5.2 - Applications

In this section, we try to understand how the supply-demand analysis can be applied. In particular, we look at two examples of government intervention in the form of price control. Often, it becomes necessary for the government to regulate the prices of certain goods and services when their prices are either too high or too low in comparison to the desired levels. We will analyse these issues within the framework of perfect competition to look at what impact these regulations have on the market for these goods.

It is not very uncommon to come across instances where government fixes a maximum allowable price for certain goods. The government-imposed upper limit on the price of a good or service is called price ceiling. Price ceiling is generally imposed on necessary items like wheat, rice, kerosene, sugar and it is fixed below the market-determined price since at the market-determined price some section of the population will not be able to afford these goods.

Let us examine the effects of price ceiling on market equilibrium through the example of market for wheat. Figure 5.7 shows the market supply curve SS and the market demand curve DD for wheat. The equilibrium price and quantity of wheat are p and q respectively. When the government imposes price ceiling at p_c which is lower than the equilibrium price level, there will be an excess demand for wheat in the market at that price. The consumers demand q_c kilograms of wheat whereas the firms supply q' kilograms.

Hence, though the intention of the government was to help the consumers, it could end up creating shortage of wheat. How is the quantity of wheat (q') then distributed among the consumers? One way of doing this is to distribute it to everyone, through a system of rationing. Ration coupons are issued to the consumers so that no individual can buy more than a certain amount of wheat and this stipulated amount of wheat is sold through ration shops which are also called fair price shops.

For certain goods and services, fall in price below a particular level is not desirable and hence the government sets floors or minimum prices for these goods and services. The government-imposed lower limit on the price that may be charged for a particular good or service is called price floor. Most well-known examples of imposition of price floor are agricultural price support programmes and the minimum wage legislation.

Figure 5.8 shows the market supply and the market demand curve for a commodity on which price floor is imposed. The market equilibrium here would occur at price p and quantity q. But when the government imposes a floor higher than the equilibrium price at p_f, the market demand is q_f whereas the firms want to supply q′, thereby leading to an excess supply in the market equal to q_f q′.