Price Ceilings and Price Floors Maximum Price: a price ceiling above which the price of a good or service is not allowed to increase Minimum Price: a price floor below which the price of a good or service is not allowed to decrease

Background 

Governments and regulatory authorities may impose minimum and maximum prices

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Eg. the minimum wage – a minimum price for an hour of labour

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This may cause a disequilibrium within the market and the market mechanism (the 3 functions of price) do not correct it because they can’t.

Maximum Prices Normally price would rise to eliminate excess demand and encourage an extension in supply

S Free market Equilibrium

Price Ceiling Pmax Excess Demand D

This cannot happen so the excess demand remains, usually in the form of a queue or waiting list

Maximum Prices - Analysis This could cause bribery and corruption of officials who regulate the waiting list

S Free market Equilibrium

Price Ceiling Pmax Excess Demand D

Alternatively secondary or ‘black’ markets may emerge where supply from the primary market is resold to those who are willing to pay more

Maximum Prices - Analysis Free market Equilibrium

S Price Ceiling

Pmax

D

Excess Supply

What would the consequence of this price ceiling be?

Minimum Prices Free market Equilibrium

S Price Floor

Pmin

D

Excess Supply

Normally price would fall to eliminate excess supply and encourage an extension in demand This cannot happen so the excess supply remains.

Minimum Prices - Analysis Free market Equilibrium



S Price Floor

Pmin

D

Excess Supply

Examples are the minimum wage and when governments intervene in agricultural markets to protect the incomes of farmers

Minimum Prices - Analysis Free market Equilibrium

S



Price Floor Pmin

D

Excess Demand

What difference would this price floor make?

Min and Max Prices Evaluation 

Market intervention of this kind prevents the market from working and can distort the signals within the market, which lead to a misallocation of resources

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E.g. Prices of Coffee Beans are made subject to a price floor in order to protect the standards of living for growers in developing countries. This price floor is above the markets equilibrium and as a result price is forced up.

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Explain with reference to the 3 functions of price the way the market will react and comment upon the possible implications of this given that this price increase has been caused by government intervention rather than market forces

Min and Max Prices Evaluation 

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S – A signal will go to suppliers to increase production and for new firms to enter the market I – The incentive for firms to supply coffee will increase which will increase supply

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R – Consumers will ration their coffee consumption in response to the price increase, this will contribute to the situation of excess supply

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The consequence – a market in disequilibrium (excess supply) but standards of living for growers are protected

Free market Equilibrium

S Price Floor

Pmin

D

Excess Supply

Zero Pricing D

QS

Price = 0

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S and D curves meet the X axis where P=0

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NHS: in disequilibrium (excess demand) resulting in long waiting lists

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Rush Hour Traffic: again there is excess demand resulting in congestion

S

Price P=0

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QD Quantity

Zero Pricing D

Rush Hour Traffic: again there is excess demand resulting in congestion

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One solution is to increase the cost of certain route at certain times of the day/week through toll charges

Price

S

P=Toll

P=0

QS



QD Quantity

Examination Style Questions (d) Discuss the case for and against the Brazilian Government intervening in the market for coffee beans to help increase incomes for farmers Points to use:  Possibility of a minimum price for coffee beans  Draw a diagram  What will the impact of this be?  Given Figure 2, how much difference to the selling price would a 25% price increase in coffee beans make to the cost of a coffee?  What are the risks/drawbacks of implementing a minimum price in terms of distorting the market mechanism?  What are the implications of the consequent stockpiles (inc. opportunity cost)? This question is very similar to the 25 mark kind we will face in Jan 2011