Lets take up a role of Policy Maker and analyse how government policy affect the market outcome.
Not all markets are allowed to function freely. Supply and Demand may result in prices that are unfair to buyers or to sellers. Government may set a price and it may differ from the equilibrium price that the market sets.
This action will interfere with the “clearing function” which equilibrium conditions create. A shortage (as in the case of a price that is below equilibrium) or a surplus (as in the case of a price that is above equilibrium) is the result of these government price setting actions.
- There are two types of price control: price ceilings and price floors. Price ceilings sets a legal maximum price at which a goods can be sold. A price floors sets a legal minimum price at which a good can be sold.
- Price Ceilings: In a competitive market, a price that is below the equilibrium causes shortages, because quantity demanded exceeds quantity supplied. The resulting shortage tends to put upward pressure on price until it goes back to equilibrium and eliminating the shortage. On the other hand, if the government sets a price ceiling that is above or higher than the equilibrium price, it will have no effect.