Price Mechanism and its Application (Government Intervention)

Direct price controls

Price ceilings

Price flooors

is the maximum legal market price set and allowed by the government.

For a price ceiling to be effective, the legal market price has to be set below the free market equilibrium price.

REASONS FOR PRICE CEILINGS

  1. Affordability & fairness. In times of war / famine, gov may set maximum prices for basic goods to allow some of the poor to buy a good that they would otherwise be unable to afford or prevent exploitation by suppliers who may charge a high price during such times of shortages.
  2. As an anti-inflationary policy i.e. to prevent continuous increase in prices of many products which could be detrimental to
    economic growth & people’s standard of living.

EFFECTS OF PRICE CEILINGS

  1. The goods and services will be made more affordable to those who previously could not afford them.
  2. But, The resulting shortage would result in an inefficient allocation of resources since societal welfare is reduced as illustrated by the deadweight loss area.
  3. Emergence of black markets where goods are sold illegally at market prices above the legislated maximum market prices.
  4. Allocation of the good or service on a ‘first-come, first-served’ basis, which is likely to lead to queues developing, or firms adopting waiting lists. Consumers would thus also incur the additional opportunity cost of extra time spent searching or waiting for the good or service.
  5. The issue of fairness will be a problem as those who need it most may not be amongst the first in line. Even if they are, then there is the issue of time and resources wasted in queuing much earlier than necessary.
  6. Firms deciding which customers should be allowed to buy, for example, by giving preference to regular customers.
  7. Rationing through the issue of coupons which can also be administratively expensive.

is the minimum legal market price set and allowed by the government.

For a price floor to be effective, the legal market price has to be set above the free market equilibrium price.

REASONS FOR PRICE FLOORS

  1. To protect producers’ (eg. farmers) incomes. If the industry is subjected to price fluctuations, minimum prices would prevent producers’ income from falling during periods of low demand (relative to supply) though this may have the opposite effect of lowering their income since quantity transacted would decrease.
  2. In the case of wages, minimum wage legislation can be used to prevent wage rates from falling below a certain level, hence ensuring an acceptable level of living standards.
  3. To prevent some ppl from consuming the product

EFFECTS OF A PRICE FLOOR

  1. Higher revenue for producer
  2. May cause a fall in producer’s revenue if gov didn’t buy all the surplus and if PED>1.
  3. The artificially high prices may cushion inefficiency. Firms may feel less need to find more efficient methods of production and to cut their costs if their profits are being protected by the legislated minimum market prices which are higher than the free market equilibrium prices.
  4. Also the high price may discourage firms from producing alternative goods which they could produce more efficiently or which are in higher demand, but nevertheless have a lower free market price.

DIRECT QUANTITY CONTROLS

QUOTAS

is the legal limit set by the government on the quantity of a good that can be transacted in a market.

REASONS FOR QUOTAS

  1. To reduce consumption of certain goods that it deems to be overconsumed and potentially harmful to society. For example, overconsumption of cars, leading to excessive pollution and traffic congestion and hence the introduction of the Vehicle Quota System and COEs.
  2. To protect domestic industries from foreign competition by restricting the quantity of foreign imports legally allowed to be supplied in the country.

EFFECTS OF A QUOTA

  1. Setting a quota below the free market equilibrium quantity,
    decreases consumption of the good and raises its prevailing market price, ceteris paribus. This enables the government to reduce the consumption of certain goods, by restricting the quantity available in the market and raising the market equilibrium price.

Taxes

are involuntary payment of funds to the government by a household or firm for which the household or firm receives no good or service in return.

Direct taxes – Taxes on income and wealth. Paid directly to the tax authorities. Examples are personal income tax and capital gains tax.

Indirect taxes – Taxes on expenditure. They are paid to the tax authorities, not by the consumer, but by the suppliers of the goods or services. Consumers, however, may pay the tax indirectly in the form of higher prices. Examples are the Value Added Tax (VAT), Goods and Services Tax (GST) and excise duties on cigarettes, alcoholic drinks and petrol.

Specific tax (i.e. a fixed amount of tax is charged per unit sold): Good or service is taxed a fixed amount per unit (e.g. $3 per unit), therefore tax per unit of the good is the same regardless of the price of the good.

SUBSIDIES

are the payment of money to a household or firm by the government for which it receives no good or service in return. Subsidies are also known as negative taxes.

Direct subsidies – Subsidies that increase housholds’ income and wealth. Paid directly to households. Examples are cash benefits, child benefits and old-age pensions.

Indirect subsidies – Subsidies on expenditure. Paid directly to the suppliers of the goods or services and consumers benefit indirectly through reduced price. Examples are subsidised education and health care, and concessionary bus fares for the elderly.