Market Intervention and Competitive Market

Intervention in Markets

Two Ways to Intervene

  • There are two direct methods to intervene in a market:

    • Change the Price:

    • Causes market price (P) to differ from the equilibrium price (P*).

    • Change the Quantity:

    • Causes the quantity traded to differ from the equilibrium quantity (Q*).

Price Floors in Perfectly Competitive Markets

Concept of Price Floors

  • A price floor is a minimum price set by the government to prevent prices from falling below a certain level.

  • Effects of a price floor:

    • Keeps prices above equilibrium, which leads to a surplus in the market.

    • May result in a misallocation of resources and overproduction.

    • Can create deadweight loss (DWL) by eliminating economic surplus.

  • Example:

    • When a price floor is set at $14:

    • The quantity sold is determined by demand at that price level, leading to a surplus.

    • Producer surplus (PS) may increase or decrease depending on how the price floor impacts quantities.

Efficiency and Price Floors

  • In equilibrium, let:

    • Original equilibrium price = $8, quantity = 1,800.

    • Consumer surplus defined as areas G, H, J, Producer surplus defined as areas I, K, L.

  • With a price floor set at $12:

    • Quantity sold = 1,400.

  • New consumer and producer surplus values:

    • Consumer Surplus: Area G

    • Producer Surplus: Area H + I + L

    • Deadweight Loss: Areas J + K (loss of efficiency due to the price floor).

  • Consumers and producers can have differing experiences based on the changes in surplus: If the gain in producer surplus (H) exceeds the loss (K), the change is beneficial for producers collectively.

Price Ceilings in Perfectly Competitive Markets

Concept of Price Ceilings

  • A price ceiling is a maximum price set by the government to prevent prices from rising above a certain level.

  • Effects of a price ceiling:

    • Creates a shortage in the market as supply cannot meet demand at the ceiling price.

    • Reduces the quantity traded, incentivizes black market activity.

    • Creates deadweight loss (DWL) and reduces producer surplus.

  • Example:

    • With a price ceiling at PCeiling:

    • The market might face a shortage due to restricted selling prices.

Efficiency and Price Ceilings

  • Original equilibrium price/surplus scenario:

    • Equilibrium price = $600, quantity = 20,000.

  • With price ceiling at $400:

    • Quantity sold = 15,000.

  • New consumer surplus: T + V.

  • New producer surplus: X.

  • Deadweight Loss (loss of efficiency due to price ceiling): Areas U + W.

  • Evaluation:

    • Consumers’ net benefit depends on whether the gained surplus area (V) is greater than the lost surplus area (U).

Quotas in Perfectly Competitive Markets

Concept of Quotas

  • A quota limits the quantity traded in a market, influencing prices and production.

  • A quota is not the same as a shortage; it is a government-imposed limit.

Example of Quotas

  • A market displaying excess supply can be corrected with a quota to limit units available for trade.

  • Effects of quotas:

    • Raises the price paid by consumers.

    • Benefits producers when the gain in surplus from higher prices exceeds loss from reduced quantity sold.

    • Quotas are often used to manage common resources conservatively.

Tax in Perfectly Competitive Markets

Introduction to Excise Tax

  • An excise tax is a tax implemented on a specific good or service to raise revenue.

Tax Incidence

  • Tax incidence refers to how the burden of a tax is shared between consumers and producers.

  • True or False Statement:

    • The group that sends the money to the government is the most affected by a tax.

Showing a Tax

  • To illustrate the effect of a tax:

    • Shift supply curve upward by the amount of the tax.

    • Tax wedge is defined as the vertical distance between the supply curves with and without tax.

    • Pconsumer becomes higher, and Pproducer becomes lower due to the tax.

  • Effects on the market:

    • Increase in market price for consumers and decrease in net revenue for producers.

    • Reduction in quantity of goods sold leading to deadweight loss.

Tariffs in Perfectly Competitive Open Markets

Concept of Tariffs

  • A tariff imposes a tax on imported goods, which increases consumer prices.

  • Tariffs are intended to protect domestic producers by making imported goods more expensive.

Import Dynamics

  • Imports occur in markets when the world price is lower than the domestic price.

    • Example:

    • Domestic consumers willing to buy at world price or lower.

    • Domestic producers unwilling to produce at lower world price levels.

Effects of Tariffs

  • Tariffs raise domestic prices for all consumers.

  • Domestic producers benefit from less competition due to decreased imports.

  • The government earns revenue from the tariffs while economic surplus is reduced (deadweight loss occurs).

Summary of Market Interventions

  • Market interventions can be categorized as:

    • Price Controls:

    • Price Ceiling: Prevents price from exceeding a max level.

    • Price Floor: Prevents price from dropping below a min level.

    • Quotas: Limitation on quantities traded in a market.

    • Taxes: Such as excise taxes to generate revenue.

    • Subsidies: Government funding injected into a market to increase quantities exchanged.

    • Tariffs: Tax on imports meant to generate revenue and protect domestic markets.