Transcript Price Controls

MICROECONOMICS –
PRICE CONTROLS
BLINK & DORTON,
2007, p40-48
PRICE CONTROLS
• Although it may seem to be an optimum situation, the
free market does not always lead to the best outcomes
for products and consumers or society in general.
• Governments normally choose to intervene in the
market in order to achieve a different outcome. There
are 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 “the ceiling”.
• 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
was allowed to operate freely.)
Maximum (Low) Price Controls
• 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.
MAXIMUM PRICE
CONTROLS
Without government
interference, the
equilibrium quantity
demanded and supplied
would 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. A the price Pmax Q2
will be demanded, but
only Q1 will be supplied.
There is a problem of
excess demand. The
consumption of bread
actually falls from Qe to Q1
even though it is at a
lower price.
Problems with Maximum
(Low) Price Controls
• The excess demand creates a problem.
• Excess demand results in shortages.
• Shortages may lead to the emergence of a black
market (an illegal market) where the product is
sold at a higher price, somewhere between the
maximum price and the equilibrium price.
• There may also be queues developing in the
shops and producers my start to decide who is
going to be allowed to buy.
• Governments may be forced to reverse price
controls or reduce price controls.
Government responses to Problems
with Maximum Price Controls
Two Options.
Shift the Demand Curve to the Left
• It could attempt to shift the demand curve to the left,
until equilibrium is reached the maximum price, but
this would limit the consumption of the product.
Shift the Supply Curve to the Right
• Shift the supply curve to the right until equilibrium is
reached at the maximum price, with more being
demand and supplied. This option is normally used
and can be implemented in several ways.
Government responses to Problems
with Maximum Price Controls
How to shift the supply curve to the right
1. The government could offer subsidies to the
firms in the industry to encourage them to
produce more.
2. The government could start to produce the
product themselves, thus increasing the supply.
3. If the government had previously stored some of
the product (eg: buffer stocks) it could release
some of the stocks onto the market. Not
possible for perishable products like bread.
Action to Solve the Problem
of Excess Demand
If the government is able
to shift the supply curve
to the right by subsidies
or direct provision, the
equilibrium will be
reached at Pmax with Q2
loaves of bread being
demanded and supplied.
If the government occurs
a cost in the terms of
subsidy this will have an
opportunity cost.
Money supporting the
bread industry may
mean less for 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”.
Why do governments sets
minimum prices?
1. To attempt to raise incomes for producers of
goods and services that the government thinks
are important, such as agricultural products.
These industries may be helped because their
prices are subject to large fluctuations or
because there is a lot of foreign competition.
2. To protect workers by setting a minimum wage,
to ensure that workers can earn enough to lead
a reasonable existence.
Minimum Price Controls
Without government
interference, the
equilibrium quantity
demanded and supplied
would be Qe and at a
price of Pe. The
government imposes a
minimum price of Pmin. in
order to increase the
revenue of producers of
wheat. However, at Pmin
only Q1 will be demanded
because the price has
risen but Q2 will now be
supplied. There is a
problem of excess supply.
Consumption of wheat
will fall to Q1, albeit at a
higher price.
Government Response to excess
supply problems (p43)
• The government would normally eliminate the
excess supply by buying up the surplus
products, at the minimum price, thus shifting
the demand curve to the right, creating new
equilibrium.
• The government could then store the surplus,
destroy it or attempt to sell it abroad.
• Storage is expense and destroying it wasteful.
Government Response to excess
supply problems
• Selling it abroad is an option, but is often causes angry
reactions from foreign governments involved, who
claim that products are being dumped on their markets
and will harm their domestic industries.
• In some cases such as the European Union agricultural
farmers are guaranteed a minimum price and are paid
to “set aside” land that they would have used to
produce the product in question.
• Farmers in the EU are then paid the price for an
estimated harvest and nothing is actually grown.
• There is always an opportunity cost with such policies.
Government Action to
solve problem of Excess
Supply
The government
would normally
eliminate the excess
supply by buying up
the surplus products,
at the minimum
price, thus shifting
the demand curve to
the right and
creating a new
equilibrium at Pmin
with Q2 being
demanded and
supplied. The new
demand curve,
would be D +
government
spending.
OTHER WAYS TO MAINTAIN THE MINIMUM PRICE
QUOTAS
Producers could
be limited by
quotas restricting
supply so they it
does not exceed
Q1. This would
keep the price at
Pmin but it would
mean only a
limited number
of producers
would receive it.
OTHER WAYS TO MAINTAIN THE
MINIMUM (High) PRICE
• The government could also attempt to
increase demand for the product by
advertising or, if appropriate....
• by restricting supplies of the product that are
being imported, through protectionist
policies, thus increasing demand for domestic
products.
Problems with guaranteed minimum prices, paid
by the government
• Firms may think that they do not have to be as
cost-conscious as they should be and this may
lead to inefficiency and as waste of resources.
• It may also lead to firms producing more of
the protected product than they should and
less of other products that they could produce
more efficiently.
Price Support/Buffer Schemes
AIM: PRICE STABILITY (p30)
• This is a situation where a government
intervenes in a market to stabalise prices.
• This has been attempted in markets for
commodities (raw materials) whose prices are
often unstable.
• Producer of agricultural commodities such as
wheat, coffee or coca are very much at the
mercy of the weather and also dangers like
insects, and crop diseases.
Price Issues for
agricultural commodities
• If conditions are excellent (eg: perfect amount of
sun/rain) there might be what is known as a
bumper crop and abundant supply.
• This will drive the price of the product down and
impact on the income of producers.
• If there is a poor weather, such that the supply of
crops falls, this will drive the price up, but this will
only be for the benefit of the farmers who have
the crops.
• Producers face volatile prices.
Price Issues for
Industrial or Mineral commodities
• Another category of raw materials is industrial or
mineral commodities such as copper, rubber or
tin.
• These produce face volatile prices 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.
• Periods of high economic growth = greater
income for commodity producers.
• Periods of low economic growth = lower incomes
for commodity producers.
Demand / Supply Factors
Commodity Markets
• Both demand and supply-side factors create
instability in commodity markets.
• Unstable incomes may result in lower
standards of living with negative
consequences for commodity producers and
their communities.
• Governments may attempt to intervene to
protect prices from extreme fluctuations by
buffer stock scheme.
BUFFER STOCK
• To operate a buffer stock scheme, the “buffer
stock manager” sets a price band with a
highest possible price and the lowest possible
price.
• It then intervenes in the market whenever
free market forces push the price either above
the top price or below the bottom price.
The Price Band Set in Buffer Stock Scheme
A Surplus in Buffer Stock
Scheme
An 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 of supply of Q1
to Q2. In order to
maintain the price at
$2, the buffer stock
manager would have
to buy this excess
supply (surplus). The
surplus would them
have to be stored.
A Shortage in a Buffer
Stock Scheme
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. The buffer stock
manager would have to
intervene to prevent the
price from going above
the price band. The
manager could do this
by selling coffee from
stored stocks.
Problems with Buffer Stock Schemes
• Most of the problems are similar to the problems
outlined with minimum prices.
• Ideally works with non perishable goods.
• However, even non perishable goods can have high
storage costs.
• Significant improvements in technologies, means that
persistent surpluses have to be brought by government
which is expensive.
• There may be few “bad” seasons to releases the stock.
• Choosing the appropriate price band can be
problematic. Producers want the highest possible
band, which results in surpluses.
Commodity Agreements
• When different countries work together to
operate a buffer stock for a particular
commodity, it is known as a commodity price
agreement.
• They were pioneered in the 1960s through the
United Nations Conference on Trade and
Development (UNCTAD).
• They were designed to support commodity
producers in developing countries.
Commodity Agreements
• There are many cases where developing
countries are dependent on the export of a
few commodities for their export revenues.
• Some countries have seen slow growth and
little development as a result of low
commodity prices.
EXAMINATION QUESTIONS
Short Response Questions
1.Using demand and supply analysis, explain
how resources are allocated through
changes in price in a market economy.
(10 marks)
2.Using an appropriate diagram, explain the
likely consequences of an increase in the
legislated minimum wage? (10 marks)
EXAMINATION QUESTIONS
Essay Question
1a. Explain the role of prices in allocating resources in
a market economy (10 marks)
b. Evaluate the consequences of government
intervention in the market place in setting
maximum prices. (15 marks)
2a. Explain how a buffer stock scheme is expected to
work. (10 marks)
b. Evaluate the likely success of an international
buffer stock scheme in the coffee industry. (15 marks)