Chapter 15

Market Interventions

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics
The effect of a tax or subsidy Policies designed to raise prices Import tariffs and quotas

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Taxes
A specific tax is a fixed dollar amount that must be paid on each unit bought or paid An ad valorem tax is a tax that is stated as a percentage of the goods price The incidence of a tax indicates how much of the tax burden is borne by various market participants In studying the effects of taxes its important to distinguish between the amount a consumer pays for a good and the amount a firm receives
Use Pb for the amount a consumer pays, Ps for the amount a firm receives If the tax is T per unit, then Ps = Pb - T
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The Burden of a Tax

Consider the effect of a specific tax of T dollars per gallon paid by gas stations on their sales of gasoline Graphically, there are three ways to determine the taxs effect:
Shift the supply curve up by T Shift the demand curve down by T Use a wedge between the amounts consumers pay and firms receive

All three methods yield the same results Makes no difference whether the tax is levied on consumers or producers
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Effects of a Specific Tax

Shifting the supply curve is one way to determine a specific taxs effects Demand curve remains unchanged For any price paid by consumers, firms now receive less than when there is no tax
Wont be willing to supply as much as before Supply curve with the tax is a distance T above the original supply curve

New equilibrium price paid by consumers is price at which the demand curve and new supply curve cross
Amount bought and sold falls Price paid by consumers rises; price received by firms falls

In a competitive market the burden of a tax is shared by consumers and firms

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Figure 15.1: Effects of a Specific Tax Shifting the Supply Curve

ST

Price Paid by Consumers ($/gallon)

Increase in Consumer Cost per Gallon

S Po + T Pb Po Ps = Pb - T B
T

Decrease in Firms Receipts per Gallon

D QT Qo

Gallons of Gas per Month

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Tax Incidence
Incidence of a tax depends on the shapes of the demand and supply curves In general, the more elastic is demand and less elastic is supply, the more of the tax is borne by firms

Es Consumers' share of tax = s d E E

Consumers bear the larger share of the tax when demand is less elastic than supply

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Figure 15.2: Incidence of a Specific Tax Two Special Cases

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Figure 15.3: Effects of a Specific Tax Shifting the Demand Curve

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Welfare Effects of a Tax

Use the no-tax demand and supply curve to measure aggregate surplus in the absence of a tax The tax reduces the amount bought and sold to the quantity at which the distance between the supply and demand curves is T Since quantity bought and sold is higher without the tax, so is aggregate surplus To see the welfare effect of the tax, compute the difference in aggregate surplus at the quantities with and without the tax The deadweight loss of taxation is the lost aggregate surplus due to a tax

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Welfare Effects of a Tax

Welfare effects can be used to assess winners and losers from a tax or other policy Graphical analysis of a tax shows:
Consumers and producers both lose, government gains tax revenue Society overall loses (deadweight loss)

Taxation can be used to move resources from the private sector to the government
But the government receives less than private parties give up Effect of a tax on welfare depends on what is done with the revenue

Use algebra to compute the value of deadweight loss from a tax

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Figure 15.6: Welfare Effects of a Specific Tax

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Which Goods Should be Taxed?

Size of the deadweight loss from taxation of a good depends on the shapes of the demand and supply curves
If supply or demand is perfectly inelastic, for example, there is no deadweight loss The tax doesnt change the quantity bought and sold

If either supply or demand is very inelastic, deadweight loss caused by a tax will be low
Implies the government should aim to tax good for which the deadweight loss from taxation will be low

If two goods have equal and constant marginal cost, the good with less elastic demand should face a larger tax Distributional considerations can also affect the choice of goods to tax
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Figure 15.8: Taxation with No Deadweight Loss

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Sample Problem 1 (15.1):

The market demand function for corn is Qd 15 2P and the market supply function is Qs = 5P -2.5, both measured in billions of bushels per year. Suppose the government imposes a $2.10 tax per bushel. What will be the effects on aggregate surplus, consumer surplus and producer surplus? What will be the deadweight loss created by the tax?

Subsidies and Their Effects

A subsidy is a payment that reduces the amount that buyers pay for a good or increases the amount that sellers receive Subsidies can be either specific or ad valorem (like taxes) Often result from lobbying efforts
Usually increase sales of the affected goods Cause deadweight loss

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Subsidies and Their Effects

Consider the effect of a government subsidy of T dollars for each gallon of ethanol produced Can find the equilibrium with the subsidy by:
Shifting supply curve down by T Shifting demand curve up by T Looking for the quantity at which the demand curve lies a distance of T below the no-subsidy supply curve

Consumers pay T dollars less than firms receive Subsidy increases the amount bought and sold
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Welfare Effects of Subsidies

Welfare analysis of a subsidy shows consumers and producers both gain The sum of the reduction in price to consumers and the increase in price to firms exactly equals the size of the subsidy
The side of the market whose demand or supply is less elastic has a larger price change

Aggregate surplus falls

This is because the government incurs an expense, the per-unit subsidy times the number of units sold
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Figure 15.9: Deadweight Loss of a Subsidy

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Policies Designed to Raise Prices

Governments often attempt to manipulate markets to benefit a particular group When they want to help sellers in a market, they turn to policies meant to raise prices A price floor establishes a minimum price that sellers can charge A price support program raises the market price by making purchases of the good, increasing demand Production quotas impose limits on the quantity that individual firms can produce Voluntary production reduction programs offer firms inducements to decrease their output voluntarily
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Figure 15.12 (a): Price Floor

A price floor establishes a minimum price that sellers can charge With minimum price of P, quantity bought and sold is Q1

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Figure 15.12 (b): Price Support

A price support program raises the market price by making purchases of the good, increasing demand Here, total sales are Q2:
Government purchases Q2Q1 Private buyers purchase Q1 Price is P

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Figure 15.12 (c): Production Quota

Production quotas impose limits on the quantity that individual firms can produce Total sales of Q1 are achieved through a production quota Could also be achieved through a voluntary reduction program
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Welfare Effects of Policies for Raising Prices

Compare all four policies, each raising the price of milk from P0 to P1 All create deadweight loss Price support program is least efficient
Causes unused milk to be produced

Other three policies create equal deadweight loss Price floor and production quota have same effects
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Figure 15.13: Welfare Effects of Policies for Raising Prices

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Figure 15.13: Welfare Effects of Policies for Raising Prices

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Policies that Lower Prices

Sometimes governments adopt policies that are designed to lower prices
To improve the well-being of buyers Example: rent control laws

Reduces amount of the good available for purchase

Creates deadweight loss

Because buyers cant purchase all they want at the ceiling price, they may behave inefficiently
Increases deadweight loss Example: extreme searching for rent-controlled apartments

Sellers have an incentive to inefficiently degrade the quality of their products

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Figure 15.16: Price Ceiling

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Sample Problem 2 (15.12):

Suppose that the demand function for pizzas is Qd = 65,800 1,200P and the supply function is Qs = 4,000P 20,000. Suppose the College Student Party is elected and places a price ceiling on pizza of $10 per pizza. How many pizzas will be bought and sold? Assuming that the highest willingness to pay consumers are the ones to consume the supplied pizzas, what will the effect be on the aggregate, consumer, and producer surplus?

Import Tariffs and Quotas

Many countries use tariffs or quotas to discourage imports
Example: the U.S. imposes a tariff on frozen orange juice

A tariff is a tax on imports

A tariff is a tax on sellers in a market But only on foreign sellers

A quota directly limits the total quantity of a good that can be imported In some cases governments use a mix of tariffs and quotas
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Tariffs
Analyzing the effects of a tariff, T, assume that the country consumes a small share of the worlds production of the good
Doesnt affect world price, Pw Import supply curve is horizontal at Pw

Tariff shifts the import supply curve upward by the distance T

Foreign firms must now sell their goods for Pw + T Price to domestic consumers rises, domestic consumption falls Amount sold by domestic producers increases Imports decline
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Figure 15.17: Effects of a Tariff

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Welfare Effects of Tariff

The domestic government is concerned with domestic aggregate surplus: the sum of consumer surplus, domestic producer surplus, and government revenue Under the tariff:
Consumers are worse off Domestic consumers are better off Government receives revenue equal to the quantity of imports times the amount of the tariff Domestic deadweight loss arises from reduction in total consumption

The tariff allocates production inefficiently away from foreign producers to domestic producers
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Figure 15.18: Welfare Effects of a Tariff

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Sample Problem 3 (15.14):

The market demand function for corn is Qd 15 2P and the market supply function is Qs = 5P -2.5, both measured in billions of bushels per year. Suppose the import supply curve is infinitely elastic at a price of $1.50 per bushel. What would be the welfare effects of a $0.50 per bushel tariff?

Quotas
A quota limits the supply of imports to some maximum quantity The government can use either a quota or a tariff to achieve a desired outcome of imports and domestic price
Consumers and domestic firms are both as well off with the quota as with the tariff Difference is that government revenue is zero under the quota Instead, revenue is earned by foreign firms lucky enough to import their goods Quota has lower domestic aggregate surplus than tariff

If government allocates import rights to domestic firms, domestic firms producer surplus would increase
Domestic aggregate surplus would be the same for quota and tariff
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Figure 15.19: Effects of a Quota

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