You will remember that equilibrium price is a price at which both demand and supply are in balance, that is, the quantity demanded and quantity supplied is exactly the same. In a competitive market, this price is not set by suppliers or by consumers but is automatically determined by the interaction of consumers and suppliers through their buying and selling activities. Attempts to put price above or below equilibrium price in a market economy simply will not work, unless theres government intervention. If prices are placed above equilibrium surpluses will result and this will automatically push prices down to equilibrium again. If prices are placed below equilibrium, shortages will result and this will automatically push prices up to equilibrium again. If there are changes to demand or supply or both, a new equilibrium price will be set by the automatic market mechanism.
There are times, however, when prices are placed above equilibrium and times when they are placed below. What do you think will happen when prices are placed above or below equilibrium? If prices are above equilibrium, suppliers will supply more quantity (Law of Supply) but consumers will demand less quantity (Law of Demand). This condition will lead to surpluses. Consequently, if prices are placed below equilibrium, suppliers will supply smaller quantities but consumers will demand more. This leads to shortages.
Although some people argue that the prices of goods or service should best be left to market mechanism, there are others who believe that prices should be fixed to protect certain groups of societies (vital industries, the poor, etc). These people are of the opinion that price cannot be left entirely to market forces because if it is, the wealth of the nation will not be justly distributed. Malaysia is one country that holds the proposition that every citizen has the right to enjoy the wealth of the country. As such Malaysia will selectively set prices of certain commodities. The government has the authority to set prices above or below equilibrium.
Consider this example. Assume that the equilibrium price of chickens is RM4.50 a kilogram. At this price the quantity demanded and the quantity supplied is equal. But at this equilibrium price, chicken suppliers are barely making profits and some suppliers may quit and leave the market. If this happens, the nation will be in short supply of chickens. To protect the chicken suppliers and to prevent them from giving up supplying chickens (which may have adverse effect on the well-being of society in general), the government agrees to put the minimum price per kilogram of chickens that the suppliers can sell. Minimum price means the minimum price that can be placed on any good or service and it is usually above equilibrium. If the government allows the minimum price of chickens to be RM5.00 per kilogram, then chickens cannot be sold below this price in the market. It can be sold above the price however. Whether consumers like it or not, they must pay a minimum of RM5.00 per kilogram. Legally, suppliers cannot sell below the floor price. They may, if they wish, sell it above the floor price. When prices are placed above equilibrium, surpluses will result. It helps producers and they will continue to produce consistent with the law of supply that states at higher prices more quantities will be produced. The minimum price at which a good or service can be sold is called price floor.
Now consider this example. Assume the equilibrium price of newspapers is RM1.50 per unit. At this price the quantity demanded and the quantity supplied is equal. But at this equilibrium price, it is hurting low-income earners who find the newspaper too expensive to buy. If the price remains at RM1.50, then only the rich can afford newspapers. The poor will then be deprived of news. The government, wanting a wider coverage of news among its citizens, can put a maximum price at which newspapers is sold. The maximum price a good or service can be sold and usually set below equilibrium is called price ceiling. The government may price newspapers at RM1.00 per copy, which is well below its equilibrium price. What happens when prices are set below equilibrium? More copies will be demanded than is supplied, leading to a condition of surplus. But in the case of the newspapers, the poor now has access to them. Price ceilings benefit the consumer.
Lets take another example: Petrol.
Petrol is a necessity and regardless of how high its price, there will be people willing and able to buy them. But there will also be those who cannot afford them. So the price of petrol needs to be controlled by the government. If it is not controlled, the equilibrium price may be so high that a portion of country's citizens may be without petrol at all. So the government will set a price very much below equilibrium. If the equilibrium price of petrol is RM2.00 per liter, the government may set the maximum price at which petrol can be sold at RM1.30 per liter. At this price more can afford to buy. The RM1.30 per liter of petrol set by the government is called its ceiling price. Legally, suppliers cannot sell it higher than the ceiling price. They may, if they so wish, sell it at lower then the ceiling price.
Price ceilings lead to shortages because more quantity will be demanded than supplied. Shortages may lead to the possibility of back marketing. Since the goods are in great demand, some people are willing to buy at higher prices from illegal sellers.