Price Legislation

Price Legislation

Whenever the forces of demand and supply are allowed to fix market prices of commodities in a competitive market, some of the prices may be unfairly high to buyers or unfairly low to sellers. In such instances, the government may attempt to regulate or limit prices through legislation.

1) Maximum Price Control (Price Ceiling):

A maximum price or price ceiling is a legal price set below the equilibrium market price, above which a seller cannot charge for a product. It is set to safeguard consumers when the equilibrium market price for a commodity is found to be unfairly high. Maximum prices are normally set for essential goods such as pharmaceutical drugs or services such as house rent. When a maximum price is set for a good, it increases the quantity demanded while the quantity supplied decreases, thereby resulting in persistent excess demand or shortage of the good.

Figure: Price Ceiling Effect

From the figure above, the equilibrium market price is \(P_e\) while the maximum price is fixed at \(P_c\) below the equilibrium price. Because the price ceiling is not a market-clearing price, the quantity demanded will increase from \(Q_e\) to \(Q_c\) while the quantity supplied will decrease from \(Q_e\) to \(Q_1\). This reaffirms the assertion that whenever a price ceiling is set for a good, it results in a persistent shortage of the good.

The persistent shortage caused by the price ceiling will, in turn, pose the following problems:

a) Rationing: Government may have to apportion the quantity supplied of \(Q_1\) among buyers who want to consume a greater amount of \(Q_c\). This may be done through the issue of coupons which must be surrendered together with cash to obtain the good.

b) Queuing: Whenever the good is available, people will form long queues for it. The queues may be physical lines of people outside suppliers’ shops typically in the case of essential commodities like drugs, bread, milk, etc., or long waiting lists in the case of consumer durables such as cars, television sets, etc.

c) Black (Parallel) Markets: Black or parallel markets in which the good is illegally sold will spring up. In the illegal market, the price at which the good will be sold is usually higher than the equilibrium price.

d) Selling at Sellers’ Preference: Sellers may choose several ways to sell the good – first-come, first-served, selling to relatives and friends first, etc.

e) Random Allocation: This is selling by luck or chance. This may defeat the aim of setting the maximum price to ensure that the poor as well as the rich get the good. Selling may go to all rich or all poor.

Government may solve the various problems caused by maximum price control by accompanying it with certain other policies such as:

a) The government coming out with policies to reduce the consumption of the good. Policies that will discourage consumption may include:

  1. Reducing income levels through increased direct taxes when the good is a normal good.
  2. Finding cheaper substitutes for the good.
  3. Creating an impression that the price of the good would be reduced further to enhance consumer expectations of a further price cut so that they demand less now.

b) The government may also adopt economic policies that would increase the supply of the good. Such supply management policies may include:

  1. Government subsidising the cost of producing the good.
  2. Creating investment incentives to attract new firms to supply more of the good.
  3. Importing more of the good from cheaper sources to augment domestic supply.

2) Minimum Price Control (Price Floor):

A minimum price or price floor is a legal price set above the equilibrium market price. One can buy at or above the minimum price but cannot buy at a price below it. It is set to protect the incomes of producers when the equilibrium market price for a product is found to be unfairly low. Minimum prices are normally set for agricultural products to protect the incomes of farmers. When a minimum price is set for a good, it reduces the quantity demanded while quantity supplied increases, thereby resulting in excess supply or surplus of the good.

Figure: Price Floor Effect

From the figure above, the equilibrium market price is \(P_e\) which may be unfairly low, necessitating the setting of a price floor of \(P_f\) by the government. Because the price floor is higher than the equilibrium price, quantity supplied will increase from \(Q_e\) to \(Q_1\) while the quantity demanded will decrease from \(Q_e\) to \(Q_f\). Therefore, whenever a price floor is set, it creates a persistent surplus of the good.

The persistent surplus created by a price floor will, in turn, pose the following problems to producers of the good:

a) It brings about a lot of frustrated sellers wishing to dispose of surplus supplies.

b) Sellers, when frustrated, may be willing to sell the commodity at P1, which is well below the equilibrium price.

c) The sellers will allocate quotas among themselves.

d) There will be buyers’ preferences as they choose whom to buy from.

e) It brings about conditional sales. The good with a surplus may be sold with others that are in shortage.

To make minimum price control policies achieve their aim, certain policies should be adopted by the government concurrently:

a) The government should increase the incomes of consumers so that they can buy more if the commodity is a normal good, and/or encourage increased consumption of the commodity through advertisements and other sales promotions strategies.

b) The government enters the market after setting the price floor to buy the surplus, store and sell from its own stockpiles (buffer stock) during times of shortage.

c) Financial institutions may make funds available for private individuals to buy and store the surpluses and sell them during the lean season.

d) The government should encourage exportation of the surplus to needy countries. The government could promote such exports by creating incentives for exports, such as lowering of export duties.

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