Theory: Changes in Market Equilibrium - Price Controls

Microeconomics: Effects of Government Intervention – Price Controls

In most industrial countries, markets are hardly ever free from types of government intervention. This intervention takes many forms, such as: taxes, subsidies and regulation. Moreover, governments often use price controls as one of their main forms of market intervention.

Price controls occur when the government increases or reduces the price of the product in the market. They can do this by implementing a ‘ceiling’ price where the price can go no higher than this ‘ceiling’ or a ‘floor’ price where the price can go no lower than this ‘floor’.

So what effect would this have on the market? Let’s use supply-demand analysis to graphically imagine these effects…

In the above diagram, the government has implemented a ceiling price as their price control. This ceiling price therefore has altered the market equilibrium price and quantity. Prior to the change the equilibrium between supply and demand was at (Q,P). Now, however, the market is in a state of disequilibrium.

As we have discussed before, a fall in the market price leads to a reduction in supply and an increase in demand levels because consumers will be able to buy more but producers will be faced with higher relative production costs. The implementation of a ceiling price which is lower than the equilibrium price has the effect of reducing the price. Therefore, in this case there would be a fall in supply and an increase in demand. This would then cause a state of excess of demand (D > S) which would cause a shortage. Shortages can sometimes lead to supply rationing and sometimes it can in fact spill over into other markets where it creates an artificial increase in demand. For instance, in the USA in the 1970’s gas prices were increased by the government, this lead to shortages as well as artificially increasing demand in oil markets as it is a substitute for gas.

In these circumstances, some people stand to win and some people stand to lose from price controls. Typically the producers of the product lose out whilst the consumers gain. The buyers get to purchase at a lower price and some suppliers leave the market. However, not all consumers gain. As we have mentioned before an increase in demand from a lower price is caused by more people being able to afford the product, however because some of the suppliers leave the market there are those who have been ‘rationed’ out of purchasing.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

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