Notes05 - Notes 05 Introductory Microeconomics ECON 1110...

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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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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 P min , then the quantity demanded will decrease from Q* to Qd, and the quantity supplied will increase from Q* to Qs. Qd
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This note was uploaded on 03/03/2009 for the course ECON 1110 taught by Professor Wissink during the Fall '06 term at Cornell University (Engineering School).

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Notes05 - Notes 05 Introductory Microeconomics ECON 1110...

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