Question

Suppose the current equilibrium price of a case of 24 Poland Springs .5 liter bottles is $4.99. The government passes a law that requires the price to be no more than $3.50. What will be the affect on quantity supplied and demanded? Will a new equilibrium price be found? If so, how? (Hint: draw the described situation.)

Answer 1

Given is that the equilibrium price of .5 litre bottles is $4.99 at equilibrium quantity of 24. This is the initial situation and occurs at the intersection of demand and supply. So we have a equilibrium here at e point. Here quantity supplied equals quantity demanded.

Now when government passes a law due to which prices cannot be more than $3.50 it means that the government imposes a price ceiling (maximum chargeable price) in the market. This law is binding on the market equilibrium. Due to this the equilibrium cannot adjust to the point where supply and demand equal. So at $3.50 there is a gap between quantity demanded Qd and quantity supplied Qs. At a lower price than the equilibrium, sellers supply less quantity while consumers demand a higher quantity (from law of demand and supply). This points are labelled in the diagram. The positive difference between Qd and Qs indicates a shortage in the market because all the demand is not met by supply. Hence here equilibrium cannot exist due to the binding nature of the new law. The only way equilibrium can exist here if government's price ceiling is above equilibrium price and only then will it not be binding and market forces can equilibriate demand and supply to its original level.