Tutor2u - Government Intervention – Maximum Prices
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Maximum prices or similar forms of price controls are certainly topical once again! Until recently, housing rent controls were just about the only applied example of price capping in markets that made it into exam questions. But now we see instances of possible price ceilings in energy, telecommunications and calls for wage caps in the labour market. Once again, start with the basic analysis of where a maximum price must be set to have an impact on the market. Then analyse with reference to elasticity of demand and supply. Look to be able to critically evaluate price controls as a form of intervention – which stakeholders gain and which lose out? Are there better alternative policies?
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Tutor2u - Government Intervention – Maximum Prices
- 1. Government Intervention – Maximum Prices
- 3. Maximum Prices / Price Caps – Some Topical Issues Housing Rent Controls Energy Price Caps to control fuel bills Caps on CEO Pay /Bonuses Cap on Mobile Roaming Charges Price capping for water companies Cap on interest rates charged by pay-day lenders Cap on annual charges to pension plans Currency peg e.g. Hong Kong / US dollar The government or an industry regulator can set a maximum price to prevent the market price from rising above a certain level
- 4. Maximum Price Analysis Diagram Quantity supplied P1 Q1 A maximum price must be set below the normal free market equilibrium price to have any effect on price and output Market Demand Max Price Q2 Price Q3 Market Supply Max Price (price ceiling) Free Market Equilibrium An alternative to a maximum rent is a rent subsidy for housing which is the equivalent of an increase in income
- 5. Maximum Price Analysis – “Black Market” Prices Quantity supplied P1 Q1 If quantity is restricted to Q3, then some consumers will be willing to pay a higher “unofficial price” at P2 Producers can extract extra consumer surplus at higher price Market Demand Max Price Q2 Price Q3 Max Price P2 Market Supply Extracted consumer surplus above the official price ceiling Possible unofficial price above the ceiling Some rationing or auction process may be needed if output = Q3
- 6. Applied Micro: Plans for an Energy Price Cap Output P1 Q1 D Max Price Price of gas Q3 S In 2013, Labour Leader Ed Milliband, announced that he would consider capping fuel prices if elected into Government in 2015 • Milliband argues that rising fuel prices benefit only the privately- owned firms that sell the fuel. • These firms benefit unfairly because there is limited competition in the fuel generation and retail markets. • Because demand for fuel is price inelastic, an increase in fuel bills reduces people’s real purchasing power • The main case for the energy price cap proposal is to increase fairness for families on low incomes Opponents of an price cap argue that competition is a better long term strategy
- 7. Evaluating Price Caps in Different Markets A maximum price also involves a normative judgement on behalf of the government about what that price should be Benefits • A useful surrogate for competition • Holds prices down – consumer welfare gains • Incentives for businesses to cut costs to maintain profits Downsides • Reduces profits – less money for capital investment • May dissuade new entrants • Firms might raise prices in other ways Alternatives • Measures to reduce entry barriers in an industry • Higher taxes on monopoly profits e.g. a windfall tax
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Editor's Notes
- Maximum prices or similar forms of price controls are certainly topical once again! Until recently, housing rent controls were just about the only applied example of price capping in markets that made it into exam questions. But now we see instances of possible price ceilings in energy, telecommunications and calls for wage caps in the labour market. Once again, start with the basic analysis of where a maximum price must be set to have an impact on the market. Then analyse with reference to elasticity of demand and supply. Look to be able to critically evaluate price controls as a form of intervention – which stakeholders gain and which lose out? Are there better alternative policies?