Question

a) The government is currently considering setting a maximum price (price ceiling) for basic goods to ensure that people can get access to these goods at this current time. Fully explain your answer and also use a single diagram to demonstrate the likely outcomes of this policy if the maximum price is set: 1. Below the current free-market price More people would be able to afford this time but having this at a set maximum price would result in high demand and the production will not be able to meet these demands 2. Above the current free-market price 3. At the current free market price

Answer 1

Introduction: -

For Understanding the graphs, we need to know, the meaning of a price ceiling. A price ceiling is the maximum price which a government may set beyond which, the producer cannot sell the good. This is usually done to ensure that while a market stays profitable for the producer, it does not damage the consumer too much.

For example, most countries have set an upper limit in terms of the price that may be charged from the consumer to avail face masks in the market. This then prevents producers from over charging the customers which was a big problem during the recent pandemic situation.

Case Details: -

The following graph has been used to answer all of the questions as posted in the case study in detail the graph is as follows: -

In the graph, a demand and supply curve has been denoted and the effect of the price being set above and below the equilibrium price or at the equilibrium price is described. The demand graph is downward sloping, indicating that at lower prices, there is more demand for the good. Similarly, the supply curve is upward sloping, indicating that at higher prices, since the level of profits are higher, the supply is higher as well.

Equilibrium is the point wherein demand and supply meet i.e. the satisfaction of the consumers as well as profits of the producers are maximized at this level without hurting one another.

All specific questions and the effects are as follows: -

Part 1)

In the above graph, the blue line below the equilibrium indicates a price ceiling below the equilibrium price. As this happens, the quantity supplied shrinks from Q to Q1 this is because, suppliers do not get the same profit levels as they earlier would while the demand increases from Q to Q2 because people now would get additional quantity for the same income spent.

For example, consider a situation wherein the equilibrium price of a good was 10$ and the profits which a producer was making on the same were 6$ per unit sold i.e. his cost price was 4$ per unit. Now, if the price ceiling is applied at say 6$, then the profits which producers would make shrinks to 2$ per unit. This would then mean that some producers would not want to invest in such markets where returns have diminished and the quantity supplied would reduce.

On the contrary, the demand will increase as price drops from 10$ to 6$ as a lot more people would be able to purchase the commodity.

Shortage here is defined as the gap between what the supplier is willing to supply at the price of the price ceiling and what the people are ready to buy at that price respectively.

Part 2)

When a price ceiling is set above the market equilibrium price, even though, suppliers would want to sell at the price ceiling, there would be no use to the producer, as at that price the demand would be lower. Therefore, there is no effect on the market in this situation because since the demand decline would be sufficient to lower down the profits of the producer, he would prefer to offer the same for a lower price point.

Even if some producers, began selling at the ceiling price in this situation, demand would shift over to other alternatives as producers would have the added advantage of extra demand if they sold at the equilibrium price.

Therefore, any price ceiling which is above the ceiling price would not affect the markets which would then sit at equilibrium only.

Part 3)

When we set a price ceiling at the equilibrium position, the market observes no significant change. The equilibrium quantity and price are charged from the consumer while the profits of the producer are also at the level which is desirable for the market. This method is usually not chosen since mostly through the help of price ceilings, the government wants to decrease the prices of goods and services which are currently selling in the market place.

Please feel free to ask your doubts in the comments section.