(a) With the aid of a diagram, explain the effects of fixing a price (i) above the equilibrium price, (ii) below the equilibrium price [5 marks each] (b) (i...

Answer Details

(a) Effects of fixing a price away from equilibrium. Equilibrium price is where the demand and supply curves intersect, so quantity demanded equals quantity supplied.

(i) Price fixed above the equilibrium price (a minimum price or price floor). At a price higher than equilibrium, quantity supplied exceeds quantity demanded, so a surplus (excess supply) results. Producers offer more than consumers are willing to buy, leaving unsold goods. Governments often set such a floor to protect producers (for example a guaranteed minimum price for farmers), and may have to buy up the surplus. On a demand-and-supply diagram, the controlled price is drawn as a horizontal line above the equilibrium, and the horizontal gap between the supply and demand curves at that price measures the surplus.

(ii) Price fixed below the equilibrium price (a maximum price or price ceiling). At a price lower than equilibrium, quantity demanded exceeds quantity supplied, so a shortage (excess demand) results. Governments set such a ceiling to help consumers buy essential goods cheaply, but the shortage often leads to rationing, queues, hoarding, and a black market. On the diagram, the controlled price is a horizontal line below the equilibrium, and the horizontal gap between the demand and supply curves at that price measures the shortage.

(b)(i) Abnormal demand. Abnormal (or exceptional) demand is a situation in which more of a good is bought as its price rises and less is bought as its price falls, contrary to the ordinary law of demand. The demand curve for such a good slopes upward from left to right.

(b)(ii) Two reasons for its occurrence.

• Giffen goods. These are inferior staple goods (for example a cheap staple food) on which poor consumers spend a large part of their income; when the price rises they become poorer in real terms and buy even more of the cheap staple, cutting out dearer substitutes.
• Goods of ostentation (Veblen/prestige goods) and expectation of further price changes. For prestige goods (for example diamonds), a higher price raises their appeal, so more is demanded; also, if buyers expect prices to keep rising, they buy more now despite the higher price.