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In 2020, the COVID-19 pandemic struck India. Amid “rising cases” in June, Karnataka’s State Government imposed “price caps” on medical tests for COVID-19. The test, at this time, was an essential service. Hence, its price elasticity and income elasticity of demand would be very low. The government intervened to increase social equity by ensuring that this service demanded across groups of varying income, remains publicly accessible.
Price ceilings are binding restrictions on maximum prices for goods or services. Unlike taxes and subsidies, they deviate an otherwise free market from equilibrium by causing excess demand (Hoang et al., 2020). Price ceilings are set to support low-income consumers and promote equity, especially for essential services.
Graph 1 represents the undisturbed market equilibrium for the product, which forms at ‘F’. Government intervention, of establishing a price ceiling at ‘D’, became necessary when “several reports” indicated abnormally high prices, threatening to block market access for economically weaker groups. The government thereby reduced the potential for price discrimination and attempted to increase consumer equity.
However, price ceilings create shortages. Since the “ceiling rate” is lesser than the market price, ‘E’, producers are expected to supply only ‘A’ units, while the market shall demand ‘C’, leading to a shortage of (A - C) units. This policy results in negative welfare impacts. Allocative efficiency is no longer achieved, as the ceiling price deviates from the market-clearing price. Social surplus is no longer maximised as there is a welfare loss, (△GFI, Graph 1), which represents the benefits lost due to resource misallocation. Though the product would be available for a cheaper price, its accessibility would reduce. Furthermore, this shortage could lead to nonprice rationing and the creation of underground markets which would distort equity.
The price ceiling would hinder product development. Since firms’ total revenue decreases, from (EOBF) to (DOAG) in Graph 1, firms’ profits reduce. Hence, firms have lower incentives to invest in research and development. If firms invest in development, in the long run, costs of production may reduce and a more advanced product could be created. Since that development is less likely to take place now, the costs are unlikely to reduce in the future. Thus, present inequity due to the product could lead its future inequity.
Consumers who demanded the test at higher prices, ‘E’, may no longer have access to it. Similarly, producers willing to supply it at price ‘E’ will now reduce their supply. This policy is unfair to consumers and producers intending to trade at high prices and demand a further developed product. This policy is made primarily for economically weaker consumers of society. Therefore, the government implements it, acknowledging the cost of creating equity.
Positive consumption externalities occur when consumers of a good create external benefits for society (Tragakes, 2020). Graph 2 represents this externality for the product, and its resultant shortage.
COVID-19 tests are rivalrous and excludable merit goods, with a positive consumption externality of (Z - K) units (Graph 2). A rational consumer of this product, if infected, would attempt to prevent the spread of COVID-19, protecting people around him. Without this product, he would not know of his infection, and could spread the virus to society. Thus, the marginal social benefit, ‘Z’, exceeds the marginal private benefit, ‘K’).
Products with positive consumption externalities are under-allocated by the free market. The equilibrium forms at ‘S’, though ‘T’ is socially optimal. This is another cause for the product’s shortage of (M – L) units, and resultant welfare loss, △TSJ (Graph 2). This could be disproportionately harmful for economically vulnerable groups of people, making government intervention more important to achieve social equity.
Alternative policies for this product which would increase accessibility and equity:
Subsidisation – Consumers pay less for the same quantity. Producers would increase production and wouldn’t bear losses. However, this bears a significant opportunity cost.
Research and development investments – Support technological advancements that would reduce costs of production (and hence, the price) of the good. They are expensive in the short run, but contribute to long-term growth.
Direct Government provision – Ensures adequate supply, affordability. However, it is very expensive.
Price ceilings would protect low-income groups from abnormally high prices, especially in the short run. However, it could induce non-price rationing and decreased product development. The price ceiling induces a positive consumption externality for those who could consume the product, but the shortage it creates also reduces the social benefit induced in the entire market. The shortage is also caused by the externality itself, rendering some consumers significantly worse-off.
The government could pursue its objective of equity via alternate methods suggested above, which are likely to be more efficient in the long run. As COVID-19 tests are medical essentials and play a vital role in personal and economic security, producers may extend production beyond the quantity determined by classical price mechanisms.
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Hoang, P., Wray, S., & Chakraborty, T. (2020). Economics for the IB diploma (p. 125). Hodder Education.
Tragakes, E. (2020). Economics for the IB Diploma coursebook with Cambridge Elevate edition. (3rd ed.). Cambridge University Press.