2.7b Role of government in microeconomics [PRICE FLOOR+CEILING]

Question 1

What is a price ceiling, and why is it used?

Answer 1

The market price for a good or service is sometimes unaffordable. This is common for essential goods and services, such as rented accommodation or food. The government can set a maximum price, also known as a price ceiling, below the equilibrium price to prevent producers from selling their product above it. This is done to protect consumers and is usually applied to necessity and/or merit goods.

Question 2

Why does a gov want to introduce a price ceiling?

Answer 2

• increases consumption of the good or service
• reduce the price of certain goods or services for low-income consumers.
• prevent exploitation by monopolies (so they don’t have full control over price)

Question 3

By introducing a price ceiling, what is created as a result?

Answer 3

Excess demand

Question 4

What can be done to eliminate the excess demand after using a price ceiling?

Answer 4

To eliminate the excess demand the supply curve has to shift outwards:

• grant subsidies to the producers to encourage them to increase supply by producing more of the good.
• increase supply by producing the shortfall quantity of the good itself to meet total demand.
• store some of the product (as long as it is not a perishable good) before setting the price ceiling, then increase supply when needed by releasing some of its stocks on to the market.

Question 5

What are some advantages of a price ceiling?

Answer 5

• Some consumers can buy good/ services at lower price
• May gain some political popularity
• Takes power away from Monopolies

Question 6

What are some disadvantages of a price ceiling?

Answer 6

• Produces shortages
• Some people won’t be able to consume good because of shortage
• Eliminates allocative efficiency
• Generates welfare loss
• Producers sell a smaller quantity, total revenue falls

Question 7

In this DIG, what is the:

• consumer surplus
• producer surplus
• welfare loss

Answer 7

Consumer surplus: blue
Producer surplus: red
Welfare loss: yellow

Question 8

What is a price floor?

Answer 8

A price floor (or minimum price) is a form of price control set by the government that imposes a price guarantee set above the equilibrium price to encourage the supply of a certain good or service.

Question 9

Why is a price floor used?

Answer 9

• To discourage consumption of certain goods (eg. minimum price of alcohol)
• To protect producers as they are guaranteed a price (eg. farmers to protect them against supply-side shocks or cheaper foreign goods)
• To protect workers in the labour market, the government sets a minimum wage to guarantee a wage which enables workers to have a decent living condition

Question 10

When a price floor is introduced, what is created as an effect of this?

Answer 10

Excess supply

Question 11

Explain the effects of the introduction of a price floor using the DIG:

Answer 11

• -> At price P min, more producers are willing and able to produce supply. Quantity supplied increases from Q to Qs (as shown by the expansion along the demand curve)
• -> At price P min, less consumers are willing and able to consume. Quantity demanded decreases from Q to Qd (as shown by the contraction along the demand curve). This creates excess supply Qd - Qs

Question 12

What can be done with the excess supply (surplus)?

Answer 12

• Store it (storage space, expiration date, storage costs)
• Release the excess supply, to help farmers during poor harvests –> opportunity cost to the government of buying the excess starch and store it
• Export it, but the importing country may not want the good, especially if the exported good is cheaper than the domestically produced good. The domestic country would accuse the exporting country of dumping the products onto them.
• Destroy it, but this is very wasteful

Question 13

What does government do to excess supply?

Answer 13

Government purchases excess supply at the price floor price