NEU Business School

E-BBA Program

Topic 4
Market efficiency and
Government Intervention:
Tax and price controls

Lecturer: Dr. Tran Thi Hong Viet.

 Consumer Surplus (CS) and
Producer Surplus (PS)
P ($)
A
Consumer Surplus (CS): The
maximum amount a consumer is 16 S
willing to pay minus the price 14
MC
paid 12
= 6 $+4$+2$+0$ = 12$
Pe=10 E

8
Produce Surplus (PS): The
6
market price minus the
D
producer’s willingness to accept 4
= 6 $+4 $+2$+0$= 12$ MU
B
Q
1 2 3 4
 Market Equilibrium and
Efficiency
• NSB= CS+PS
Net Social Benefit (NSB) or Total Surplus
equals consumer surplus (CS) plus Producer
Surplus (PS), reflecting market efficiency

• At market equilibrium (assume that

market is perfect competition), NSB is
maximum, where market is efficient
(allocative and productive efficiency)
 Price controls:
Price Ceiling & Price Floor
P P
S Surplus S
P1

pE E PE E

P1 D D
Shortages Q Q
QA QB QM QN

What ?
Why ?
Example? After set price controls, what
Effects? the G should do ?
Problems?
 Price Ceilings and
Shortages
• What? Price ceiling is the maximum legal price a
seller may charge for a product or service, below
equilibrium price.
• Why? To support buyers
• Example?
– Pharmacy/ Wartime price controls
– Rent controls
• Effects? Price ceilings result in shortages
• Problems ? Reduce efficiency of the market
– Black market, price shock
– Shrink NSB
– Rationing problem
– Quality problem
Price Ceilings (Maximum Price)
P D S

The result of
imposing a
legal price
P ceiling is a...
Pc

S
D
Q
Qs Qe Qd
 Price Ceilings (cont.)
P D S
Price
shock

P’

P Legal Price Ceiling

Pc
S Shortage
D
Q
Qs Qe Qd
How a Ceiling price reduce NSB ?
P
A

At Pe:
S
CS= dt AE Pe B
PS= dt Pe EC
NSB= dt AEC
Pe E
At Pc:
Cs= dt ABIPc
PS= dt PcIC Pc I
NSB= dt ABIC D

So, Deadweight loss C

Q
DL= dt BEI
2 4
Price floor/Supports and
Surpluses
• What? Price support or ‘price floor’ is a
minimum price fixed by government, above
equilibrium prices
• Why? To support producers
• Example?
– Agricultural support prices
– Minimum wage legislation
• Effects? Price support results in surpluses
• Problems ? Reduce efficiency of market
– Price drop
– Shrink NSB
– Unemployment/crime
 Price floor and Surpluses
P (Minimum Price)
D S

Surplus
Pf

Pe Legal Price
Support
P’
Price drop S D
Q
Qd Q Qs
 APPLICATION

How does a minimum price (floor price) affect

the market?

Why is the U.S. government storing billions of pounds of

powdered milk in warehouses and caves?

• The minimum price for powdered milk is $9.90 per hundred

pounds.

• To prevent the market price from falling below $9.90, the U.S.
government purchases any resulting surpluses at this price.

• In recent years, the market demand for powdered milk has been
relatively low, so the government has purchased millions of
pounds of powdered milk.

• In the last year, the government’s stockpile of powdered milk

reached 1.28 billion pounds.

Why doesn’t the government just give all its powdered milk away?
Tax and it’s Impact analysis
by Elasticity concept

• What is effect of sales/excise tax to Price

?
• Who really pays/ bears the burden of tax
(tax incidence)? Buyers or Sellers?
Depends on Elasticity of demand and
supply
 Impact of Tax to price
P
5
4.5
Tax $1
4
3.5
3
Price ($ per bottle)

2 S1
D
S
1

0 5 10 15 20 25 30 35 40 Q
Quantity demanded (thousands of bottles/month)
 Incidence of a Sales Tax
P Tax $1
5
Consumer’s tax
4.5 incidence
4
3.5 Producer’s tax
3
incidence
Price ($ per bottle)

2 S1
D
S
1

0 5 10 15 20 25 30 35 40 Q
Quantity demanded (thousands of bottles/month)
Elastic Demand & Incidence
P Tax $1
5
Consumer’s tax
4.2 incidence
4
3.2
3 D
Price ($ per bottle)

2 S1 Producer’s tax
incidence
S
1

0 5 10 15 20 25 30 35 40 Q
Quantity demanded (thousands of bottles/month)
Inelastic Demand & Incidence
P Tax $1
5
4.8 Consumer’s tax
incidence
4
3.8 Producer’s tax
3
incidence
Price ($ per bottle)

2 S1

S
1
D

0 5 10 15 20 25 30 35 40 Q
Quantity demanded (thousands of bottles/month)
Tax Burden and Deadweight
Loss (DL)

The Deadweight Loss or
Excess Burden of a Tax

When the supply curve is

horizontal, a tax increases the
equilibrium price by the tax ($1
per pound in this example).

Consumer surplus decreases

by the areas B and C. Total tax
revenue collected is shown by
rectangle B, so the total burden
exceeds tax revenue by triangle
C. Triangle C is sometimes
known as the deadweight loss
or excess burden of the tax.
 APPLICATION

RESPONSE TO LOWER TAXES IN

FRENCH RESTAURANTS
How Does a Tax Cut Affect Prices?

In France, regular restaurants pay a 20 percent value-added tax (VAT) on sit-down

meals, while fast-food restaurants pay just a 5 percent tax on take-away meals. A
group of large restaurant owners made the following pledge. If the nation were to cut
its VAT rate on restaurant meals to 5 percent, the owners would

• cut the prices of restaurant meals by 5 percent;

• increase the wages paid to waiters and dishwashers by 10 percent.

The owners predicted that these changes would increase the quantity of restaurant
meals sold by 14 percent and increase restaurant employment by 40,000 workers.

Does the pledge of the restaurant owners make economic sense?

• Although the actual numbers in the owners’ pledge for lower prices and higher
wages may not be correct, the pledge is consistent with the economics of tax
shifting.