Economic Terms

These are imposed by governments to control prices in specific markets. The control will be structured to reduce price fluctuations or prevent very high/low prices.

These are imposed by Governments to control the price in specific markets. The control will be structured to reduce price fluctuations or prevent very high/low prices.

These restrictions governing the price a market can sell a product for, is done in order to improve on the outcome achieved by the free market.

The two forms of price controls are:

• Maximum Price
• Minimum Price

The important point to understand when evaluating the effectiveness of price controls is the position of the price relative to the equilibrium price. For a maximum price to be binding, the max. price needs to be set below the market equilibrium price to force pressure on firms for the existing price to fall. Likewise, for a minimum price to be binding, the min. price needs to be set above the market equilibrium price to force pressure for the existing price to rise. Below is a set of diagrams to show this:

Because these price controls are distorting the market equilibrium that would prevail under the free market, it does introduce welfare implication for society. Under a max. price, producer surplus decreases (as firms are selling less goods at a lower price) and consumer surplus has a net increase (as the fall in consumption is overridden by the benefit of falling prices). However, there is a dead weight loss triangle that is created from this price because of that fact there is a loss of potential beneficial exchanges which could of been made at the market equilibrium i.e. producers were willing to sell at a higher price and consumers willing to purchase at a higher price. Therefore, social welfare is likely to be reduced. 

Likewise, for a min. price, producer surplus has a net increase (as firms are selling goods at a higher price despite the fall in consumption) and consumer surplus has a decreases (as consumption falls as well as prices rising). However, there is a dead weight loss triangle that is created from this price because of that fact there is a loss of potential beneficial exchanges which could of been made at the market equilibrium i.e. producers were willing to sell at a lower price and consumers willing to purchase at a lower price. Therefore, social welfare is likely to be reduced.

The welfare implications of the price controls is shown below in a demand and supply framework.

 Therefore it is the presence of the disequilibrium in the market which creates the dead weight loss triangle.

In terms of policy solutions, the government could introduce a subsidy in order to maintain the maximum price. This will outwardly shift the supply curve and remove the dead weight loss triangle and increase social welfare. However, this is expensive from the government's perspective as the subsidy may need to be financed by higher taxes or diverted expenditure from other areas of the economy. This also involves an opportunity cost, as alternative projects have had to be sacrificed as a result.

To eliminate the excess supply in the presence of a minimum price, the government could buy up the surplus of stock that firms have, in order to prevent them from dumping them on the market for a lower price. By doing so would shift the demand curve outwards and remove the dead weight loss triangle. This policy is similar to what is seen in a buffer stock scheme in agricultural markets. The main issue with this policy is that the government will be left with a surplus of stock of the good, this is problematic because storing inventories of a good can be very expensive from the government's perspective, but at the same time destroying this stock of goods is seen as a waste of resources. 

Below is set of diagrams to show the desired outcome of these policies (move to point c):

 

The rate of inflation is less than 0%.

The action of selling the same product to different groups of people (or in different circumstances) for different prices. This is done so that firms can convert as much consumer surplus into revenue and profits. 

There are three different forms of price discrimination that firms can choose from:

1. First Degree Price Discrimination - charging consumers the maximum price they are willing to pay for 
2. Second Degree Price Discrimination - charging consumers different prices based on the quantities consumed
3. Third Degree Price Discrimination - charging consumers different prices based on the type of market segment they are in

However, producers only have the ability to set these forms of price discrimination if certain conditions in the market hold:

1. The firms involved must be price makers to ensure that they can set the appropriate price that fits into their pricing strategies. Therefore, price discrimination is a strategy that can only be used if the market is imperfectly competitive. The more market power an individual firm has, the more successful price discrimination is likely to be for the firm. In a perfectly competitive market, price discrimination cannot take place because all firms have to take the current prevailing price as given. 
2. The firm involved must be able to segregate the market into different types of consumers. Price discrimination is unsuccessful in markets that cannot be segregated because it allows the resale of the product from one consumer to another. This means that consumers who can purchase the product at a low price and then go on to sell their product onto a consumer that was facing a higher price. This is not the case for train tickets as children are charged a lower price than adults and cannot sell this ticket onto adults because of the fact that the markets has been divided into two sub-markets. Firms can segregate the market by dividing consumers up into different types based on: the time of consumption, gender, age, income status, location and consumption preferences.
3. The consumers that are sold a product must have different price elasticities of demand, so that the firm can charge the consumers that are willing to pay a higher price a higher price, but for consumers who are not willing to pay a high price will be charged a lower price, so that encourages more consumers to consume. Therefore the elasticity of demand for consumers signals to firms how reluctant certain consumers are for paying a high price i.e. inelastic demand signals to the firm a high price and elastic demand signals to firms a low price.

The most common example of price discrimination is third degree price discrimination in which firms identify different types of consumers and a separate price is charged to each of the type of consumers e.g. train, cinema and theme park tickets.

Price discrimination diagrams can often be quite complicated to draw so the best way to draw these types of diagrams to remember a step by step procedure in which a new element on the diagrams is placed on at each step to make sure all elements of the price discrimination diagrams have been drawn. Below we are going to show the step by step process that needs to be taken  to highlight the impact of third degree price discrimination on the different sub-markets as well as the firm. For this particular case we are assuming that the firm involved is a monopolist and the conditions that are required for price discrimination are satisfied and the monopolist has segregated the market into two sub-markets - A and B. 

For the step by step process, the new elements added in at each stage will be highlighted in red and the stage achieved at the previous stage will be highlighted in black. 

This step involves setting up the diagrams. As this is a micro diagram for a a specific diagram the x axis represents quantity and the y axis represents price.

This step concerns drawing the two separate demand curves for market segment A and B. The monopolist splits the market into two sub-markets based on the fact that the consumers in the two sub-markets have a different elasticity of demand. Sub-market A faces an inelastic demand curve and sub-market B faces and elastic demand curve.

At any price above P, there are no sales to market B, so therefore at P and above the monopolist demand curve follows the same shape as the demand curve for market A.

At prices below P, sales are made to both sub-markets (B represents the demand corresponding to Market A and C represents the demand corresponding to Market B). Therefore, the part of the demand curve for the monopolist below the price of P is formed by adding horizontally the two sub-market demand curves together below this price.

The Marginal Revenue curve is always twice as steep as the Average Revenue curve.

The MR curve for the monopolist is formed by combing the marginal revenue curves from both sub-markets, using the same logic of how the AR curves were formed. The MR curve for the monopolist is twice as steep as the relevant sections of the AR curve.

 

Marginal Cost curve for the monopolist takes the usual tick-shaped form.

Monopolist profit maximises at the usual profit-maximising condition of MR=MC, but as a result of the market power it holds it can set a price up to the AR curve.

As the monopolist applies price discrimination to the two sub-markets the price of P is not set across the sub-markets. Instead they maximise profits by selling a higher quantity to market B and sell less to market A. To profit maximise across markets the condition that needs to be satisfied is that the MR_A=MR_B=MR across all markets. To achieve this the sub-markets needs to be charged different prices. Market A which has an inelastic demand curve, a higher price is charged because consumers are willing to buy the product at a higher price. However, market B has an elastic demand curve so a lower price to maximise the amount of revenue the monopolist can exploit from these reluctant consumers.

To identify the profits made by the monopolist via price discrimination the average cost curve needs to be drawn on for the monopolist.

Supernormal profits represent difference between sales revenue and costs of production. This method of price discrimination brings the monopolist larger profits at the expense of consumer surplus. 

Through the fact that the market becomes segmented, the pricing strategy increases total revenue when compared under a fixed pricing strategy and this increases the level of profit accruing to the monopolist as a result of an increase in sales. Also because of that fact that the firm has increased their scale of production it means it is likely to see a reduction in the firms costs as a result of a movement down the average cost curve, which can further increase profits in the long-run. However, whether the increased profits lead to better quality products and lower prices for consumers depends on the type of firm involved and whether they have the incentive to invest in R&D projects which can feed through to dynamic efficiency benefits. This may all depend on the type of industry at hand.

An evaluation point that could be mentioned when talking about price discrimination is the impact on consumers. This is because there are two types of consumers in the market and some will experience higher prices whilst others will experience lower prices and therefore the overall impact seen on consumers will all depend on the experience that consumers have in the market.

When the rate of inflation reduces e.g. CPI grew by 2.2% in the year to October 2013 but reduced to 2.1% in the year to November 2013.

The proportionate change of the quantity demanded of a good in response to a proportionate change in price.

A good is classified as inelastic if it has a PED value that it less than 1.

A good is classified as elastic if it has a PED value that is greater than 1.

A good is classified as unit elastic if it has a PED value that is equal to 1.

The value of the PED for a good determines the type (slope and position) of demand curve in the market.

The proportionate change of the quantity supplied of a good in response to a proportionate change in price.

A good is classified as inelastic if it has a PES value that it less than 1.

A good is classified as elastic if it has a PES value that is greater than 1.

A good is classified as unit elastic if it has a PES value that is equal to 1.

The value of the PES for a good determines the type (slope and position) of supply curve in the market.

When the prices of goods and services rise over a period of time. The rate of inflation is positive.

The average price of goods and services in an economy. This is normally determined by measuring the price changes relating to a representative sample of goods and services

A firm that has a very strong market position and is able to dictate the price that consumers pay for its goods and services. This is normally associated with a firm that possesses monopoly power.

Below is a diagram to show how monopolistic firms can restrict output and charge whatever price they wish to do so to maximise profits. This is not the case in perfectly competitive markets where all firms have to take the market price as given and are price takers as they are all competing over a homogeneous good.