How to Control the Price-Level in a Free Market?

The following article will guide you about how to control the price-level in a free market.

1. Maximum Price Legislation:

We know that the price of a product is determined by the forces of demand and supply in a free market. However, at times the government considers it necessary, on economic and political grounds, to fix prices for particular commodities.

This is because the government apprehends that if competition is kept alive and markets totally free, prices may rise to a very high level indeed.

Consequently, most people would not be able to buy certain commodities. An example of this would be the fixing of prices of various foods in times of war or emergency. Even in normal peace time if the free market decided, the prices might be so high that poor people could not afford to buy these necessities, particularly in poor countries like our own.

The effect of such price fixing is illustrated in Fig. 9.9. The equilibrium price is OP, but the government considers this as too high. So it fixes a maximum price of OP₁. At this controlled price the quantity demanded (OQ₁) is greater than the quantity supplied (OQ₂), i.e., there is excess demand (or shortage). In the absence of government intervention the price would rise and this excess demand would be automatically eliminated. But because of price control, no such adjustment can occur and the excess demand remains.

There is, therefore, a shortage of commodity in relation to the demand for it. So the limited quantity available has to be allocated somehow among eager buyers. It may be on a ‘first come, first served’ basis. The result would be large queues outside any shop which was having a stock of the commodity.

The results of this type of distribution are not necessarily fair. Sellers may keep a certain amount ‘under the counter’ to give to regular (favoured) customers or friends. A ‘black market’ may develop where those who can afford it will offer higher prices (indicated by point A) to acquire the limited quantity of the commodity available by depriving others. The next result could be a higher price P₂ (instead of P) and a smaller quantity supplied Q₁ (instead of Q). So we have the worst of both the worlds.

The solution to the problem lies in intro­ducing some sort of rationing. The government has to take the responsibility of distributing the commodity among all sections of society at fair prices. But (government) price control will not be truly effective unless k is supported by administered rationing.

2. Price Control-Cum-Rationing:

Fig. 9.10 shows the same type of situation as that given in Fig. 9.9. The price is controlled at OP₁. At this price there is a shortage of the product of amount Q₂Q_1. Now, to prevent black marketing the government issues ration coupons to the amount OQ₂. This means that the demand for the product is fixed at OQ₂ and this will be equal to supply at the price OP₁. Thus, by using rationing, the government has succeeded in balancing the quantities demanded and offered for sale at the controlled price.

If the maximum legal price is fixed below the equilibrium level, ‘a black market’ is still likely to develop unless the authorities are totally successful in enforcing the price through strong administration. If black market develops, the price will be OP₂.

The suppliers them­selves may well be getting only OP_1, but the traders will be able to make a gain by charging a price which is higher than the legal maximum price. Thus again we have the worst of both the worlds a smaller quantity (Q₂ instead of Q) and a higher price (P₂ rather than P). (The student can verity that if the maximum legal price is fixed above the equilibrium level the market would be automatically cleared).

Main Objectives of Such Control:

Price control and rationing are usually adopted during war-time to meet the shortage of essential goods and to control the war-time inflation. Even during peace time these may be adopted as anti-inflationary measures as found at present in our country.

These measures have some important objectives:

(a) main­taining stability in the price of essential goods and preventing inflationary rise in prices

(b) protecting the interest of consumers through the supply of essential goods at controlled prices

(c) protecting the interest of the producers through the minimum guarantee prices for selected goods, especially agri­cultural products

(d) an equitable sharing out of the scarce, essential goods among the people

(e) reducing the effects of inequality of wealth by fixing the per head quota of each of the essential goods.

Problem Created by Price Control:

But price control and rationing have a limited eff­icacy as the empirical evidences indicate that they merely suppress the symptoms of inflat­ion without curing the disease of inflation.

These measures have several difficulties:

(a) difficulties in fixing the prices of different goods at fair levels,

(b) difficulties in enforcing the price-control regulations owing to admi­nistrative inefficiency,

(c) difficulties in distri­buting the rationed goods among the people,

(d) misuse of the techniques of price control and rationing by the authorities,

(e) restriction on the freedom of choice of consumers, and

(f) various evils like long queues at the ration shops, black marketing etc. due to short supply of controlled goods.

However, a policy of rationing is usually undertaken only in exceptional circumstances, such as war time or some other crisis. This is not a feasible proposition in normal times.

3. Minimum Price Legislation:

The government may also fix up a minimum price for a commodity. Suppose a minimum price is fixed above the equilibrium, or market price. The effect of such a policy is illustrated in Fig. 9.11. The free market price would be OP, but the government has fixed minimum price of OP₁.

At this legal minimum price quantity OQ₁ is supplied but only OQ₂ is demanded. So there is an excess supply or surplus of FG. If the surplus appears on the market there is likely to be a downward pressure on price. So the government must buy the surplus (Q₂Q₁) and store it for future use. The government can release this surplus in the future if, due to shortage or any other reason, price moves above OP₁ (which is the legal minimum price).

The government may also fix wages. If the government fixes a minimum wage above the equilibrium level for a certain type of labour, the demand for that type of labour will fall (from OQ to OQ₂ in Fig. 9.11).

Thus, although the people in work will have a guaranteed higher wage, the effect of the policy may be to reduce the level of employment amongst that type of labour. In this case the distance FG would measure surplus labour or the magnitude of involuntary unemployment. The number of job seekers at this wage (OQ₁) would far exceed the number of jobs available (OQ₂).

So some workers would have to remain unemployed. They would prefer to accept any wage instead of remaining idle. But they will not be permitted to do so. In such a situation the trade union assumes a very important responsibility. It has to perform an allocation function, i.e., allocating the limited number of jobs among the large number of job- seekers. This is known as job allocation or rationing.