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Effects of Government Intervention Price Controls

Topic 3

Some

cases market forces are not allowed to determine equilibrium price and quantity authorities (Govt.)

Price Controls

Intervention by

Price Ceilings Price Floors Taxes

on on

Producers Consumers

A price ceiling is the maximum legal price a seller may charge for a good or service
P

Pe
Maximum price

D
O
fig

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Govt. sets the price LOWER than the equilibrium.

Price Ceilings

Why would they do this? What is the result? Who benefits? Who loses? What is likely to happen?

Why would they do it?

To

keep the price down to an acceptable level. wartime price controls may be imposed on essential items such as petrol, rice etc. To help the poor & the disadvantaged
During

What are the results?

P

Pe

maximum price

shortage

D
fig

Qs

Qd

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What are likely to happen?

Effects:

dealing with resulting shortages => rationing black markets

Effect of price control on black-market prices P

Pb
Blackmarketeers profits

Pe

Price ceiling

Pg

D O Qs Qd
fig

Gainers Consumers who are able to obtain supplies at the price ceiling

Gainers & Losers?

Losers: Consumers who cannot obtain supplies (even though they are willing to purchase at the equilibrium price )

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Price Controls- Consumer Surplus & Producer Surplus

Originally
CS = A+B PS = C+E+F

After Price ceiling

CS = A+C PS = F

What about B & E?

net loss in total surplus

Price Floors

A price floor is the minimum price set by the govt for a good or service Govt. sets the price floor HIGHER than the equilibrium Why would they do this? What is the result? Who benefits? Who loses? What is likely to happen?

To

support prices (income) in important sectors of the economy (eg. Agriculture). To protect workers (eg. minimum wages)

Why does the government do it?

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What is the impact?

P

S
minimum price

surplus

Pe

D
O

Qd

Qs

fig

Losers: Gainers Consumers who have to Suppliers who receive higher price per unit and pay higher prices for the probably, higher income. goods.
Workers

Gainers & Losers?

who are in job receive a higher wage

Workers

who were previously working, are now unemployed

Price Controls, CS & PS (contd.)

Originally
CS = A+B+C PS = E+F

After Price floor

CS = A PS = C+F

What about B & E?

net loss in total surplus

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Taxes on Producers
Supply curve shifts up
vertical shift = amount of tax

Equilibrium price increases, equilibrium quantity decreases Notice the difference in amount of tax and increase in price. As elasticity of demand and supply vary, the burden changes

Taxes on Producers

Effects of imposing tax on producers:

P
Tax

S1

E1
Consumers tax burden
Producers tax burden

So

E0 D Q1 Q0

Consumers tax burden > Producers tax burden if Demand is relatively inelastic

Taxes on Producers

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Taxes on Producers

Taxes on producers

Taxes on Producers

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Taxes on Consumers Demand curve shifts

down
vertical shift = amount of tax

Equilibrium price decreases, equilibrium quantity decreases Notice the difference in amount of tax and decrease in price. As elasticity of demand and supply vary, the burden changes

Elasticity and Tax burden

- Summary

Deman d Supply

Elastic Producer Consumer

Inelastic Consumer Producer

So, the burden of tax is not affected by who it is levied on (producer or consumer). It is affected by the elasticities of demand & supply

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The Effect of a Tariff

Sdom

Ddom & Sdom show the domestic demand and supply for a good. If the world price is Pw, and there is free trade,

Pw+ T

Pw

At a domestic price Pw + T, where T is the size of the tariff, quantity of domestic demand falls to Qd', quantity of domestic supply rises to Qs' and imports fall.

Qs Qs'

Qd' Qd Quantity

domestic firms supply Qs, domestic demand is Qd and the difference is imported. Ddom A tariff can stimulate domestic supply and restrict imports.

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The Welfare Costs of a Tariff

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The tariff leads both to transfers and net social losses. Consumer surplus is decreased by the area between Pw+T, Pw and D. S
The government raises revenue i.e. there is a transfer to the government, and there is a transfer in the form of extra profits to producers.

Pw+ T

Pw

D
Qs Qs' Qd' Qd Quantity

There is also dead-weight loss from consumption inefficiency.

There is a social deadweight cost from production inefficiency, given that the good could be imported at Pw.

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Optimal Tariff
Lets

assume that country A is an economically large country (a large world importer of a product L) Country B exports product L. Lets consider the situation under free trade and after an import tariff is imposed by country A.

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International Free-trade Equilibrium

Husted/Melvin, 2001, Addison Wesley Longman, Inc. All rights reserved.

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Illustration of a Tariff for a Large Country

Husted/Melvin, 2001, Addison Wesley Longman, Inc. All rights reserved.

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Welfare

Cost of a tariff Imposed by a large Country -$a -$b -$c -$d

in CS in PS in G revenue

$a $c -$b +$e -$d +$e

Net welfare change

Optimal tariff would max $e - $(b + d)

Comparison of the Effects of Import Tariffs and Production Subsidies

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Domestic

production can also be increased and imports reduced through the use of a production subsidy

Actually

, temporary production subsidies rather than import tariffs are sometimes suggested by economists

WHY?

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Let's

compare the effects of these two trade restrictions on the welfare of the society = dead weight loss
(a) Tariff (b) Subsidy
Price Sdom Sdom Sdom+ s

Price

P P

Sw + t Sw

P+ s P Sw Ddom Qs

Ddom Qs Qsd Qd Quantity Qs Qd

Quantity

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Export subsidies
"commercial

policy to boost exports"

Exports

Price

Sdom B Sw+ s F Sw

P P C

A G E

Ddom Qd Qd Qs Qs Quantity

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Export subsidies contd

Under

free trade, consumers demand Qd, production is Qs, and exports are GE. With a subsidy on exports alone, domestic producers will restrict supply to the home market to Qd so that home consumers pay P, the same as producers can earn by exporting. Total output is Qs, and exports AB. Area EFB shows the social cost of producing goods whose marginal cost exceeds the world price for which they are sold. Area CGA shows the social cost of restricting consumption when marginal benefits exceeds the world price of the good

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