PRICE CEILING GOVERNMENT INTERVENTION

Price Ceiling in a Competitive Market



Price Ceiling in a Competitive Market

PART A

Q1- Explain why governments sometimes impose a price ceiling in a competitive market. Illustrate the effects with the diagram. Choose a case study where a price ceiling has been used. Identify why the price ceiling was thought to be necessary in this market. Identify the results of the government intervention. Suggest a better way of dealing with the issue in your case study.

Ans. Impact of Government Imposed Price Ceiling that is above the equilibrium price when a price ceiling imposed by a government is higher than the market equilibrium price, the price ceiling has no impact on the economy. It does not restrict supply nor encourage demand. The case study of Hong Kong illustrates the scope and limitations of the central bank's role in asset pricing developments. It shows how, in spite of considerable vigilance on the part of the authorities, bank lending can fuel soaring asset prices. It also shows how simple indicators can be developed to detect signs of speculative excesses. The prudential measures used by the authorities in Hong Kong can contain the extent of irrational exuberance and contribute to the soundness of banks. But such measures have not been very successful in preventing bubble formation. Bubble containment also requires action in fields outside traditional monetary and banking policy. For example, to moderate price fluctuation in the property market, the HKSAR government has recently embarked on policy measures to relax supply side constraints.

Hong Kong has seen quite a few sharp swings in asset prices in the past two decades. Stock prices, for instance, soared in 1981, 1987, 1993 and 1997 to unusual levels of valuation. Price-earning multiples exceeded twenty, before crashing by more than a third on each occasion. Property prices rose by more than 20% per annum on seven occasions in the past 10 years, with an increase of about 40.5% in 1992. Buoyed by optimism about Hong Kong's future and its beneficial relations with China, home prices, with historically low rental yields of less than 3% before the onset of the Asian financial turmoil in the second half of 1997, may well qualify as a bubble.

A major policy concern is the impact of asset prices on aggregate demand and inflationary pressure. Hong Kong's experience suggests that rising property prices have played a significant role in raising rents and the housing-cost component of consumer prices. Stock prices do not seem to affect inflation directly, but nonetheless contribute to aggregate demand by increasing business investment in fixed assets. The impact of falling asset prices on the economy and the banking system also appears manageable, as the degree of leverage among corporations is not excessive and bank lending practices remain prudent.

Recent research suggests that the channels of monetary transmission are broad and diverse. Traditional indicators employed by the authorities, including real economic activity, consumer prices and external payments position, often do not provide adequate diagnostic tools for analyzing the impact ...