Economic Impacts of Price Controls and Taxes

These flashcards cover essential vocabulary and concepts from the lecture on economic impacts of price controls, taxes, and subsidies.

How do Price Controls impact market equilibrium and efficiency?

Price controls, such as ceilings and floors, prevent the market from reaching its natural equilibrium. This can lead to shortages (price ceilings) or surpluses (price floors), causing inefficiency and deadweight loss by misallocating resources and reducing total consumer and producer surplus.

What are the typical consequences of a binding price ceiling?

A binding price ceiling (set below equilibrium) typically leads to a shortage (quantity demanded exceeds quantity supplied). This can result in:

• Inefficient allocation to consumers (those who value the good most may not get it).

• Wasted resources (buyers spending time searching for goods).

• Reduced quality of goods.

• Emergence of black markets.
  On a graph, it appears as a horizontal line below the equilibrium price, creating a gap between quantity demanded and quantity supplied.

Explain deadweight loss in the context of a price control and how it's illustrated graphically.

Deadweight loss is the reduction in total consumer and producer surplus that results from a market distortion, such as a binding price ceiling or price floor. Graphically, it's the triangular area representing the lost gains from transactions that no longer occur due to the intervention; for example, transactions where the buyer's willingness to pay exceeded the seller's cost but were prevented by the price control.

What are the typical consequences of a binding price floor?

A binding price floor (set above equilibrium) typically leads to a surplus (quantity supplied exceeds quantity demanded). This can result in:

• Inefficiently low quantity transacted.

• Inefficient allocation of sales among producers.

• Wasted resources (e.g., unsold goods, government purchases of surplus).

• Inefficiently high quality offerings (producers competing on quality rather than price).
  On a graph, it appears as a horizontal line above the equilibrium price, resulting in a gap between quantity supplied and quantity demanded.

How does elasticity influence the impact of an excise tax on market outcomes and tax incidence?

The more inelastic demand or supply is, the greater the burden of an excise tax falls on that side of the market.

• If demand is more inelastic than supply, consumers bear a larger share of the tax.

• If supply is more inelastic than demand, producers bear a larger share.
  A tax shifts either the supply or demand curve, creating a wedge between the price buyers pay and the price sellers receive. The deadweight loss from the tax is smaller when demand or supply is more inelastic, as the quantity reduction is less severe.

Using an example, distinguish between quantity demanded and demand.

A change in quantity demanded refers to a movement along the demand curve, caused solely by a change in the good's own price (e.g., a decrease in price leads to more units purchased). A change in demand refers to a shift of the entire demand curve (left or right), caused by factors other than the good's price, such as income, tastes, price of related goods, or expectations (e.g., a new health report boosts consumer preference for a product, shifting demand outwards).

Using an example, distinguish between quantity supplied and supply.

A change in quantity supplied refers to a movement along the supply curve, caused solely by a change in the good's own price (e.g., an increase in price prompts producers to offer more units). A change in supply refers to a shift of the entire supply curve (left or right), caused by factors other than the good's price, such as input prices, technology, number of sellers, or expectations (e.g., a technological innovation reduces production costs, shifting supply outwards).

How does a subsidy impact market equilibrium, consumer and producer surplus, and overall welfare consequences?

A subsidy (a payment to producers or consumers) effectively reduces the cost of production or increases the willingness to pay. This shifts the supply curve down (or demand curve up), leading to:

• A higher equilibrium quantity and a lower effective price for consumers.

• An increase in both consumer surplus and producer surplus.
  However, the cost of the subsidy to the government can exceed the gains in consumer and producer surplus, leading to a deadweight loss. Graphically, the total area of CS + PS increases, but total welfare (CS + PS - Government Cost) often decreases as the quantity is inefficiently high.

How is marginal cost related to the supply curve, and how does it influence a firm's production decisions?

For a competitive firm, the marginal cost curve above the average variable cost curve represents the firm's supply curve. Firms will produce up to the point where marginal cost equals the market price (P = MC) to maximize profits. If P > MC, producing an additional unit adds more to revenue than to cost, increasing profit. If P < MC, producing an additional unit adds more to cost than to revenue, decreasing profit.

Explain how a binding price ceiling can lead to inefficient allocation to consumers.

A binding price ceiling creates a shortage, meaning there isn't enough of the good for everyone who wants it at the controlled price. This often leads to non-price rationing mechanisms, such as first-come, first-served, or arbitrary allocation. Consequently, the good may end up in the hands of consumers who value it less (or have a lower willingness to pay) than other consumers who are unable to acquire it, thus resulting in inefficient allocation to consumers. For example, rent control might leave apartments empty while highly motivated new residents cannot find housing.

If demand for a vital medicine like chemotherapy drugs is highly inelastic, how would an excise tax on these drugs affect patients and pharmaceutical companies?

If demand for chemotherapy drugs is highly inelastic, an excise tax would result in:

• A significant increase in the price paid by consumers (patients), as they are largely unresponsive to price changes due to necessity.

• Only a small decrease in the quantity sold.

• The tax incidence would fall disproportionately on consumers, meaning patients would bear most of the tax burden in the form of higher prices. Pharmaceutical companies would see a relatively smaller reduction in the price they receive per unit.

Describe Perfectly Inelastic Supply/Demand with an example for each, and discuss their implications for market interventions.

• Perfectly inelastic supply means the quantity supplied remains constant regardless of price changes (e.g., original artwork by a deceased artist, a fixed amount of land). Implications for intervention: A tax on such a good falls entirely on producers without affecting quantity, and there is no deadweight loss on the supply side.

• Perfectly inelastic demand means the quantity demanded remains constant regardless of price changes (e.g., life-saving medicine with no substitutes). Implications for intervention: A tax on such a good falls entirely on consumers without affecting quantity, and a price ceiling below the equilibrium price would cause a severe shortage with minimal quantity adjustment.

How is producer surplus represented on a supply and demand graph, and what happens to it under a binding price ceiling?

Producer surplus is the area above the supply curve and below the price received by sellers. On a graph, it's typically a triangular area. Under a binding price ceiling, the price sellers receive is mandated to be lower than the equilibrium price. This reduces the number of units supplied and decreases the price per unit, resulting in a significant decrease in producer surplus.

How is consumer surplus represented on a supply and demand graph, and what happens to it under a binding price floor?

Consumer surplus is the area below the demand curve and above the price paid by buyers. On a graph, it's typically a triangular area. Under a binding price floor, the price buyers pay is mandated to be higher than the equilibrium price. This reduces the number of units demanded and increases the price per unit. The result is a decrease in consumer surplus.