In a free market, the prices of individual commodities are set by the laws of supply and demand. An increase in demand or decrease in supply usually results in a higher price, while a decrease in consumer demand or an increase in supply usually results in a lower price. When the price of a commodity does not seem to follow the laws of supply and demand, it is sometimes referred to as a cost distortion, price distortion or market distortion.
Cost distortions usually result from government actions. Without government interference, prices tend to follow the laws of supply and demand. However, governments sometimes pass laws or allocate funds in ways that artificially alter, or distort, the cost of specific commodities. Cost distortions may be deliberate, or they may be unintended consequences of government policies. There are a few types of government actions that can result in cost distortions.
Subsidies are funds allocated by a government and given to the producers or consumers of a specific commodity. The domestic agricultural industry frequently is a recipient of government subsidization. Because farmers receive financial assistance to grow their produce, they are able to sell it more cheaply than they could without government intervention. This means that the prices of many farm products in the United States are distorted so that they are lower than they would be in a truly free market.
Limits on Price
Sometimes, a government will pass laws that specifically set limits on the price of a commodity or commodities. When a price cannot legally go below a certain level, it is known as a price floor. The term "price ceiling" refers to a situation in which the price of a commodity cannot legally be set above a certain level. For example, some municipalities set a price ceiling on the amount of rent that can be charged by landlords. This distorts the cost of housing so that it is lower than it would be if left up to market forces.
When the government prohibits a commodity, one consequence is to distort the price of that commodity on the black market. For example, Cuban cigars are expensive not only because they are considered to be a fine product, but also because U.S. government prohibition has made them scarce.