question_answer

Define price floor. Explain the implications of price floor.

Or

Market of a good is in equilibrium. Demand for the good 'decreases'. Explain the chain of effects of this change.

 

Answer:

When Government fixes prices of a product at a level higher than the equilibrium price, it is called support price (or floor price). It is the minimum price at which the producer must be paid for their products support price is generally fixed for agricultural products like food grains, sugar etc to safeguard the interest of producers (farmers). For instance, Food Corporation of India (FCI) purchases wheat from the farmers at its fixed price and stores it in go down as buffer stock. The aim of support price is to insulate farmers from the fluctuations in their incomes caused by the price variations in the free market.

This diagram shows OP as the equilibrium price and OQ as equilibrium quantity of wheat. ?The government fixes price at OP, slightly above equilibrium price\[O{{P}_{1}}\]. Traders in the market are now bound to pay at\[O{{P}_{1}}\], but, a rise in price causes market demand to contract from OQ to OQ, on the other hand market supply expands from OQ to \[O{{Q}_{2}}\].

There emerges excess supply - ab =\[{{Q}_{1\,\,}}{{Q}_{2\,\,}}(O{{Q}_{2}}\,\,-\,\,O{{Q}_{1}}).\] the government buys this surplus and stores it as a buffer stock.

Or

(i) \[{{D}_{1\,\,}}{{D}_{1}}\] is the initial demand curve and SS is the supply curve.

(ii) Both curves are cutting at point E which is the equilibrium point.

(iii) At point E \[O{{P}_{1}}\] is the equilibrium price and \[O{{Q}_{1}}\] is the equilibrium Quantity.

(iv) As the demand decreases \[{{D}_{1\,\,}}{{D}_{1}}\] shifts to \[{{D}_{2\,\,}}{{D}_{2}}\]in left.

(v) At the existing Price\[O{{P}_{1}}\], demand falls from E to F.

(vi) As an immediate impact, there is excess supply in the market. It is EF (at the existing price.)

(vii) Due to excess supply. Price fall from \[O{{P}_{1}}\]too \[O{{P}_{2}}\] Due to fall in price the quantity supplied tends to contract. The contraction of supply occurs from E to K.

(viii) The above process remains continue till excess supply is fully eliminated, and the market clears itself once again.

(ix) The net effect of decrease in demand is

(a) Decrease in equilibrium Price from \[O{{P}_{1}}\] to \[O{{P}_{2}}\] and

(b) Decrease in equilibrium quantity from \[O{{Q}_{1}}\]  to\[O{{Q}_{2}}\].