Chapter 6 - Government intervention, in this chapter you will learn: The effect of a price ceiling or a price floor on the equilibrium price and quantity, the effect of a tax or a subsidy on the equilibrium price and quantity, how elasticity and time period influence the impact of a market intervention.
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Chapter 6
Government Intervention
What will you learn in this chapter?
• The effect of a price ceiling or a price floor on
the equilibrium price and quantity.
• The effect of a tax or a subsidy on the
equilibrium price and quantity.
• How elasticity and time period influence the
impact of a market intervention.
Why Intervene?
• Markets gravitate toward equilibrium.
• When markets work well, prices adjust until
the quantity of the good demanded is equal to
the quantity supplied.
• There are three reasons why a government
may step in and intervene in a market:
– Correcting market failures.
– Changing the distribution of benefits.
– Encouraging or discouraging consumption of
certain goods.
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Four real‐world interventions
• In this chapter, four real‐world examples of government
intervention will be analyzed.
– Mexican tortilla prices and the government setting a
maximum price.
– U.S. milk prices and the government setting a minimum
price.
– U.S. fatty foods and the government taxing high fat and
high calorie foods.
– Mexican tortilla prices and the government subsidizing
tortilla producers.
• These examples require both positive and normative
analysis.
– What are the trade‐offs?
– Do the benefits outweigh the costs?
Price controls
– Price ceiling : A maximum legal price at which a good
can be sold.
• Typically placed on essential goods and services such as food,
gasoline, and electricity.
– Price floor : A minimum legal price at which a good can
be sold.
• Typically placed on agricultural goods that are risky to
produce.
• The price controls provide incentives or
disincentives to produce more or less than the
equilibrium quantity.
Price ceilings
0
25
50
75
100
125
Quantity of tortillas (millions of lbs.)
S
D
Price (¢/lb.)
0 25 50 75 100 125
Price (¢ / lb.)
Quantity of tortillas (millions of lbs.)
Shortage
S
D
Producers supply
a lower quantity.
Consumers demand
a higher quantity.
Suppose the Mexican government imposes a price ceiling on tortillas.
What effect does this have on the market?
Efficient market with a price of $0.50
per lb. and 50 million lbs. of tortilla
Inefficient market with a price ceiling set at $0.25 per lb. and 25 million lbs.
Price ceiling
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Price ceilings
• Did the price ceiling meet the goal of providing
low‐priced tortillas to consumers?
– Yes. Consumers were able to buy some tortillas at
the low price of $0.25 a pound.
– No. Consumers wanted to buy three times as many
tortillas as producers were willing to supply.
• How did the price ceiling effect welfare?
– This question can be answered using differences in
consumer surplus and producer surplus
before/after government intervention.
Welfare effects of a price ceiling
Price ceiling
Producer surplus
Consumer surplus
Deadweight loss
0
25
50
75
100
125
Quantity of tortillas (millions of lbs.)
S
D
Price (¢/lb.)
government sets the price at $25.
• Reduction in tortillas sold by 25 million.
• Deadweight loss occurs.
• Transfer of surplus from producers to consumers.
A price ceiling causes a deadweight loss to occur as well
as a transfer of welfare from producers to consumers.
2
1
Welfare effects of a price ceiling
• Are price ceilings worth the decrease in total surplus?
– Normative question about which people can disagree.
• One way to answer is through studying the allocation of
tortillas.
• Because a price ceiling causes a shortage, goods must
be rationed.
– Rationed equally.
– First‐come, first‐served basis.
– Rationed to those who are given preference by the
government, or to the friends and family of sellers.
• Shortages cause people to engage in rent‐seeking
behavior, such as bribing whoever is in charge of
allocating scarce supplies.
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Ineffective price ceiling
1 Supply increases,
and the supply curve
shifts to the right.
2 At the new equilibrium point, the price is below the price ceiling.
0
25
50
75
100
125
Quantity of tortillas (millions of lbs.)
S 1
S 2
D
Price (¢/lb.) • Suppose the
government sets the price at $25.
–Reduction in tortillas sold by 25 million
• Over time, if the supply increases sufficiently, the price ceiling may
become nonbinding.
– No effect on market equilibrium
A price ceiling does not always affect the market
outcome if the ceiling is set above the equilibrium price.
Price ceiling
Price floors
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5 10 15 20 25 30 35
Quantity of milk (billions of gals.)
Price ($/gal.)
D S
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
5 10 15 2 0 25 30 35
Quantity of milk (billions of gals.)
Price ($/gal.)
D
S Excess supply
Price floor
Quantity supplied and quantity demanded move
in opposite directions.
Suppose the U.S. government imposes a price floor on milk. What
effect does this have on the market?
Efficient market with a price of $2.50
per gallon and 15 million gallons of
milk being produced
Inefficient market with a price ceiling set at $3 per gallon and 20 million gallons of milk being produced
Price floors
• Did the price floor meet the goal of providing
support to producers?
– Yes. Producers were able to sell some milk at a
higher price of $3.00 per gallon.
– No. Some producers may not be able to sell all of
their milk because demand no longer meets
supply.
• How did the price floor affect welfare?
– This question can be answered using the difference
in consumer and producer surplus before/after
government intervention.
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Welfare effects of a price floor
Price ($/gal.)
Quantity of milk (billions of gals.)
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5 10 15 20 25 30 35
Producer surplus
S
D
Consumer surplus
Deadweight loss
government sets the market price to $3.
• Reduction in milk sold
by 5 million gallons.
• Deadweight loss occurs (Area 1).
• Transfer of surplus (Area 2) from consumers to producers.
A price floor causes a deadweight loss to occur as well as
a transfer of welfare from consumers to producers.
Price floor 2
1
Welfare effects of a price floor
• Are price floors worth the decrease in total
surplus?
– Normative question about which people can disagree.
• One way to answer is through studying how much
excess milk will the government have to buy.
– The answer is the entire amount of excess supply
created by the price floor.
– In the above case, 10 billion gallons will be purchased
at $3 per gallon.
– The cost to maintain the price floor is then $30 billion.
Ineffective price floor
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
5 10 15 20 25 30 35
Price floor
1 Supply decreases, shifts to the left.
Price ($/gal)
Quantity of Milk (billions of gals.)
S 1
D
S 2
2 At the new equilibrium point, the price is above the price ceiling.
government set the price at $3.
–Increase in milk sold
by 5 million gallons
• Over time, if the supply decreases sufficiently, the price floor may
become nonbinding.
– No effect on market equilibrium
A price floor does not always affect the market outcome
if the floor is set below the equilibrium price.
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Active Learning: Determining market price
and quantity with price controls
Suppose the government has been convinced to institute a price ceiling on housing
rentals for $400 per month. Demand for housing is given as P = 900 – 20Q and supply is
P = 40Q, where Q is measured in thousands of housing units
1 Solve for equilibrium price and quantity without a price control
2 Solve for the price and quantity with a price control
3 Why might a price control may have opposite effects then intended?
Taxes and Subsidies
• Price incentives can be divided into categories:
– Taxes : Either the buyer or the seller must pay some
extra amount to the government on top of the sale
price.
• Typically placed on seller.
– Subsidies : Either the buyer or the seller receives a
payment from the government that lowers the sale
price.
• Taxes and subsidies can be used to correct market
failures and provide incentives or disincentives to
produce more or less than the equilibrium
quantity.
Taxes
• Using the case of fatty foods in the U.S., rather
than banning them, what would happen if the
government taxed them?
• Taxes have two primary effects:
– Discourage production and consumption of the good
that is taxed.
– Raise government revenue through the fees paid by
those who continue buying and selling the good.
• A tax will reduce consumption and provide a new
source of public revenue.
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Effects of a tax paid by the seller
0
20
40
60
80
5 10 15 20 25 30 35 40 45
Price (¢)
Quantity of Whizbangs (millions)
S
D
S E
E
Buyers pay 60¢
Sellers receive 40¢
after the tax
Tax Wedge
adds $0.20 to all prices, the amount of the tax.
• Taxes drives a wedge between the buyer’s price and the seller’s price.
quantity decreases from
30 million to 25 million.
Suppose the government imposes a $0.20 tax on each unit sold, which
the seller must pay. What effect does this have on the market?
Effects of a tax paid by the seller
0
20
40
60
80
5 10 15 20 25 30 35 40 45
Price (¢)
Quantity of Whizbangs (millions)
Tax $0.20
S2
E1 E
S1
D
Deadweight loss
generated is
TR = Tax*Qpost‐tax
• Tax revenue is a transfer from consumers and producers to the government.
from loss of quantity sold.
The tax revenue and deadweight loss from the tax on sellers can be
calculated.
Quantity sold 25 million 2
Tax revenue = 5 million
($0.20 *25 million)
Active Learning: Tax revenue and surpluses
Price ($/gal.)
Quantity of milk (billions of gals.)
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5 10 15 20 25 30 35
S
D
Suppose the government imposes a $1 tax that sellers must pay.
Estimate the tax revenue, deadweight loss, and differences in
consumer and producer surplus if the before‐tax consumer surplus
is 11.25 billion and before‐tax producer surplus is 11.25 billion.
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Effects of a tax paid by the buyer
0
20
40
60
80
5 10 15 20 25 30 35 40 45
Buyers pay 60¢
with 20¢ in taxes
Sellers receive 40¢
E1
E2
S
D1
D2
Quantity of Whizbangs (millions)
Price (¢)
Tax Wedge
curve is $0.20 lower, the amount
of the tax.
• Taxes drives a wedge between the buyer’s price and the seller’s price.
• The equilibrium quantity decreases from 30 million to
25 million.
Suppose the government imposes a $0.20 tax on each unit sold, which
the buyer must pay. What effect does this have on the market?
Effects of a tax on buyers and sellers
Regardless of whether a tax is imposed on buyers or
sellers, there are four identical effects resulting from
taxes:
• Equilibrium quantity falls.
• Buyers pay more per unit purchased and sellers
receive less.
– A tax wedge forms, equal to the difference between the
price paid by buyers and the price received by sellers.
• The government receives revenue equal to the
amount of the tax multiplied by the new equilibrium
quantity.
• The tax causes a deadweight loss.
Tax incidence
S 2
S 1
D
66
30 22
46
Buyers pay 66¢, sellers receive 46¢.
Price (¢)
Quantity of Whizbangs (mil.)
S 2
S 1 D
54
30 22 34
Price (¢)
Quantity of Whizbangs (mil.)
Buyers pay 54¢
sellers receive 34¢
Price (¢) S 2
S 1
D
60
30
25
40
Quantity of Whizbangs (mil.)
Buyers pay 60¢
sellers receive 40¢
Equal incidence – The sellers’
tax burden is equal to the Sellers pay more – The sellers’ tax burden is greater Buyers pay more – The sellers’ tax burden is less
Suppose the government imposes a $0.20 tax on each unit sold, which the seller must
pay. Who bears the burden, or tax incidence, of a tax?
• Tax incidence is equal to the loss in consumer and producer surplus going to tax
revenue
• Whichever side of the market is more price elastic will shoulder less of the burden
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Subsidies
• Using the case of tortillas in Mexico, rather
than using price controls, what would happen
if the government subsidized them?
• Subsidies have two primary effects.
– Encourages production and consumption of the
good that is subsidized.
– Government provides money through the subsidy
to producers who continue to sell the good.
• A subsidy will increase consumption of the
good.
Subsidies
D
S 1 S 2
70
50 62
88
53
Quantity of Tortillas (millions of pounds)
Price (¢/lb.)
E 1
E 2
subtracts $0.35 from all prices, the amount of the subsidy.
– Buyers pay $0.53
– Sellers receive $0.88
quantity increases from
50 million to 62 million.
Suppose the government imposes a $0.35 subsidy on each unit sold,
which the seller receives. What effect does this have on the market?
Government intervention: A summary
Intervention Reason for using Effect on price Effect on quantity Who gains and who loses?
Price floor To protect producers’
income Price cannot gobelow the set
minimum.
Quantity demanded decreases and quantity supplied increases, creating excess supply.
Producers who can sell all their goods earn more revenue per item; other producers are stuck with an unwanted excess supply.
Price ceiling To keep consumer
costs low
Price cannot go above the set maximum.
Quantity demanded increases and quantity supplied decreases,
Consumers who can buy all the goods they want benefit; other consumers suffer from shortages.
Tax To discourage an
activity or collect
money to pay for its
consequences; to
increase government
revenue
Price increases Equilibrium quantity decreases.
Government receives increased revenue; society may gain if the tax decreases socially harmful the good that is taxed share the cost. Which group bears more price elasticity of supply and demand.
Subsidy To encourage an
activity; to provide
benefits to a certain
group
Price decreases Equilibrium quantity increases.
Buyers purchase more goods
at a lower price. Society may benefit if the subsidy encourages socially beneficial behavior The government and ultimately the taxpayers bear the cost.
The following table summarizes the effect of all four government policies
analyzed in this chapter.
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How big is the effect of a tax or subsidy?
1
Inelastic supply and
demand:
Equilibrium quantity
decreases by 3 M.
Inelastic supply and elastic
demand:
Equilibrium quantity
decreases by 7 M.
Elastic supply and inelastic demand:
Equilibrium quantity decreases by 4 M.
Elastic supply and demand:
Equilibrium quantity decreases by 20 M.
Can the effect of a tax or subsidy on the equilibrium quantity be predicted ahead of
time?
• Yes, if the price elasticity of supply and demand are known
• The more elastic the supply or demand is, the greater the change in quantity
Suppose there is a $0.20 tax paid by the seller
0
20
40
60
80
10 20 30 40
Price (¢)
D
S 2
S
Quantity of Whizbangs (millions)
S 1
D
0
20
40
60
80
10 20 30 40
Price (¢) S 2
Quantity of Whizbangs (millions)
0 20 40 60 80
10 20 30 40
Price (¢)
D
S 1
S 2
Quantity of Whizbangs (millions)
0 20 40 60 80
10 20 30 40
Price (¢)
D
S 1
S 2
Quantity of Whizbangs (millions)
Long‐run versus short‐run impact
Price ($)
Gasoline (billions of gals.)
Price floor
S
S
Price ($)
Price floor
Gasoline (billions of gals.)
Excess supply Excess supply
The effect of a government intervention may be lagged
• One example is gasoline and price controls of gasoline
• Because buyers and sellers take time to respond to changes in price, sometimes the
full effect of price controls becomes clear only in the long‐run
In the short run, driving habits are difficult to
change and producers take time to increase
production.
Effect on quantity is small.
In the long run, driving habits can be production.
Effect on quantity is large.
Summary
• Basic tools for understanding government
interventions were introduced:
– Price controls (floors and ceilings).
– Taxes/subsidies.
• Determining whether the direct supply,
demand, or both should shift.