In a previous article Supply, demand and market equilibrium we discussed how prices is determined by supply and demand if all else stays equal. In this article I want to talk about ways in which prices can be manipulated to be something other than the equilibrium price and the effect it has on the economy.
The Price system performs two important functions:
- It provides a mechanism to distribute scarce goods and services to consumers (Price rationing).
- It determines the allocation of resources to Producers and the final mix of outputs.
In free markets products and services in short supply will be distributed to those willing and able to pay a higher price. Prices will continue to raise until market equilibrium is reached where demand equals supply. If the price system is not allowed to function and prices are kept at levels where supply and demand is not in equilibrium, the economy will make a loss (Called deadweight loss)
Consumer surplus is the difference between the maximum a person is willing to pay for something and the current market price.
Producer surplus is the difference between the total cost of production and the current market price.
Deadweight loss is the net loss of producer and consumer surplus from underproduction or overproduction
Alternative rationing mechanisms
Sometimes alternative rationing mechanisms are used by government and companies to distribute scarce products and services. Fairness is often used as justification for policies designed to bypass price rationing. For example they will argue that price-gouging is bad, income is unfairly distributed or that some items are necessities that everyone should be able to afford. Unfortunately these alternative rationing mechanisms are often difficult and costly to apply and may have unintended effects. Examples of such alternative mechanisms include price ceilings/floors, queuing, ration coupons and favoured customers.
Price ceilings and price floors
Sometimes governments specify the maximum price sellers may charge for a product. This usually prevents the market from reaching equilibrium and perpetuate the shortage. This could cause unintended side effects. For example, suppliers may increase prices on services associated with the product for which there is a price ceiling.
Price floors are also sometimes specified to prevent a price from dropping below a certain level. A common example of price floors are minimum wages where employers are not permitted to pay workers less than a certain minimum. In the same way that Price ceilings cause shortages, price floors causes excess supply. Specifying minimum wages above the equilibrium price leads to wasteful unemployment. By lowering the price, more labour will be demanded.
Another rationing mechanism is to keep the prices low but let people wait in line. Under this system, products are still distributed to those willing to sacrifice the most, but these sacrifices are measured in hours and aggravation instead of money.
During times of short supply, suppliers may decide to sell to friends and favorite customers instead of the general public. This may cause customers to make side payments in an attempt to become a favorite customer.
Ration coupons are tickets or coupons that entitle individuals to purchase a certain amount of a scarce product. The intention is to give all people equal opportunity to own the scarce product, but this usually result in the trading of coupons. Coupon trading restrictions may be implemented but it is impossible to prevent black markets from forming. A black market is a market where illegal trading takes place at market-determined prices.
Governments often add import tax to products. The effect of the additional tax is:
- Government gets an additional income
- Import tax push up the price of the product for consumers, so demand decrease. In the case of tax on oil imports, lower demand can reduce pollution.
- Domestic producers does not pay the additional import tax but they can charge the same higher price, which makes it more profitable for domestic producers. Domestic production increases.
- Seeing that demand goes down and domestic production increases, the country becomes less dependent on imports from foreign countries.
- The down side to this is that consumers still pay a higher price.
There are many reasons why producers would over or under produce over and above the alternative rationing mechanisms mentioned above. These reasons are:
- Monopoly power can cause companies to under produce and over price
- Price fixing can also interfere with supply and demand equilibrium. In South Africa we have a Competition Commission who investigate price fixing allegations and fine companies involved.
- Taxes can distort customer choice. For example, carbon and sin tax have been used by Governments to increase income and at the same time change consumer behavior.
- Subsidies can also distort production levels. Some countries for example subsidize their farmers, which makes it difficult for South African farmers to compete with cheaper imported products.
- External costs like pollution and congestion may lead to underproduction. Water shortages and load shedding are good examples from a South African context.
The moral of the story is that price can be manipulated to be something other than the equilibrium price, but it is usually costly and ineffective to do so and we may end up with unintended side-effects.
Karl E. Case, Ray C.Fair, Principles of economics. Seventh Edition, Pearson Prentice Hall, 2004, Chapter 4