Question

Respond to each of the following questions:

1. Explain how price and output is determined in a market economy free of government interference.

2. Assume the government decides to institute a price ceiling in the aforementioned market. Discuss: 1) what a price ceiling is and include an example; 2) the change in the prevailing price and output; and 3, the concept of economic surplus and the impact on economic surplus due to the price ceiling.

3. Enacting price controls, either price ceiling or price floor, is a departure from market forces, i.e., the “Invisible Hand.” Explain.

Answer 1

1) Price and output is determined in a market economy when demand = supply. In the diagram below, equilibrium price is P* and output is Y*.

2) A price ceiling is more effective if it is imposed below equilibrium price. It is imposed when government manadates a maximum price which a producer can charge a consumer. For example: government impose price ceiling such that landlords cannot more rent than tenants due to price ceiling.

2.2) It will reduce price from P* to P1. At this price, demand is Q1 while supply is Q2 which result in shortage of goods of Q1 - Q2.

2.3) Price ceiling will reduce the total surplus by area of triangle CDE because it result in deadweight loss of society.

3) It is true that price ceiling and price floor result in disequilibrium in market because price ceiling result in shortage of goods while price floor results in surplus of goods.

If there is no government interference or we say invisible hand works properly, shortage of goods influence buyers to pay more price for the good and influence producers to raise price to extract maximum price from consumers. It will result in rise in price till it reaches equilibrium level. Likeiwse, price floor will reduce price till it reaches equilibrium level.