05 Notes Introductory Microeconomics ECON 1110 IV. GOVERNMENT INTERVENTION IN MARKETS Even in capitalist economies, governments intervene in most markets. Five widespread forms of intervention are: Quotas, Price floors (minimum prices), Price ceilings (maximum prices), Taxes, and Subsidies. QUOTA: is a prohibition to produce or sell more than a fixed amount of a good. Consider the following diagram that is initially in equilibrium at the efficient price and quantity of P* and Q*. The efficient CS and PS are located in the usual places. Now assume that the government sets a quota that makes it illegal to produce and sell more than Qmax. If the suppliers only produced Qmax and sold it at the efficient price P*, then there would be excess demand. In response to the excess demand, suppliers raise their price until the quantity demanded is equal to the quantity supplied of Qmax. On the diagram we can identify this price by moving vertically from Qmax to the demand curve the price is P.
QUOTA
$/Q
P
S
P*
D Qmax Q* Q
There are several implications. First, because the equilibrium quantity is less that the efficient quantity, gains from trade (GFT) have decreased. In the diagram the gains from trade have decreased by the amount of the grey triangle. The amount of the decrease in gains from trade relative to the efficient level of gains from trade is called the deadweight loss (DWL). More formally, DWL is equal to the efficient level of GFT minus the actual equilibrium level of GFT (DWL=GFT*-GFT).
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Second, it is clear the CS has decreased. The price demanders pay has increased and the quantity they consume has increased, so CS is now only the small orange triangle. Third, it appears that PS has increased. It is not definite that PS will always increase when a quota in imposed (for example is the quota is set to zero then PS will decrease), but it is possible. In the diagram PS tended to decrease because the quantity decreased, but PS tended to increase because the price increased. For small decreased in quantity the price effect will dominate the quantity effect and PS will increase. For larger changes in quantity the quantity effect will dominate the price effect and PS will decrease. PRICE MINIMUM: is a prohibition to sell a given good at a price lower than a legislated price. If the price minimum is higher than the equilibrium price with no government intervention (i.e., the market clearing price), then the price minimum will cause an excess supply of the good. An important example is a minimum wage. When set above the market clearing price, a minimum wage will create unemployment and a higher wage for those who keep their jobs. Consider the following diagram. Initially the equilibrium is at price P* and quantity Q*;
producer and consumer surplus are located in the standard way. If the minimum legal price is raised to Pmin, then the quantity demanded will decrease from Q* to Qd, and the quantity supplied will increase from Q* to Qs.
PRICE MINIMUM $/Q
Pmin
S
P*
D Qd Qs Q
It is in this sense that a minimum wage results in unemployment. First, consumers want to hire Q*-Qd fewer workers, and second Qs-Q* more workers enter the workforce. If the
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government doesnt force consumers to hire workers they dont want, the actual number of workers that get hired is Qd. The total consumer surplus is now the orange triangle, and the total producer surplus is now the blue area. Note that the gains from trade (the sum of consumer and producer surplus) are now smaller than it was at the efficient point. The gains from trade are smaller by the amount of the grey triangle the DWL. Notice that the effect of a quota and a price minimum are essentially the same. In both cases the CS definitely decreases and PS could increase or decrease depending on the magnitude of the drop in quantity. PRICE MAXIMUM: is a prohibition to sell a given good at a price higher than a certain price. If the price maximum is lower than the market clearing price, then the price ceiling will cause an excess demand for the good. An important example is a rent control. When set below the market clearing price, such a control will create an excess demand for housing, and a lower rent for those who can find a house to rent. The excess demand may lead to the creation of a black market, where consumers bribe suppliers in order to receive a house. More generally, price ceilings can lead to wasteful activities such as queues (e.g., in gas stations when there is a binding price ceiling for gas), or inefficient resale markets. Consider the following diagram.
$/Q PRICE MAZIMUM
S
P* Pmax D Qs Q* Qd Q
Initially the equilibrium is at price P* and quantity Q*; producer and consumer surplus are located in the standard way. If the maximum legal price that can be charged is lower to Pmax, then the quantity supplied will decrease from Q* to Qs, and the quantity demanded will increase from Q* to Qd. Since it is impossible to consume what isnt produced, only Qs in produced and consumed. As a result, the consumer surplus is indicated by the orange area and the
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producer surplus is indicated by the blue area. It is definite in this case that the PS has decreased since both quantity and price have decreased. It is not definite whether CS has increased or decreased; the decrease in quantity decreases CS but the decrease in price increases CS. For small changes in quantity CS increases and for large changes in quantity CS decreases. Note that GFT have decreased, and the DWL is equal to the grey triangle.
PER UNIT TAX: The government charges a tax of t dollars per unit, for each unit of a good that is bought or sold. The tax is equal across all units. The per unit tax creates a gap between the price paid by the consumers and the price received by the sellers. This gap will equal the size of the tax. The new (after tax) equilibrium will consist of a consumer price Pc and a producer price Pp such that Ps = Pd - t, and an equilibrium quantity Qe such that Qe = D(Pd) = S(Ps) = S(Pd tax). Graphically, the tax introduces a vertical wedge between the supply and demand curves. This wedge is equal to the tax. In the following diagram the initial equilibrium occurred at price P* and quantity Q*. The tax means that the price demanders pay is greater than the amount suppliers receive, by the amount of the tax. The tax affects both prices: it increases Pd and decreases Ps. An increase in Pd decreases quantity demanded and a decrease in Ps decreases quantity supplied. There are several implications of the tax. First, because the equilibrium quantity decreases, the gains from trade decrease. The after tax GFT is equal to TV-TC, so the DWL is equal to the area of the grey triangle. While GFT is always equal to TV-TC, it is not equal to PS+CS when there are taxes. The reason is that the government now earns revenue, so that GFT is now equal to PS+CS+government tax revenue. The dark grey area is the tax revenue collected by the government (tax * quantity). Second, both CS and PS decrease. Consumers are paying a higher price, and quantity has decreased, resulting in a lower CS. Producers are receiving a lower after-tax price, and quantity has decreased, resulting in lower PS. Notice that regardless about who pays the tax, suppliers and demanders are both worse off.
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Notice that the demand price is taken off of the original demand curve and the supply price is taken off of the original supply curve.
Pd Per unit tax
S
P* Ps D Qe Q* Q
TAX INCIDENCE: indicates how the tax burden is de facto split between producers and consumers. With a tax CS and PS each decease. The economic incidence measures the magnitude of the decrease in each of CS and PS separately. Calculating the economic incidence isnt as straightforward as finding out who pays the tax because the economic incidence is independent of the legal incidence (who is administratively responsible for the tax). A graphical way to understand why the economic incidence is independent of the legal incidence is to calculate the after tax equilibrium as follows. First, for a tax levied on suppliers, shift the supply curve upward by the amount of the tax, the new equilibrium is where this new supply intersects demand. The net price received by suppliers can be found by evaluating the old supply curve at the new equilibrium quantity. On the other hand, for a tax levied on consumers, shift the demand curve downward by the amount of the tax, the new equilibrium is where this new demand intersects supply. The total price paid by consumers can be found by evaluating the old demand curve at the new equilibrium quantity. (Note: this graphical approach fails when the tax is levied on either suppliers or consumers when they have a perfectly inelastic behavior. In which case, the more general wedge approach should be used.) The important points to remember about per unit taxes are: i) Taxes increase the price to demanders, decreases the price to suppliers, reduce the equilibrium quantity, and reduce the gains from trade.
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ii)
The economic incidence of a tax is independent of whether the government levies the taxes on suppliers or demanders. If a tax is levied on the demander or the supplier, the demand price will rise by an identical amount.
iii)
The deadweight loss of a tax is smaller the less elastic are demand and supply. Therefore, if the government is interested in raising tax revenue in a way that minimizes deadweight loss, it should tax those markets with very inelastic supply or demand.
iv)
The incidence of a tax fall most heavily on the supplier or demander with the less elastic supply or demand.
PER UNIT SUBSIDIES: are exactly like a negative tax. Rather than the government taking a fixed amount t per transaction, it gives an amount s per transaction, as demonstrated in the following diagram. If the government subsidizes demand, there is a vertical increase in demand equal to the per unit subsidy. If the government subsidizes supply there is a vertical drop in the supply curve equal to the subsidy. The subsidy drives a wedge between the price demanders pay and the price suppliers receive, but in the case of subsidies the demand price is lower than the supply price. Subsidies increase the equilibrium quantity. Because the equilibrium is quantity greater than the efficient quantity Q* there is deadweight loss equal to the grey rectangle.
S Ps Per unit subsidy P*
Pd Q* Qs=Qd
D Q
It is difficult to explain subsidies using diagrams because areas overlap. I am forced to use several diagrams. In the following diagram the orange triangle represents the level of consumer surplus after the subsidy. It is clear that subsidies increase CS, so consumers would be expected to be in favor of subsidies.
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S Ps Per unit subsidy P*
Pd Q* Qs=Qd
D Q
In the following diagram the blue triangle represents the new level of producer surplus. It is clear that PS with subsidies is larger than without, so suppliers would be in favor of subsidies.
S Ps Per unit subsidy P*
Pd Q* Qs=Qd
D Q
If CS and PS each increase with subsidies each increase, how can there be DWL? The answer is that we havent accounted for government expenditure yet. Recall that in the tax case the government received revenue so that to account for the full gains from trade we added CS, PS and government revenue. In the subsidy case the government pays money out, so to account for gains from trade we add CS and PS, but subtract government expenditure. The following dark grey rectangle is the total amount of government expenditure (the subsidy times the number of units consumed).
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S Ps Per unit subsidy P*
Pd Q* Qs=Qd
D Q
INCIDENCE OF A SUBSIDY: As a result of the subsidy s and the increase in quantity to Qs=Qd. Ps is greater than Pd by an amount s, the subsidy. The subsidy increases both CS and PS. The largest benefits accrue to the The important points to remember about per unit subsidies are: i) ii) Subsidies increase the price to suppliers, decreases the price to demanders, increase the equilibrium quantity, and reduce the gains from trade. The economic incidence of a subsidy is independent of whether the government pays the subsidies to suppliers or demanders. iii) If a subsidy is paid to the demander or the supplier, the demand price will fall by an identical amount. The benefits of a subsidy accrue most heavily to the supplier or demander with the least elastic response to the subsidy.
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PROBLEMS 1. Assume that initially the market for T-shirts is in equilibrium, without any taxes or subsidies. A new $1 per T-shirt is adopted. The efficiency loss due to this tax is: a) Equal to the change in total revenues received by the supplier b) Is equal to the deadweight loss plus welfare loss c) Equal to the gains from trade before the tax is adopted minus the gains from trade after the tax has been imposed. d) Smaller the more elastic is the supply of T-shirts e) Both (c) and (d) are correct Questions 2 and 3 are based on this information: Suppose a wise government offers to pay a subsidy of $10 per tie to producers for each tie they sell. 2. Which of the following is true? a) producers of ties will be made worse off due to the subsidy because the price of ties will fall b) consumers of ties will be made worse off due to the subsidy because the subsidy will cause an excess demand for ties c) as long as the first laws of supply and demand apply to ties, consumers and suppliers of ties will both benefit from the subsidy d) the lower the elasticity of the supply of ties, the greater will be the impact of the subsidy on the consumption of ties e) both (a) and (c) are correct 3. Which of the following information about the effects of the subsidy will enable you to compute the price elasticity of demand for ties? a) the exact dollar change in the price of ties and the exact number of ties sold before the subsidy b) the elasticity of supply of ties, combined with the fact that the subsidy is exactly $10 per tie c) the percentage changes in both the equilibrium price and quantity of ties that result from the subsidy d) the number of ties sold before and after the subsidy, plus the fact that the subsidy is $10 per tie e) the original price and quantity of ties, plus the size of the subsidy 4. In Canada employers must pay a tax of $20 per day for every employee that they employ to fund unemployment benefits. TFU and explain: Because this tax is paid by employers and not employees, it has no impact on salaries or the number of people employed.
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5. The question is based on the following information that shows the marginal cost and value of producing and consuming T-shirts. Unit 1 2 3 4 5 6 7 8 9 10 11 MC $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $6.50 $7.00 MV $20 $18 $16 $14 $12 $10 $8 $7 $6 $5 $4
a) What are the efficient price, quantity, consumer surplus, producer surplus, and the gains from trade in the above market? b) If a tax of $3 per unit is applied to the producer of T-shirts, what will be the new equilibrium price and quantity, consumer surplus, producer surplus, government tax revenues and deadweight loss? c) If the tax was applied to the consumer instead of the producer, what would consumer and producer surplus be? d) If the government set a quota of 4 units, what would be the equilibrium price, consumer and producer surplus? Would producers be in favor or this quota, relative to the efficient point? e) If the government set a price minimum of $14, what would be the equilibrium quantity, consumer surplus and producer surplus.? Which would producers prefer, a quota of 4 units or a price minimum of $14. f) If the government set a price maximum of $3.50 what would be the equilibrium quantity, consumer surplus and producer surplus? Which would producers prefer, a quota of 4 or a price maximum of $3.50? 6. Ceteris paribus, the greater the elasticity of supply of a good on which a per unit tax is levied a) The greater will be the reduction in mutually beneficial exchange b) The greater will be the share of the tax that is borne by consumers c) The smaller will be the tax revenues generated by the tax d) Both a) and b) are correct e) All of the above
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7. To be effective (i.e., to alter the amount of exchange that takes place), a price minimum must a) be below the price at which any demander would buy any of the good b) be above the equilibrium price c) be equal to marginal cost at the new equilibrium quantity d) be below the cost at which the lowest cost producer can produce any positive amount of the good in question e) none of the above 8. To be effective (i.e., to alter the amount of exchange that takes place), a price minimum must a) be below the price at which any demander would buy any of the good b) be above the equilibrium price c) be equal to marginal cost at the new equilibrium quantity d) be below the cost at which the lowest cost producer can produce any positive amount of the good in question e) none of the above 9. Suppose the supply of banana pickers is positively sloped and demand for banana pickers is negatively sloped. Also suppose that the governments levies a $1 per unit tax on the suppliers of banana pickers. Which of the following statements is correct? a) the price of pickers will rise by exactly $1 per unit b) ceteris paribus, the quantity of pickers consumed will be greater one month after the tax in imposed than it is one week after the tax in imposed c) the price of pickers will rise by more than $1 if the demand for pickers is inelastic d) the price of pickers will rise by less than $1 e) none of the above
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Questions 10-13 are based on the figure shown below. Suppose the demand and supply of kiwis are given by D and S, respectively. (For the moment, ignore the line labeled S T)
10. a) b) c) d) e) 11. a) b) c) d) e) 12. a) b) c) d) e) 13. a) b) c) d) e)
In this diagram, the equilibrium price is shown by the distance 0A 0B 0C 0E 0F In this diagram, the total value to consumers of consuming K units is shown by the area ARG 0GRK ARC ARK0 0CRK In this diagram, the level of producer surplus in equilibrium is shown by the area EWG CRG ARG ARC CRK0 In this diagram, the total gains from trade in equilibrium are shown by the area EWG CRG ARG ARC CRK0
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Questions 14-17 are based on the figure shown below. Suppose the demand and supply of pineapples initially are given by D and S respectively. Then the government decides to levy a per unit excise tax on suppliers, causing the supply curve to shift to ST.
14. a) b) c) d) e) 15. a) b) c) d) e) 16. a) b) c) d) e) 17. a) b) c) d) e)
Given this information, the size of the per unit tax is shown by the distance MW CR MN MT GE The new equilibrium quantity that results from the tax is shown by the distance 0H 0J 0K 0L 0B The tax receipts collected by the government are shown by the area BMJ0 BMWF EMWG EWJ0 Both b) and c) The deadweight loss caused by the tax is shown by the area MRW MNR BMRWE AMWG UTWV
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18. Suppose the government imposes a binding (i.e. effective) price floor (minimum price) on cantelopes. Assume that the demand for cantelopes is inelastic over the relevant range. Consider these three measures: consumer surplus, producer surplus, gains from trade. How do each of these, respectively, change as a result of the price floor? a) up, up, up b) up, down, down c) down, uncertain, down d) down, down, up e) up, down, uncertain 19. Consider the market for loans from Pawn Shops. The way that pawn shops work is that people who desire a loan must leave something of value with the pawn shop. The pawn shop then lends them money. Historically, interest rates that pawn shops charged became extremely high. To stop pawn shops from exploiting people in dire need of a loan, most states have placed an effective maximum annual interest rate of 240% on loans made by pawn shops. The result of this regulation is which of the following? a) The actual interest rate being charged is greater than the efficient level. b) Producer surplus is less than the efficient level. c) Because customers are no longer being exploited, gains from trade are greater. d) All demanders of loans are better off e) None of the above
20. Assume that, for the purpose of improved societal health, the government sets a minimum price at which cigarettes can be purchased. The effect of this price minimum will be which of the following? a) Total gains from trade will increase due to the improved health of the population b) The price of cigarettes will rise c) The quantity demanded will decrease d) All of the above e) Answers b) and c) only
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