The amount supplied and the quantity demanded are equal at the equilibrium price in a market that is functioning freely. However, government interference in markets is common. When the equilibrium price so reached is either too high or too low(unprofitable) for the producers of the commodity, the government may need to intervene in the process of fixing prices.
The two types of government interventions are:
- Price Ceiling
- Price Floor
1. Price Ceiling
When the equilibrium price established by the free play of demand and supply is too high for the poor, the government plays a significant role in regulating the prices of essential commodities(wheat, sugar, kerosene, etc.). Price Ceiling refers to fixing the maximum price of a commodity at a level lower than the equilibrium price. Simply put, price ceilings are higher limits set by the government on the price of a product.
Need for Price Ceiling
It is often enforced on essential items and is set below the equilibrium or market-determined price. The equilibrium price is too high for the average person to afford, which is why there is a price ceiling.
Demand curve DD and supply curve SS intersect at point E in the above diagram, and as a result, equilibrium price OP is established.
- Assume that the equilibrium price of OP is high and that many low-income individuals cannot afford the product at this price.
- As a result, the government intervenes and sets the maximum price (also referred to as the Price Ceiling) at OP1, which is lower than the equilibrium price OP.
- Producers are only willing to supply P1A (or OQ1) at this controlled price (OP1), but consumers want P1B(or OQ2).
- The ceiling has the effect of creating a shortage equal to AB(Q1Q2), which could further encourage black marketing.
Consequences of Price Ceiling:
i) Black Marketing:
A market in which commodities are sold at a price higher than the maximum price fixed by the government is known as Black Market.
- Black Marketing refers to a situation when a good covered by the government’s control policy is being sold illegally at a price greater than the one set by the government. This condition is referred to as a direct consequence or implication of price ceilings.
- It may occur, especially as a consequence of the presence of customers who are willing to spend a higher price for the commodity rather than go without it.
To increase profits from black marketing, producers of the product will sometimes purposefully reduce the availability of the product in the legal market.
ii) Rationing System:
Rationing is a technique adopted by the government to sell a minimum quota of essential commodities at a higher price less than the equilibrium price to supply goods to the poor community at a cheaper price.
- The government may also impose the “Rationing System” to fulfil the excessive demand.
- Consumers are given ration cards/coupons to use in ration shops to purchase commodities at a cheaper price.
- Consumers must stand in huge lines to purchase products from ration shops. The ration shops occasionally run out of certain items or their quality is poor.
iii) Dual Price Policy:
To prevent the occurrence of black marketing, the government may also permit a system where two prices for the same commodity are offered simultaneously. A defined amount of the product is provided to clients under this system at a cheaper price through fair pricing shops, while at the same time, the commodity is also made available in the open market at a price set by market forces of supply and demand.
2. Price Floor or Minimum Support Price (MSP)
Through the Price Floor, the government also intervenes in the price determination process. Price Floor refers to the minimum price (above the equilibrium price), fixed by the government, which the producers must be paid for their produce.
The establishment of a lower limit on the price that may be charged for a specific commodity or service is referred to as setting a price floor or minimum price ceiling. Government sets a price (known as the Price Floor) that is higher than the equilibrium price when it believes that the price determined by supply and demand is not fair from the perspective of the producers.
Need for Price Floor
When the government determines that the equilibrium price is too low for the producers, a price floor is required.
- The most well-known examples of imposing price floors are minimum wage legislation and agricultural price support schemes.
- For various agricultural products like wheat, sugarcane, and others, the Indian government maintains several minimum support price programs, and the floor is often set at a level higher than the price determined by the market for these goods.
As seen in the diagram, demand curve DD and supply curve SS intersect at point E, as a result, equilibrium price OP is established.
- Assume that the government sets OP1 as the minimum price (also known as the price floor), which is higher than the equilibrium price OP, to protect the interests of the producers and encourage increased production.
- Producers are only willing to supply P1B (or OQ2) at this ‘Support price’ (OP1), but consumers want P1A (or OQ1). This forms a situation of market surplus, which is equal to AB as sown in the diagram.
The term “Floor Price” also refers to the “Support Price,” which is typically set above the equilibrium price to safeguard the interests of producers like farmers. The government purchases all of the agricultural products that farmers are unable to sell on the free market at this support price.
- The government may decide to buy the excess supply for exports or to build up its buffer stocks.
Implications of Price Ceiling or Minimum Price Ceiling
Typically, the price floor is established at a level above the equilibrium price. As a result, there is an excess supply. As the producers are unable to sell what they want to sell, they turn to illegal sales of goods and services at the price below the minimum price.
Buffer Stock acts as a Tool for Price Floor
Governments can use buffer stock as a powerful instrument to maintain a price floor. When the market price is lower than what the government believes should be paid to the farmers and producers, it buys the commodity from them at a higher price to save a stock of it for possible release in the event of future shortages.