Government Intervention: Price Controls (DP IB Economics)
Revision Note
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
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.
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
(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
(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
(1 mark)
Step 2: Calculate the sales revenue assuming suppliers meet demand
(1 mark)
Step 3: Calculate the difference between the two
(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)
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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
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
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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
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
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
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