Price Ceiling and Price Floor - Research Paper Example

Introduction In a perfect economy, the market moves to an equilibrium. The prices of a good rise or fall to its equilibrium level – the level at which the quantity of a good demanded by customers is equal to the quantity of good that producers are prepared to supply. However, a Government has to undertake certain price control mechanisms. The reasons behind such a price control might be anything: Political Reasons; Social reasons; or to benefit a particular group of society. However, indications point that such Government intervention to control prices lead to inefficiency in market. This essay analyzes price controls as imposed by the Government and their effect on the market efficiency. Price Controls and their types Defined in the simplest of terms, price controls can be defined as definition of a certain maximum or minimum level of the prices by the Government at which a good will be available in the market. The two most basic level of price control mechanisms undertaken by the Government are: Price Ceiling and Price Floor. The Price Ceiling is the maximum price at which a good can be sold in the market whereas Price Floor is the minimum price at which the good will be sold in the market (Mankiw, 2008). While price Ceiling is generally meant to save consumer interest, price floor is intended towards saving the interest of the supplier. Price Ceilings can be categorized into two types: Binding Price ceilings are the one which are at level lower than the equilibrium price and hence have significant impact on the market equilibrium. Non-binding price ceilings are set at a level higher than the equilibrium level. Examples of price ceiling include setting up rent control in New York, while setting of minimum wages is an example of price floor. Price floors are often imposed during crises like wars, droughts or natural disasters. Price floors are generally set for agricultural products to save the interest of the farmers. Price Controls in Indonesia Indonesia, where more than 20% of the population is below the poverty line, Government takes active participation in controlling the prices. In order to curb inflation, the Government of Indonesia has time and again imposed control on the price of rise. The price control is also aimed at helping farmers. Prior to this, the Government had imposed price controls on cement because of the strategic nature of the industry. The Government set a maximum retail price at which cement could be sold and allocated production and distribution quotas amongst all the players. As a result of this, consumers in areas having cement factories had to supply to other areas where there were no cement factories. This intervention also let to a cartel amongst cement players of the country. Price Ceilings and Market Efficiencies The diagram below shows the market dynamics and the application of a price ceiling in the market: While, S denotes the Supply curve, D represents the Demand curve. E is the point of market equilibrium. Now if the Government wants to impose a price ceiling P, we can see that the price ceiling line intersects the demand the supply curve at points B and A respectively. This creates a shortage in the market as can be seen from the diagram. This leads to Inefficient Allocation to Customers. Consumers who are in desperate need of the good may not get it whereas those who can do without it will get the good. The rationing that Government does to prevent this inefficient allocation is even more costly (Deacon et al., 1989). Another inefficiency caused by price ceiling is that of Wasted Resources. As a result of the shortage that is created from the price ceiling, a lot of effort and time of people is wasted to search for the good. The opportunity cost associated with this wastage is bad to the economy of the country. Tarr (1994) in his research “The Welfare Costs of Price Controls for Cars and Color Televisions in Poland: Contrasting Estimates of Rent-Seeking from Recent Experience” concluded that the social cost of waiting for a television set was 10 times the size of standard deadweight loss and that the overall cost was more than the industry’s total sales. Price ceiling may also result in some suppliers going out of the market as a result of their inability to cope with the reduced prices. Other suppliers, in order to cope with the reduced price may drop the quality of the product or the service provided. Thus price ceiling also leads to Inefficiently Low Quality. Hemmasi and Kemintz (2003) found that in an oligopolistic setting, price ceiling leads to improved average quality in the market. Ronnen (1991) suggested a minimum quality model where quality was found to be directly affected by regulatory constraints. Price ceilings also lead to illegal activities such as Black Marketing. Because of shortage and customer’s ability to buy at a higher price, certain unscrupulous elements may hoard goods and then sell it at a higher price in the black market. Price Floors and Market Efficiencies The graph below shows the concept of price floors and the way it disturbs the market efficiency: As can be seen in the graph above, price floors result in creation of quantity surplus. This leads to inefficient allocation of sales amongst sellers – Sellers who are able to make a sale are not the always that have gained the maximum profit from the selling. Like price ceilings, price floors also result in waste of resources. Wastage of resources may in the form of unwanted surplus that needs to be destroyed in case of agricultural products or the time wasted by would be workers in searching for a job. Price floors may also lead to goods and services being offered at inefficiently high quality. At the same time, price floors like minimum wages act may also lead to concealment of employment by workers. Conclusion As can be seen, price controls although may be attractive for the Governments to regulate the market, the control actually leads to market inefficiencies which are not in the best interest of the country’s economy. Price controls lead to inefficiencies in the form of inefficient allocation, wasted resources, inefficient high or low quality and illegal activities. References Deacon, R., and Sonstelie, J. (1989). The Welfare Costs of Rationing by Waiting. Economic Inquiry, Vol. 27, No. 2 Kemnitz, Alexander and Hemmasi, Cyrus, (2003), Price ceilings and quality competition, Economics Bulletin, 4, issue 20, p. 1-9. Mankiw, N.G. (2008). Principles of Microeconomics. Cengage Learning. Ronnen, U., 1991, Minimum quality standards, fixed costs, and competition, RAND Journal of Economics 22, 490-504. Tarr, D. (1994). The Welfare Costs of Price Controls for Cars and Color Televisions in Poland: Contrasting Estimates of Rent-Seeking from Recent Experience. World Bank Economic Review, Vol 8, issue 3. Read More