Answer to Question #181006 in Microeconomics for Thompho

Question

Use the diagram to explain how a black market can develop when the government intervenes in the price mechanism by fixing prices

Answer 1

In order to protect the interest of the consumers the government imposes price ceiling or maximum price above which no one will sell the commodity. This is called ‘price ceiling’ or ‘maximum price legislation’.

Again, prices of commodities may tumble if there are surplus productions. This happens mainly in the case of agricultural commodities when there is a bumper production. “Too low” prices of such agricultural commodities cause hardship to farmers. To prevent prices from falling further, the government may adopt “minimum price legislation” to protect the interests of farmers or producers,

The effect of maximum price legislation can be explained in terms of Fig. 4.28 where the DD and SS curves cut each other at point E. Equilibrium price thus obtained is OP and the equilibrium quantity is OQ. Let us suppose that the government thinks that this OP price is “too high”. So, it fixes a maximum price at OP_max, below the equilibrium price (OP_max < OP).