Ah. The great cornerstone of economics. The demand and supply concept basically sums up the majority of our lessons back in school.
Demand and Supply
Demand is the willingness of the consumers to pay for a good. The more expensive the good, the less people want it. Supply is the willingness of the producers to produce a good. The higher the price of the good, the more producers will produce it.
Price is therefore the signalling mechanism that determines how much to produce and consume.
In general, there are two kinds of price intervention. The price floor set the price above the market equilibrium.
This aims to benefit the producers, for example a minimum wage law. However, this will result in less demand for the good and excessive supply.
The second kind of intervention is a price ceiling, in which the price is set below the market equilibrium.
This aims to benefit the consumers, for example an oil price cap. However, this will result in shortages due to less supply for the good and excessive demand. As the market is robust, the market will still seek to reach equilibrium above the price ceiling via other means such as the black market.
Costs of Price Intervention
- Efficiency Loss – efficiency is achieved when all trades that can make everyone better-off is being made. No one can be made better-off without the expense of others. By preventing the market from reaching equilibrium, the economy is not at the optimal state.
- Allocation Inefficiency – consumers who wants the goods the most may not get them. Without price mechanism to allocate the goods, people may resort to other inefficient mechanism, such as the waiting and queuing mechanism.
The benefit of price intervention is equity. Equity is hard to achieve while efficiency is easy. Therefore, the challenge that all policymakers face is the equity-efficiency trade-offs when implementing policies.
(Reference: MIT OCW Principles of Microeconomics)