6.7 Price controls and Market Failure Flashcards
Draw the diagram
What is a minimum price and how can it solve market failure in de-merit goods?
Minimum prices are price floors set above the equilibrium price in the market to discourage consumption of de-merit goods. For goods like alcoholic drinks, minimum prices can be used to raise the price above equilibrium levels from P1 to P2 to internalize the negative externality and discourage consumption, solving overconsumption issues and bringing the market to the allocative efficient production level from Q1 to Q*, eradicating a prior misallocation of resources.
Con: Demand for de-merit goods such as alcohol is highly price inelastic
Minimum Price to Solve De-Merit Good Market Failure Cons/Evaluation
Demand for alcohol for example is price inelastic. This is because it is addictive and there aren’t many good substitutes available. Therefore as price increases due to the minimum price, quantity will decrease due to the law of demand, but proportionately less than the price increase. The decrease in quantity will help to reduce the misallocation of resources but not by enough to fully solve the market failure if Q* is below the new guantity demanded and thus consumed in the market. In this sense, consumers are absorbing a large proportion of the price rise and not reducing consumption greatly. Any overconsumption and overproduction problems will remain.
Con: Could be regressive
Minimum Price to Solve De-Merit Good Market Failure Cons/Evaluation
The poor will suffer proportionately more than the rich as minimum prices are regressive, meaning they take a greater proportion of the poor’s income than they do of the rich, which could widen income inequality in society. Consumers are burdened even more if the demand for the product is price inelastic due to alcohol being addictive in nature.
Con: There can be unintended consequences of imposing a minimum price (i.e. Black markets, Consumers going over the border)
Minimum Price to Solve De-Merit Good Market Failure Cons/Evaluation
There can be unintended consequences of imposing a minimum price on alcohol leading to government failure where the costs of intervention outweigh the benefits. For example, a black market may form where consumers can find an alternative supply at a lower price or consumers may switch to legal alternatives that are actually worse for them just because they are cheaper than the better quality but higher priced alcoholic drinks. This could be dangerous for the consumer as they do not know what is in the product they are consuming, worsening the extent of the negative externalities generated. Once more, the government has created a new market failure (an unintended consequence), which needs spending to police. If significant, the costs of the policy will outweigh the benefits resulting in government failure. Consumers may go across the border and smuggle alcohol where prices are lower. This will not reduce consumption with overconsumption and a misallocation of resources remaining in the market.
Con: Knowing the right level to set the minimum price is extremely difficult
Knowing the right level to set the minimum price is extremely difficult. This is because putting an accurate value on the negative externalities generated is highly complex in reality. There are ways this can be done but not perfectly. As a consequence, the minimum price might be set too low where the externality is not internalised thus the price increase is not large enough to reduce quantity to the socially optimum level of output. If the minimum price is set too high the unintended consequences mentioned above can occur and lead to government failure. Other examples include firms shutting down or leaving the country causing unemployment.
Con: Government must now deal with excess supply
Minimum Price to Solve Volatility Market Failure Cons/Evaluation
The government having created an excess supply of AB must now buy it up which is costly; this is known as intervention buying. The first major issue is what happens with the excess stock. Destroying it would be highly wasteful, storing it very expensive and dumping it abroad politically sensitive given the impact dumping has on producers abroad. Furthermore the large financial cost of intervention buying needs to be funded perhaps by tax rises in the future or spending cuts to public services both of which will hurt consumers. It can be argued that in developing countries especially this is not an efficient use of government revenue, which could have been used more productively elsewhere in the economy to promote development.
Con: Improvement of living standards depends if there is intervention buying
Minimum Price to Solve Volatility Market Failure Cons/Evaluation
The assumption that minimum prices will improve the living standards of primary commodity producers depends heavily on whether intervention buying of the excess supply AB takes place. In developing countries, governments may not be able to afford it leaving the producers to deal with storing or destroying the excess stock - a waste of resources and a hit to profitability for the producer going against the intentions of the policy.
Draw the diagram
How can a maximum price or price ceiling solve income inequality market failure?
A maximum price or price ceiling is set below the free market equilibrium price, decreasing prices from P1 to P2. As a result there is an extension of demand to Qd improving the affordability of essential goods and services like housing or food. Implementing rent control will allow those who need accommodation but cannot afford it in the free market to access housing, improving their living standards, reducing any under consumption issues and thus improving the allocation of resources.
Con: A maximum price creates a shortage of AB in the market
- A maximum price creates a shortage of AB in the market meaning many consumers will not able to access housing or food despite the lower prices as existing suppliers have now left the market or are simply not willing to supply at such a low price. These consumers receive no benefit and must suffer from being on long waiting listings with uncertainty, queuing and significant competition with other buyers.
- The government can reduce the extent of the excess demand problem by excluded those who clearly can afford the good or service. Perhaps to be eligible for rent control, incomes must be below a certain threshold and living time in a city must be beyond a certain number of years. This would reduce the need and thus the cost of excessive government intervention to increase supply and it would mean that only those who are in need of lower prices to access these goods benefit.
Con: Black market formation
The consumers that are not able to purchase the good or service may find alternative supply in the black market where price exploitation, uncertainty and a loss of tax revenue will result. This is not in the best interest of consumers but they may be left no choice. The government has created a market failure here (an unintended consequence), which needs spending to police. If significant, the costs of the policy will outweigh the benefits resulting in government failure. Consumers may alternatively be forced to smuggle food from abroad to survive, a problem the government has created making outcomes worse not better for consumers.
Con: Problems of Subsidisation or Supplying Excess demand
The government may have improved the living standards of some consumers but has created the excess demand AB, which must be dealt with. One option is to subsidise producers in the market, which would lower their costs of production, shifting the supply curve to the right to satisfy the excess demand. Another option would be for the government themselves to supply the excess demand either by building new housing or by releasing any stocks of food they have stored onto the market (difficult however for perishable items). Both options are very costly which carries a large opportunity cost. Funding may come from tax rises in the future or spending cuts to public services both of which will hurt consumers.
Con: If the government can’t afford proper policing
If the government cannot afford proper policing to enforce the maximum price, producers will over price, feeling they won’t get caught, thus the maximum price will not work at all in improving affordability of essential goods and services. In this sense effective enforcement is crucial for a maximum price policy to benefit those on low incomes as it is intended to do.
Con: Depends on the level the maximum price is set at
The impact of a maximum price depends heavily on the level it is set at. If set a long way below the equilibrium price, some consumers will benefit enormous from lower prices but the extent of the shortage and thus black market activity will be higher thus risking significant government failure. If on the other hand the maximum price is set only slightly below the equilibrium price, the excess demand issue and black market activity lessens but consumers do not receive the benefit of being able to afford essential goods and services going against the intention of the policy.
