In market allocation, prices adjust until the quantity demanded equals the quantity supplied. In a price control scenario, an authority sets a maximum or minimum price, and the quantities no longer match. Exam questions give a schedule or diagram and ask you to say which situation you are looking at and what follows.
This lesson belongs to specialisation and allocation and links forward to supply and equilibrium.
How do I tell the two situations apart?
Find the equilibrium first: the price at which quantity demanded equals quantity supplied. Then check the price actually in use.
- Price equals equilibrium: market allocation, no shortage or surplus.
- Price below equilibrium by rule: a maximum price, so a shortage appears.
- Price above equilibrium by rule: a minimum price, so a surplus appears.
Describe what the model shows, and leave opinions about whether the rule is good or bad out of the answer unless the question asks you to evaluate with evidence.
Worked example
The fictional market for flour in Kampung Seri has this weekly schedule.
| Price per kg (RM) | Quantity demanded (kg) | Quantity supplied (kg) |
|---|---|---|
| 2 | 80 | 20 |
| 3 | 70 | 40 |
| 4 | 60 | 60 |
| 5 | 50 | 80 |
| 6 | 40 | 100 |
Step 1, equilibrium. At RM4, both quantities are 60 kg. Market price is RM4.
Step 2, a maximum price of RM3. At RM3, buyers want 70 kg and sellers offer 40 kg.
Step 3, shortage. 70 − 40 = 30 kg. Only 40 kg is actually sold, because sellers will not supply more at that price.
Step 4, a minimum price of RM5. Buyers want 50 kg and sellers offer 80 kg. The surplus is 80 − 50 = 30 kg, and only 50 kg can be sold.
Step 5, write the contrast. “At the market price of RM4, 60 kg is bought and sold. A maximum price of RM3 reduces the quantity traded to 40 kg and creates a 30 kg shortage.”
What mistake do students make?
Many students use the quantity demanded as the quantity traded when a maximum price is in place.
Mistaken answer: At RM3, 70 kg is sold.
At RM3, buyers want 70 kg, but sellers supply only 40 kg. The amount sold is the smaller of the two.
Correct it by asking, “Who limits the trade?” Under a maximum price, supply limits it.
Check yourself
Use the Kampung Seri table.
1. What is the equilibrium price and quantity?
Show answer
RM4 and 60 kg, because quantity demanded equals quantity supplied there.
2. A minimum price of RM6 is set. What happens, and how big is it?
Show answer
Quantity demanded is 40 kg and quantity supplied is 100 kg. There is a surplus of 60 kg, and only 40 kg is sold.
3. A maximum price of RM5 is set. Explain why nothing changes in the model.
Show answer
RM5 is above the equilibrium price of RM4, so the rule does not bind. The market can still settle at RM4, where there is no shortage.
Where does this lead next?
You can now describe the two situations. In using a supplied model to describe an incentive you will use a schedule to explain why people change behaviour. Then check yourself on the mixed practice set.
Diagrams reward careful reading, and our teachers often rehearse this with students in online one-to-one Economics tuition.