In Australia, we have a market that is relatively free of government intervention. But what if it goes out of hand? What if the price or quantity for a good is either too high or too low? What happens if a necessary good or service isn’t even provided? This is when the government intervenes with the market.
When the price of a good becomes too high, the government reaction would be to apply a price ceiling or a maximum price. This in turn reduces the price but creates a shortage in quantity and therefore imposes a loss upon a company. Suppose a company provides a train service, the equilibrium price is 3 and the equilibrium quantity is 30. The price is too high for the government and it imposes the price ceiling at 2, the company will therefore only be able to supply at 20 while the demand is 40. This negative difference between QD and QS creates a shortage and therefore is a loss for the company. When quantity is too high the government imposes taxes on that item. The outcome of this is an increase in equilibrium price and a reduction in equilibrium quantity. For example if a company produces something and it emits carbon dioxide, the government will tax (negative externality) the amount of this gas created and this will therefore affect both price and quantity.
If a quantity is too low though, the government can use subsidies (positive externality) to reduce equilibrium price and therefore increase equilibrium quantity. For example if the good is a merit good i.e. provides a benefit for the society, the government will attempt to support it by offering subsidies so a higher quantity is available. When price is too low though, the government will place a price floor that prevents a product from falling below that level. Suppose the price of wool is too low at 3 and because of this there is a lack of profit in the market which leads to the loss of many competitors. If the government wants more wool and farmers, it can impose a price floor at 4 which will...