Chapter 6
Government Intervention
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What will you learn in this chapter?
• The effect of a price ceiling or a price floor on the equilibrium price and quantity.
• The effect of a tax or a subsidy on the equilibrium price and quantity.
• How elasticity and time period influence the impact of a market intervention.
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Why Intervene?
• Markets gravitate toward equilibrium.
• When markets work well, prices adjust until the quantity of the good demanded is equal to the quantity supplied.
• There are three reasons why a government may step in and intervene in a market:
– Correcting market failures.
– Changing the distribution of benefits.
– Encouraging or discouraging consumption of certain goods.
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Four real‐world interventions
• In this chapter, four real‐world examples of government intervention will be analyzed.
– Mexican tortilla prices and the government setting a maximum price.
– U.S. milk prices and the government setting a minimum price.
– U.S. fatty foods and the government taxing high fat and high calorie foods.
– Mexican tortilla prices and the government subsidizing
tortilla producers.
• These examples require both positive and normative
analysis.
– What are the trade‐offs?
– Do the benefits outweigh the costs?
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Price controls
• Price controls can be divided into categories:
– Price ceiling: A maximum legal price at which a good can be sold.
• Typically placed on essential goods and services such as food, gasoline, and electricity.
– Price floor: A minimum legal price at which a good can be sold.
• Typically placed on agricultural goods that are risky to produce.
• The price controls provide incentives or disincentives to produce more or less than the equilibrium quantity.
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Price ceilings
Suppose the Mexican government imposes a price ceiling on tortillas. What effect does this have on the market?
Price (¢/lb.)
125
Price (¢ / lb.)
125
Producers supply
a lower quantity.
100
S
100
75
75
50
50
S
Consumers demand
a higher quantity.
Price
ceiling
25
25
Shortage
D
D
0
25
50
75
100
Quantity of tortillas (millions of lbs.)
Efficient market with a price of $0.50 per lb. and 50 million lbs. of tortilla.
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0
25
50
75
100
Quantity of tortillas (millions of lbs.)
Inefficient market with a price ceiling set at $0.25 per lb. and 25 million lbs. of tortilla being produced.
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Price ceilings
• Did the price ceiling meet the goal of providing low‐priced tortillas to consumers?
– Yes. Consumers were able to buy some tortillas at the low price of $0.25 a pound.
– No. Consumers wanted to buy three times as many tortillas as producers were willing to supply.
• How did the price ceiling effect welfare?
– This question can be answered using differences in consumer surplus and producer surplus before/after government intervention.
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Welfare effects of a price ceiling
A price ceiling causes a deadweight loss to occur as well as a transfer of welfare from producers to consumers.
Price (¢/lb.)
Producer surplus
125
Consumer surplus
Deadweight loss
100
S
75
1
50
2
Price
ceiling
25
D
0
25
50
75
100
Quantity of tortillas (millions of lbs.)
• Suppose the government sets the price at $25.
• Reduction in tortillas sold by 25 million.
• Deadweight loss occurs.
• Transfer of surplus from producers to consumers.
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Welfare effects of a price ceiling
• Are price ceilings worth the decrease in total surplus?
– Normative question about which people can disagree.
• One way to answer is through studying the allocation of tortillas.
• Because a price ceiling causes a shortage, goods must be rationed.
– Rationed equally.
– First‐come, first‐served basis.
– Rationed to those who are given preference by the government, or to the friends and family of sellers.
• Shortages cause people to engage in rent‐seeking behavior, such as bribing whoever is in charge of allocating scarce supplies.
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Ineffective price ceiling
A price ceiling does not always affect the market outcome if the ceiling is set above the equilibrium price.
• Suppose the government sets the price at $25.
Price (¢/lb.)
125
1. Supply increases,
and the supply curve
shifts to the right.
100
75
– Reduction in tortillas sold by 25 million.
S1
2. At the new equilibrium
point, the price is below
the price ceiling.
50
S2
25
Price ceiling
• Over time, if the supply increases sufficiently, the price ceiling may become nonbinding.
– No effect on market equilibrium.
D
25
50
75
100
Quantity of tortillas (millions of lbs.)
0
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Price floors
Suppose the U.S. government imposes a price floor on milk. What effect does this have on the market?
Price ($/gal.)
4.5
Price ($/gal.)
4.5
S
4
S
4
3.5
3.5
Price floor
3
3
2.5
2.5
2
2
Quantity supplied and
quantity demanded move
in opposite directions.
1.5
1.5
D
1
D
1
0.5
0.5
0
Excess supply
5 10 15 20 25 30 35
Quantity of milk (billions of gals.)
Efficient market with a price of $2.50 per gallon and 15 million gallons of milk being produced.
0
5 10 15 20 25 30 35
Quantity of milk (billions of gals.)
Inefficient market with a price ceiling set at $3 per gallon and 20 million gallons of milk being produced.
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Price floors
• Did the price floor meet the goal of providing support to producers?
– Yes. Producers were able to sell some milk at a higher price of $3.00 per gallon.
– No. Some producers may not be able to sell all of their milk because demand no longer meets supply.
• How did the price floor affect welfare?
– This question can be answered using the difference in consumer and producer surplus before/after government intervention.
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Welfare effects of a price floor
A price floor causes a deadweight loss to occur as well as a transfer of welfare from consumers to producers.
Producer surplus
Price ($/gal.)
Consumer surplus
4.5
Deadweight loss
S
4
3.5
3
Price
floor
2
1
2.5
2
1.5
1
0.5
D
0
5
10
15
20
25
30
35
Quantity of milk (billions of gals.)
• Suppose the government sets the market price to $3.
• Reduction in milk sold by 5 million gallons.
• Deadweight loss occurs (Area 1).
• Transfer of surplus (Area 2) from consumers to producers.
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Welfare effects of a price floor
• Are price floors worth the decrease in total surplus?
– Normative question about which people can disagree.
• One way to answer is through studying how much excess milk will the government have to buy.
– The answer is the entire amount of excess supply created by the price floor.
– In the above case, 10 billion gallons will be purchased at $3 per gallon.
– The cost to maintain the price floor is then $30 billion.
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Ineffective price floor
A price floor does not always affect the market outcome if the floor is set below the equilibrium price.
Price ($/gal)
S2
6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
1. Supply decreases,
and the supply curve
shifts to the left.
S1
Price floor
D
5
10
15
20
25
2. At the new
equilibrium point, the
price is above the
price ceiling.
30
• Suppose the government set the price at $3.
– Increase in milk sold by 5 million gallons.
• Over time, if the supply decreases sufficiently, the price floor may become nonbinding.
– No effect on market equilibrium.
35
Quantity of Milk (billions of gals.)
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Active Learning: Determining market price and quantity with price controls
Suppose the government has been convinced to institute a price ceiling on housing rentals for $400 per month. Demand for housing is given as P = 900 – 20Q and supply is P = 40Q, where Q is measured in thousands of housing units.
1.
Solve for equilibrium price and quantity without a price control.
2.
Solve for the price and quantity with a price control.
3.
Why might a price control may have opposite effects then intended?
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Taxes and Subsidies
• Price incentives can be divided into categories:
– Taxes: Either the buyer or the seller must pay some extra amount to the government on top of the sale price.
• Typically placed on seller.
– Subsidies: Either the buyer or the seller receives a payment from the government that lowers the sale price.
• Taxes and subsidies can be used to correct market failures and provide incentives or disincentives to produce more or less than the equilibrium quantity.
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Taxes
• Using the case of fatty foods in the U.S., rather than banning them, what would happen if the government taxed them?
• Taxes have two primary effects:
– Discourage production and consumption of the good that is taxed.
– Raise government revenue through the fees paid by those who continue buying and selling the good.
• A tax will reduce consumption and provide a new source of public revenue.
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Effects of a tax paid by the seller
Suppose the government imposes a $0.20 tax on each unit sold, which the seller must pay. What effect does this have on the market?
Price (¢)
80
• The new supply curve adds $0.20 to all prices, the amount of the tax.
• Taxes drives a wedge between the buyer’s price and the seller’s price.
• The equilibrium quantity decreases from 30 million to 25 million.
S
2
S
1
E
2
Buyers pay 60¢ 60
E
1
Tax Wedge
Sellers receive 40¢ 40
after the tax
D
20
0
5
10
15
20
25
30
35
40
45
Quantity of Whizbangs (millions)
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Effects of a tax paid by the seller
The tax revenue and deadweight loss from the tax on sellers can be calculated.
Deadweight loss
Price (¢)
80
• The tax revenue generated is
S2
S1
Quantity sold 25 million
TR = Tax*Qpost‐tax
E2
60
• Tax revenue is a transfer from consumers and producers to the government.
• Deadweight loss occurs from loss of quantity sold.
E1
Tax revenue = 5 million
($0.20 *25 million)
Tax $0.20
40
D
20
0
5
10
15
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20
25
30
35
40
45
Quantity of Whizbangs (millions)
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Active Learning: Tax revenue and surpluses
Suppose the government imposes a $1 tax that sellers must pay. Estimate the tax revenue, deadweight loss, and differences in consumer and producer surplus if the before‐tax consumer surplus is 11.25 billion and before‐tax producer surplus is 11.25 billion. Price ($/gal.)
S
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
D
5
10
15
20
25
30
35
Quantity of milk (billions of gals.)
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Effects of a tax paid by the buyer
Suppose the government imposes a $0.20 tax on each unit sold, which the buyer must pay. What effect does this have on the market?
• The new demand curve is $0.20 lower, the amount of the tax.
• Taxes drives a wedge between the buyer’s price and the seller’s price.
• The equilibrium quantity decreases from 30 million to 25 million.
Price (¢)
80
S
Buyers pay 60¢ 60
with 20¢ in taxes
Tax Wedge
E1
Sellers receive 40¢ 40
E2
D1
20
D2
0
5
10
15
20
25
30
35
40
45
Quantity of Whizbangs (millions)
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Effects of a tax on buyers and sellers
Regardless of whether a tax is imposed on buyers or sellers, there are four identical effects resulting from taxes:
• Equilibrium quantity falls.
• Buyers pay more per unit purchased and sellers receive less.
– A tax wedge forms, equal to the difference between the price paid by buyers and the price received by sellers.
• The government receives revenue equal to the amount of the tax multiplied by the new equilibrium quantity.
• The tax causes a deadweight loss.
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Tax incidence
Suppose the government imposes a $0.20 tax on each unit sold, which the seller must pay. Who bears the burden, or tax incidence, of a tax?
• Tax incidence is equal to the loss in consumer and producer surplus going to tax revenue.
• Whichever side of the market is more price elastic will shoulder less of the burden.
Price (¢)
S2
Price (¢)
S2
Buyers pay 54¢
sellers receive 34¢
S1
60
S1
Price (¢)
S2
66
S1
54
D
40
46
D
D
34
Buyers pay 66¢,
sellers receive 46¢.
Buyers pay 60¢
sellers receive 40¢
25 30
Quantity of Whizbangs (mil.)
Equal incidence – The sellers’ tax burden is equal to the buyers’ tax burden.
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Quantity of Whizbangs (mil.)
22 30
Quantity of Whizbangs (mil.)
Sellers pay more – The Buyers pay more – The sellers’ tax burden is greater sellers’ tax burden is less than the buyers’ tax burden. than the buyers’ tax burden.
Sellers’ tax burden
Buyers’ tax burden
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Subsidies
• Using the case of tortillas in Mexico, rather than using price controls, what would happen if the government subsidized them?
• Subsidies have two primary effects.
– Encourages production and consumption of the good that is subsidized.
– Government provides money through the subsidy to producers who continue to sell the good.
• A subsidy will increase consumption of the good.
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Subsidies
Suppose the government imposes a $0.35 subsidy on each unit sold, which the seller receives. What effect does this have on the market?
Price (¢/lb.)
S1
S2
88
70
E1
• The new supply curve subtracts $0.35 from all prices, the amount of the subsidy.
– Buyers pay $0.53.
– Sellers receive $0.88.
E2
53
• The equilibrium quantity increases from 50 million to 62 million.
D
50 62
Quantity of Tortillas (millions of pounds)
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Government intervention: A summary
The following table summarizes the effect of all four government policies analyzed in this chapter.
Intervention
Price floor
Reason for using
Effect on price
Effect on quantity
Who gains and who loses?
To protect producers’
income
Price cannot go
below the set
minimum.
Quantity demanded
decreases and quantity
supplied increases,
creating excess supply.
Producers who can sell all
their goods earn more revenue
per item; other producers are
stuck with an unwanted excess
supply.
To keep consumer
costs low
Price cannot go
above the set
maximum.
Quantity demanded
increases and quantity
supplied decreases,
creating a shortage.
Consumers who can buy all the
goods they want benefit; other
consumers suffer from shortages.
Tax
To discourage an
activity or collect
money to pay for its
consequences; to
increase government
revenue
Price increases.
Equilibrium quantity
decreases.
Government receives increased
revenue; society may gain if the
tax decreases socially harmful
behavior. Buyers and sellers of
the good that is taxed share the
cost. Which group bears more
of the burden depends on the
price elasticity of supply and
demand.
Subsidy
To encourage an
activity; to provide
benefits to a certain
group
Price decreases.
Equilibrium quantity
increases.
Buyers purchase more goods
at a lower price. Society may
benefit if the subsidy encourages
socially beneficial behavior . The
government and ultimately the
taxpayers bear the cost.
Price ceiling
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How big is the effect of a tax or subsidy?
Can the effect of a tax or subsidy on the equilibrium quantity be predicted ahead of time?
• Yes, if the price elasticity of supply and demand are known.
• The more elastic the supply or demand is, the greater the change in quantity.
Suppose there is a $0.20 tax paid by the seller.
S2
Price (¢)
80
S1
Price (¢)
Price (¢)
Price (¢)
80
S2
S1
60
60
40
40
20
S2
80
60
D
20
S1
40
80
S2
60
S1
D
40
D
20
20
D
0
10 20 30 40
0
10 20 30 40
Quantity of Whizbangs (millions) Quantity of Whizbangs (millions)
Inelastic supply and
demand:
Equilibrium quantity
decreases by 3 M.
Inelastic supply and elastic
demand:
Equilibrium quantity
decreases by 7 M.
0
10 20 30 40
10 20 30 40
0
Quantity of Whizbangs (millions)
Quantity of Whizbangs (millions)
Elastic supply and inelastic
demand:
Equilibrium quantity
decreases by 4 M.
Elastic supply and demand:
Equilibrium quantity
decreases by 20 M.
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Long‐run versus short‐run impact
The effect of a government intervention may be lagged.
• One example is gasoline and price controls of gasoline.
• Because buyers and sellers take time to respond to changes in price, sometimes the full effect of price controls becomes clear only in the long‐run.
Price ($)
Price ($)
Excess supply
Excess supply
S
S
Price
floor
Price
floor
D
D
Gasoline (billions of gals.)
Gasoline (billions of gals.)
In the short run, driving habits are difficult to change and producers take time to increase production.
Effect on quantity is small.
In the long run, driving habits can be changed and producers can increase production.
Effect on quantity is large.
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Summary
• Basic tools for understanding government interventions were introduced:
– Price controls (floors and ceilings).
– Taxes/subsidies.
• Determining whether the direct supply, demand, or both should shift.
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