Lecture 6 - Market in Action PDF

CHAPTER 5 CHAPTER OUTLINE Market in 1. Government – Controlled Prices Action Price Ceiling Price Floor 1  1. Government - Controlled Prices Sometimes governments decide to use some mechanism rather tha...

CHAPTER 5 CHAPTER OUTLINE Market in 1. Government – Controlled Prices Action Price Ceiling Price Floor 1  1. Government - Controlled Prices Sometimes governments decide to use some mechanism rather than the market system to set prices. They set the price of some products to protect consumers (price ceiling) or producers (price floor).  Price Ceiling A maximum price, set by government, below the equilibrium price and it is not permitted to rise. In 1974, a ceiling price of $0.57 per Figure 5.1: Excess Demand (Shortage) gallon of gasoline was imposed. If the Created by a Price price had been set by the interaction of Ceiling supply and demand instead, it would have increased to approximately $1.50 per gallon. At $0.57 per gallon, the quantity demanded exceeded the quantity supplied. Because the price system was not allowed to function, an alternative rationing system had to be found to distribute the available supply of gasoline.  Price Ceiling 1.It is a maximum price; below or lower than the equilibrium price. 2.It is an obligatory price; not permitted to increase. 3.It is set to protect consumers. 4.The price ceiling creates a shortage (excess demand). This shortage causes: Queuing: Waiting in lines to distribute goods and services. Favored customers: Those who receive special treatment from dealers during situations of excess demand. The black market: A market in which illegal trading takes place, since the sellers sell the available quantity of a certain good at a price higher than the price ceiling set by the government to increase their revenue.  As a solution for this shortage (excess demand): 1. The government may distribute the limited amounts of products available using ration coupons. Ration coupons are tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. 2. The government may increase the supply of that product, for example by giving a subsidy to the producers for producing each unit of that product, so that the supply curve shifts to the right to fill in the shortage.  The Impact of a Price Ceiling Price S S` Figure 5.2: the impact of price ceiling PBM P* P Ceiling Shortage D Qs Qd Quantity Q* o Numerical Example Assuming that in the market of rice, the equilibrium price = $6 and the equilibrium quantity = 14 Units. If the government imposed a price ceiling of $4 per unit, 1. Find the effect of this policy on the market of this product (shortage or surplus). 2. Detect graphically the black-market price. 3. What is your advice to the government to make this price ceiling an equilibrium price?  The Impact of a Price Ceiling Price S Figure 5.3: Example of the impact of price A ceiling $6 $4 Shortage D 10 16 Quantity 14 2. Detect graphically the black-market price. The black market is created because quantity supplied in the market is limited by 10 units. As long as the government is keeping the price ceiling at $4 per unit the quantity supplied will be only 10 units In this case the supply curve will be vertical line S`, and the black-market price will be decided by the intersection between the demand curve D and the vertical supply curve S`. the equilibrium price in the black market will be measure by this equation: Qd = Qs 9  Measure the black-market price Price S` S B Figure 5.4: Example of $8 the price of black market A $6 $4 Shortage D 10 16 Quantity 14 3. What should the government do to restore equilibrium back? The government should fill the gap between Qd and Qs at the price ceiling. So, the government should shift supply curve to the right to fill the shortage by importing 6 units or by giving subsidy to producers for each produced unit of the product. 11  The Government should shift supply to fill the gap or the shortage between the Qd and Qs. Price S S` A $6 C $4 Shortage D 10 16 Quantity 14  It is a minimum price; above or higher than the equilibrium price. It is an obligatory price; not permitted Price Floor to decrease. It is set to protect producers (agriculture producers). The price floor creates a surplus (excess supply).  Impact of a Price Floor Price Surplus S C Figure 5.5: P-floor price floor P* D` D Qd Q* Qs Quantity  As a solution for this surplus (excess supply) the government will be forced to buy the surplus products resulted from this policy to get rid of the excess supply. the demand will increase and shifts to the right to fill the surplus. Example: minimum wage A price floor set for the price of labor, and the result will be surplus of labor, or unemployment. o Numerical Example In the market of a certain good assume that the equilibrium Price = $6 & equilibrium Quantity = 14 Units, If the government imposed a price floor of $8 per unit, 1. Find the effect of this policy on the market of this product. (Excess demand or excess supply) 2. Detect graphically the price if there is no government’s action. 3. What is your advice to the government to make the price floor an equilibrium price? 1. Find the effect of this policy on the market of this product. (Excess demand or excess supply)? At the price floor of $8 which is above the equilibrium market price, this will create excess supply (surplus). Qd < QS. 2. Detect graphically the price if there is no government’s action As long as the government is keeping the price floor at $8 per unit the quantity supplied will be > 14 (eg.:18 units) In this case the supply curve will be vertical line S` So, the price will be decided by the intersection between the demand curve D and the vertical supply curve S`. The price is determined by: Qd = Qs ⇒ P = $2 The Impact of a Price Floor Price Surplus S` S $8 A $6 $2 B D 12 14 18 Quantity 3. What is your advice to the government to make the price floor an equilibrium price? The government should buy the excess supply at the price floor. So, the government should shift demand curve to the right to D` to buy the surplus of 6 units. The new Equilibrium point is C  Impact of a Price Floor Price Surplus S C $8 $6 A $2 B D` D 12 14 18 Quantity Market Equilibrium Points Point A is the equilibrium point in the free market with no government intervention. Point B is equilibrium point in the black market if government does not take extra action to make its price ceiling or price floor equilibrium. Point C is equilibrium point if the government decided to take extra action to make its price equilibrium price: by increasing supply in the case of price ceiling (to satisfy the shortage) by increasing demand in the case of price floor (by purchasing the surplus)  Price Controls https://www.youtube.com/watch?v=1EzY4Vl460U © 2014 Pearson Education Canada Inc. 22