Price controls - Business Environment

Governments occasionally take the view that a particular equilibrium price is politically, socially or economically unacceptable. In such circumstances, one course of action is the imposition of price controls. This involves the institutional setting of prices at either above or below the true market equilibrium. For example, if it was felt that the equilibrium price of a good was too high, then the government might try to impose a lower price on the market. This would now be the maximum acceptable price or price ceiling. Price may not rise above this ceiling. Alternatively, the equilibrium price could be seen as too low. In this case, a higher price, or price floor is imposed, below which price should not fall. Figure illustrates the market for a basic food stuff. Imagine that it is wartime and the disruption has shifted the supply curve to the left. This could be largely due to a movement of resources away from the production of this good and towards munitions.The free market price at P1 is seen to be unacceptably high relative to the pre-war price, and the decision is made to impose a price ceiling of P2. It is hoped that such a ceiling will alleviate the problems of consumers who could not afford the free market price.
The problem now is that at the price ceiling only Q3 units will be supplied, where as demand is for Q2. The volume of output Q3Q2 therefore represents an excess of demand over supply. Many customers are frustrated in their desire to purchase that good. To help bring order to the situation, a system of rationing might be introduced.

This could allocate the limited output between the many customers in a more orderly fashion than ‘first come, first served’. For example, one unit could be allocated per person and priority could be given to the old and the sick. This does not solve the problem of excess demand. It is commonly found in such situations that illegal trading starts to emerge at a price above the ceiling. To obtain the good many would be willing to pay a higher price. This is commonly referred to as black market trading. Figure illustrates the market for a specific type of labour. The downwards loping demand curve indicates that, at lower wages, employers will wish to take on additional workers. The supply curve shows how more people will offer themselves for work as wage rates increase. At the intersection of the curves, the market is in equilibrium. Imagine that this equilibrium wage is seen to be too low, and the authorities seek to impose a minimum wage of W2. Employers are not permitted to pay any less than this amount. It is hoped that the policy will improve the welfare of workers by raising their living standards to some acceptable level.At this minimum wage, employment becomes more attractive, and Q3 persons seek employment. On the other hand, employers only wish to take on Q2 workers.There is now a situation of excess supply. Only Q2 find work, the remainder Q2Q3are unsuccessful. The policy has actually reduced the level of employment from Q1to Q2. In such a situation, there will be a temptation to flout the legislation. For example, unscrupulous employers observing the ranks of unemployed would realize that many would willingly work at less than the minimum wage.


The above examples illustrate the problems that arise once price is imposed away from its equilibrium. Further examples of such price controls would include the guaranteed minimum prices to farmers within the Common Agricultural Policy (CAP) of the European Union (see case study at end of, and various post-war attempts to control the cost of rented accommodation at a price affordable to the low paid. The former has been associated with overproduction and the need to control the mountains of excess supply, while the latter tended to result in landlords taking their properties off the rental market in order to seek more profitable returns. The success of such policies requires careful control and monitoring. In many circumstances, it might be better to consider alternative ways of achieving the policy goals.

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