Lecture 3:

Government Interventions
(Supply & Demand)
ECO 101: INTRODUCTION TO MICROECONOMICS
This Week’s Class
◦Lecture:
◦ What is consumer & producer surplus and how do they relate to efficiency?
◦ How do price controls work? (& when do they?)
◦ How do taxes affect Supply & Demand?
◦ Who pays these taxes?
◦Tutorial:
◦ Calculating Total Surplus
◦ Tax Incidence and the equivalence between taxing buyers and sellers
Market Efficiency
◦Going to start with two ideas of surplus:
◦ Producer Surplus
◦ Consumer Surplus
◦The idea of Total Surplus will be our measure of efficiency:
𝐓𝐨𝐭𝐚𝐥 𝐒𝐮𝐫𝐩𝐥𝐮𝐬 = 𝐂𝐨𝐧𝐬𝐮𝐦𝐞𝐫 𝐒𝐮𝐫𝐩𝐥𝐮𝐬 + 𝐏𝐫𝐨𝐝𝐮𝐜𝐞𝐫 𝐒𝐮𝐫𝐩𝐥𝐮𝐬

◦We’ll define each of these in turn graphically.

◦It’ll all make sense. Stay with me.
 p Why do we think free markets are efficient?
◦Where is the free market
equilibrium? (i.e. p* & Q*)
S
◦What is CS, PS, & TS?
◦ PS similar to profits (MC).
◦ CS is gap between WTP and
p!∗ price actually paid.
◦I will show you that:
D ◦ If 𝑝 > 𝑝!∗ , TS is reduced.
◦ If 𝑝 < 𝑝!∗ , TS is also reduced.
◦This shows that the free
market equilibrium actually
Q maximises Total Surplus.
Q∗!
Price Controls
◦Sometimes the Government intervenes to control
prices.
◦Price Ceiling: A restriction that the price cannot go above
a certain level. Any examples?

◦Price Floor: A minimum price that must be paid for the

good.
 Price Controls
p S ◦Price Controls (when
Surplus =
binding) prevent the
(Q3 – Q2) market from clearing.
p# Price Floor Generates either:
Q2 Q3 ◦ Surpluses: A surplus occurs
p!∗ when the price is kept high,
and supply exceeds demand.
Q4 Q5
(QS > QD)
Price Ceiling
p$ ◦ Shortage: A shortage occurs
Shortage = when the price is kept low,
(Q5 – Q4)
D
and demand exceeds supply.
Q (QS < QD)
p
What are the equilibrium effects of a price ceiling?
A
◦Suppose that the
Government sets a price
B C S ceiling such that p ≤ p2?
◦ What happens to p* & Q*?
F
∗ D
p!
E ◦ What happens to CS & PS?
◦ What happens to TS?
G H
p$ ◦ Where is the DWL?
D
◦Does this generate a
I
shortage or a surplus?
◦Who wins and who loses
Q from this policy?
Q$ Q∗!
 p Non-Binding Price Ceilings
◦What if instead, the
Government sets a price
S ceiling such that p ≤ p3?
p#
◦ What happens to p* & Q*?
p!∗ ◦This is called a non-binding
price ceiling.
D
◦In the case where the ceiling
is above p*, it is non-binding
and nothing changes.
◦The example before (p ≤ p2)
Q has a binding price ceiling.
Q∗!
 The Example of Rent Controls
Rent ◦ Rent controls is a famous and
common application.
◦ In the housing market:
◦ Demand = renters
◦ Supply = landlords
◦ Inelastically supplied in the
R∗! short-run.
◦ More elastic in long-run.
◦ Why is this difference in
elasticities so?
◦ This is (loosely) how urban
economists actually think
about urban S&D.
Q∗! Housing
 How Rent Controls Affects the Housing Market
Rent ◦ Rent controls acts as a price
ceiling.
◦ This leads to a shortage of
housing in the short-run.
◦ Again – winners and losers.
◦ In the long-run, the supply
declines more dramatically.
R∗! ◦ Rent controls can exacerbate
housing shortages over time.
◦ Rent controls do act as a large
distortion.
◦ Access to affordable housing is
an important issues – it just is
tough.
Q∗! Housing
 The Black Market
p ◦ Price Ceilings can be tricky to
S enforce.
◦ Some demand remains unserved,
p# who would buy at the
equilibrium price.
◦ Sellers can then turn to the black
p!∗ market (or called the informal
economy) to meet this demand.
Price Ceiling ◦ Can sell to rest of excess demand at
p$ ∗
p3 (even higher than p! ).
◦ These controls are only powerful
D if they can be enforced.
Q$ Q∗! Q
p
What are the equilibrium effects of a price floor?
A
◦Intuitively the same
approach as a price ceiling.
p# B C S ◦Suppose that the
Government sets a price
∗ D
p!
E F
ceiling such that p ≥ p3?
(Note: binding)
G H
p$ ◦ p & Q?
D
◦ CS?
I
◦ PS?
◦ TS?
Q ◦ DWL?
Q$ Q∗!
 w
The Example of Minimum Wage
◦ In the labour market:
◦ Demand = Firms
◦ Supply = Workers
◦ Price = wage rate (w).
Price Floor ◦ Minimum wage is a price floor.
◦ Does it create a surplus or
w!∗ shortage?
◦ Who are the winners and losers?
◦ What needs to be true for only a
minor employment reduction?
◦ More about the debate in this
week’s podcast!
L∗! L
 w
Does the minimum wage create unemployment?
◦ Unemployment: workers who
S want to work but cannot find it.
Unemployment
◦ Need to be in the labour force.
Labour ◦ More in Macro next semester.
Decline
Price Floor ◦ The concern with minimum
wages is in the decline of
employment.
w!∗ ◦ How big is the decline in
employment?
◦ Labour Decline: L∗! − L#
◦ How big is unemployment?
D ◦ Unemployment:L$ − L#
L
◦ Is there unemployment at w!∗ ?
Quotas
◦Quotas are similar to price controls, but with the
limitation on Q in stead of p.
◦A quota is a limit (maximum) on the quantity of goods
that may be traded.
◦ An example is that Q ≤ Q2.
◦Some examples include:
◦ Canadian dairy.
◦ Urban taxi drivers (pre-Uber/Lyft!).
p
What are the equilibrium effects of a quota?
A
◦Intuitively the same
approach as price controls.
S
◦Suppose that the
p# B C
Government sets a Quota
E F such that Q ≤ Q2?
∗ D
p! ◦ p & Q?
G H ◦ CS?
D ◦ PS?
◦ TS?
I
◦ DWL?
◦Note this quota is binding if
Q it is below Q*.
Q$ Q∗!
 p
Calculating CS, PS, & TS
p#
𝐻𝑒𝑖𝑔ℎ𝑡 ∗ 𝐵𝑎𝑠𝑒
𝐶𝑆 =
2
S 𝑝# − 𝑝!∗ 𝑄!∗ − 𝑄$
𝐶𝑆 =
2
p!∗
𝐻𝑒𝑖𝑔ℎ𝑡 ∗ 𝐵𝑎𝑠𝑒
𝑃𝑆 =
D 2
𝑝!∗ − 𝑝$ 𝑄!∗ − 𝑄$
𝑃𝑆 =
2
p$
Q 𝑇𝑆 = 𝑃𝑆 + 𝐶𝑆
Q$ Q∗!
10-minute Break
Excise Taxes
◦Excise taxes are a per-unit tax collected by the government
at the point of sale.
◦This means that the full price a buyer must pay for one unit
of a good is both the seller’s price and this per-unit tax.
◦What is the point of taxation? Why does the Government
do it?

◦Some examples?
 P
How do Excise Taxes work?
◦ Suppose that there is now an excise
tax of “t”.
◦ We can no longer stay in
equilibrium. (Q*,p*)
S
C ◦ The consumer receives the
p# consumer price (pc = p3).
A
p!∗ ◦ The supplier receives the seller
price (ps = p2).
p$ ◦ 𝒑𝒄 = 𝒑𝒔 + 𝒕
B
D ◦ Q will decrease until the vertical
difference between supply and
demand = t.
◦ Q decreases to Q∗#.
◦ The difference between prices is the
Q tax (t).
Q∗$ Q∗!
 p An Alternative Formulation
◦ Suppose a $2 tax on producers.
◦ Supply will decrease, for any given
seller price.
C S ◦ The seller price will now get to keep
p# $2 than the consumer price.
A ◦ The seller price is $2 lower.
p!∗
◦ What about a $2 on consumers.
p$ ◦ Demand will decrease, for any
B given seller price.
D
◦ The consumer must pay the seller
price and tax.
◦ Their price is $2 higher.
Q ◦ Delivers same Q* and prices as
previous slide.
Q∗$ Q∗!
p An Alternative Formulation
◦Again, a tax of $10.
◦Suppose also:
◦ D: 𝑄 = 100 − 𝑝
◦ S: 𝑄 = 4𝑝
◦Can solve it by finding the $10
gap between D & S.
◦Can do a tax on producers by
affecting supply.
◦Can do a tax on consumers by
affecting demand.
Q
 p Who pays this tax?
◦The idea of tax incidence is
how is this tax shared
between sellers and buyers?
S
p#
◦But I said the buyer is
explicitly paying the tax, so
p!∗ 𝑡 how is the seller paying?
p$ ◦ Note that the equilibrium seller
price has dropped.
D ◦ & The equilibrium buyer price
has not risen by the full “t”.
◦Buyer’s incidence: p! − p"∗
∗
Q ◦Seller’s incidence: p" − p$
Q∗$ Q∗!
 p Does it matter who we tax? (Spoilers: No)
◦ Can tax either consumers
(demand) or suppliers.
◦ The gap between supply and
S demand needs to be equal to
p# the tax (𝒕).
p!∗ 𝑡 ◦ Note, it is not clear if the sale
“sticker price” need include the tax
p$ – typically it does.
D ◦ If tax supply: “Higher” p includes tax.
◦ If tax demand: “Lower” p does not.
◦ Ultimately, if we tax supply or
demand, Q* will be the same.
◦ And the incidence will also be the
same.
Q∗$ Q∗! Q
p How do Excise Taxes affect Total Surplus?
A

TR = tQ∗$ ◦Now at new equilibrium at

𝑝$∗ and 𝑄$∗ .
p# − p∗$ = t
B C S ◦What price does the buyer
p# face? Where is the CS?
F
∗ D
p! E ◦What price does the seller
p$ get? Where is the PS?
D ◦How much tax revenue (TR)
G H

does the government raise?

I ◦Is there any Deadweight
Loss? Where?
Q
◦ Referred to as distortion.
Q∗$ Q∗!
 p How does Elasticity affect tax incidence?
◦Start with our current
example.
Buyer incidence
S
p#
p!∗ 𝑡
p$
Seller incidence D

Q
 p How does Elasticity affect tax incidence?
D ◦Start with our current
example.
p# ◦What would happen if
Demand was very inelastic
p!∗ S
p$
and Supply was very elastic?

Q
p How does Elasticity affect tax incidence?
S ◦Start with our current
example.
◦What would happen if
Demand was very inelastic
p# and Supply was very elastic?
p!∗ ◦What about if Demand was
very elastic and Supply was
p$ D very inelastic?
◦Those who are least
responsive to price (i.e. more
inelastic) end up with most
Q of the tax burden – and lose
the most surplus.
Subsidies
◦Subsidies are essentially a negative tax.
◦The government provide suppliers with a fixed payment for
each unit purchased.
◦Why might the government subsidize something?

◦What are some examples of government subsidies?

p How do subsidies work?
◦ Suppose that there is now an
subsidy of “s”.
◦ So instead of paying p* in
S equilibrium, a consumer is
p# actually paying (p*-s).
p∗ s ◦ If levied on consumer.
p$ ◦ Therefore, the gap between
supply & demand to again be
D equal to “s”.
◦ What is the seller price?
◦ What is the consumer price?
Q ◦ Difference made up by subsidy.
Q∗
p Surplus Under Subsidies
A
◦The surplus under subsidies is
more graphically complicated.
S
◦What is Producer Surplus in
B C J this example?
F ◦ Recall the PS is the difference
∗ D E
p s between the seller price and S.
G H K
◦What is Consumer Surplus in
this example?
D
◦ CS is the difference between D &
consumer price.
I
◦Note here there is overlap.
Q ◦Gains in TS = BGKFJ? No!
Q∗ ◦ Note BGHFC is duplicated.
p Surplus Under Subsidies
A
◦ Large gain in surplus (BGKFJ).
◦ So should we be subsidizing
everything?
C
S ◦ Maybe (prob not) <- normative
B J

F ◦ Do subsidies increase Total

∗ D E
Surplus?
p DWL s
G H ◦ No. Why not?
K
D ◦ Subsidy costs society = s*Q∗
#
◦ Therefore cost of BGKJ.
I
◦ Net loss (DWL) of FJK.
Q ◦ Not to say subsidies are not useful.
◦ Just do cause inefficiencies.
Q∗ Q∗$
Conclusion
◦We have covered a major measure of economic
welfare: Total Surplus (& CS & PS).
◦Evaluated some basic government policy and its
effects on Surplus.
◦Will continue to be an important tool going forward:
◦ International Trade (Next Week).
◦ Public Goods (The Week After).