Examination of the justification of governmental price ceiling

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Content page

1.     The determination of market price and supply………………………………………………. 2

2.     Theoretical determination of quantity by producers……………………………………….. 5

3.     Examination of the justification of governmental price ceiling………………………… 6

4.     Consequence of governmental price control………………………………………………….. 7

4.1      Expected consequences…………………………………………………………………….. 7

4.2      Actual consequences………………………………………………………………………… 7

4.2.1     Shortage………………………………………………………………………………… 7

4.2.2     Black market………………………………………………………………………….. 8

4.2.3     Increased administrative cost……………………………………………………. 8

4.2.4     Reduces in social welfare…………………………………………………………. 9

5.     Recommendations……………………………………………………………………………………. 10

5.1      Import of rice…………………………………………………………………………………. 10

5.2      Create a perfect competitive market………………………………………………….. 10

Reference……………………………………………………………………………………………………… 12

1.        The determination of market price and supply

 

A free market economy is described by Baumol (2002) as a machine that generates innovation and growth in dramatic profusion by itself with the institutional impediments to its development being sufficiently reduced. Under this description in a market economy the role of the states has been reduced to a neutral role majoring in administration and legislation of the economy so that the products are priced through mutual consent between customers and suppliers. Before the actual discussion of how the market price and the quantity of a certain product supplied are determined such a free market, two curve need be understood first. The first is the demand curve from the perspective of consumers as shown in the chart 1.0 below.

 

Chart 1.0 Demand curve

The demand curve could be easily understood in empirical way, with the drop of the price from P1 to P2, the quantity demanded by consumers increases accordingly along the down slope demand curve from Q1 to Q2, vice versa.

 

Chart 2.0 Supply curve

 

Another factor that could jointly decide the forming of the prices and quantity supplied in a free market environment is the supply of the certain products. The supply curve is demonstrated in chart 2.0 above. The supply curve unlike the demand curve is a escalating slope which means that the quantity of the products that the suppliers are willing to supply will increase along the supply curve from Q1 to Q2 when the market price increases from P1 to P2, vice versa. This supply curve could be understood in this way that when the price of the products is higher due to the demand increases for example, then the manufactures would be willing to supply more by enlarging the scale of production since high prices means more profits.

 

Chart 3.0 Determination of market price and supply quantity

The demand curve and the supply curve together decide the price and quantity supplied of the product in the free market. As shown in the chart 3.0 above, when the two curves are put together to view the demand and supply situations at the same time, there will be a cross point which is a free market equilibrium point. The price level Pe is the market prices set by the free market and the accordingly in this prices level, there will be an equal supply and demand level Qe in the market. In normal market situations, the demand curve will not change dramatically in a certain period since people tend to consume the similar quantity level of a certain products. But supply curve could changed if there are factors that influence the corn production such as weather factors. For example, if in  particular year the supply level of corn drops due to more land is developed in a industrial level, then the supply curve will move to S2 from S1. Provided with unchanged demand curve, the equilibrium point will have a negative shift from A1 to A2 leading to the higher prices and forced less demand in the market as shown in Chart 4.0. Such movement is also a market reaction to a supply drop in a free market.

 

 

Chart 4.0 Movement of supply curve

 

 

 

 

2.        Theoretical determination of quantity by producers

 

 

Chart 5 The marginal method of profit maximization (Source: Knowledgerush.com 2009)

 

Usually there are two ways that the producers could use to decide the quantity that they are willing to provide according to the current market prices. One is a total cost and total revenue way, and the other is marginal approach. Let’s focus on the marginal method. To maximize the profit, producers will keep increasing their supply if the marginal profit is positive which will contribute to the total profit. When the marginal profit become zero then the profit has reached a maximized status because the further increase of supply could be add to the total profit. For example, as the chart above illustrates, when the market price is P which equals the marginal revenues, the producers would be happy to supply with the quantity of Q because the intersection point A represents that marginal cost equals marginal revenue to ensure that the suppliers’ profit is maximized.

 

 

3.        Examination of the justification of governmental price ceiling

 

Government is the supervisor of the market and it could perform an important role in protecting consumers or producers by adopting policies to create a more complex market condition. In the agricultural industry, two most used governmental intervention are price floor which is a minimum allowable price above the equilibrium price and price ceiling which is a maximum allowable price. Below let us focus on the price ceiling of rice in Sri Lanka agricultural industry.

 

Chart 6.0 Rice retail prices movement in Sri Lanka (per kg)

Source: Central bank of Sri Lanka 2008

 

As the chart tells, the retail prices of Samba, Kekulu and Nadu rice in Sri Lanka all rose dramatically in the beginning of 2008 leading to a price ceiling policy by the government of setting the three rice prices Rs. 70, Rs. 65 and Rs. 65 respectively to control the soaring trend of the rice prices.

 

The justifiable for Sri Lanka government to limit the soaring price of the rice which have been too far way the average level since the average rice prices from January 2005 to January 2008 are only 46, 37, and 36 respectively, if the rice price kept raising, it would substantially harm consumers’ welfare since high price make rice unattainable to the poor people. But there will be advantages and disadvantages for the Sri Lanka government to use the price ceiling strategy which will be discussed below.

 

4.        Consequence of governmental price control

 

4.1    Expected consequences

 

One of the expected consequences of the price ceiling is to stabilize the price of the rice and protect the consumers. By setting price ceiling, the market price was intervened and under close monitoring by the government. The priority of the government in the first place is to protect the poor who are in disadvantageous position since they cannot meet the price increases. The second expected consequence is targeting on the middle man as it is well known that the middlemen and sellers tend to keep speculative stocks which will increase the temporary shortages of rice which will contribute to the rapid growth of the price. By setting price ceiling, one of the targets of the government is to force the middlemen to release these speculative stocks to increase the supply in the market. The third initiative of controlling the price of the rice deeply roots in the government’ role of supervision over the economy and the society as a whole. Policymakers are led to control prices because they view the market’s outcomes as unfair (Mankiw 2009, p122). By controlling the soaring rice price, the government is also aiming at improving market outcomes.

 

4.2    Actual consequences

 

4.2.1            Shortage

 

As illustrated in the chart below, the Sri Lanka government considered the market price of the rice Pe as unfair which was then the equilibrium price, by setting the price ceiling of Pc which was below the Pe there will be a forced shortage because in the price level of Pc, consumers’ demand was Qd while at the same time the suppliers were only willing to provide a quantity level of Qs. Since the government could not force the suppliers and the middlemen to sell the rice, a shortage will cause another problem: who can enjoy the relatively low price while the others cannot? Then the fairness problems again appear and need to be fixed under other mechanisms such as queuing up to buy the rice and such mechanisms also functions at a social cost.

 

Chart 7.0 Binding price ceiling causes shortage

 

4.2.2            Black market

 

A black market, or underground economy which could contain legal or illegal activities has been said to be growing rapidly mainly due to government policies  (Rahn 2009). In the situation of price ceiling, the price does not go down because there is a oversupply than the demand in that price level, in contrast there is still a shortage which provides incentive for both suppliers and buyers to turn to a black market in which prices could be set by the agreement between the both parties without governmental interventions.

 

4.2.3            Increased administrative cost

 

With the appearance of the underground purchasing of the rice in the black market and other issues that come along with the price ceiling policy, the government could not just issue the policy with enforcement since market power could even be stronger than legal forces in some situations. So it would be necessary to enforce the price ceiling in the economy by pouring more state resources in term of personnel and cash funds into the enforcement activities to closely supervise the economy. This has increased the burden of the government especially to one as small as Sri Lanka government.

 

4.2.4            Reduces in social welfare

 

 

Table 1.0 Historical average and predictable rice compared with ceiling prices

 

Consumers tend to gain while producers lose, if the ceiling price is lower than the historical average (Ellis 1992). But the case is totally a different situation, as the table above shows, the historical average prices before the ceiling price policy took effect in April 2008 were still a lot lower than the ceiling prices. What’s more, because there have been significant imperfections in Sri Lanka’s rice market (Banda, Jayawickrama & Ranathilaka 2008), then the price ceiling actually benefit the suppliers and middlemen rather than the consumers or even the producers which is different from what the government had hope to achieve in the beginning.

5.        Recommendations

 

5.1    Import of rice

 

The first policy recommended to the Sri Lanka government to cope with the rice scarcity is to release and encourage the import of the rice from the other countries to increase the supply of rice in a short term since the product of rice takes a certain period of time to achieve which means that the encouragement of rice growing could only be a long term strategy rather than a short term one. What’s more if the reasons of the shortage in the rice sector could be carefully examined, the policy barriers of the import of the rice would had previously contributed to the intensifying rice shortage in the very beginning. So an encouraging rice import policy and a more neutral import policy could be helpful to increase the rice supply to lower the market equilibrium price of rice and in the long term stabilized the rice prices. But such loose or encouraging import policy need to be used in a careful manner since if there enough of supply in the market then the large amount of import of rice could damage the interests of the producers and set the possibility of further supply shortage because low price could reduce the producers such as farmers’ incentive to focus on rice growing. So close examination of rice supply and demand would be a necessity for the import policy to act effectively.

 

5.2    Create a perfect competitive market

 

As mentioned in the study, there are significant market imperfections in the rice sector of Sri Lanka economy which hinders the normal free market functioning which contributed to soaring rice price in beginning of 2008. In such a market with anti competitive forces from the middlemen for example, the price ceiling could not perform effectively and achieve the goals set by the governments. To reduce the anti competitive forces and create a perfect competitive market, in the perspective of the government, it can enact and enforce a set of more pinpointing competitive law and policies by forbidding the anti competitive market behaviors in the rice sector such as the collusion by the retailers.

Reference

 

Baumol, W. J. 2002, The free-market innovation machine: analyzing the growth miracle of capitalism, Princeton University Press: New Jersey

 

Banda, O.G, D., Jayawickrama, J. M. A. & Ranathilaka, M. B. 2008, Sense and nonsense of rice price controls in Sri Lanka, The Peradeniya Journal of Economics, Vol. 2, No. 1 & 2, 2008

 

Central Bank of Sri Lanka 2008, Various years, Annual Report, Colombo:CBSL

 

Central bank of Sri Lanka 2008, Monthly Bulletin, January 2005 –February 2008, Colombo: CBSL.

 

Ellis, F. 1992, Agricultural Policies in Developing Countries, Cambridge: Cambridge University Press.

 

Knowledgerush.com 2009, Profit maximization, view on 2nd Nov 2010, [online] available: http://www.knowledgerush.com/kr/encyclopedia/Profit_maximization/

 

Mankiw, N. G. 2009, Principles of Economics, 5th edition, South- Western Cengage Learning, New York

 

Rahn, R. W. 2009, New underground economy, view on 2nd Nov 2010, [online] available: http://www.washingtontimes.com/news/2009/dec/09/new-underground-economy/?page=1