Question

Suppose the total demand for wheat and the total supply of wheat per month in the Kansas City grain market are as shown in the following table. Suppose that the government establishes a price ceiling of \(3.70 for wheat. What might prompt the government to establish this price ceiling? Explain carefully the main effects. Demonstrate your answer graphically. Next, suppose that the government establishes a price floor of \)4.60 for wheat. What will be the main effects of this price floor? Demonstrate your answer graphically.

Thousand of bushels demanded	Price per bushel ($)	Thousands of bushel supplied
85	3.40	72
80	3.70	73
75	4.00	75
70	4.30	77
65	4.70	79
60	4.90	81

Short answer

The following diagram explains the presence of a price ceiling ($3.70) and a price floor ($4.60), given the equilibrium price is $4.00.

The government established a price ceiling to protect the consumers from high market prices. The price ceiling created a shortage in the market.

The government establishes a price floor to protect the sellers from low market-determined prices. The price floor created a surplus in the market.

Step-by-step solution

Effects of the price ceiling

The price ceiling sets the maximum price that a consumer should pay to a seller, or the seller can charge a consumer for his/her goods and services. It becomes legally binding only if it is below the market-determined prices as the set price prevents the movement towards a higher equilibrium price. The effect is the excess demand or shortage of supply in the market because of the lower price.

Graphical representation of price ceiling at $3.70

The diagram given below shows the quantity demanded and the quantity supplied of wheat (in thousands of bushels) at different prices using the data given in the table. The equilibrium is achieved when the quantity demanded is equal to the quantity supplied at a price equal to $ 4.

A price ceiling of $3.70 stops the market’s price mechanism from reaching an equilibrium state where the quantity demanded is equal to the supplied amount. At this price, consumers pay lower prices to sellers for the good or service. Hence, the unhappy sellers supply less, and happy consumers demand more. This creates a shortage in the market, and consequently, the quantity demanded is more than the quantity supplied.

It creates the following problems:

• Rationing: Limited supply of wheat is provided to a few customers based on some form of discrimination. For example, the price ceiling results in a long queue in front of a ration shop, only those who can wait for a long time get the ration.
• Black markets: Higher demand is met by charging higher prices in the underground market illegally.

Effects of price floor

The price floor sets the minimum price that a seller should receive for his/her goods and services. It becomes legally binding only if it is above the market-determined prices as the set price floor prevents the movement towards a lower equilibrium price. The effect is the excess supply (surplus) or shortage of demand in the market because of the higher price.

Graphical representation of price floor at $4.60

The diagram given below shows the quantity demanded of wheat and the quantity supplied of wheat (in thousands of bushels) at different prices, using the data in the table. The equilibrium is achieved when the quantity demanded is equal to the quantity supplied at a price equal to $ 4.

A price floor of $4.60 stops the market’s price mechanism from reaching an equilibrium state where the quantity demanded is equal to the supplied amount. At this price, consumers pay higher prices to sellers for the goods or services. Hence, the happy sellers supply more, and unhappy consumers demand less. This creates a surplus problem in the market. The quantity supplied is more than the quantity demanded.

This creates the following problems:

• Distorting market incentives: This means a high-cost producer will continue producing wheat despite making losses (as the prices are not market-determined and are unnecessarily higher). The production of other valuable goods is ignored.
• Improper resources allocation: The scarce resources are allocated to the wheat production activity despite being non-profitable in actual terms, as stated above. There is allocative inefficiency and can create environmental damage.