Introduction Although it may seem to be an optimum situation, the free market does not always lead to the best outcomes for all producers and consumers,

Price Control

Introduction

Although it may seem to be an optimum situation, the free market does not always lead to the best outcomes for all producers and consumers, or for society in general and so governments often choose to intervene in the market in order to achieve a different outcome.

There are a number of situations where this occurs:

• maximum prices • minimum prices • price support/buffer stock schemes • commodity agreements.

Maximum (low) price controls

This is a situation where the government sets a maximum price, below the equilibrium price, which then prevents producers from raising the price above it.

These are sometimes known as ceiling prices, since the price is not able to go above “the ceiling”.

Reasons for this

Maximum prices are usually set to protect consumers and they are normally imposed in markets where the product in question is a necessity and/or a merit good (a good that would be underprovided if the market were allowed to operate freely).

For example, governments may set maximum prices in agricultural and food markets during times of food shortages to ensure low-cost food for the poor, or they may set maximum prices on rented accommodation in an attempt to ensure affordable accommodation for those on low incomes.

Without government interference, the equilibrium quantity demanded and supplied would be Qe, at a price of Pe

The government imposes a maximum price of PMax in order to help the consumers of bread.

However, a problem now arises.

At the price of P max Q2 will be demanded because the price has fallen, but only Q1 will be supplied. Now we have a situation of excess demand. It may even fall from Qe to Q1

This in turn may create a black market where the product is sold at a higher price ,or lines to appearing in stores and the questions of who gets to buy the product will have to be answered.

Since this is not “fair” for the consumers the government may need to make an attempt to solve the shortage problem.

Solutions

The government could attempt to shift the demand curve to the left, until equilibrium is reached at the maximum price, but this would limit the consumption of the product, which goes against the point of imposing the maximum price.

OR The government can attempt to shift the supply

curve to right, until equilibrium is reached at the maximum price, with more being supplied and demanded.

How to shift the supply curve to the

right. The government could offer subsidies to the

firms in the industry to encourage them to produce more.

The government could start to produce the product themselves, thus increasing the supply.

If the government had previously stored some of the product (see buffer stocks will be discussed later), then they could release some of the stocks (stored goods) onto the market. However, if the product were perishable, like bread, this would not be possible.

As we can see in Figure 4.5, if the government is able to shift the supply curve to the right, by subsidizing, direct provision, or using stored bread, then equilibrium will be reached at PMax, With Q2 loaves of bread being demanded and supplied.

However, it is fair to say that this may well mean that the government incurs a cost, especially in the case of a subsidy, and that this will have an opportunity cost.

• If the government spends money supporting the bread industry, it may have to reduce expenditure in some other area, such as education or health care.

Minimum (high) price controls

This is a situation where the government sets a minimum price, above the equilibrium price, which then prevents producers from reducing the price below it.

These are sometimes known as floor prices, since the price is not able to go below “the floor”.

2 Reasons for minimum prices

controls To attempt to raise incomes for producers of

goods and services that the government thinks are important, such as agricultural products. They may be helped because their prices are subject to large fluctuations, or because there is a lot of foreign competition.

To protect workers by setting a minimum wage to ensure that workers earn enough to lead a reasonable existence.

without government interference, the equilibrium quantity demanded and supplied would be Qe, at a price of P.

The government imposes a minimum price of P in order to increase revenue of the producers of wheat. However, a problem now arises.

At the price P, only Q1 will be demanded because the price has risen, but Q2 will be now be supplied.

So we have a situation of excess supply. If the government does not intervene further, they find that consumption of wheat actually falls from Qe to Qi, but at a higher price.

Excess supply creates problems. Producers will find that they have surpluses and will be tempted to try to get around the price controls and sell their excess supply for a lower price, somewhere between Pminandpe

Government intervention

The government would normally eliminate the excess supply by ring up the surplus products, at the minimum price, thus shifting demand curve to the right and creating a new equilibrium at p min, with Q2 being demanded and supplied.

The new demand curve would be D + government buying.

The government could then store the surplus, destroy it, or attempt to sell it abroad.

Storage is expensive, destroying is wasteful, selling abroad not always popular.

In some cases, such as the European Union agricultural policy, farmers are guaranteed a minimum price and then are paid to “set aside” land that they would have used to the product in question.

This of course than creates an opportunity cost “what else could the money have been used for”

There are two other ways that the minimum price can be maintained.

First, producers could be limited by quotas, restricting supply so that it does not exceed Q1. would keep price at Pmin but would mean that only a limited number r of producers would receive it.

Second the government could attempt to increase demand for the product by advertising or, if appropriate, by restricting supplies of the product that are being imported, through protectionists policies, thus increasing demand for domestic products.

This of course also creates problems – firms get complacent or produce more of the protected products than is needed

Price support/buffer stock schemes

This is a situation where a government intervenes in a market to stabilize prices.

This has been attempted in markets for commodities (raw materials), whose prices are often unstable.

Good conditions will create a bumper crop and increase the supply drive the price down

Bad conditions will limit the supply, drive the price up, but the will only benefit the farmers who have the crop.

Raw materials/ mineral

commodities. These producers also face volatile prices, but mainly

due to factors that cause big swings in demand.

Changes in the world economy are likely to have a large impact on producers of such commodities.

As world income grows, demand for industrial commodities rises as industries expand output to meet increased world demand, leading to a positive situation where price increases lead to greater income for commodity producers.

However, a slowdown in the world economy has a similarly large impact, as demand for industrial commodities falls, resulting in lower incomes for commodity producers.

Both demand and supply-side factors create instability in commodity markets. Producers, uncertain about the future, will find planning difficult.

Unstable incomes may result in lower standards of living, with negative consequences for commodity producers and their communities.

A buffer stock scheme is implemented in which the government will intervene if the price is too high or too low.

Quantity of coffee

--------------------------------- Top price

price

band

------------------------------------------Bottom

price

If there is a bumper crop, then supply will increase. Consider the example shown in Figure 4.10, where the increase in supply from S1 to S2 would push the price below the acceptable bottom price of $2 per kilo.

At the bottom price, there would be an excess supply of Q1 to Q2.

In order to maintain the price at $2, the buffer stock manager would have to buy up this excess supply (surplus).

However, if there is poor weather or a problem with pests, such that supply were to fall considerably from S1 to S2. then this would push the price above the acceptable top price of $4.

At the top acceptable price, there would be excess demand (shortage) of Q1 to Q2.

As part of its commitment, the buffer stock manager would have to intervene to prevent the price from going above the price band.

The manager would do this by selling coffee from the stored stocks, i.e. sell quantity Q1 to Q2 from the buffer stocks.

Problems with this.

Only works with non perishable goods (storage is still expensive)

Does the government continue to buy surplus every year.

What is the appropriate price band to sell the produce at. (producers want a high price) – continued surplus.

Commodity agreements

When different countries work together to operate a buffer stock scheme for a particular commodity, it is known as a “commodity price agreement”.

There are many cases where developing countries are dependent on the export of a few commodities for their export revenues, and some countries have seen slow growth and little development as a result of low commodity prices.

As we know this is not a great solution.