Price Formation and Government Intervention

<Last updated 12.04.2020>

Dear reader,

Hi! If you are interested in Economics, I’ve prepared the below to help you understand how prices are formed and why government intervenes. You should take a look at this short article in which I explain how price balances Supply and Demand and how the Government can affect the market for goods and services .

We have analyzed how Demand and Supply are formed based on consumer, or household, preferences and business operations > depending on their production functions. We are now going to see how in a free market the dynamics of demand and supply form the equilibrium prices.

In a market, equilibrium exists when the price succeeds in balancing Supply and Demand, a price level in which no entity, buyer or seller, wants to deviate from that level.

> When there is a case of Excess Demand, it means that the quantity (Q2) that consumers/buyers are willing to buy at that P1 price is higher than the quantity Q1 which producers/sellers are wiling to sell at that price. In this case the consumers will be willing to buy at  higher price in order to acquire the good they need.

> If the price is higher than the Equilibrium Price we have the state of Excess Supply. This means that the quantity (Q2) consumers/buyers are willing to buy at P1 price is lower than the quantity (Q1) that producers/sellers are wiling to sell at that  price. In this case the producers will be willing to lower the price in order to sell the excess quantity supplied. We will then return back to equilibrium, if other factors are fixed (not changing).

When there is an excess supply or demand, in a free market price will adjust to the level where quantity demanded will be equal to the quantity supplied. To the Equilibrium Price level (EP). What ever other price level is formed, it is not permanent, except EP in this model. When factors change that cause shifts of the curves, then we have a new equilibrium price level as shown at the following diagrams.

> If demand for Good A increases, let’s say because consumer’s income increased, then consumers will demand higher amount of Good A at each price level. The demand curve shifts to the right. EP is now higher. EQ is higher.

> If supply for Good A increases, let’s say because cost of production decreased, then suppliers will supply higher amount of Good A at each price level. The supply curve shifts to the right. EP is now lower. EQ is higher.

> In the following case, the simultaneous increase in Demand and decrease in Supply lead to a higher EP price. The diagram shows a possible outcome based on how demand and supply shift. Another possible outcome would be to have lower or higher Equilibrium Quantity and not the same as before. Outcomes are based on how far demand or supply shift and on the slope of each > results in different outcome levels.

We are now going to see how the Government intervenes in the market and sets maximum price levels for some goods and services (in the past this was happening often, during periods of war for example).  The government, as a response to consumer pressures for price decrease, sets a maximum price for providing a good or service. This is the function “Setting Prices“.

A maximum price (price ceiling) for providing a good or service is forced by law (EP MAX). In example, house/apartment rent. This creates an excess demand. Consumers demand more quantity than suppliers are willing/can provide/supply. Many consumers that want to buy quantities of the Good A will remain unsatisfied since less quantity is provided/supplied. In this example, it might lead to consumers, who want desperately to rent a house, to pay extra (after private agreement against the law) without the amount being recorded in production/provision (so not through the market = black market or underground economy as we call it).

In the case of Government intervention setting a minimum price, it means that, if the price cannot be lower than the Equilibrium Price, there will be an excess supply. In this case, the quantity demanded is lower than the quantity supplied. Some of the producers/suppliers will not be able to sell their products. The government sometimes buys (government purchases the excess supply > subsidy) and feeds the poor or provides the products to schools for free. > But worsens government budget deficit. 

In the following case of government intervention, there is the implementation of a minimum wage > The government sets a minimum wage to increase the standard of living. This creates excess supply for Labor. Businesses have higher costs for labor and so they demand less labor (in the Labor/Workforce Market) while more workers want to work for a higher wage. This leads to unemployment since many people that can and are willing to work will be left without a job.

“I hope I am clear on this one. If not, contact us on social media and we will do our best to help you.

Thank you for reading my articles and watching my videos.”

Marios Kyriakou