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In most modern mixed economies markets are rarely free of government intervention. Besides imposing indirect taxes and giving subsidies, governments often regulate even competitive markets in various ways. One method of such control is price control.
For political and other reasons the governments of different countries impose price control on short-supply items. Fig. 2.19 shows the effects of various price control. The free market price is P0 and the equilibrium quantity is Q0. If now the maximum legal price of the commodity is fixed below the equilibrium level, called the ceiling price, say at Pmax the quantity supplied will fall to Q1.
This is because some producers (with higher cost) will produce less and some of them will leave the industry. On the other hand the quantity demanded will rise to Q2. So there will emerge a situation of excess demand (shortage) of Q1– Q2. If there is no government control on price, the forces of competition will cause the price to rise if there is excess demand pressure. But now this is not possible.
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No one can pay more than Pmax. So some illegal means will develop to pay extra price due to the limited amount of the commodity which is available. There will be black marketing. So neither the producer will gain nor the consumer. The gainers will be the black marketers. So we have the worst of both the worlds — a smaller quantity and higher price.
This is why liberal economists like Van Hayek and Milton Friedman have opined that price control is likely to have some undesirable consequences. The solution to the problem lies in introducing some sort of government (administered) allocation system, called rationing. Such a system is in operation in India. Price-control cum-rationing creates other problems also.
Sometime excess demand spills into other markets, where it artificially increases demand of uncontrolled items.
Gainers and Losers:
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No economic policy benefits all the economic agents at the same time. It is because one man’s wage is another man’s price. In Fig 2.19 we see that producers lose. They get less price and some inefficient (high- cost) producers leave the industry. Some, but not all consumers gain.
Those who are still able to buy the commodity at a lower price gain. But those who cannot buy the good at all are worse off (in the absence of government allocation or rationing). In order to evaluate the welfare effects of price control we have to apply the two important concepts, viz., consumers’ surplus and producers’ surplus.
Fig. 2.20 shows the changes in consumers’ surplus and producers’ surplus resulting from the government price control.
1. Change in Consumers’ Surplus:
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The consumers who are still able to buy the good enjoy an increase in consumers’ surplus, which is given by the rectangle A in Fig. 2.20.
This area measures the fall in price of each unit times the number of unit’s consumers are able to buy at the lower price:
Area A = (P0 – Pmax) Q1
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On the other hand, those consumers who are no longer able to buy the commodity lose surplus. This loss is shown by the triangle B, i.e., the area below the demand curve but above the market price P0. This area measures the net benefit to consumers (their total benefit less what they would have had to pay) that is lost because of the fall in output from Q0Q1.
So the net change in consumers’ surplus in Fig. 2.20 is A-B. Since rectangle A is larger than the triangle B, the net change in consumers’ surplus is positive.
2. Change in Producers’ Surplus:
As a result of price control efficient (low-cost) producers will stay in the market but will receive a lower price for their output. But others (high- cost producers) will leave the market. Both groups will lose producers’ surplus. Those producers who manage to survive in the market and produce Q1 units will now receive a lower price. So they lose to the extent of rectangle A.
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This is additional loss of producers’ surplus due to fall in production. The triangle C measures this loss.
The total loss of producers’ surplus has therefore two components:
(i) Loss of those who stay in the market but produce less and
(ii) Additional loss for those producers who have left the market.
Therefore the net change in producers’ surplus is – A – C. So producers clearly lose as a result of price control.
3. Deadweight Loss:
The total change in surplus due to price control is (A – B) + (- A – C) = – B – C. This is known as deadweight loss and is shown by the two triangles B and C. This net loss of total surplus is essentially an efficiency loss caused by price controls because the loss in producers’ surplus exceeds the gain in consumers’ surplus.
If the demand curve is very inelastic, price controls can lead to a net loss of consumer welfare, as Fig. 2.21 shows. In this figure the loss to consumers who are no longer a able to buy the commodity is measured by the triangle B.
It is larger than rectangle A which measures the gains to consumers who are able to buy the good. If the commodity is a highly essential item of consumption such as kerosene or wheat which consumers value highly, those who are deprived of the item will together suffer a huge welfare loss, price of the item will together suffer a huge welfare loss.
In short, if the maximum legal price of a commodity is fixed below the equilibrium level, too little is produced. Consequently consumers and producers as a whole are worse off.
Fixation of Maximum Price above the Equilibrium Level:
At times government policy seeks to raise prices above market clearing levels, rather than lower them. Let us suppose now that the maximum legal price of a commodity Pmax is fixed above the equilibrium level (P0), as Fig. 2.22 shows.
Producers will be eager to produce Q2 units, but consumers will buy less (Q1 instead of Q2). So if producers produce exactly what they succeed in selling, the actual output will be Q1, and there will be loss of total surplus.
In Fig. 2.22 rectangle A now represents a transfer of money from consumers to producers (who now receive a higher price), but triangles B and C conjointly measure deadweight loss. Due to higher price some consumers can no longer buy the good. So triangle B measures a loss of consumers’ surplus.
Some producers are no longer producing the commodity due to low demand. The loss of producers’ surplus is given by the triangle C.
If some producers increase their supply due to high price, they will be left with unsold output of Q1Q2 = FG. It is, of course, possible for the government to buy up the entire stock to maintain production at Q2 or near to it. In both cases the total welfare loss will exceed triangles B and C. Thus the one thing is clear at least: deviations from the competitive market equilibrium lead to efficiency loss.
Case Example I: Market for Air Travel:
Suppose the government of a country fixes the minimum air fare above the market clearing level as has been done in the USA in 1980. Such a situation is illustrated in Fig. 2.23. At price Pmin, airlines corporations would be eager to supply Q2, much above the quantity Q1 that consumers are ready to buy.
Suppose they supply Q3. The shaded area F measures the cost of unsold output. Profits are lower as a result of regulation because triangle C and the shaded area F together exceed rectangle A. In addition, consumers lose A + B.
Case Example II: The Market for Kidneys:
Although health is not treated as wealth, now-a-days we find growing business in human organs particularly kidneys. The kidney-rich but cash-poor people sell their kidneys to kidney-poor but cash-rich people. The tools demand and supply can be applied to examine the effect of a legal enactment on the market for kidneys. In Fig. 2.24 the equilibrium (market clearing) price is P0 and the quantity supplied at this price is Q0.
Now suppose the government passes an act banning the sale of kidneys. This means that price virtually falls to zero. Even at a zero price a minimum quantity (Qmin) of kidneys will be donated as is indicated by the supply curve S. Thus the upward sloping supply curve S becomes completely inelastic at zero price. In this case rectangle A and triangle C together measure the loss to suppliers. The gain to consumers (if they receive kidneys at zero cost) is given by rectangle A less rectangle C.
In reality, kidneys are normally rationed on the basis of willingness to pay. So those who are able to pay will pay the market clearing price Pmax when S’ is the supply curve, in which case the total value of kidneys is measured by the rectangles A and D.
Minimum Price:
Let us now examine what happens if the minimum legal price of a commodity is fixed above the equilibrium level. In Fig. 2.25 at the minimum there is an excess supply of Q1Q2. Producers will now offer Q2 units but consumers will buy only Q1 units.
Consumers’ Surplus:
Those consumers who continue to buy the commodity now pay a higher price and so suffer a loss of surplus. This is shown by rectangle A in Fig. 2.25. Some consumers who can no longer buy the commodity due to higher price suffer a loss given by triangle B. So the total loss of consumers’ surplus is, therefore,
∆CS = – A – B
Thus consumers are clearly worse off as a result of this policy.
Producers’ Surplus:
In contrast, producers receive a higher price for the units they sell, which results in an increase of surplus, given by rectangle A, which shows transfer of money from consumers to producers. But the fall in sales from Q0 to Q1 leads to a loss of surplus, which is given by triangle C.
Moreover, since producers can sell only Q2 units, they do not get any revenue to cover the cost of producing Q1 – Q2 units which is measured by the area under the supply curve. This cost is measured by the shaded area H.
Thus if producers fail to respond to unsold output by cutting production the total change in producers’ surplus is;
∆PS = A – B – C
If area H is sufficiently large, a minimum price can even result in a net loss of producers’ surplus, i.e., producers as a whole lose due to minimum price fixation above the equilibrium level. Consequently this type of government intervention can reduce the profit of producers due to the cost of excess production (Q1 – Q2).
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