Explain, with the help of a diagram, how a free market would react if a minimum price which had been set above the equilibrium is removed.
A free market economy has no government intervention unlike planned and mixed economies.. Resources are allocated based on demand and supply. Hence resources are allocated optimally in the market as marginal social cost equals to marginal social benefits.
A minimum price is a legally set price by the government above the equilibrium price. Therefore supplier and consumer are only able to buy or sell the goods at the said minimum price or above. This is mainly to benefit producers' income such as farmers who will lose out due fluctuating prices for their agricultural goods. The same policy is also applied on wages. The minimum wage will help low income earners to sustain a reasonable standard of living.
Diagram 1 shows the minimum price imposed on a good. Before removal of the minimum pruce, the goods are sold at Pmin. At this price level, the quantity supplied QS is larger than the quantity demanded QD. This creates surplus in the market. Hence there will be a disequilibrium in the resource allocation.
A removal of the said policy will bring down the price to P*. At this point Qd=QS, the market clears and no excess surplus is seen. Additionally, consumers gain the most from the removal. At min price. consumer surplus is only at A, however after the removal consumer surplus increases to A+B+C. Producers income will fall as now they produce less and it affects their producer surplus as well. The removal of minimum pricing will decrease their surplus from B+C+D+E+F (assuming the excess is bought by the government) to only C+E.
The extent of change in the market clearing quantity before and after the removal of minimum price depends on price elasticity of supply (PES) and price elasticity of demand (PED). A combination of an elastic PED and inelastic PES will give the largest change in the market clearing quantity.
In conclusion, in a free market without government intervention, the removal of minimum price will enable the economy to allocate resources optimally.