Suggest how the use of min/max price controls could be used to regulate pricing in various markets (15)
Price controls are defined as government-mandated maximum or minimum price that can be charged for specified goods, which are known as price ceiling or price floor respectively.
Price ceiling is defined as a legally established maximum price that sellers can sell for the good or service. Sellers are prohibited from selling above the stipulated price but prices can fall below it. A price ceiling is set below the existing equilibrium; by doing so, the government protects consumers in cases of supply shocks and expected price hikes.
From the diagram, consumers pay p1 before a max price and derive consumer surplus of a+b. With max price, they now pay lower price at Pmax; improving equity in the market. Welfare increases to a+c.
Nevertheless, there is a resultant excess demand which results in a shortage. As seen, Qd>Qs and there is a resultant shortage, which might perpetuate the growth of an illegal or informal market. There is also a drop in producer surplus to area e. Because the society now consumes at Qs, there is an under-allocation and a resultant welfare loss b+d. Governments may have to increase supply of agricultural products either using subsidy or buffer stock from previous purchase.
A price floor may help to protect the producers when there is a bountiful harvest and an expected drop in price. The demand for agricultural products is price inelastic as expenditure on these products tend to take up a small proportion of most consumers’ income. With a higher price due to the implementation of a price floor, it will lead to a less than proportionate fall in quantity demanded. Producers of agricultural products will have an increase in their total revenue due to the higher price. Assuming that total cost remains constant, an increase in total revenue will lead to higher profits (where profits = total revenue-total cost) earned for the producers.
However, the implementation of a price floor may not always be able to protect the producers. If the price elasticity of demand for agricultural products is more than one due to the availability of close substitutes from other countries, a higher price due to the price floor will lead to a more than proportionate fall in quantity demanded for agricultural products, resulting in a fall in total revenue for the producers. Assuming total cost remains constant, there will be a fall in the profits earned for the producers.
In addition, a price floor may also give rise to certain problems. From Figure 2, with the implementation of the price floor above the market equilibrium price, the market will only consume up to the point (Qd) where the demand curve intersects the price floor line at Pf. Due to the lower amount of agricultural products consumed, there will be a loss of consumer surplus, the resultant surplus is shown by the top shaded area. On the producers’ side, due to the fall in the amount of agricultural products consumed by the consumers, there is a fall in the amount of goods sold, leading to a fall in their producer surplus. The total deadweight loss to the society with the implementation of the price floor is shown by the shaded triangle, assuming that the government does not buy the surplus Qd to Qs.
The government will also have to incur higher expenditure in order to maintain the stockpile for the producers and it will be wasteful if the surpluses are disposed of or destroyed especially if these are perishables which cannot be stored for long. These surpluses represent a misallocation of resources in the country as scarce resources are used to produce unused goods. In addition, financing the annual surpluses of agricultural products will impose heavy tax burden on the taxpayers which renders such schemes unsustainable in the long run.Therefore, in order for the price floor to be effective in the market for agricultural products, the government will have to buy back the surplus so that the producers can continue their production.
Moreover, with the implementation of the price floor, producers are less motivated to look for cheaper and more efficient methods of production as they now have a minimum guaranteed price and their profits are being protected by the high mandatory price, leading to productive inefficiency. Due to this, more producers may also be attracted into the market for agricultural products, thereby creating an even greater surplus of agricultural products.
Due to the costs incurred from the implementation of the price floor, there may be other ways to protect the producers. The government may provide subsidies for the producers to seek more productive ways which will aid them in reducing their cost of production, leading to a rise in their profits, ceteris paribus. In addition, the government may also want to implement import-substitution policies which advocate replacing foreign imports of agricultural products with domestic production, thereby increasing the demand for local agricultural products and the profits for the producers.
In conclusion, price controls can be implemented in the short run to address unexpected demand or supply shocks. For example, in the short run, a poor harvest can lead to high prices and this may lead to low-income households not being able to purchase food. In this case, price controls should be implemented in order to achieve equity among the rich and the poor quickly. However, once harvest has stabilized, the governments should aim to remove the price controls as soon as possible in order to prevent the negative consequences of the price controls.
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