Question

Without government intervention, the market price moves to the level at which the quantity supplied equals the quantity demanded through the interactions of supply and demand. But governments intervene in the market now and then to control prices.

1. What are the market inefficiencies the price controls measures such as price ceilings and price floors create? Why do price ceilings and price floors lead to productive and allocative (marketing) inefficiency?
2. Who benefits and who loses from government interventions in markets through price control methods known as price ceilings and price floors? Why price controls are used despite their well-known problems?

Answer 1

a. The price ceiling and price floor are the two methods usually adopted by the government to control prices in a market. Price ceiling is fixing maximum price where the producers are not allowed to sell a price above the legally fixed price. This ceiling may be above or below the equilibrium market price. Price floor is the fixation of minimum price below that no sales is allowed. The price floor also may be below or above the equilibrium price. The price ceiling prevents the rising of prices above a certain limit whereas the price floor prevents the falling of price below a certain level. The price ceiling is resorted to prevent the over exploitation on consumers by the producers. This is a supportive measure to the consumers. The price floor is a supportive measure on producers as it ensures stable income to them.

An unregulated free market ensures maximum productive and Allocative efficiencies. But the government intervention in the form of price ceiling and price floor creates market imperfections like productive and Allocative inefficiencies and deadweight loss to the economy. The reason is that the price ceiling and price floor prevent the movement of supply and demand and prevent its self adjusting mechanism. The price ceiling and price floor creates excess supply or shortage that prevents the market to adjust itself. For example if the price ceiling is fixed above the equilibrium of the market cause excess supply. On the other hand if it is fixed below the equilibrium price there will be shortage in the market. Likewise a price floor above the equilibrium price creates excess supply and below the equilibrium price creates shortage.

Regarding the economic effects both the ceiling and floor both creates economic inefficiencies. A productive efficiency occurs when the producers are able to produce maximum output with minimum cost. It the point where the marginal cost equates with the average cost. But this efficiency is prevented by the government when it adopts price control. For example if a price ceiling or price floor is fixed above the equilibrium price the demand will be less than the optimum which compels the producers to restrict the output and thus they will operate at the highest level of average and marginal cost. On the other hand a price control set below the equilibrium price cause shortage where the producers are not able to equate the MC with MR. The maximization of profit to the producers occurs when MC=MR. In both the case there will be unutilized resources due absence of capacity utilization.

The Allocative efficiency is a situation when goods and services are distributed according to the preference of the consumers. The Allocative efficiency is attained when the marginal cost is equal to marginal benefit. In other words the Allocative efficiency is one where the marginal cost at which the producers are willing to supply equates with the price that the consumers are willing to pay (MC=MR). This condition is satisfied when only the market demand curve intersects with the market supply. At the equilibrium of the market the consumer’s and the producer’s surplus is the maximum. The price fixation causes loss of satisfaction either to the consumers or producers. In short the price controls like price ceiling and price floor creates productive and Allocative inefficiencies.

b. If the price control is adopted above the equilibrium price whether it is price floor or ceiling the producers are benefited and the consumers will be the losers. On the other hand if it is implemented below the equilibrium price the consumers are the gainers and the producers are the losers. In price ceiling there will be the transfer of economic welfare from one section of the society to the other. These methods are good for nothing and rather created deadweight loss. The deadweight loss is the loss of satisfaction to the producers when they are unable to produce at their fuller capacity. The deadweight loss occurs to the consumers which results from a situation where the consumers are unable to consume goods and services as they desire.

Despite the drawbacks of price control, a government usually adopts price ceiling of price floor in order to obtain certain desired object. The first one is to prevent the black marketing. In a free market economy the producers are taking undue advantage of black marketing when there is high demand for products. In such situations the consumers are overexploited by the black marketers. Secondly certain necessary goods like food, housing etc must be available to the society at affordable prices. Sometimes the price control is adopted to ensure fair revenue to the producers and prevent the shortage in the economy. Thirdly the use of certain luxury goods to be prevented from the point of view of larger economic interest. Lastly the price control is adopted to prevent the frequent changes in price and ensure stable price which is essential for economic growth.