IBEconomicsDPHLRevision Notes2. Microeconomics2.7 The Role of Government in MicroeconomicsGovernment Intervention: Price Controls

Government Intervention: Price Controls (DP IB Economics)

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Price Ceilings (Maximum Prices)

  • Price controls are used by governments to influence the levels of production or consumption

  • Two types of control are commonly used: maximum price (price ceiling) and minimum price (price floor)
      

  • A price ceiling is set by the government below the existing free market equilibrium price and sellers cannot legally sell the good/service at a higher price
     

  • Governments will often use price ceilings in order to help consumers

    • Sometimes they are used for long periods of time, e.g. to keep rents lower in housing rental markets

    • Other times, they are short-term solutions to unusual price increases, e.g. petrol
       

1-4-1-government-intervention---maximum-price_edexcel-al-economics

The price ceiling (Pmax) sits below the free market price (Pe) and creates a condition of excess demand (shortage)
   

Diagram Analysis

  • The initial market equilibrium is at PeQe

  • A price ceiling is imposed at Pmax

    • The lower price reduces the incentive to supply and there is a contraction in quantity supplied (QS) from Qe → Qs

    • The lower price increases the incentive to consume and there is an extension in quantity demanded (QD) from Qe → Qd

    • This creates a condition of excess demand equal to QsQd 

Key points to note on consumer surplus

  • When price ceilings are used, they create a condition of excess demand. In the longer term, suppliers will adjust to this situation and supply less (Qs), so this actually decreases the overall consumer surplus

    • For those individual consumers who are able to purchase the good at the lower price, their consumer surplus increases

    • But many consumers are unable to purchase the product any more, so the overall value of consumer surplus in the market decreases
       

  • To calculate consumer surplus after the price ceiling, using the trapezoid formula often is the quickest way to determine the correct value

    • In the worked example below, there is a visual representation of calculating the area of a trapezoid (shaded pink area) where a is the length of one side, b the length of the other side - and h is the height between the two sides.

Worked Example

In order to support consumers during a two week festive period in Indonesia, the government has set a price ceiling (Pmax) on chicken at $2 per kilogram for this period.

2-7-3-calculating-area-of-a-trapezoid

 

Answers:

a) Using the graph, calculate the change in the consumer surplus resulting from this government intervention. [2]

Step 1: Calculate the consumer surplus before the policy 

Consumer space surplus space before space the space policy space equals space fraction numerator 30 comma 000 space cross times space 3.50 over denominator 2 end fraction Consumer space surplus space before space the space policy space equals space $ 52 comma 500 space

(1 mark)
 

Step 2: Calculate the consumer surplus after the policy

Remember! Theory states that suppliers do not supply past the intersection of Pmax and Qty

Consumer space surplus space after space the space policy space equals space Area space of space the space trapezoid Consumer space surplus space after space the space policy space equals fraction numerator straight a space plus space straight b over denominator 2 end fraction space straight x space straight h Consumer space surplus space after space the space policy space equals fraction numerator 6.5 space plus space 5.25 over denominator 2 end fraction space straight x space 12 comma 000 Consumer space surplus space after space the space policy space equals $ 70 comma 500 space space

(1 mark)

Step 3: Calculate the difference between old and new consumer surplus

The change in consumer surplus = $70,500 - $52,500

= $18,000 (1 mark)

b) As this is a short term policy, assuming suppliers continue to meet demand, calculate the change in supplier revenue as a result of this policy. [3]

Step 1: Calculate the original sales revenue

Sales space revenue space equals space price space straight x space quantity Sales space revenue space equals space $ 3.50 space straight x space 30 comma 000 Sales space revenue space equals space $ 105 comma 000(1 mark)
 

Step 2: Calculate the sales revenue assuming suppliers meet demand

Sales space revenue space equals space price space straight x space quantity Sales space revenue space equals space $ 2.00 space straight x space 45 comma 000 Sales space revenue space equals space $ 90 comma 000(1 mark)
 

Step 3: Calculate the difference between the two

Change space in space sales space revenue space equals space $ 90 comma 000 space minus space $ 105 comma 000 Change space in space sales space revenue space equals space minus $ 15 comma 000 (1 mark)

Examiner Tip

Remember, when price ceilings are used, they create a condition of excess demand. In the longer term, suppliers will adjust to this situation and supply less, so this actually decreases the overall consumer surplus. For those individual consumers who are able to purchase the good at the lower price, their consumer surplus increases. But many consumers are unable to purchase the product any more, so the overall value of consumer surplus in the market decreases.

An Evaluation of Price Ceilings

The Advantages and Disadvantages of Using Price Ceilings (Maximum Prices)


Advantages


Disadvantages

  • Some consumers benefit as they purchase at lower prices. For these consumers their consumer surplus increases

  • Price ceilings can stabilise markets in the short-term during periods of intense disruption e.g. Covid supplies at the start of the pandemic

  •  Some consumers are unable to purchase due to the shortage

  • Producers lose out as the price is below what they would usually receive: their producer surplus falls

  • The unmet demand usually encourages the creation of illegal markets (black/grey markets) as desperate buyers turn to illegal bidding

  • Maximum prices distort market forces and therefore can result in an inefficient allocation of scarce resources e.g. price ceilings of housing rentals in the property market create a shortage

  • When used in necessity markets, Governments may be forced to intervene further by supplying the good/service themselves in order to meet the excess demand

Price Floors (Minimum Prices)

  • A price floor (minimum price) is set by the government above the existing free market equilibrium price and sellers cannot legally sell the good/service at a lower price
     

  • Governments will often use price floors in order to help producers or to decrease consumption of a demerit good e.g. alcohol 
     

1-4-1-government-intervention---minimum-price_edexcel-al-economics

The imposition of a price floor (Pmin) above the free market price (Pe) creates a condition of excess supply (surplus)

Diagram Analysis

  • The initial market equilibrium is at PeQe

  • A price floor is imposed at Pmin

    • The higher price increases the incentive to supply and there is an extension in QS from Qe → Qs

    • The higher price decreases the incentive to consume and there is a contraction in QD from Qe → Qd

    • This creates a condition of excess supply equal to QdQs      

An Evaluation of Price Floors

The Advantages and Disadvantages of Using Price Floors (Minimum Prices) in Product Markets


Advantages


Disadvantages

  • In agricultural markets, producers benefit as they receive a higher price (Governments will often purchase the excess supply and store it or export it)
     

  • When used in demerit markets, output falls (Governments will not purchase the excess supply of a demerit good)
     

  • Producers usually lower their output in the market to match the QD at the minimum price and this helps to reduce the external costs

  • It costs the government to purchase the excess supply and an opportunity cost is involved

  • Farmers may become over-dependent on the Government's help

  • Producers lower output which may result in an increase in unemployment in the industry

Worked Example

The French government has imposed a minimum price on the market for butter. Refer to the graph below and answer the questions that follow

A demand and supply diagram which has three price points on it. Students have to identify which price point is a minimum price and perform some calculations

 

Answers:

a) From the three price points, identify which price point would represent the price floor [1]

  • €15

  • (The price floor is always above the market price)
     

b) Explain the impact on the market of the imposition of this price floor [2]

  • It creates a condition of excess supply (1 mark)

  • With consumers demanding only demanding 1,500 units and producers supplying 3,500 units, the excess supply = 2,000 units (1 mark)
     

c) Calculate the change in producer revenue after the imposition of the price floor [3]

  • Producer revenue before the price floor = €10 x 2,500 = €25,000 (1 mark)

  • Producer revenue after the price floor = €15 x 1,500 = €22,500 (1 mark)

  • Producer revenue has decreased by €2,500 (1 mark)

Price Floors (Minimum Prices) in Labour Markets

  • Minimum prices are also used in the labour market to protect workers from wage exploitation 

  • A national minimum wage (NMW) is a legally imposed wage level that employers must pay their workers

    • It is set above the market rate

    • The minimum wage/hour usually varies based on age
       

3-5-3--minimum-wage_edexcel-al-economics

A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1

 

Diagram Analysis

  • The demand for labour (DL) represents the demand for workers by firms

  • The supply of labour (SL) represents the supply of labour by workers

  • The market equilibrium wage & quantity for truck drivers in the UK is seen at WeQe

  • The UK government imposes a national minimum wage (NMW) at W1

  • Incentivised by higher wages, the supply of labour increases from Qe to Qs

  • Facing higher production costs, the demand for labour by firms decreases from Qe to Qd

  • This means that at a wage rate of W1 there is excess supply of labour & the potential for unemployment equal to QdQs  

An Evaluation of Minimum Wages

The Advantages and Disadvantages of using Minimum Wages in Labour Markets


Advantages


Disadvantages

  • Guarantees a minimum income for the lowest paid workers

  • Higher income levels help to increase consumption in the economy

  • May incentivise workers to be more productive

  • Raises the costs of production for firms who may respond by raising the price of goods/services

  • If firms are unable to raise their prices, the introduction of a minimum wage may force them to lay off some workers (increase unemployment)

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