Question

With the aid of supply and demand diagrams demonstrate that any effective price controls (i.e., either price ceilings below the equilibrium price, or else price floors above the equilibrium price) in a competitive market will reduce the actual quantity that can be traded (i.e. bought and sold) in that market.

Answer 1

Solution. We will go case by case, But before that we assume, market has linear demand and supply curve. Demand and supply curve are denoted by DD and SS respectively.

Case(I): Price Ceiling

Under price ceiling, we know, market prices are controlled as such that market price cannot go above the certain level, this policy takes effect when market price(P_e) are unaffordable for buyers in genral.

Hence P_c < P_e, where P_c is a ceiling price.

Using the diagram representation we can argue that Q_e is the equilibrium quantity price for competitive economy at price P_e.

since P_c < P_e, we can see that horizontal line from P_c cuts SS and DD curves and gives quantity supply and quantity demand as Q_c^s and Q_c^d respectively. The maximum trade in the market can be Q_c^s since sellers are not willing to sell more than it at price P_c.

Result: Trade volume is decrease by (Q_e-Q_c^s) by imposing price ceiling the market since Q_c^s < Q_e.

Case (II): Price Floor

Under price floor, we know, market prices are controlled as such that market price cannot go below the certain level, this policy takes effect when market price(P_e) are too less and sellers are not able to get reasoable price for there products in general.

Hence P_f >P_e, where P_f is a floor price.

Using the diagram representation we can argue that Q_e is the equilibrium quantity price for competitive economy at price P_e.

since P_f > P_e we can see that horizontal line at P_f cuts DD and SS curves and gives quantity demanded and supplied as Q_c^s and Q_c^d at P_f respectively. The maximum trade in the market can be Q_f^d since buyers are not willing to buy more than it at P_f.

Result: Trade volume is decrease by (Q_e-Q_f^d) by imposing price floor in market since Q_f^d < Q_e.