Supply and Demand: Government Intervention

Government Intervention

  • Government intervention can:
    • Prohibit the market from reaching equilibrium through price controls.
    • Change the equilibrium using taxes or subsidies.

Price Controls

  • Prevent the market from reaching equilibrium.
  • Types:
    • Price Ceiling: A maximum legal price.
    • Price Floor: A minimum legal price.

Price Ceiling

  • To be effective, a price ceiling (PC) must be less than the equilibrium price (P_0).
  • Example: Price ceiling on tortillas.
  • Welfare effects:
    • Reduction in quantity sold.
    • Deadweight loss (DWL).
    • Transfer of surplus from producers to consumers.
  • Illustration:
    • If the government sets a price ceiling at $0.25, there is a reduction in tortillas sold by 25 million.
    • Deadweight loss (area 1) and transfer of surplus (area 2) from producers to consumers.
  • Considerations:
    • Are producers better off?
    • Are consumers better off?
    • What is the overall effect on total surplus (TS)?
  • Allocation of goods under a price ceiling:
    • Coupon rationing.
    • Rent-seeking behavior.
    • Rationing by preference.
    • Queue-rationing.
  • Questions:
    • Are price ceilings worth the decrease in TS?
    • What about non-binding price ceilings (price ceilings above the equilibrium)?

Price Floor

  • To be effective, a price floor (PF) must be greater than the equilibrium price (P_0).
  • Example: Price floor on milk.
  • Welfare effects:
    • Excess supply.
    • Deadweight loss (DWL).
    • Transfer of surplus from consumers to producers.
  • Illustration:
    • If the government sets the market price to $3, there is a reduction in milk sold by 5 million gallons.
    • Deadweight loss occurs (area 1) and transfer of surplus (area 2) from consumers to producers.
  • Considerations:
    • Are producers better off?
    • Are consumers better off?
    • What is the overall effect on total surplus (TS)?
  • Allocation of goods under a price floor.
  • Questions:
    • Are price floors worth the decrease in TS?
    • Can the government ensure farmers gain?
    • What about non-binding price floors? (price floors below the equilibrium)

Taxes and Subsidies

  • Used to correct market failures and provide incentives/disincentives to change production/consumption.
  • Taxes:
    • Discourage production and consumption of the taxed good.
    • Raise government revenue from those who continue buying/selling the good.
    • Reduce consumption and provide a new source of public revenue.

Effects of a Tax on the Seller

  • The new supply curve adds the tax amount to all prices.
  • Taxes drive a wedge between the buyer’s price and the seller’s price.
  • The equilibrium quantity decreases.
  • Illustration:
    • If the government imposes a $0.20 tax on each unit sold, the seller must pay this.
    • Deadweight Loss (DWL) and Tax revenue will be created

Example of Tax on Seller

  • Suppose the government imposes a $1 tax that sellers must pay.
  • After the tax, buyers pay $3/unit but sellers keep only $2/unit.
  • Calculations:
    • Tax Revenue (TR) = 1 * 10M = $10M
    • Deadweight Loss (DWL) = \frac{1}{2} * (15M - 10M) * (3 - 2) = 2.5M
    • New Consumer Surplus (CS) = 0.5 * ($4 - $3) * 10M = $5M
    • New Producer Surplus (PS) = 0.5 * ($2 - $1) * 10M = $5M

Example of Tax on Buyer

  • Suppose the government imposes a $1 tax that buyers must pay.
  • After the tax, sellers receive $/unit but buyers pay $/unit

General Effects of a Tax

  • Regardless of whether the tax is imposed on buyers or sellers:
    • Equilibrium quantity falls.
    • Buyers pay more per unit, and sellers receive less (tax wedge).
    • Government receives revenue = (tax) * (new equilibrium quantity).
    • The tax causes a deadweight loss.

Subsidies

  • Encourage production and consumption of the subsidized good.
  • Government provides money through the subsidy to producers who continue to sell the good.
  • A subsidy will increase consumption of the good.

Subsidies for the Seller

  • The supply curve shifts down by the amount of the subsidy.
  • Buyers pay less, and sellers receive more.
  • Equilibrium quantity increases.
  • Illustration:
    • If the government imposes a $0.35 subsidy on each unit sold, the seller receives it.
    • Buyers pay $0.53 and sellers receive $0.88.
    • Equilibrium quantity increases by 12 million.
    • Government spending on subsidy = 0.35 * 62M = $21.7M

Subsidy for Seller (cont’d)

  • Deadweight loss (DWL) occurs because the cost of the subsidy to the government > TS increase.
  • Additional calculations:
    • Additional CS = ($0.70 - $0.53) * 50 + 0.5 * ($0.70 - $0.53) * (62 - 50) = $9.52M
    • Additional PS = ($0.88 - $0.70) * 50 + 0.5 * ($0.88 - $0.70) * (62 - 50) = $10.08M

Subsidies for Seller (cont’d)

  • Deadweight loss = government expenditure – increase in CS – increase in PS
  • Calculations:
    • Government Expenditure (GE) = $21.7M
    • Change in CS = $9.52M
    • Change in PS = $10.08M
    • DWL = 21.7M – 9.52M – 10.08M = 0.5(0.88-0.53)(62-50) = $2.1M

General Effects of a Subsidy

  • Regardless of whether the subsidy is imposed on buyers or sellers:
    • Equilibrium quantity rises.
    • Buyers pay less per unit, and sellers receive more.
    • Government expenditure = (subsidy) * (new quantity bought and sold).
    • The subsidy causes a deadweight loss.