Question

3. Suppose there was no insurance for prescription drugs. Draw a demand and supply curve for the market for prescription drugs. Explain what would happen to prices and quantity transacted if the government decided that the market price was too high and imposed an effective price ceiling on prescription drugs below the market price. Draw this in your diagram. A. b. What would happen over time if these price controls remain in place?

Answer 1

3. (a) An effective price ceiling reduces price less than the equilibrium price, at where there is excess demand. A graph is as below.

As can be seen, the demand and supply clears at the market equilibrium, where price is P0 and quantity is Q0. But the government introduces a price ceiling of P1. This means that the commodity can not be charged for more than P1 dollars.

Now, as P1 is less than P0, it is where the quantity demanded (Q2) is greater than the quantity supplied (Q1), referring to the situation of excess demand. The price ceiling is 'effective' indeed as if it was imposed higher than the price P0, it would not have any effect in the market. The effective price ceiling is price setted by government below the equilibrium price.

In this case, the quantity produced is Q1, and yet quantity demanded is higher, this will be the equilibrium quantity. Equilibrium price would be the price ceiling itself, P1. The product distribution would be random or probabilistic, for example, a token system would help distribute the commodity to the consumers.

(b) As said, an effective price flooring reduces the charging price less than the equilibrium price which leads to excess demand, and thus creates a shortage in the market. The consequences are discussed as below.

Over time, this might lead to black-marketing, as the producers would want to increase their surplus, they would charge more price up to where the quantity demanded was equal to quantity supplied. In the above graph, the producers may charge price up to P2 as a black market price.

The government intervention in distribution would require them to put queuing and rationing. Also, the quality of the product may deteriorate over time by producers so as to increase their profits, as P and Q wouldn't change.