Question

For many years, the Chinese government imposed price ceilings on fresh fish, to promote ‘fair’ prices. The price was equivalent to $4/kilo, and at this price, a fisher (a firm) earned zero profits. There were many people who wanted to buy fresh fish at this price but could not obtain it. As part of China’s economic reforms, the government abolished the fish price ceilings. The price immediately shot up to $12/kilo, but after a year, the price dropped to $8/kilo and has stayed there ever since. Assume that fishing is an increasing cost-competitive industry. Using diagrams for the firm and industry, explain the adjustment from the original position, where the ceiling existed to the final long-run equilibrium

Answer 1

Price ceiling is set by government so that price of a commodity cannot exceed a certain level. Hence prices are not determined by forces of supply and demand. When a price ceiling is implemented, it creates excess demand and lesser supply(if price set by authorities is below equilibrium price, which is determined by market forces).

Below, I have explained short run and long run movements of price and quantity using graphs. The left graph shows industry supply-demand curve, whereas right one shows cost curves for a particular firm in this industry. Industry supply/demand curve denoted by S/D. This firms cost curves are shown as ATC(Average total cost), AVC(average variable cost) and MC(marginal costs). This is an increasing cost firm.

In this Chinese market for fishes, government imposes a price ceiling at $4. As evident from graph, it creates excess demand for fishes in market. At this price, a particular firm is earning zero profit, i.e. it is just able to cover up its variable costs.

Here, quantity supplies in industry is Qs, quantity demanded is Qd, and this particular firm supplies q amount of fishes

Now, government allows prices to be determined at market prices. As soon as ceiling is removed, prices shoot up. At $12, this firm is able to earn positive profits, hence it has become profitable to sell fishes now. Many firms now enter the market for fishes because they can earn supernormal profits:

quantity supplied and demanded in industry now equals Q*, while this firm supplies q* fishes

In the long run, as many firms enter the market, supply of fishes rises. So, industry supply curve shifts to right, so equilibrium price falls to $8. From diagram, we can see that this firm can now cover all its cost because price=average total cost for this firm. Has the price been below ATC, firm may have shut down since it will be unable to cover all its cost even in the long run.

equilibrium quantity in market is at Q', while the firm supplies q' fishes. Prices stay at this level, unless any shocks are observed in the market.