Use a diagram to show the consequences of government imposing a price above or below the free market equilibrium

Authors Avatar by ayu_iyou (student)

Nadinda Ayu

11RIn

Microeconomics

MOD

1. Use a diagram to show the consequences of government imposing a price above or below the free market equilibrium. (10)

        When government imposes the free market and prohibits a price from going above a certain level, we call it price ceiling. If the price ceiling is below the equilibrium price, then shortages are created. The intention of price ceiling is to protect consumers from rapid price increases. However, this intention comes with consequences that are unintended. An example of price ceiling is the gasoline shortages in the 1970s. The diagram below will show the consequences of price ceiling:

        

In the first stage (before government imposing), the equilibrium price of oil per gallons is $1.20. This is where the number of demand equals to the quantity of product sold. The graph of demand and supply when government imposes the price below the free market equilibrium is shown below:

        

        We can see form the graph that the supply contracts from point A, the equilibrium, to point B, which represents the quantity of gallons if the price of oil was to be changed to $1. When supply contracts, it means that the quantity of oil that is supplied becomes less. Because of the shortage of oil, the demand will extend. The lack of supply of oil and the excess demand, scarcity will occur. Even though scarcity of oil existed before, shortages did not happen before the government imposed.  

Another outcome of price ceiling is the illegal economic activities that may occur. Because the maximum price that the government pointed is less than the equilibrium price, producers would feel that they could earn more money. With the shortage and the excess demand of oil, producers would then sell the products at a higher price illegally, and they would succeed in doing so because consumers would still need the oil that is so scarce in the market.

Join now!

Because illegal economic activities would occur, the government would then need to hire inspectors. These inspectors would have to supervise the oil market. Hiring inspectors would cost the government more money; therefore the government spending will increase. However, the producers of oil that are investigated would still find a way around the rules and regulations from the inspectors. For example, the producers would lie about their income as they have sold their product in the black market to make more money. This would lead to tax evasion as well, because they would understate their own income.

2. ...

This is a preview of the whole essay