Introduction
 Although it may seem to be an optimum situation,
the free market does not always lead to the best
outcomes for all producers and consumers, or for
society in general and so governments often choose
to intervene in the market in order to achieve a
different outcome.
 There are a number of situations where this occurs:
• maximum prices
• minimum prices
• price support/buffer stock schemes
• commodity agreements.
Maximum (low) price
controls
 This is a situation where the government sets a
maximum price, below the equilibrium price, which
then prevents producers from raising the price
above it.
 These are sometimes known as ceiling prices, since
the price is not able to go above “the ceiling”.
Reasons for this
 Maximum prices are usually set to protect
consumers and they are normally imposed in
markets where the product in question is a
necessity and/or a merit good (a good that would be
underprovided if the market were allowed to
operate freely).
 For example, governments may set maximum prices
in agricultural and food markets during times of food
shortages to ensure low-cost food for the poor, or
they may set maximum prices on rented
accommodation in an attempt to ensure affordable
accommodation for those on low incomes.
 Without government
interference, the
equilibrium quantity
demanded and
supplied would be Qe,
at a price of Pe
 The government
imposes a maximum
price of PMax in order
to help the consumers
of bread.
 However, a problem
now arises.
 At the price of P max
Q2 will be demanded
because the price has
fallen, but only Q1 will
be supplied. Now we
have a situation of
excess demand. It
may even fall from Qe
to Q1
 This in turn may create a black market where the
product is sold at a higher price ,or lines to
appearing in stores and the questions of who gets to
buy the product will have to be answered.
 Since this is not “fair” for the consumers the
government may need to make an attempt to solve
the shortage problem.
Solutions
 The government could attempt to shift the demand
curve to the left, until equilibrium is reached at the
maximum price, but this would limit the
consumption of the product, which goes against the
point of imposing the maximum price.
OR
 The government can attempt to shift the supply
curve to right, until equilibrium is reached at the
maximum price, with more being supplied and
demanded.
How to shift the supply
curve to the right.
 The government could offer subsidies to the
firms in the industry to encourage them to
produce more.
 The government could start to produce the
product themselves, thus increasing the supply.
 If the government had previously stored some
of the product (see buffer stocks will be
discussed later), then they could release some of
the stocks (stored goods) onto the market.
However, if the product were perishable, like
bread, this would not be possible.
 As we can see in Figure 4.5,
if the government is able to
shift the supply curve to
the right, by subsidizing,
direct provision, or using
stored bread, then
equilibrium will be reached
at PMax, With Q2 loaves of
bread being demanded and
supplied.
 However, it is fair to say
that this may well mean
that the government incurs
a cost, especially in the
case of a subsidy, and that
this will have an
opportunity cost.
•
If the government spends
money supporting the
bread industry, it may
have to reduce
expenditure in some
other area, such as
education or health care.
Minimum (high) price
controls
 This is a situation where the government sets
a minimum price, above the equilibrium
price, which then prevents producers from
reducing the price below it.
 These are sometimes known as floor prices,
since the price is not able to go below “the
floor”.
2 Reasons for minimum
prices controls
 To attempt to raise incomes for producers of goods
and services that the government thinks are
important, such as agricultural products. They may
be helped because their prices are subject to large
fluctuations, or because there is a lot of foreign
competition.
 To protect workers by setting a minimum wage to
ensure that workers earn enough to lead a
reasonable existence.
 without government
interference, the
equilibrium quantity
demanded and
supplied would be Qe,
at a price of P.
 The government
imposes a minimum
price of P in order to
increase revenue of
the producers of
wheat. However, a
problem now
arises.
 At the price P, only Q1
will be demanded
because the price
has risen, but Q2 will be
now be supplied.
 So we have a situation of
excess supply. If the
government does not
intervene further, they
find that consumption of
wheat actually falls from
Qe to Qi, but at a higher
price.
 Excess supply creates problems. Producers will find
that they have surpluses and will be tempted to try
to get around the price controls and sell their excess
supply for a lower price, somewhere between
Pminandpe
Government intervention
 The government would
normally eliminate the
excess supply by ring up
the surplus products, at the
minimum price, thus
shifting demand curve to
the right and creating a
new equilibrium at p min,
with Q2 being demanded
and supplied.
 The new demand curve
would be D + government
buying.
 The government could then store the surplus,
destroy it, or attempt to sell it abroad.
 Storage is expensive, destroying is wasteful, selling
abroad not always popular.
 In some cases, such as the European Union
agricultural policy, farmers are guaranteed a
minimum price and then are paid to “set aside” land
that they would have used to the product in
question.
 This of course than creates an opportunity cost
“what else could the money have been used for”
 There are two other
ways that the minimum
price can be maintained.
 First, producers could
be limited by quotas,
restricting
supply so that it does
not exceed Q1.
would keep price at Pmin
but would mean that
only a limited number r
of producers would
receive it.
 Second the government could attempt to increase
demand for the product by advertising or, if
appropriate, by restricting supplies of the product
that are being imported, through protectionists
policies, thus increasing demand for domestic
products.
 This of course also creates problems – firms get
complacent or produce more of the protected
products than is needed
Price support/buffer stock
schemes
 This is a situation where a government intervenes in
a market to stabilize prices.
 This has been attempted in markets for commodities
(raw materials), whose prices are often unstable.
 Good conditions will create a bumper crop and
increase the supply drive the price down
 Bad conditions will limit the supply, drive the price
up, but the will only benefit the farmers who have
the crop.
Raw materials/ mineral
commodities.
 These producers also face volatile prices, but mainly due to
factors that cause big swings in demand.
 Changes in the world economy are likely to have a large impact
on producers of such commodities.
 As world income grows,
demand for industrial commodities rises as industries expand
output to meet increased world demand, leading to a positive
situation where price increases lead to greater income for
commodity producers.
 However, a slowdown in the world economy has a similarly
large impact, as demand for industrial commodities falls,
resulting in lower incomes for commodity producers.
 Both demand and supply-side
factors create instability in
commodity markets.
Producers, uncertain about the
future, will find planning
difficult.
--------------------------------- Top price
 Unstable incomes may result in
lower standards of living,
with negative consequences
for commodity producers and
their communities.
 A buffer stock scheme is
implemented in which the
government will intervene if
the price is too high or too low.
price
band
------------------------------------------Bottom
price
Quantity of coffee
 If there is a bumper crop, then
supply will increase. Consider
the example shown in Figure
4.10, where the increase in
supply from S1 to S2 would
push the price below the
acceptable bottom price of $2
per kilo.
 At the bottom price, there
would be an excess supply of
Q1 to Q2.
 In order to maintain the price
at $2, the buffer stock manager
would have to buy up this
excess supply (surplus).
 However, if there is poor
weather or a problem with pests,
such that supply were to fall
considerably from S1 to S2. then
this would push the price above
the acceptable top price of $4.
 At the top acceptable price,
there would be excess demand
(shortage) of Q1 to Q2.
 As part of its commitment, the
buffer stock manager would
have to intervene to prevent the
price from going above the price
band.
 The manager would do this by
selling coffee from the stored
stocks, i.e. sell quantity Q1 to Q2
from the buffer stocks.
Problems with this.
 Only works with non perishable goods
(storage is still expensive)
 Does the government continue to buy
surplus every year.
 What is the appropriate price band to
sell the produce at. (producers want a
high price) – continued surplus.
Commodity agreements
 When different countries work together to
operate a buffer stock scheme for a particular
commodity, it is known as a “commodity price
agreement”.
 There are many cases where developing countries
are dependent on the export of a few
commodities for their export revenues, and some
countries have seen slow growth and little
development as a result of low commodity prices.
 As we know this is not a great solution.