SEM-1/ECO/MICRO/Govt.

intervention in market mechanism/Maximum price legislation

P
S1
D1 S0

B
PB
D0 E
P1

P0
F

Fig.-1
S0 D1

D0
0 Q1 Q
Q2

In a market economy, equilibrium market price is determined through the free interplay of market demand
and supply forces. Let the market demand curve for any commodity at the initial level be denoted by D 0,
and the market supply curve for that commodity be denoted by S 0. So, the equilibrium price (P) of the
commodity is P0 at which aggregate market demand is just equal to the aggregate market supply (See
Fig.-1). Now, if for some reason or other, there is an increase in market demand for that commodity then
the market demand curve would shift to the rightward direction from D0D0 to D1D1. As a result,
equilibrium market price would rise from P 0 to P1. If that increased price causes trouble for the common
people of the country then government may intervene into this market mechanism through the imposition
of ‘maximum price legislation’ or a ‘price ceiling’. Thus, the seller would not be allowed to charge a price
higher than P0.

At this ceiling price, aggregate market demand for the commodity = 0Q 2, but aggregate market supply of
the commodity = 0Q1. So, there arises an excess demand for the commodity to the extent of Q 1Q2.
Normally, this excess demand situation leads to an increase in market price. But in case of price ceiling,
price is not allowed to rise above P0.

Thus, through such price ceiling legislation the ‘price rationing’ mode of the market mechanism is
restricted (price rationing means that with the rise in price, the demand for the commodity will fall). So,
the price rationing system has to be substituted by some other system.

This shortage in the commodity market can be solved in the following ways:

(a) Some suppliers may distribute the available goods following ‘first come – first served’ basis.
But this type of distribution depends upon the discretionary power of the suppliers since they may
show some bias towards some known persons.

Dr. Debashis Mazumdar/HoD/ECO/THC 1

 (b) Further, if this problem of shortage is dealt with through the discretionary power of the suppliers
then there would be a long queue in front of some shops, and the wastage of time might have
large opportunity costs for the buyers.
(c) The government may issue ration cards to the common people so as to distribute the available
good amongst the consumers. This is known as commodity rationing.

However, if the price ceiling legislation is not properly supplemented by the quantity rationing then there
may arise ‘black marketing’ where some of the dishonest sellers would charge the demand price (the
maximum price that any buyer is ready to pay for given quantity). In Fig.-1, the black market price of Q1
quantity would be PB. Thus, by selling 0Q1 quantity, the ‘white income’ of the seller (which is submitted
to the government) would be Area (0P0FQ1) and the ‘black income’ would be Area(P0PBBF) (See Fig.-1).

If the government announces punishment for such dishonest sellers ( let the punishment amount be Z) and
if the probability of being caught is ‘p’, then the probable penalty payment for any seller is ‘p.Z’. If this
penalty payment is less than the black income then there is every possibility that the black marketing will
continue. However, after the penalty payment, that raises the cost burden of the sellers, the market supply
curve will shift to the left, say, from S 0 to S1(See Fig.-1).

Again, if such price ceiling continues for long, some of sellers would leave the market if the ceiling price
fails to cover their average variable costs. As a result, we get two effects: (i) The market supply curve
gradually shifts to the leftward direction, and (ii) the shifted market supply curve becomes relatively
inelastic (i.e. the supply may not respond adequately to changes in market price).

P S3 S2 S1
S0
H
P3

P1 E

G
P0
F

Fig.-2
S0 D1

0 Q
Q3 Q0
Fig.-2 shows that the market supply curve shifts gradually to the left from S0 to S1 and ultimately to S3,
and they become steeper showing relatively inelastic supply. Hence, when the government withdraws the
price ceiling legislation, then the equilibrium price in the market might be P 3 which is much higher than
the original equilibrium price P0, and equilibrium quantity will also decline from Q 0 to Q3.

Dr. Debashis Mazumdar/HoD/ECO/THC 2