Answer to Question #184326 in Microeconomics for Pravika Maharaj

Question

Question 3

1. Market systems may not allocate resources efficiently for many reasons. This is known as market failure Governments intervene in order to correct such market failures. Imposition of price controls is one of such interventions. Using relevant diagrams, discuss the use of (1) maximum prices and (2) minimum price controls in markets and their consequences in the context of the Eskom case above [20 marks]
2. The effect of subsidising a product/service, to a large extent, depend on the price elasticity of that product/service. Draw two diagrams, one with a relatively inelastic demand curve and one with a relatively elastic demand curve. Explain the different effects of the introduction of a subsidy on electricity in terms of price and quantity. [10 Mark]

Answer 1

1.

ii. A price limit, in which the government mandates a maximum acceptable price for a product, and a price floor, in which the government mandates a minimum price, below which the price is not allowed to fall, are two types of price controls.

Price caps are used by governments to shield customers from conditions that may make essential goods prohibitively costly. Such circumstances can arise during times of high inflation or when a commodity is owned by a monopoly, in this case Eskom, both of which can trigger problems if introduced, resulting in shortages. If a government sets unreasonable price limits, it may result in market failures or even economic crises.

Benefits of Highest Prices

• The benefit is that they would result in lower energy costs for customers, which could be significant if the supplier (Eskom) has monopoly control and is exploiting consumers. Maximum prices are a way to get prices closer to a "fair" and "competitive" equilibrium.

• Socially important commodities, such as food, rent, and electricity, are normally subject to maximum prices.

The drawback of maximum prices

• The downside is that it would result in a reduction in power supply. • A maximum price can also lead to a shortage – where demand exceeds supply, resulting in electricity rationing and outages in certain areas of the economy.

• A maximum price will lead to the rise of black markets as people attempt to solve the power crisis by paying much more than the market price for alternative energy sources.

The effect of maximum price legislation can be depicted as; 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 OPmax, below the equilibrium price (OPmax < OP).

The main criticism leveled against eskom's price ceiling type of price controls is that by artificially lowering costs, demand rises to the point where supply cannot keep up, resulting in electricity shortages.

ii. Minimum prices, also known as price floors, are the government's fixed minimum legally permissible prices for a good. It entails two policies that go hand in hand with a minimum price: first, the government must clear the market by buying excess stock, and non-perishable goods must be stored until required.

Certainly, the government's legal floor price is held higher than the equilibrium price calculated by the demand and supply curves.

The effect of floor price has been shown below; OP is the equilibrium price determined by the intersection of DD and SS curves. Suppose, price crashes below OP— thereby causing great hardships to producers. To woo the producers, the government fixes the minimum price at OPmin below which no one will be allowed to sell.

Minimum Prices Have a Drawback

• Minimum rates promote oversupply and are inefficient. • Minimum prices result in higher prices for customers, forcing them to pay more for energy. Since the government encourages municipalities and state-run institutions to purchase power from Eskom, it is inefficient in supplying power to customers in South Africa.

2.a)i. Relatively inelastic demand curve.

ii. Relatively elastic demand curve.

b.)A subsidy has the effect of shifting the supply curve downward by the volume of the subsidy. In effect, this is a supply increase. The subsidy has the effect of lowering consumer prices while increasing the price paid to producers.

• It would be costly; the government would have to collect a considerable amount of tax revenue; and there is a claim that subsidizing monopolies(eskom) decreases their incentives to cut costs. As a result, it is argued that a government should refrain from subsidizing businesses unless there is a compelling social profit.

When the government provides subsidies to the supplier, Eskom is able to offer critical power services. This raises the overall supply of electricity and power, which raises the quantity of that good or service demanded, lowering the overall price of that good or service. In this way more customers are served with this utility .