Notes05 - Notes 05 Introductory Microeconomics ECON 1110 IV...

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Notes 05– 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’. Qmax D S P* Q* Q $/Q P’ QUOTA 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’). 1
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