2.0 Governments in markets-price controls

where does a Government does not intervene

In free markets where there is no government intervention, the price and output in a market are determined by demand and supply.

When does the government intervene?

when the market price and output do not maximise welfare in society

(high prices negatively impact low-income households)

price controls

government imposed limits on how high or low a price can be charged for a product or service.

• price ceiling

• price floor

Price ceiling

A maximum price set by a government to prevent the price of a good or service from rising above a fixed level.

example of price ceiling

rent controls in a housing market are a maximum price where market rents cannot rise above a certain price.

• help tenants afford housing

• may lead to shortages

Reasons for maximum prices

• protect low-income consumers from rising prices they can’t afford

• often placed on goods society ought to able to consume ffe

effects of a maximum price

positive

• greater affordability

• consumer protection (crisis)

negative

• shortages

• lower quality

• reduced supply

• black market

how do maximum prices lead to shortages?

Maximum price is set below the market equilibrium, making the product cheaper. this increases demand but discourages supply, since producers earn less.

As a result demand exceeds supply causing a shortage

Impact on stakeholders

1. consumers

gain consumer surplus, lose out due to high demand

2. producers

lose producer surplus, cause producers to leave market

=> goods sold illegally can make high profit

3. government

• policy benefits (political popularity, protects vulnerable groups, reduce inequality)

• cost of setting up and enforcing the maximum price and the loss of tax revenue that might come from lower sales in the market

4. Welfare

• loss of welfare because of the loss of consumer surplus of consumers who no longer buy the good when the maximum price is imposed.

• welfare loss of the producer surplus from producers who leave the market due to the maximum price

max price leads to loss of welfare

1. the benefits of the maximum price are concentrated amongst a relatively small number of consumers

2. wider costs for rest of society

Costs > benefit

price floors

A minimum price is a lower limit set by the government to prevent the price of a good or service from falling below a certain level.

Reasons for minimum prices

• to protect producers in markets

• (Could increase employment)

• aims to offer stable income to producers

Example of minimum price

Agricultural market

• support farmers and protect the food supply

• struggle due to unstable prices and weather (PES - inelastic for farmers especially in short-term)

impact on stakeholders

1. consumers

• consumer surplus lost, as they have to pay above equilibrium price

• bad effect on low income households

2. producers

• producer surplus increases = higher revenue and profits

• stabilise incomes long-term

• paid more per unit

3. government

• Minimum prices represent an opportunity cost to the government - buy the excess supply (cost of storing) - to support the producers (ex:farmers)

• expensive to manage for gov, costs > benefits

4. welfare

• misallocation of resources in agricultural markets (producers produce more than consumers want to buy) - too many resources go into their production, leaving fewer for other producers.

• lead to surplus - not everything is sold off so the government must buy the surplus

an outcome in the market when price floors operate

more producers enter the market In the long-run

What is the rationing function of prices? How does it fall with a maximum price?

1. The rationing function of price allocates goods to those most willing and able to buy

2. A maximum price prevents price from rising so demand can’t be limited by price, leading to shortages and inefficient allocation

How do the income effect and substitution effect tie into maximum prices ?

Income effect: lower prices make consumers feel richer → buy more

Substitution effect: lower prices makes the good more attractive vs substitutes → more demand

• both effects increase demand but if supply falls because of the price ceiling a shortage results