MONASH

BUSINESS
SCHOOL

ECF1100 Microeconomics
Week 4 – Supply, demand and government policies, market
efficiency and costs of taxation and subsidies
Dr. George Rivers
We are up to week 4

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Learning objectives

1. Understand willingness to pay and willingness to sell

2. Look at the maximisation of consumer and producer

surplus under market equilibrium

3. Examine the effects of government price ceilings and

price floors

4. Examine the effects of government taxes and subsidies

5. Investigate and define deadweight loss in the market

due to government policies

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Consumer surplus

The difference
between the highest
price a consumer is
willing to pay and
the price the
consumer actually
pays.

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Producer surplus

The difference
between the
lowest price a
firm would have
been willing to
accept and the
price it actually
receives.

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Total surplus in equilibrium

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Economic efficiency and competitive markets

– Equilibrium in a competitive market results in the economically

efficient level of output where MB = MC.

– Economic surplus: The sum of consumer surplus and producer

surplus.

– Deadweight loss: Foregone economic surplus resulting from a

market not being in competitive equilibrium.

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Economic efficiency and competitive markets

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Price Floor (minimum price)

A legally determined minimum price that sellers may receive.

Without the price floor, the
Price
equilibrium is (p, q).
With the price floor at pmin,
supply
there is excess supply of
qS - q D.
A
As a result, producer surplus
pmin
changes from ___ to ____,
B
consumer surplus changes
p E
from ____ to ___,
C F and total surplus changes
from ____ to ____.
D
demand Thus the deadweight loss of
the price floor is _____.
qD q qS Quantity

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Example of price floor minimum wages

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Price ceiling (maximum price)

A legally determined maximum price that sellers may receive.

Price
Without the price ceiling, the
equilibrium is (p, q).
supply With the price ceiling at pmax,
there is excess demand of qD
- q S.
As a result, producer surplus
A changes from ___ to ____,
p D consumer surplus changes
from ____ to ___,
B E
pmax and total surplus changes
from ____ to ____.
C
demand Thus the deadweight loss of
the price ceiling is _____.
qS q qD Quantity

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Example of price ceiling (rent control short run)
(a) Rent control in the short run
(supply and demand are inelastic)
Rental
price of
a flat Supply

Controlled rent

Shortage
Demand

0 Quantity of
flats
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Example of price ceiling (rent control short run)

(b) Rent control in the long run

(supply and demand are elastic)
Rental
price of
a flat

Supply

Controlled rent

Shortage Demand

0 Quantity of
flats
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Effect of a tax

Price S+t Before tax, the equilibrium price is

p* and quantity is q*. The price
D consumers pay is equal to the price
producers receive.

pc The tax t per unit creates a wedge

S
between the price consumers pay
and the price sellers receive.
p*
Consumers pay pc, producers
pp receive pp, and the equilibrium
quantity is q’. Tax revenue is ____.

q’ q* Quantity

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Tax on soft drinks

Will a tax on soft drinks work?

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Incidence of a tax

• Division of burden of tax between buyers and sellers in a market.

• Who Actually Pays a Tax? The answer depends on:

– The price elasticity of demand.

– The price elasticity of supply.

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Incidence of a tax

Price S+t Demand curve is flatter

tax = t than supply curve, so
S demand is more elastic.
After the tax, consumers
pay pc and producers
pc receive pp.
p1 A Consumers’ burden
of the tax is pc - p1,
pp D and producers’ burden
B of the tax is p1 - pp.

Quantity

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Tax and deadweight loss

• Tax creates a deadweight loss by reducing the quantity

exchanged and the gains from trade.

• The size of the deadweight loss depends on elasticities.

• If sellers or buyers can more flexibly adjust to the adverse

changes in price, then the deadweight loss is larger (as more
gains from trade will be lost).

• The deadweight loss is larger if demand and/or supply is more

price-elastic.

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Tax and deadweight loss

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Deadweight loss of a tax

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Subsidy

• A subsidy is a payment from government, to consumers or sellers,

for each unit of a good that is bought or sold.

• Subsidies can be regarded as negative taxes.

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Effect of a subsidy to sellers

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Incidence of a subsidy (First home owners grant)

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Deadweight loss of a subsidy

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Deadweight loss of a subsidy

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