Solutions to Market Failure: Maximum & Minimum Prices (Cambridge (CIE) IGCSE Economics): Revision Note

Intervention to address market failure

• Four of the most commonly used methods to address market failure in markets are

  • maximum prices

  • minimum prices  

  • indirect taxation

  • subsidies

• Additional methods of intervention include regulation, nationalisation, privatisation, and government (state) provision of public goods

Maximum prices

• A maximum price is set by the government below the existing free market equilibrium price and sellers cannot legally sell the good/service at a higher price 

• Governments will often use maximum prices in order to help consumers.

  • Sometimes they are used for long periods of time e.g. housing rental markets.

  • Other times they are short-term solutions to unusual price increases e.g. petrol 

Diagram analysis

• The initial market equilibrium is at P_eQ_e

• A maximum price is imposed at P_max

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

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

  • This creates a condition of excess demand equal to Q_sQ_d 

Evaluating the use of maximum prices

Minimum prices

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

• Governments will often use minimum prices in order to help producers or to decrease consumption of a demerit good such as alcohol 

Diagram analysis

• The initial market equilibrium is at P_eQ_e

• A minimum price is imposed at P_min

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

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

  • This creates a condition of excess supply Q_dQ_s 

Evaluating the use of minimum prices in product markets

 Minimum prices in labour markets  

• Minimum prices are also used in the labour market to protect workers from wage exploitation

  • These are called national minimum wages 

• A national minimum wage (NMW) is a legally imposed wage level that employers must pay their workers

  • It is set above the market rate

  • The minimum wage per hour varies based on age
     

Diagram analysis

• The demand for labour (D_L) represents the demand for workers by firms

• The supply of labour (S_L) represents the supply of labour by workers

• The market equilibrium wage and quantity for truck drivers in the UK is seen at W_eQ_e

• The UK government imposes a national minimum wage (NMW) at W₁

• Incentivised by higher wages, the supply of labour increases from Q_e to Q_s

• Facing higher production costs, the demand for labour by firms decreases from Q_e to Q_d

• This means that at a wage rate of W₁ there is excess supply of labour and the potential for unemployment equal to Q_dQ_s  

Evaluating the use of a minimum wage in labour markets