IB Guides

Price controls

Price ceilings (maximum prices): rationale, consequences and examples

Price ceilings (maximum prices): is a situation where government sets a maximum price, below the equilibrium price to prevent producers from raising the price above it.

  • Set to protect consumers
  • Usually in markets of necessity or merit goods (good that would be underprovided if the market were allowed to operate freely)
  • I.e. Maximum food price controls during food shortage?ensure low-cost food for the poor.
  • I.e. Maximum rent controls?ensure affordable accommodation for those on low incomes.
Figure 3.12 - A price ceilling
 
  • If maximum price is imposed at Pmax, Q2 will be demanded because price has fallen, but only Q1 will be supplied. ?excess demand
  • Eventually consumption will fall from Qe to Q1, even though it is at a lower price
  • Consumer expenditure (firm’s revenue) will decrease

Consequences of maximum price:

  1. Shortages: leads to forming of black market/underground parallel market (where product is sold at a higher price, somewhere between Pe and Pmax.)
  2. Non-price rationing mechanisms: Long queues or reservations → can determine the order in which consumers are served.
  3. Welfare impacts: Producer surplus decreases, consumer surplus increase
  4. Inefficient resource allocation: allocatively inefficient

Impacts on stakeholders:

  1. Consumers: lower prices, but have to go through non-price rationing mechanisms
  2. Producers: lower selling price → revenue decreases
  3. Government: increase spending on solving the consequences → subsidize or direct provision to shift the supply curve to right → reduce government expenditure in other areas → opportunity cost

Price floors (minimum prices): rationale, consequences and examples

Price floors (minimum prices): is a situation where the government sets a minimum price, above the equilibrium price to prevent producers from reducing the price below it.

  • Set to protect producers of goods & services that government thinks are important. i.e. agricultural products
  • To protect workers by setting minimum wage → ensure workers earn enough to lead a reasonable existence
Figure 3.13 - A price floor
 
  • If minimum price is imposed at Pmin, only Q1 will be demanded since the price has risen, but Q2 will now be supplied. → excess supply
  • Consumption will fall from Qe to Q1
  • Consumer expenditure (firm’s revenue) will decrease.

Consequences of minimum price:

  1. Surpluses: producer will be tempted to get around the price controls and sell their excess supply for a lower price, somewhere between Pmin & Pe.
  2. Disposal of the surplus by the government
  3. Welfare impact: producer surplus increases, consumer surplus decreases
  4. Inefficient resource allocation: allocatively inefficient 

Impacts on stakeholders:

  1. Consumers: higher prices
  2. Producer: higher selling price → less cost-conscious → inefficiency & waste of resources OR producing more of protected product than other products that they could produce more efficiently
  3. Government: increase spending on solving the consequences → store, destroy or selling the surplus abroad (dumping → harm other domestic industries → angry reaction from foreign governments) OR increase demand by advertising or restricting supplies of imports through protectionist policies (thus increase demand for domestic products)
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