Friday, March 30, 2007

Price ceilings and product quality

A day after saying the UAE Dairy and Juices Association was not involved in the recent decision of producers to hike prices, its general manager is now saying that if the Ministry of the Economy bans the price increases then quality will suffer:
The Ministry of Economy's decision to restrict price increases for diary products will force firms to compromise on quality in order to reduce costs, the Chairman of the UAE Dairy and Juices Association has warned.

Dr Ahmad Al Tijani said the ministry can stabilise prices by subsidising dairy products instead of prohibiting a price increase.
Economic theory tells us that government imposed price ceilings have different effects depending on whether the market is monopolized or competitive.

Consider first the case where quality cannot be varied, only quantity. (Alternatively, think of this as the case where the government monitors quality and sets the price ceiling accordingly.) In this case, an increase in costs will push up the competitive market price. If the government freezes price, then producers will cut production and a shortage arises. Monopoly prices also increase when costs increase. A price freeze, however, will in this case actually cause the monopolist to choose to expand output for a cost increase that is not too large.

If quality can be varied and the government does not monitor quality, then market forces can pretty much undo the effect a price ceiling; this is true whether markets are competitive or monopolized. I say "pretty much undo" because exact undoing can only be achieved when the one "quality" of the product that is not monitored is the size of the package. If size of the package is still monitored then firms respond to price ceilings by changing other characteristics of the product and the effect of the ceiling is not completely undone.

Cartels are one means of monopolizing a market. In a price-fixing cartel members agree on price. The agreed upon price acts like a price floor and creates excess supply. Members of the cartel then compete with each other for sales by increasing quality. In general, consumers view the quality to be too high in the sense that the premium in quality over the competitive level is not justified by the price hike.

The bottomline? If a trade association organizes itself as a cartel, then a cost increase together with a government imposed price freeze will have the following result. The cost increases will cause each of the producers to reduce quantity. Excess supply will shrink or disappear, dissipating the excessive competition in quality. Quality will fall towards the competitive level; that is, a desirable fall in quality.

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