Question

12. Calculate the fictional gain or loss of industry resulting from price ceiling and price floor

Answer 1

Lets take an example of water supply demand graph for USA an equilibrium price Pe and equilibrium quantity traded Qe. Assume, there is not govt intervention and equilibrium point is achieved by interaction between buyers and sellers.

The Initial supply curve is given by S1 and demand curve by D1.

1. Price Ceiling

Suppose there is a drought. In this case:

- Supply curve will shift to the left since there is shortage of water to supply

- Due to shifting of supply curve, a new equilibrium point(e1) will be achieved with reduced quantity Q2 and increased prices P2 as shown below

Now lets assume that the government fixed maximum price cap at pe( which is the initial equlibrium point). Thus, at this point, water suppliers would be willing to supply Qs against demand Qe.( Please see the graph).Thus, the market will be in disequilibrium where there will be less supply and more demand. Lets analyze the revenue by looking at the graph

Revenue earned in case of price capping: A( sum of rectangle at price Pe and Qs

In case capping was not imposed, equilibrium would be at e2. Revenue would have been A+B+C

Clearly, Firms loose revenue in case of price ceiling

2. Price Floor

Price floor is the concept where the price cannot be lower than a particular point. Lets say there is excess of corn this summer due to favorable weather. This will increase the supply( supply curve will shift to the right). which will increase the quantity traded, but the prices would fall( since there is higher supply than demand.) See the following graph:

Because of the increase in supply, following will happen:

- Equilibrium price decrease from Pe to P2

- Quantity increases from Qe to Q2

Now lets say that the government says that the price cannot go below Pe, it means that the govt imposes price floor at Pe.Lets analyze what happens to the revenue for the corn producers:

If there was no price floor:

Revenue earned: A+B( Look at point e2 at Price P2 and Quantity Q2)

In case of price floor:

Revenue earned: A+B+C+D+E( look at point which has Price Pe and quantity Qs. With price floors, farmers would be wiling to supply more corn)

Clearly, Firms gain revenue in case of price flooring

However, we are not assuming the demand to perfectly inelastic or elastic.