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This article is the first article in a new series by Minerva’s Rethinking Economics Hub. You can read the second article here.


India forces producers to set a maximum price on their products. The intention is to protect consumers from high prices, but it is criticized for disturbing the free market.

Every packaged product sold in India has to have a MRP – maximum retail price – the maximum price that can be charged for the product. Thus you should never have to pay above that price. It is printed on every product, and you can double-check the price on the product with the price on the bill.

Recently India also introduced the GST – the goods and services tax. That is the tax you see on restaurant or shopping bills. Now, this tax is already included in the MRP. If a shop seller tries to charge you for GST on top of the price of the product, you can happily refuse.

Exceptions: restaurants and hotels

Restaurants and hotels can charge you a higher MRP on packaged products, like water bottles. However, they are technically not allowed to charge you the GST on top of that water bottle. This practically never happens. They always charge you. Additionally, sellers can apply cooling charges, which can increase the price.

 

Be the smart economist who makes informed choices

Winning the margin via price discrimination

When sellers illegally charge tourists more than locals, this counts as price discrimination. From each customer, they can get the highest price they are willing to pay. Consumer surplus decreases (dark blue triangles in Image 1), since the price adjusts for each consumer (P2 → P0) while the demand curve (red line) remains the same. Producer surplus increases (shaded blue) for every discriminatory step. While this price discrimination may be seen as unfair as it distinguishes between customers, it can also be seen as fair to charge tourists higher for their visit, as their willingness to pay is higher.

Image 1: Price Discrimination

The economics of price ceiling and perfect competition

Economists highly criticize the MRP for its intrusion of the free market. This makes sense as the government imposes a price ceiling on goods. Let us visit the microeconomics of this:

Image 2: Free Market

Image 2 shows the free market equilibrium of supply and demand (blue lines). Where the two blue lines cross is the market equilibrium and thus the efficient price (Pe) at the efficient quantity (Qe) given consumers’ demand and producers’ supply. Consumer surplus (purple) is the area between the demand curve and the market price, and shows the amount consumers paid less, even though they were willing to pay more. Producer surplus (orange) is the area between the supply curve and the market price, and shows the amount of money producers received more for a product, even though they were willing to accept less for it.

 

Image 3: Price Ceiling

Image 3 shows the imposition of a price ceiling. The green horizontal line is the MRP, since we set the price lower than what it naturally (efficiently) might become. The imposed price equals the supply curve at a lower quantity (Qs) and the demand curve at a higher quantity (Qd). This means there is less supply but more demand than at market equilibrium. This situation creates shortages, since more consumers want to buy the product at this price than there is quantity supplied. It also creates deadweight loss (red) , which is a loss to society as it takes away money from everyone. On the bright side, you can see that consumer surplus (purple), increased, since the price decreased, which is beneficial to consumers. However, producer surplus (orange) decreased, which can disincentivize production and innovation.

Avoid price ceilings by setting a high MRP

Some firms cheat their way around this framework. One way is for producers to set very high MRPs, thus retailers can just choose their prices to be lower depending on the supply and demand in their local environment. That creates a mini perfect competition environment: Sellers that price products above the equilibrium price will have to face new incoming sellers that sell the product for cheaper. This will either drive out or force sellers to sell their product for cheaper, settling at the equilibrium price.

The MRP can give a sense of assurance to citizens and tourists in a country where corruption persists. It provides a reference to avoid paying double the price. However, it distorts the market since it creates shortages or fails to deliver products to regions since transportation costs cannot be accounted for in higher prices. Arguably, you could view this as fair. Maybe the debate on whether to keep MRP boils down to the interventionist versus free market debate. For now the system seems to work, but as the country becomes more digital and less corrupt, the MRP should seriously be reconsidered.