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):
