Price Controls & Direct Provision (Cambridge (CIE) A Level Economics): Revision Note

State provision

• Merit goods and public goods are under-provided in a free market, causing a market failure

• Public goods are beneficial for society and are not provided by private firms due to the free rider problem

  • They are usually provided free at the point of consumption, but are paid for through general taxation

  • Examples include roads, parks, lighthouses, national defence

• Merit goods are beneficial to society but consumers cannot always access them as they are priced out of the market (e.g. private education or healthcare)

• To solve the market failure, governments can provide these goods and services

The advantages and disadvantages of state provision

Price ceilings (maximum prices)

• A price ceiling is a maximum price set by the government. Sellers cannot legally sell the good or service at a higher price

• The price ceiling is set below the existing equilibrium market price  

• Governments will often use price ceilings to help consumers if the market price is too high, especially for essential goods and services

  • This may increase consumption of merit goods, helping to generate positive externalities (external benefits)

  • It may also improve equity by making essential goods more affordable for low-income consumers

  • Sometimes they are used for long periods of time, e.g., rent controls to keep rents lower in housing rental markets

  • Other times, they are short-term solutions aimed at limiting unusual price increases, e.g., petrol

Impact of a price ceiling

Diagram analysis

• The initial market equilibrium is at P_eQ_e

• A price ceiling is imposed at P_max below the equilibrium level

  • The lower price reduces the incentive to supply and there is a contraction in quantity supplied (QS) from Q_e → Q_s

  • The lower price increases the incentive to consume and there is an extension in quantity demanded (QD) from Q_e → Q_d

• This creates a condition of excess demand (shortage) equal to Q_sQ_d

  • The shortage may lead to non-price rationing, such as queues, waiting lists or favouritism

  • It may also encourage the development of black markets

• The aim of this policy is to promote equity in the market for essential goods and services and it attempts to solve market failure caused by income inequality

Evaluating the use of price ceilings

Price floors (minimum prices)

• A price floor (minimum price) is set by the government above the existing free market equilibrium price and sellers cannot legally sell the good/service at a lower price

• Governments will often use price floors to help producers or to decrease consumption of a demerit good

  • By reducing consumption of demerit goods, price floors can help to reduce negative externalities (external costs) and move output closer to the socially optimal level

    • In Wales and Scotland, governments have introduced a minimum price of alcohol at 50 pence per unit

• Minimum prices are also used in the labour market to protect workers from wage exploitation. These are called minimum wages

Impact of a price floor

Diagram analysis 

• The initial market equilibrium is at P_eQ_e

• A price floor is imposed at Pmin above the equilibrium level

  • The higher price increases the incentive to supply and there is an extension in supply from Q_e → Q_s

  • The higher price decreases the incentive to consume and there is a contraction in demand from Q_e → Q_d

  • This creates an excess supply equal to Q_dQ_s 

• In the case of demerit goods, this discourages consumption, reducing output to a level that may be closer to the socially optimal level if the price floor is set appropriately

• Consumers lose from higher prices, while producers gain

• There is likely to be a deadweight loss, indicating a loss of allocative efficiency

Evaluating the use of price floors