Price Ceiling and Price Floor

Market systems may not allocate resources efficiently for many reasons. This is known as market failure. Governments intervene in order to correct such market failures. Imposition of price controls is one such intervention. Using relevant diagrams, discuss the use of (i) maximum prices, and (ii) minimum price controls in the markets and the consequences of each approach to the market and the society.

Market failure refers to a situation when the economy is not in a state of balance that is, the allocation of goods and services is not efficient and there exists a possibility that some different level of allocation might make the consumer better-off than before.

In cases of market failure, the market forces of demand and supply are not efficient enough and therefore the government must play its role of a welfare agency by intervening in the market. The intervention of government to correct market failures can be seen through two cases that is,

(i) Price ceiling and (ii) Price Floor.

The Economics of Price Ceiling

Price ceiling, as the name suggests means fixing a maximum limit (ceiling, which basically means roof) for the price of a commodity. We know that in a competitive market, the prices of goods and services are determined by the market forces of demand and supply.

In many cases, there is a possibility that the prices which are determined by the market forces of demand and supply are too high and that everyone in the economy, mainly the poor cannot afford it. In such cases, the government plays its role by intervening in the markets and imposing a price ceiling, that is a maximum price on the commodity. This maximum price is generally lower than the equilibrium price.

Price Ceiling means fixing a maximum price for the commodity which is generally lower than the equilibrium price.

Let us try to understand how the price ceiling operates this with the help of an example.

Suppose that the good in our study on which the government has imposed a maximum price that is, ceiling is rice. The equilibrium price is determined by the interaction of the free market forces, demand and supply curve for rice. The demand and supply for rice are affected when government imposes the price ceiling. Let us understand the impacts of price ceiling with the help of a diagram.

Impacts of Price ceiling

Impacts of Price ceiling
Equilibrium price = OP
Equilibrium Quantity = OQ
Ceiling Price Level = OP*
Excess demand = ab = Q’Q”       

In the above diagram, the initial demand curve is D and the initial supply curve is S. Equilibrium (the state of balance) is achieved at the point where both demand and supply curves intersect. This occurs at point E, the point of market equilibrium. The price level at this point is represented by OP and the level of quantity is represented by OQ. Now, considering that many people, mainly the poor people are not able to afford rice at this price level. To ensure that the commodities are available for everyone. Government tries to impose a maximum price that sellers can charge and we call it a price ceiling. This happens at P* and this price ceiling level, OP* is lower than the equilibrium level of price, OP.

Let’s now consider the effect of this maximum price level on the demand and supply. This new price ceiling level intersects the demand curve at point b and supply curve at point a. When price falls, demand for rice extends from OQ to OQ” and creates an excess demand equal to OQ” - OQ. Supply falls from OQ to OQ’ because the new price intersects the supply curve at point a where quantity demanded equals OQ’. The reduction in the quantity supplied equals OQ-OQ’. Consequently, there arises a gap between demand and supply. This gap shows that quantity demanded (OQ”) is greater than quantity supplied (OQ’) which shows that it is a situation of excess demand.

Consequences of Excess demand from price Ceiling

The gap between the demand and supply shows that people demand more than what is currently supplied in the economy. A situation of partial hunger continues to exist because people are unable to buy rice to the extent they wish to buy. To tackle this problem, government introduces rationing which means that consumption quotas will be decided and each person will be given a fixed percentage of rice at the ceiling price. But, the story does not end here. Rationing the commodity has its own limitations.

Government set ups their ration shops at different areas to distribute these commodities through public distribution system. There is no well-defined structure and people will have to stand in long lines to get their share of the commodity. This wastes not only time, but also energy as one has to wait for hours to get their allotted quota.

It is generally seen that commodities offered through this rationing mechanism are low in quality. So, one might get rice at a lower price but with this reduced price, quality deteriorates too and poor eats low quality of rice.

Another big problem which arises because of the ill practices adopted by the shopkeepers and the middlemen involved is of corruption. Rather than transporting rice to these rations shops, it is being transferred to the black markets. The poor thus, does not get their allotted share of the commodity as decided by the government. This does not eliminate the problem of scarcity and the problem of excess demand is not tackled.

What should the government then do to ensure that everyone gets a fair amount of the commodity?

The most important step that it can take is to enhance its public distribution system. The government should make sure that the person involved are honest and trustworthy and that in any case, goods will not be delivered to the black market.

It should conduct surveys at the different locations where rationed goods are supplied and ask the poor if they are getting their adequate share at the ceiling price. And if not, then the involved parties should be held answerable. Strict actions should be taken against those who try to violate the distribution mechanism. When this comprehensive system will be evolved, keeping in mind the practices that arises due to lack of integrity, it will be ensured that the goods meant for the poor are actually delivered to them.

The Economic Policy of Price Floor

Price floor, as the name suggests means fixing a minimum limit (floor, which basically means ground) for the price of a commodity. It might seem a bit appalling in the very first place to see that government has to fix a minimum price for a commodity but it is true.

We know that in a competitive market, the prices of goods and services are determined by the market forces of demand and supply.

There are cases, which shows that the prices determined by the market forces of demand and supply are too low and that the producers will not be able to earn enough profit at this level, which is necessary for their survival.

Price Floor means fixing a minimum price for the commodity which is generally higher than the equilibrium price.

Let’s take the example of corianders in Rajasthan. Coriander is a crop which cannot be stored without adequate maintenance for a much longer time after its harvest. Most farmers therefore sell their produce immediately after the harvest. There is an increased supply in the market and consequently the prices fall down. This reduced price may not promise returns to the farmers which he should get for his good harvest. Such a situation might compel them to reduce their output which might create shortage for the commodity in the economy.

So, to tackle this situation government plays its role by intervening in the markets and imposing a price floor, that is the minimum (lowest) price on the commodity. This lowest price is generally higher than the equilibrium price. Let’s understand this with the help for a diagram:

Impacts of Price floor

Impacts of Price floor
Equilibrium price = OP
Equilibrium Quantity = OQ
Floor Price Level = OP*
Excess supply = ab = Q’Q”       

In the above diagram, the initial demand curve is D and the initial supply curve is S. Equilibrium is achieved at the point where demand and supply curves intersect. This occurs at point E, the point of market equilibrium. The price level at this point is represented by OP and the level of quantity is represented by OQ. Now, considering that this price is too low and that the procedures will not get adequate returns at this price, the government intervenes and fixes a minimum price level known as price floor. This happens at OP* and this price floor level is lower than the equilibrium level of price, OP.

Let us now consider the effect of this minimum price level on the demand and supply.

This new price floor level intersects the demand curve at point a and supply curve at point b. When price rises, demand for coriander falls from OQ to OQ’. Supply rises from OQ to OQ” because the new price intersects the supply curve at point b where quantity demanded equals OQ”. Consequently, there arises a gap between demand and supply. And, this gap shows that there is an excess supply in the economy which equals to OQ”-OQ’. Thus, imposing the price floor creates an excess supply in the economy.

Consequences of Price Floor Policy

What does this excess supply mean?

It means that the farmers are supplying more than what the consumers demand in the market. The traders / buyers might not buy the entire coriander harvest at this increased price. This hits the farmers even harder as they will not be able to sell their entire output. In such a situation, government introduces this minimum support price which is equal to the price floor level. It means that the government will buy that excess produce from the farmers which they are unable to sell in the markets at this minimum price, which is above the equilibrium level of price.

What the government does by buying this excess produce is to be considered next. The purchase of commodities, coriander in this case is kept by the government as the buffer stock. Buffer stock refers to the stock of goods that government keeps with itself in its warehouses to be used during the periods of scarcity and to offset the price fluctuations.

Another major step that the government can take is to restrict the production of wheat. To do so, it can impose a legal restriction on the area that is employed under the production of coriander. This restriction reduces the output that is being produced by the farmers and this further reduces the market supply and the market price level of coriander rises. But, this comes with a serious limitation. We know that many farmers in Rajasthan are small farmers and that they produce barely enough for their survival. A part of what they produce is kept by them to meet their consumption needs and the rest is sold out in the market. Putting a restriction on the quantity they produce may lead to the problem of fallowing of land which means keeping the land idle. This is again a problem because this causes a cut in the farmers’ income. Therefore, in any way the government cannot reduce the market supply as it would turn out to affect the farmers even more adversely. In such a case, the government has to bear the impact by purchasing the existing stock and maintaining it as buffer stock.

The major demerit that the government faces with it is the storage and the maintenance costs. To ensure safe storage of the produce which can be used at the time of adversities, the government will have to construct big warehouses. Proper maintenance is required to ensure that the stock does not get rotten away and also proper protection from pests is required which might eat up the entire produce.

Thus, we have seen that the government intervenes in the market whenever there is a market failure but this intervention has its own consequences and demerits. On one hand, price ceiling has the demerits of pilferage and low quality whereas on the other hand, price floor has the serious demerit of storage of the produce. The planners and the policy should make sure that to fight the market failures, a comprehensive policy which inculcates all the aspects of the problem is in place and once the strategies and actions are decided, a proper implementation mechanism should be put into place so that an adequate, just and efficient execution of the desired plans and actions is being carried out. Once this is achieved the problem of market failures will not be as disastrous as it is today.

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