Controlling Prices in Markets (Cambridge International A-Level Economics)

Using price controls to correct market failure

• Price controls are a type of government intervention in markets to change the existing market price

• To attempt to correct market failure, price controls are used to influence the levels of production or consumption in markets that are failing to allocate resources efficiently

  • This may help to reduce overconsumption of demerit goods or increase consumption of merit goods, although it may also lead to government failure

• Two types of control are commonly used:

  • A maximum price is a legally imposed maximum price set below equilibrium, above which a good or service cannot be sold
  • A minimum price is a legally imposed minimum price set above equilibrium, below which a good or service cannot be sold

Price floors (minimum prices)

Why governments control prices

• Governments use price controls to correct market failure and improve the allocation of resources

Link to social and private costs and benefits

• In many markets, the price mechanism reflects only private costs and benefits, not the full impact on society

  • Private costs/benefits → affect the individual consumer or producer
  • Social costs/benefits → include wider effects on third parties (externalities)

• As a result:

  • Market equilibrium may not be socially optimal

1. To reduce over-consumption of demerit goods

• Demerit goods generate external costs to society

• Consumers consider only their private benefits

• Therefore:

  • Marginal private benefit (MPB) > marginal social benefit (MSB)
  • Output is too high (Qe > Qopt)

• Governments may:

  • Increase prices to discourage consumption
  • Move output closer to the socially optimal level

2. To increase consumption of merit goods

• Merit goods generate external benefits to society

• Consumers underestimate the full benefits

• Therefore:

  • Marginal social benefit (MSB) > marginal private benefit (MPB)
  • Output is too low (Qe < Qopt)

• Governments may:

  • Reduce prices to encourage consumption
  • Increase access and move output towards Qopt

3. To improve equity

• Market prices may be unaffordable for some consumers

• This limits access to essential goods and services

• Governments may:

  • Control prices to improve affordability
  • Promote a more equitable distribution of resources

Exam Hint Link price controls to:

• Market equilibrium based on private costs/benefits → divergence from social optimum → government intervention to correct this