Chapter 6: Government Regulation

three reason why governments intervene

correct market failures, promote equity, and stabilize the economy

Reason 1: correct market failures

when free markets fails to produce optimal outcomes due to issues like externalities, monoplies or public goods, governments step in to regulate or provide necessary services.

Reason 2: promote equity

governments can use policies like progressive taxation and social welfare programs to redistribute wealth and address income equality

Reason 3: stabilize the economy

by managing interest rates, government spending, and fiscal policies, governments aim to mitigate economic fluctuations like recessions and period of high inflation

market failures

situations in which the assumption of efficient competitive markets fails to hold

Price controls

a regulation that sets a maximum or minimum legal price for a particular good

direct effect is to hold the price of a good up or down when the market shifts, thus preventing the market from reaching a new equilibrium

price ceiling and example

a maximum legal price at which a good can be sold.

example: rent control as rent prices cannot reach a maximum limit

deadweight loss

a loss of total surplus that occurs because the quantity of a good is bought and sold is below the market equilibrium quantity

how does price ceiling causes shortage?

A price ceiling causes a shortage when it is set below the equilibrium price because it increases demand while reducing supply

1. since the price is artifically lowered, more people can afford the good or service, leading to higher demand than usual

2. at the lower price, suppliers (or producers) make less profit and may reduce production or withdraw from the market altogether

3. when demand exceeds supply, there aren’t enough goods/services available for everyone who wants them.

Nonbinding price ceilings

a price ceiling does not always affect the market outcome. If the ceiling is set above the equilibrium price in a market, it is said to be nonbinding. That is the ceiling doesn’t bind or restrict buyers’ and sellers’ behavior because the current equilibrium is within the range allowed by the ceiling.

price floor

a minimum legal price at which a good can be sold

us does it a lot for agricultural goods

how does a price floor lead to an excess supply

a price floor causes excess supply when it is set above the equilibrium price because it decreases demand while increasing supply

1. since the price is artifically higher, producers are willing to supply more because they can make higher profits.

2. at the higher price, fewer buyers can afford the product or service, leading to less demand

3. when supply exceeds demand, there are more goods/services than people willing to buy them

4. example: the government sets a minimum wage too high so more people are willing to work because wages are higher. Thus since the wage is so high, businesses may hire fewer workers or replace them with automation to reduce costs leading to extra supply and unemployment.

Has the government accomplished its aim or supporting diary farmers and providing them with reliable income?

producers who sell their milk will be happy while producers who cannot sell their milk will be unhappy

what are nonbinding price floors?

A non-binding price floor is a price floor set below the equilibrium price, meaning it has no effect on the market because the natural market price is already higher.

How It Works:

• A price floor is a minimum legal price set by the government.

• If the price floor is below the equilibrium price, the market will continue operating at the equilibrium price because buyers and sellers already agree on a higher price.

• No surplus occurs since the price floor doesn’t force a change in supply or demand.

Example: Minimum Wage

• Suppose the equilibrium wage for workers is $15/hour.

• The government sets a minimum wage (price floor) of $10/hour.

• Since businesses are already paying above $10/hour, this price floor has no effect, and wages remain at $15/hour.

• Result: The price floor is non-binding because it does not impact market behavior.

Taxes purposes

1. revenue generation: government called taxes to find public services and income tax funds government programs

2. Redistribution of wealth: progressive tax systems reduce income inequality by taxing higher income individuals at a higher rate and funding welfare programs

3. market regulation and economic stability: taxes can control inflation economic activity

4. encouraging or discouraging behavior: sin taxes discourage unhealthy or harmful activities

5. protecting domestic industries: import taxes (tariffs) make foreign goods more expensive, encouraging consumers to buy domestically produced goods

6. funding public goods and infrastructure

7. managing externalities: taxes help correct negative externalities (costs imposed on society)

taxes on sellers

is a tax imposed on producers or businesses for each unit of food or service they sell. The shifts the supply curve leftward (decreasing supply) because production becomes more expensive.

effects of taxes on sellers

1. increase in production costs

2. higher costs lead businesses to produce fewer goods, shifting the supply curve to the left

3. to cover tax, sellers raise prices, meaning consumers pay more.

4. demand stays the same

5. equilibrium price rises and quantity demanded falld

tax wedge

the difference between the price paid by buyers and the price received by sellers, which equals the amount of tax.

effects of taxes on lost surplus and deadweight loss

1. buyers pay more —> consumers surplus decreases

2. sellers receive less after tax —> producer surplus decreases

3. the government collects revenus, but some trades no longer happen, leading to deadweight loss.

taxes on buyers

a tax imposed on consumers for purchasing a good or service. This affects demand by making the product more expensive, leading to a decrease in quantity demanded.

Effects of a tax on buyers

1. higher prices for consumers

2. Higher prices discourage some consumers from buying the product which shifts the demand curve leftward, meaning buyers demand less at every price level

3. Since fewer consumers buy the product, overall sales decreases.

4. supply stays the same

5. equilibrium price and quantity both fall

4 effects from taxes

1. equilibrium quantity falls

2. buyers pay more for each Whizbag and sellers receive less

3. the government receives revenue equal to the amount of tax multiplied by the new equilibrium quantity

4. the tax causes deadweight loss

tax incidence

the relative tax burden borne by buyers and sellers

inelastic demand burden

Consumers bear more of the tax burden if the demand for the good or service is inelastic (i.e., consumers are less responsive to price changes, often because there are fewer substitutes or the good is a necessity).

inelastic supply burden

Producers bear more of the tax burden if the supply is inelastic (i.e., producers cannot easily change the quantity they supply in response to price changes, often because production capacity is fixed in the short run).

Who gains and who loses? price floor

producers who can sell at their goods earn more revenue per item; other producers are stuck with an unwanted excess supply.

Who gains and who loses? price ceiling

consumers who can buy all the goods they want benefit; other consumers suffer from shortages.

who gains and who loses? tax

government receives increased revenue; society may gain if the tax decreases socially harmful behavior. Buyers and sellers of the good that is taxes share the cost which group bears more of the burden depends on the price elasticity of supply and demand.

How big is the effect of a tax

Overall, the larger the tax and the more inelastic the demand or supply, the greater the impact on the market (whether in terms of higher prices, reduced quantity, or changes in who bears the burden). Conversely, if demand and supply are elastic, the effects are usually more significant on the quantity traded than on the price itself.

short run taxes

Short run: More inelastic, smaller adjustments, typically higher burden on the side that is less flexible (usually consumers or producers, depending on elasticity).

the short-run effect is often more immediate and less adjustable,

long run taxes impact

• Long run: More elastic, greater adjustments, the burden tends to be more shared between consumers and producers as they adapt to the new conditions.

allows for greater flexibility and potential for both parties to adjust, leading to a more balanced outcome.