Question

Question 4: Why some governments resort to price ceiling and price floor for some goods and services? Describe three most important disadvantages of price ceiling and price floor? In what conditions do you think that price ceiling and price floor may contribute to welfare of people?

Answer 1

Laws that government enact to regulate prices are called Price Controls. Price controls come in two forms. A price ceiling keeps a price from rising above a certain level, while a price floor keeps a price from falling below a certain level. The price ceiling is set below the equilibrium price and the price floor is set above the equilibrium price. (The equilibrium price is the price level where the quantity demanded is equivalent to the quantity supplied ). Price ceiling and price floor are government imposed maximum and minimum level respectively on the price level of certain goods.Price Controls such as Price Ceiling is adopted to protect the buyers or to manage scarce resources or during difficult economic times/crisis, Price Floor is adopted to protect the sellers

Government will usually impose price ceilings when they believe that the equilibrium price in the market is too high and undesirable. Markets for essential products are usually susceptible of price ceiling. When economically disadvantaged sections of the society are unable to purchase the basic essential items it can act as an impetus for enactment of price ceiling. In some cases discontent over the prices turn into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing "too high" or falling "too low." Price ceilings are enacted in an attempt to keep prices low for those who demand the product. In order to protect the interest of the consumers the government imposes price ceiling or maximum price above which no seller will sell the commodity.

A price floor is the lowest price level a commodity can be sold at. Price floors are used by the government to prevent the prices from being too low, when the government believes that the market equilibrium price is too low it sets the price floor to protect the sellers. The most common price floor is the minimum wage. Price floors are often used in agriculture to protect  farmers.

How sometimes price controls improves welfare-

Prices of commodities may tumble if there are surplus production.This happens mainly in the case of agricultural commodities when there is bumper production. oo low prices of such agricultural commodities cause hardships to the farmers. To prevent prices from falling further, the government may adopt minimum price legislation or establish price floor to protect the interest of farmers or producers.

In monopolies where there is only one firm constituting the  whole industry and is the sole employer of that industry in such cases the monopoly takes advantage of the position and exploits the workers vulnerability and disadvantage of having no bargaining power and pays extremely low wages. In such cases when the government sets price floor / Minimum wages the monopoly has to pay the minimum wages set by the government. Thus the welfare of the workers is ensured and are protected from exploitation due to lack of bargaining power.

If price ceiling are imposed for essentials such as food, housing the section of the society which was previously not able to purchase it can now get access to it with decrease in the price level as the price level set by the government will be below the market equilibrium price. the welfare of the economically disadvantaged section can improve with price ceiling.

During crisis such as War,or any economic crisis the sellers will take advantage of the situation and inflate the prices, the government intervention to  set the prices at certain level will curtail the sellers from setting high market price and exploiting the consumers when they are at their vulnerable. Thus it ensures that the prices are not set high and the consumers can meet their needs which would not have been possible had sellers inflated the prices the consumers needs would not have been met. At the time of shortage of resources during crisis such as war or natural disaster by setting price floors efficient utilization and distribution and mitigation of wastage of resources can be ensured.

Disadvantages of price control

When the government sets price floor the consumers aren't willing to purchase as much as before since the price is above the market equilibrium price. Demand contracts. On the contrary Minimum price encourages increase in supply. This causes distortion in the market. Where there is oversupply and contraction of demand, the resources are wasted due to over supply, the demands are not met due to the price level set. It results in a deadweight loss in the society, where the overall social and economical welfare decreases. Deadweight loss is the loss to the society created due to market inefficiency and this market inefficiency occurs when demand and supply are out of equilibrium which occurs when price controls are imposed. Market equilibrium price and quantity maximizes the total welfare of the society by maximizing the producer and consumer surplus, but in case of distortion from the equilibrium level the welfare of the society reduces as either the producer or consumer or both of their surplus contracts.

When the government sets price floor which contracts supply and creates scarcity individuals who are actually in need of the product especially essential goods which are more prone to price ceiling, in case of market mechanism it ensures that those who are in most need of the product get the product as they would be willing to pay higher prices to meet the needs thus the sellers will identify them and meet their need but this is not possible with price controls. The government by setting price ceiling inadvertently discriminates among the consumers as only some consumers will be able to meet their needs while others will be left high and dry. Artificial low prices not only hurt the producers they also hurt the consumers more than benefiting them.

Price ceiling discourages the sellers from supplying at their optimal level creating artificial scarcity in the economy. The demands will not be met though the sellers have the resources to meet the demand, their production capacity will not be fully utilized as they are not willing to sell at the price level set and their production capacity will remain idle, resulting wastage of resources as they are not fully utilized. Parallel(underground ) markets (shadow economy) could arise. Since there is shortage due to price controls , people could start buying and selling the good illegally for higher prices than the set maximum price, this results in people paying inflated prices. This might result in government losing tax revenue as well as other problems associated with shadow economy. For instance During WW2 the price of goods was fixed and goods rationed . However, this encouraged people to sell on the black market through inflated prices

When prices are set below the natural levels, resources such as talent and investor capital leave the industry to seek better opportunity elsewhere. Sellers will have no incentive and adequate resources for innovation,research and development,to improve , productivity, modernize,improve efficiency when price ceiling is imposed. Thus the production capacity of the  industry will not improve which is crucial for sustainable long term economic development.