Question

During Jimmy Carter's presidency, increases in the Consumer Price Index (CPI) reached double digits. In order to combat this problem, the Carter administration launched a Wage-Price Guidelines program in which businesses could not increase prices or wages above a certain percentage or the company would be prohibited from doing business with the federal government. A company also could find itself on the prohibited list if it earned profits higher than six percent. The Carter administrated argued that higher profits are responsible for higher prices so that if a company made lower profits, its prices would be lower, too. Given what we have covered this term, did the Carter administration use accurate economic analysis and would its prohibition on "high" profits result in lower prices? Why or why not?

Answer 1

Profit percentage = (P - MC ) / MC = P/MC - 1

P = Price

MC = Marginal Cost

Now the profit can be reduced by reducing the price, or by increasing the marginal cost.

So if a firm has to control the profits, It can produce a quantity which is higher than socially optimal. This will result in the firm producing at a point where the Marginal COst of production is increasing. Now since the marginal cost is increasing, the firm can increase prices without hurting its profit margin of 6%.

Thus ordering a firm to have a fixed profit will not be of any help to counter the rise in prices.However, if the marginal cost is fixed and is a straight line, then no matter what the production be, the marginal cost will remain same. So the price cannot be increased.

In general, marginal costs usually keep on increasing and marginal revenue keep on decreasing as per the law of diminishing marginal utility. So for most cases, restricting profits is not a very effective way to counter high prices.

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