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Fig. 21.32 shows that the free market price of a commodity is P0 and equilibrium quantity is n0q0 (which is the joint contribution of n0 firms each producing q0) in a constant cost industry (which means that output expansion by all firms does not lead to a change in market price).
Now suppose the government sets the maximum price of the commodity at Pc which is less than the free market price P0, as shown in Fig. 21.33. At this price there will be excess demand or shortage. Consumers want to buy Q1 units, as is indicated by the demand curve but producers are willing to offer any n0q1 units.
So there is excess demand or shortage at the legal maximum price amounting to n0q1 – Q1. Since the new price is less than the ATC (= P0) of each firm, the industry is not in equilibrium. So some high cost producers will now leave the competitve industry.
As a result of exit of old firms the industry supply curve will shift to the left to S. and there will be acute shortage of the commodity (amounting to n1q1 – Q1). Since the reduction in the number of firms does not affect the legal maximum price the exit of firms continues, supply curve shifts to S2, shortage grows to n2q1 – Q1 and ultimately all firms leave the industry. So the competitive industry ceases to exist in the long run.
From the above analysis of price control we may make the following two interesting observations:
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1. Firstly, the longer the period over which the price control is in effect, the greater will be the shortage. This is largely due to the fact the if P < ATC in the long run, initially some firms gradually most, and ultimately all will leave the industry.
2. Secondly the longer the period over which the price control is in effect, the greater will be the rise in price required to clear the market in the short run. The reason is simple.
As more and more firms leave the industry, the farther and farther will the industry supply curve shift to the left. In the long run, price control has to be done away with. Otherwise all the firms will leave the industry and transfer their capital in the other activities where better return can be obtained.
Price Supports and Output Restrictions:
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In advanced countries like the USA governments often put floors under some prices as they put ceilings on others. An example of this is agricultural price support scheme of the US government.
This can be done in the following two ways:
(a) Price Floors:
Fig. 21.34 we show the behaviours of a competitive industry. The free market price is determined by the interaction of demand and supply curves. Here the market clearing (equilibrium) price is p0 and quantity is Q0. If the government fixes up the support price of (which is higher than equilibrium price P0) supply will increase to Q2 but demand will fall to Q1.
So there will be an excess supply or surplus of Q2 – Q1. To enforce this price the government will have to buy this surplus from the farmers. So the monetary cost to the government will be Ps × (Q2 – Q1), but this is not the only cost of government price fixing.
As Ferguson and Gould have put it, “The cost to society would be measured by the inefficient shift of resources to the farm sector and the loss consumer welfare arising from the increased price. The surplus and associated costs could be even large if we account for entry into the industry (or the failure of inefficient firms to exit) that arises, because of the price supports.”
(b) Output Restrictions:
Another way of raising agricultural prices above competitive levels is to restrict output by allocating crop quotas among farmers. An example of such crop rationing is the US ‘soil bank’ programme which limits the amount of acreage that farmer’s plant.
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This amounts to imposing government restriction on the amount of land that farmers can use to grow crops. The short-run effect of such a programme is illustrated in Fig. 21.35. Here we see that as a result of output restriction to Q1 the price of the crop under consideration rises from P0 to Ps.
Problem:
One major problem arises when the acreage restriction programme is put into effect. To maintain the same level of output farmers may cultivate the smaller plot more intensively. So farmers may use more fertiliser and introduce better seeds and fertilisers and the cost of cultivation will rise. This method is thus an inefficient alternative to extensive cultivation (i.e., using more land).
If cost of production of each farmer rises the market supply curve shifts to the left to S’. Farmers will now be able to expand output along this curve because they are meeting the government’s crops restriction by using land saving input (i.e., substitution of other inputs for land). The end result is a reduction in market price to P’s and a rise in the cost of producing the corresponding quantity Q2 (which is less quantity that would be produced in the absence of acreage restriction to (Q1).
However, there is one solution to the problem. It is quite possible for the government to impose a restriction on the area that can be put under a particular crop or the government may well impose a restriction on the amount of output that a farmer can sell.
This seems to be a preferable alternative because it provides the farmer the right incentive to produce hat output as efficiently as possible. In this case the total revenue received by farmers will be PsQ1 in Fig 21.35. However since the quantum of profits depends on costs, if this scheme is adopted farmers can maximise profits only by minimising cost.
Moreover the second scheme is also not free from defects. Since production in agriculture depends on certain factors on which farmers have very little control (such as bad weather, diseases, insects, etc. which affect the yield), in practice farmers may end up producing more than the stipulated quota. But they cannot sell this excess output. This will go waste.
Such wastage is clearly inefficient from society’s point of view. But the first scheme which imposes restriction on acreage (i.e., input rather than output) does not have this defect because a farm is free to sell as much as he is able to grow from his restricted acreage.
Thus both the schemes lead to inefficiency of one sort or another. Economists feel that there are better ways of improving the economic conditions of the farmers.
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