 million kgExcess supply (surplus) of 5 million kg (ab).

Page 11: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

What to do with surplus created??• Gov purchases surplus and exports.• Gov purchases surplus and stores it • Gov introduces production quotas to limit supply to quantity

demanded at minimum price.• Government purchases destroys surplus.• Producers destroy the surplus.

Page 12: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

Summary…

Highly inefficient since…• Consumers have to pay artificially high prices• bulk of benefit accrues to large producers • inefficient producers protected • disposal of the market surpluses entails further cost to taxpayers

Page 13: Governments can interfere with the market mechanism by… setting maximum prices (price ceilings) setting maximum prices (price ceilings) setting minimum

The welfare costs of minimum price fixingGovernment fixes minimum price (Pm) above equilibrium price. Qs falls to Qm

At P1 - consumer surplus = P1DEAt Pm – consumer surplus = PmDR

Consumers lose A (to producers) & B (disappears).

At P1 – producer surplus = 0P1EAt Pm – producer surplus = 0PmRT

Producers gain A from consumers) but lose C (disappears) Total deadweight loss to society = B + C