Government intervention

MGEC Post Session 3 (Async)

DHM 1, 2021-22

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This session
• Price controls
• Price ceilings
• Price floors

• Price supports and production quotas

• Taxes and subsidies

• References from RP Ch 9 (excluding 9.5)

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 Evaluating the Gains and Losses
from Government Policies—
Consumer and Producer Surplus
Supply–demand analysis can be applied to a wide variety of economic problems—
problems that might concern a consumer faced with a purchasing decision, a firm
faced with a long-range planning problem, or a government agency that has to design
a policy and evaluate its likely impact.

We begin by showing how consumer and producer surplus can be used to study the
welfare effects of a government policy—in other words, who gains and who loses from
the policy, and by how much.

We also use consumer and producer surplus to demonstrate the efficiency of a

competitive market.

You will see how to calculate the response of markets to changing economic
conditions or government policies and to evaluate the resulting gains and losses to
consumers and producers.
Review of Consumer and Producer Surplus

FIGURE (1 OF 2)
CONSUMER AND PRODUCER
SURPLUS
Consumer A would pay $10 for a good
whose market price is $5 and therefore
enjoys a benefit of $5.
Consumer B enjoys a benefit of $2,
and Consumer C, who values the good at
exactly the market price, enjoys no
benefit.
Consumer surplus, which measures the
total benefit to all consumers, is the
yellow-shaded area between the demand
curve and the market price.
FIGURE (2 of 2)
CONSUMER AND PRODUCER
SURPLUS
Producer surplus measures the total
profits of producers, plus rents to factor
inputs.
It is the benefit that lower-cost producers
enjoy by selling at the market price,
shown by the green-shaded area between
the supply curve and the market price.
Together, consumer and producer surplus
measure the welfare benefit of a
competitive market.
 The Efficiency of a Competitive Market
● economic efficiency Maximization of aggregate consumer and
producer surplus.

MARKET FAILURE

● market failure Situation in which an unregulated competitive market is

inefficient because prices fail to provide proper signals to consumers and
producers.

There are two important instances in which market failure can occur:
1. Externalities
2. Lack of Information

● externality Action taken by either a producer or a consumer which affects

other producers or consumers but is not accounted for by the market price.

Market failure can also occur when consumers lack information about the
quality or nature of a product and so cannot make utility-maximizing purchasing
decisions. Government intervention (e.g., requiring “truth in labeling”) may then
be desirable.
Price controls

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 Price controls

When the government intervenes to regulate prices, it can do so in two ways:

• Price floor: when the government mandates that the price of a good X cannot be
below a lower limit
• Price ceiling: when the government mandates that the price of a good X cannot be
above an upper limit
Often the result of intense political pressure or lobbying
A market with a price ceiling

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Distortion caused by a (binding) price ceiling

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Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and producers.

● deadweight loss Net loss of total (consumer plus producer) surplus.

FIGURE
CHANGE IN CONSUMER AND
PRODUCER SURPLUS FROM A
BINDING PRICE CEILING
The price of a good has been regulated
to be no higher than Pmax, which is
below the market-clearing price P0.
The gain to consumers is the difference
between rectangle A and triangle B.
The loss to producers is the sum of
rectangle A and triangle C.
Triangles B and C together measure the
deadweight loss from price controls.
Application of Consumer and Producer Surplus

FIGURE
EFFECT OF BINDING PRICE CEILING
WHEN DEMAND IS INELASTIC
If demand is sufficiently inelastic,
triangle B can be larger than rectangle
A. In this case, consumers suffer a net
loss from price controls.
 Application PRICE CONTROLS AND NATURAL GAS SHORTAGES
Supply: QS = 15.90 + 0.72PG + 0.05PO
Demand: QD = 0.02− 1.8PG + 0.69PO

FIGURE
EFFECTS OF NATURAL GAS PRICE
CONTROLS
Assuming that Po is $50 per
barrel, the market-clearing
price of natural gas was $6.40
per thousand cubic feet (mcf),
and the (hypothetical)
maximum allowable price is
$3. A shortage of 29.1 − 20.6 =
8.5 Tcf results.
The gain to consumers is
rectangle A minus triangle B,
and the loss to producers is
rectangle A plus triangle C.
The deadweight loss is the
sum of triangles B plus C.
 Application PRICE CONTROLS AND NATURAL GAS SHORTAGES
FIGURE (supplement)
EFFECTS OF NATURAL GAS PRICE
CONTROLS

A = (20.6 billion mcf ) × ($3.40/mcf) = $70.04 billion

B = (1/2) x (2.4 billion mcf) × ($1.33/mcf ) = $1.60 billion
C = (1/2) x (2.4 billion mcf ) × ($3.40/mcf ) = $4.08 billion

The annual change in consumer surplus that

would result from these hypothetical price
controls would therefore be:
A − B = 70.04 − 1.60 = $68.44 billion.

The change in producer surplus would be:

−A − C = −70.04 − 4.08 = −$74.12 billion.

And finally, the annual deadweight loss.

would be:
−B − C = −1.60 − 4.08 = −$5.68 billion.
A market with a price floor

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Distortion caused by a price floor

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Welfare effects of price ceilings

FIGURE
WELFARE LOSS WHEN PRICE IS HELD
ABOVE MARKET-CLEARING LEVEL
(BINDING PRICE FLOOR)
When price is regulated to be no lower
than P2, only Q3 will be demanded.
If Q3 is produced, the deadweight loss is
given by triangles B and C.
At price P2, producers would like to
produce more than Q3. If they do, the
deadweight loss will be even larger.
 Minimum Prices

FIGURE
PRICE MINIMUM
Price is regulated to be no lower than
Pmin.
Producers would like to supply Q2,
but consumers will buy only Q3.
If producers indeed produce Q2, the
amount Q2 − Q3 will go unsold and the
change in producer surplus will be A − C
− D. In this case, producers as a group
may be worse off.

The total change in consumer surplus is: ΔCS = −A − B

The total change in producer surplus is: ΔPS = A − C − D (assuming that sellers produce Q2)
Note: the shaded trapezoid D i.e. area under the supply curve from Q3 to Q2 is the cost of producing
the quantity Q2− Q3 if producers do not cut production in response to unsold output.
 Minimum wage in labour market

FIGURE
THE MINIMUM WAGE
Although the market-clearing wage is
w0,
firms are not allowed to pay less than
wmin.
This results in unemployment of an
amount L2 − L1
and a deadweight loss given by triangles
B and C.
 Application AIRLINE REGULATION

Airline deregulation in 1981 led to major changes in the

industry. Some airlines merged or went out of business as
new ones entered. Although prices fell considerably (to the
benefit of consumers), profits overall did not fall much.

FIGURE
EFFECT OF AIRLINE REGULATION BY
THE CIVIL AERONAUTICS BOARD

At price Pmin, airlines would like to

supply Q2, well above the quantity Q1
that consumers will buy.
Here they supply Q3. Trapezoid D is the
cost of unsold output.
Airline profits may have been lower as a
result of regulation because triangle C
and trapezoid D can together exceed
rectangle A.
In addition, consumers lose A + B.
 Application AIRLINE REGULATION

What, then, did airline deregulation do for consumers

and producers? As new airlines entered the industry and
fares went down, consumers benefited. (The actual
benefit to consumers was somewhat smaller because
quality declined as planes became more crowded and
delays and cancellations multiplied.) As for the airlines,
they became so much more efficient that producer
surplus may have increased.

TABLE AIRLINE INDUSTRY DATA

1975 1980 1990 2000 2010
Number of U.S. carriers 36 63 70 94 63

Passenger Load Factor (%) 54.0 58.0 62.4 72.1 82.1

Passenger-Mile Rate (constant 1995 dollars) 0.218 0.210 0.149 0.118 0.094

Real Cost Index (1995 = 100) 101 145 119 89 148

Real Fuel Cost Index (1995 = 100) 249 300 163 125 342

Real Cost Index w/o Fuel Cost Increases (1995 = 100) 71 87 104 85 76
Summary of price controls
Price floor Price ceiling
Surpluses Shortages
Wasteful increases in quality Reduction in quality
Lost gains from trade (DWL) Lost gains from trade (DWL)
Misallocation of resources Misallocation of resources
Wasteful lines & other search costs

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Price supports and quotas

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 Price Supports and Production Quotas
Price Supports
● price support Price set by government above free-market level and
maintained by governmental purchases of excess supply.

FIGURE
PRICE SUPPORTS
In the United States, price supports
aim to increase the prices of dairy
products, tobacco, corn, peanuts, and
so on, so that the producers of those
goods can receive higher incomes.
Under a price support program, the
government sets a support price Ps
above the market-clearing price P0,
and then buys output required to keep
the market price at that level.
Let’s examine the resulting gains and losses to consumers, producers, and the
government in the previous Figure:
CONSUMERS
Some consumers pay a higher price, while others no longer buy the good.
∆ CS=− 𝐴− 𝐵
PRODUCERS
Producers are now selling a larger quantity Q2 instead of Q0, and at a higher price Ps.

∆ PS=+ 𝐴+𝐵+ 𝐷
THE GOVERNMENT
The cost to the government (which is ultimately a cost to consumers) is
(𝑄 ¿ ¿2−𝑄 1)𝑃 𝑆 ¿
The total change in welfare is
∆ CS+∆ PS− Cost   to  Govt .=𝐷 −(𝑄 2 − 𝑄1 )𝑃 𝑆
Minimum support prices in agriculture
Overproduction of wheat and rice, underproduction of pulses

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 Application SUPPORTING THE PRICE OF WHEAT

1981 Supply: QS = 1800 + 240P

1981 Demand: QD = 3550  266P

FIGURE
THE WHEAT MARKET
IN 1981
To increase the price to
$3.70, the government must
buy a quantity of wheat Qg.
By buying 122 million bushels
of wheat, the government
1981 Total demand: QD = 3550  266P + Qg
increased the market-
clearing price from $3.46 per Qg= 506P  1750
bushel to $3.70. Qg= (506)(3.70)  1750 = 122 million bushels
Loss to consumers = −A − B = $624 million
Cost to the government = $3.70 x 112 million = $451.4 million
Gain to producers = A + B + C = $638 million
Price supports for wheat were expensive in 1981. To increase surplus of
farmers by $638 million, consumers and taxpayers had to pay $1076 million.
Production Quotas

FIGURE 9.11
SUPPLY RESTRICTIONS
To maintain a price Ps above the
market-clearing price P0, the
government can restrict supply to Q1,
either by imposing production quotas
(as with taxicab medallions) or by
giving producers a financial incentive
to reduce output (as with acreage
limitations in agriculture).
Change in CS =
Change in PS =
Change in welfare
DWL = B + C Q1
EXAMPLE 9.5 WHY CAN’T I FIND A TAXI?

The city of New York limits the number of taxis by requiring each taxi to have a
medallion (essentially a permit), and then limiting the number of medallions. In 2011
there were 13,150 medallions in New York—roughly the same number as in 1937.
Why not just issue more medallions? The reason is simple. Doing so would incur the
wrath of the current owners of medallions. Medallions can be bought and sold by the
companies that own them.
In 1937, there were plenty of medallions to go around, so they had little value. By
1947, the value of a medallion had increased to $2,500, by 1980 to $55,000, and by
2011 to $880,000. That’s right—because New York City won’t issue more medallions,
the value of a taxi medallion is approaching $1 million!
But of course that value would drop sharply if the city starting issuing more
medallions. So the New York taxi companies that collectively own the 13,150 available
medallions have done everything possible to prevent the city from issuing any more—
and have succeeded in their efforts.
If the city were to issue another 7,000 medallions for a total of about 20,000, demand
and supply would equilibrate at a price of about $350,000 per medallion– still a lot,
but just enough to lease cabs, run a taxi business, and still make a profit.
 Application WHY CAN’T I FIND A TAXI?

FIGURE 9.13
TAXI MEDALLIONS IN NEW
YORK CITY
The demand curve D shows
the quantity of medallions
demanded by taxi companies
as a function of the price of a
medallion.
The supply curve S shows the
number of medallions that
would be sold by current
owners as a function of price.
New York limits the quantity
to 13,150, so the supply
curve becomes vertical and
intersects demand at
$880,000, the market price of
a medallion in 2011.
Taxes and subsidies

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Taxes
• By far the most frequently used government intervention in markets

• “… in this world nothing can be said to be certain, except death and taxes.” –
Benjamin Franklin

• Taxes are usually the primary source of government revenues  vital for the
functioning of the government

• On the flipside, taxes can also distort the incentives of the marketplace,
causing inefficiencies
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 The Impact of a Tax or Subsidy
THE EFFECTS OF A SPECIFIC TAX
● specific tax Tax of a certain amount of money per unit sold.
FIGURE
INCIDENCE OF A TAX
Pb is the price (including the tax) paid by
buyers. Ps is the price that sellers receive,
less the tax.
Here the burden of the tax is split evenly
between buyers and sellers.
Buyers lose A + B.
Sellers lose D + C.
The government earns A + D in revenue.
The deadweight loss is B + C.

Market clearing requires four conditions to be satisfied after the tax is in place:
QD = QD(Pb) (9.1a)
QS = QS(Ps) (9.1b)
Q D = QS (9.1c)
Pb − Ps = t (9.1d)
 FIGURE
IMPACT OF A TAX DEPENDS ON ELASTICITIES OF SUPPLY AND DEMAND
(a) If demand is very inelastic relative to supply, the burden of the tax falls mostly on buyers.
(b) If demand is very elastic relative to supply, it falls mostly on sellers.
By using the following “pass-through” formula, we can calculate the percentage of the tax
that is “passed through” to consumers: Pass-through fraction = Es/(Es + |Ed|)
The incidence of a tax
• The incidence of a tax is the division of the burden of tax between
buyers and sellers

• Buyer’s incidence:

• Seller’s incidence:

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The Effects of a Subsidy

● subsidy Payment reducing the buyer’s price below the seller’s

price; i.e., a negative tax.

FIGURE
SUBSIDY
A subsidy can be thought of as a negative
tax. Like a tax, the benefit of a subsidy is
split between buyers and sellers,
depending on the relative elasticities of
supply and demand.

Conditions needed for the market to

clear with a subsidy:
QD = QD(Pb) (9.2a)
QS = QS(Ps) (9.2b)
QD = QS (9.3c)
Ps − Pb = s (9.4d)
 EXAMPLE A TAX ON GASOLINE

QD = 150 – 25Pb (Demand)

QS = 60 + 20Ps (Supply)
QD = QS (Supply must equal demand)
Pb – Ps = 1.00 (Government must receive $1.00/gallon)

150 − 25Pb = 60 + 20Ps

Pb = Ps + 1.00
150 − 25Pb = 60 + 20Ps
20Ps + 25Ps = 150 – 25 – 60
45Ps = 65, or Ps = 1.44
=> Pb = 2.44
QD = 150 – (25)(2.44) = 150 – 61, or Q = 89 bg/yr

Annual revenue from the tax tQ = (1.00)(89) = $89 billion per year
Deadweight loss: (1/2) × ($1.00/gallon) × (11 billion gallons/year = $5.5 billion per year
 EXAMPLE A TAX ON GASOLINE

FIGURE
IMPACT OF $1 GASOLINE
TAX
The price of gasoline at the
pump increases from $2.00
per gallon to $2.44, and the
quantity sold falls from 100 to
89 bg/yr.
Annual revenue from the tax is
(1.00)(89) = $89 billion (areas
A + D).
The two triangles show the
deadweight loss of $5.5 billion
per year.
Recap
• The market system leads to efficient allocation of resources through the
price mechanism
• Price signal the value of resources to society in competing uses, and incentivize
firms to align production accordingly
• Governments may intervene in market for equity concerns. Such
restrictions can take the form of price controls, taxes and subsidies, and
quotas
• The difference between the market surplus in free markets and market
surplus in regulated markets is known as the deadweight loss
• The party who bears the burden of the tax varies based on the demand and
supply elasticities in the market
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Practice Problem 1
The demand for rutabagas is Q = 2,000 – 100P and the supply of
rutabagas is Q = -100 + 200P. The government imposes a $2 per unit tax
on the sale of rutabagas.
a. How much is the economic incidence of this tax for buyers?
b. How much is the economic incidence of this tax for sellers?
c. Calculate the government revenue and the deadweight loss from
the tax.

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That’s all folks!

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Typos
• Slide 27: Qg should be 122 million bushels not 112 million.

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