price ceilings

why does the government intervene?

• in order to finance government expenditure

• to provide support to firms, the government may subsidize sunrise industries which have great potential in the future but may not be able to incur the initial start-up expenditure or compete with large firms which have achieves economies of scale.

• to provide support to households on low incomes

• to influence the levels of production on firms, the government can subsidize the production of merit goods, or levying taxes on demerit goods.

• the government can influence levels of consumptions of households and consumers through taxes and subsidies.

• to government can correct market failure if the market fails to allocate resources efficiently.

• To promote equity in income and distribution, so the government will tax the rick and subsidize the poor.

price controls

price controls take 2 forms, maximum price called a price ceiling and minimum price called price flooring.

Price ceiling

Price ceiling is the legal maximum price set below the equilibrium price in order to make a good more affordable to low-income consumers.

• increase consumption

• reduce the price

• prevent exploitation

why is the price ceiling below equilibrium?

A price ceiling is only effective if set below the equilibrium price. If the price ceiling is set above the equilibrium price, it is ineffective or non-binding because the market will push the price back to equilibrium price.

what are the consequences of price ceilings?

A price ceiling creates a persistent disequilibrium in the market because it creates a persistent shortage and the market does not go back to its equilibrium level.

• produces shortages

• generates a rationing problem (non-price rationing needs to be used)

• promotes the creation of parallel markets

• eliminates allocative efficiency and generates welfare loss

• there are consequences for market stakeholders.

how to mitigate these consequences?

The basic issue is excess demand.

to mitigate these consequences, the government might try to intervene by increasing the supply of the good until equilibrium is reached at max price.

the government can do this through:

• granting subsidies to producers (encouraging increased supply)

• increase supply by producing the shortfall quantity of the good itself

• store some of the product before setting the ceiling, then increase supply when needed by releasing some of its stocks on to the market.

consequences of price ceilings on stakeholders

• consumers- consumers gain and lose. They gain an area C from producers, but they also lose area b.

• producers are worse off because they sell a smaller quantity at a lower price. Additionally, they also lose some of their producer surplus.

• workers- are worse off because a fall in output leads to unemployment.

• government - there will be no gains or losses for the government budget.