Chapter 6 - Government intervention, in this chapter you will learn: The effect of a price ceiling or a price floor on the equilibrium price and quantity, the effect of a tax or a subsidy on the equilibrium price and quantity, how elasticity and time period influence the impact of a market intervention.
Chapter6 GovernmentIntervention â2014byMcGrawHillEducation Whatwillyoulearninthischapter? ã Theeffectofapriceceilingorapriceflooron theequilibriumpriceandquantity ã Theeffectofataxorasubsidyonthe equilibriumpriceandquantity ã Howelasticityandtimeperiodinfluencethe impactofamarketintervention â2014byMcGrawHillEducation WhyIntervene? ã Marketsgravitatetowardequilibrium ã When markets work well, prices adjust until the quantity of the good demanded is equal to the quantity supplied • There are three reasons why a government may step in and intervene in a market: – Correcting market failures – Changing the distribution of benefits Encouragingordiscouragingconsumptionof certaingoods â2014byMcGrawHillEducation Fourrealworldinterventions ã Inthischapter,fourrealworldexamplesofgovernment interventionwillbeanalyzed – Mexican tortilla prices and the government setting a maximum price – U.S. milk prices and the government setting a minimum price – U.S. fatty foods and the government taxing high fat and high calorie foods – Mexican tortilla prices and the government subsidizing tortilla producers • These examples require both positive and normative analysis – What are the trade‐offs? – Dothebenefitsoutweighthecosts? â2014byMcGrawHillEducation Pricecontrols ã Pricecontrolscanbedividedintocategories: Priceceiling:Amaximumlegalpriceatwhichagood canbesold ã Typically placed on essential goods and services such as food, gasoline, and electricity – Price floor: A minimum legal price at which a good can be sold • Typically placed on agricultural goods that are risky to produce • Thepricecontrolsprovideincentivesor disincentivestoproducemoreorlessthanthe equilibriumquantity â2014byMcGrawHillEducation Priceceilings SupposetheMexicangovernmentimposesapriceceilingontortillas. Whateffectdoesthishaveonthemarket? Price (Â/lb.) 125 Price (¢ / lb.) 125 Producers supply a lower quantity 100 S 100 75 75 50 50 S Consumers demand a higher quantity Price ceiling 25 25 Shortage D D 25 50 75 100 Quantity of tortillas (millions of lbs.) Efficient market with a price of $0.50 per lb. and 50 million lbs. of tortilla © 2014 by McGraw‐Hill Education 25 50 75 100 Quantity of tortillas (millions of lbs.) Inefficient market with a price ceiling set at $0.25 per lb. and 25 million lbs. of tortilla being produced Price ceilings • Did the price ceiling meet the goal of providing low‐priced tortillas to consumers? – Yes. Consumers were able to buy some tortillas at the low price of $0.25 a pound – No. Consumers wanted to buy three times as many tortillasasproducerswerewillingtosupply ã Howdidthepriceceilingeffectwelfare? Thisquestioncanbeansweredusingdifferencesin consumersurplusandproducersurplus before/aftergovernmentintervention â2014byMcGrawHillEducation Welfareeffectsofapriceceiling A price ceiling causes a deadweight loss to occur as well as a transfer of welfare from producers to consumers Price (¢/lb.) Producer surplus 125 Consumer surplus Deadweight loss 100 S 75 50 Price ceiling 25 D 25 50 75 100 Quantity of tortillas (millions of lbs.) • Suppose the government sets the price at $25 • Reduction in tortillas sold by 25 million • Deadweightloss occurs ã Transferofsurplus fromproducersto consumers â2014byMcGrawHillEducation Welfareeffectsofapriceceiling ã Are price ceilings worth the decrease in total surplus? – Normative question about which people can disagree • One way to answer is through studying the allocation of tortillas • Because a price ceiling causes a shortage, goods must be rationed – Rationed equally – First‐come, first‐served basis – Rationed to those who are given preference by the government, or to the friends and family of sellers • Shortages cause people to engage in rent‐seeking behavior, such as bribing whoever is in charge of allocating scarce supplies © 2014 by McGraw‐Hill Education Ineffective price ceiling A price ceiling does not always affect the market outcome if the ceiling is set above the equilibrium price • Suppose the government sets the price at $25 Price (¢/lb.) 125 Supply increases, and the supply curve shifts to the right 100 75 – Reduction in tortillas sold by 25 million S1 At the new equilibrium point, the price is below the price ceiling 50 S2 25 Price ceiling • Over time, if the supply increases sufficiently, the price ceiling may become nonbinding – No effect on market equilibrium D 25 50 75 100 Quantity of tortillas (millions of lbs.) © 2014 by McGraw‐Hill Education 10 Price floors Suppose the U.S. government imposes a price floor on milk. What effect does this have on the market? Price ($/gal.) 4.5 Price ($/gal.) 4.5 S S 3.5 3.5 Price floor 3 2.5 2.5 2 Quantity supplied and quantity demanded move in opposite directions 1.5 1.5 D D 0.5 0.5 Excess supply 10 15 20 25 30 35 Quantity of milk (billions of gals.) Efficient market with a price of $2.50 per gallon and 15 million gallons of milk being produced 10 15 20 25 30 35 Quantity of milk (billions of gals.) Inefficientmarketwithapriceceiling setat$3pergallonand20million gallonsofmilkbeingproduced â2014byMcGrawHillEducation 11 Pricefloors ã Did the price floor meet the goal of providing support to producers? – Yes. Producers were able to sell some milk at a higher price of $3.00 per gallon – No. Some producers may not be able to sell all of their milk because demand no longer meets supply • How did the price floor affect welfare? – This question can be answered using the difference in consumer and producer surplus before/after government intervention © 2014 by McGraw‐Hill Education 12 Welfare effects of a price floor A price floor causes a deadweight loss to occur as well as a transfer of welfare from consumers to producers Producer surplus Price ($/gal.) Consumer surplus 4.5 Deadweight loss S 3.5 Price floor 2.5 1.5 0.5 D 10 15 20 25 30 35 Quantity of milk (billions of gals.) • Suppose the government sets the market price to $3 • Reduction in milk sold by 5 million gallons • Deadweight loss occurs (Area 1) • Transfer of surplus (Area 2)fromconsumersto producers â2014byMcGrawHillEducation 13 Welfareeffectsofapricefloor ã Arepricefloorsworththedecreaseintotal surplus? Normativequestionaboutwhichpeoplecandisagree • One way to answer is through studying how much excess milk will the government have to buy – The answer is the entire amount of excess supply created by the price floor – In the above case, 10 billion gallons will be purchased at $3 per gallon – The cost to maintain the price floor is then $30 billion © 2014 by McGraw‐Hill Education 14 Ineffective price floor A price floor does not always affect the market outcome if the floor is set below the equilibrium price Price ($/gal) S2 5.5 4.5 3.5 2.5 1.5 0.5 Supply decreases, and the supply curve shifts to the left S1 Price floor D 10 15 20 25 At the new equilibrium point, the price is above the price ceiling 30 • Suppose the government set the price at $3 – Increase in milk sold by 5 million gallons • Over time, if the supply decreases sufficiently, the price floor may become nonbinding – No effect on market equilibrium 35 Quantity of Milk (billions of gals.) © 2014 by McGraw‐Hill Education 15 Active Learning: Determining market price and quantity with price controls Suppose the government has been convinced to institute a price ceiling on housing rentals for $400 per month. Demand for housing is given as P = 900 – 20Q and supply is P = 40Q, where Q is measured in thousands of housing units Solve for equilibrium price and quantity without a price control Solveforthepriceandquantitywithapricecontrol Whymightapricecontrolmayhaveoppositeeffectsthenintended? â2014byMcGrawHillEducation 16 TaxesandSubsidies ã Priceincentivescanbedividedintocategories: Taxes:Eitherthebuyerorthesellermustpaysome extra amount to the government on top of the sale price • Typically placed on seller – Subsidies: Either the buyer or the seller receives a payment from the government that lowers the sale price • Taxes and subsidies can be used to correct market failuresandprovideincentivesordisincentivesto producemoreorlessthantheequilibrium quantity â2014byMcGrawHillEducation 17 Taxes ã UsingthecaseoffattyfoodsintheU.S.,rather thanbanningthem,whatwouldhappenifthe governmenttaxedthem? • Taxes have two primary effects: – Discourage production and consumption of the good that is taxed – Raise government revenue through the fees paid by those who continue buying and selling the good • A tax will reduce consumption and provide a new sourceofpublicrevenue â2014byMcGrawHillEducation 18 Effectsofataxpaidbytheseller Supposethegovernmentimposesa$0.20taxoneachunitsold,which thesellermustpay.Whateffectdoesthishaveonthemarket? Price (Â) 80 • The new supply curve adds $0.20 to all prices, the amount of the tax • Taxes drives a wedge between the buyer’s price and the seller’s price • The equilibrium quantity decreases from 30 million to 25 million S S E Buyers pay 60¢ 60 E Tax Wedge Sellers receive 40¢ 40 after the tax D 20 10 15 20 25 30 35 40 45 Quantity of Whizbangs (millions) © 2014 by McGraw‐Hill Education 19 Effects of a tax paid by the seller The tax revenue and deadweight loss from the tax on sellers can be calculated Deadweight loss Price (¢) 80 • The tax revenue generated is S2 S1 Quantity sold 25 million TR = Tax*Qpost‐tax E2 60 • Tax revenue is a transfer from consumers and producers to the government • Deadweight loss occurs from loss of quantity sold E1 Tax revenue = million ($0.20 *25 million) Tax $0.20 40 D 20 10 15 © 2014 by McGraw‐Hill Education 20 25 30 35 40 45 Quantity of Whizbangs (millions) 20 Active Learning: Tax revenue and surpluses Suppose the government imposes a $1 tax that sellers must pay. Estimate the tax revenue, deadweight loss, and differences in consumer and producer surplus if the before‐tax consumer surplus is 11.25 billion and before‐tax producer surplus is 11.25 billion. Price ($/gal.) S 4.5 3.5 2.5 1.5 0.5 D 10 15 20 25 30 35 Quantity of milk (billions of gals.) â2014byMcGrawHillEducation 21 Effectsofataxpaidbythebuyer Supposethegovernmentimposesa$0.20taxoneachunitsold,which thebuyermustpay.Whateffectdoesthishaveonthemarket? ã The new demand curve is $0.20 lower, the amount of the tax • Taxes drives a wedge between the buyer’s price and the seller’s price • The equilibrium quantity decreases from 30 million to 25 million Price (¢) 80 S Buyers pay 60¢ 60 with 20¢ in taxes Tax Wedge E1 Sellers receive 40¢ 40 E2 D1 20 D2 10 15 20 25 30 35 40 45 Quantity of Whizbangs (millions) â2014byMcGrawHillEducation 22 Effectsofataxonbuyersandsellers Regardlessofwhetherataxisimposedonbuyersor sellers,therearefouridenticaleffectsresultingfrom taxes: ã Equilibriumquantityfalls ã Buyers pay more per unit purchased and sellers receive less – A tax wedge forms, equal to the difference between the price paid by buyers and the price received by sellers • The government receives revenue equal to the amount of the tax multiplied by the new equilibrium quantity ã Thetaxcausesadeadweightloss â2014byMcGrawHillEducation 23 Taxincidence Supposethegovernmentimposesa$0.20taxoneachunitsold,whichthesellermust pay.Whobearstheburden,ortaxincidence,ofatax? ã Taxincidence isequaltothelossinconsumerandproducersurplus goingtotax revenue ã Whicheversideofthemarketismorepriceelastic willshoulderlessoftheburden Price (Â) S2 Price (¢) S2 Buyers pay 54¢ sellers receive 34¢ S1 60 S1 Price (¢) S2 66 S1 54 D 40 46 D D 34 Buyers pay 66¢, sellers receive 46¢ Buyers pay 60¢ sellers receive 40¢ 25 30 Quantity of Whizbangs (mil.) Equal incidence – The sellers’ tax burden is equal to the buyers’ tax burden © 2014 by McGraw‐Hill Education 22 30 Quantity of Whizbangs (mil.) 22 30 Quantity of Whizbangs (mil.) Sellers pay more – The Buyers pay more – The sellers’ tax burden is greater sellers’ tax burden is less than the buyers’ tax burden than the buyers’ tax burden Sellers’ tax burden Buyers’ tax burden 24 Subsidies • Using the case of tortillas in Mexico, rather than using price controls, what would happen if the government subsidized them? • Subsidies have two primary effects – Encourages production and consumption of the good that is subsidized – Government provides money through the subsidy to producers who continue to sell the good • A subsidy will increase consumption of the good © 2014 by McGraw‐Hill Education 25 Subsidies Suppose the government imposes a $0.35 subsidy on each unit sold, which the seller receives. What effect does this have on the market? Price (¢/lb.) S1 S2 88 70 E1 • The new supply curve subtracts $0.35 from all prices, the amount of the subsidy – Buyers pay $0.53 – Sellers receive $0.88 E2 53 • The equilibrium quantity increases from 50 million to 62 million D 50 62 Quantity of Tortillas (millions of pounds) © 2014 by McGraw‐Hill Education 26 Government intervention: A summary The following table summarizes the effect of all four government policies analyzed in this chapter Intervention Price floor Reason for using Effect on price Effect on quantity Who gains and who loses? To protect producers’ income Price cannot go below the set minimum Quantity demanded decreases and quantity supplied increases, creating excess supply Producers who can sell all their goods earn more revenue per item; other producers are stuck with an unwanted excess supply To keep consumer costs low Price cannot go above the set maximum Quantity demanded increases and quantity supplied decreases, creating a shortage Consumers who can buy all the goods they want benefit; other consumers suffer from shortages Tax To discourage an activity or collect money to pay for its consequences; to increase government revenue Price increases Equilibrium quantity decreases Government receives increased revenue; society may gain if the tax decreases socially harmful behavior. Buyers and sellers of the good that is taxed share the cost. Which group bears more of the burden depends on the price elasticity of supply and demand Subsidy To encourage an activity; to provide benefits to a certain group Price decreases Equilibrium quantity increases Buyers purchase more goods at a lower price. Society may benefit if the subsidy encourages socially beneficial behavior The government and ultimately the taxpayers bear the cost Price ceiling © 2014 by McGraw‐Hill Education 27 How big is the effect of a tax or subsidy? Can the effect of a tax or subsidy on the equilibrium quantity be predicted ahead of time? • Yes, if the price elasticity of supply and demand are known • The more elastic the supply or demand is, the greater the change in quantity Suppose there is a $0.20 tax paid by the seller S2 Price (¢) 80 S1 Price (¢) Price (¢) Price (¢) 80 S2 S1 60 60 40 40 20 S2 80 60 D 20 S1 40 80 S2 60 S1 D 40 D 20 20 D 10 20 30 40 10 20 30 40 Quantity of Whizbangs (millions) Quantity of Whizbangs (millions) Inelastic supply and demand: Equilibrium quantity decreases by M Inelastic supply and elastic demand: Equilibrium quantity decreases by M 10 20 30 40 10 20 30 40 Quantity of Whizbangs (millions) Quantity of Whizbangs (millions) Elastic supply and inelastic demand: Equilibrium quantity decreases by M Elastic supply and demand: Equilibrium quantity decreases by 20 M â2014byMcGrawHillEducation 28 Longrunversusshortrunimpact Theeffectofagovernmentinterventionmaybelagged ã Oneexampleisgasolineandpricecontrolsofgasoline ã Because buyers and sellers take time to respond to changes in price, sometimes the full effect of price controls becomes clear only in the long‐run Price ($) Price ($) Excess supply Excess supply S S Price floor Price floor D D Gasoline (billions of gals.) Gasoline (billions of gals.) In the short run, driving habits are difficult to change and producers take time to increase production Effect on quantity is small Inthelongrun,drivinghabitscanbe changedandproducerscanincrease production Effectonquantityislarge â2014byMcGrawHillEducation 29 Summary ã Basictoolsforunderstandinggovernment interventionswereintroduced: Pricecontrols(floorsandceilings) Taxes/subsidies ã Determiningwhetherthedirectsupply, demand,orbothshouldshift â2014byMcGrawHillEducation 30 10 ...Four real‐world interventions • In this? ?chapter, four real‐world examples of? ?government? ? intervention? ?will be analyzed – Mexican tortilla prices and the? ?government? ?setting a maximum price... © 2014 by McGraw‐Hill Education 26 Government? ?intervention: A summary The following table summarizes the effect of all four? ?government? ?policies analyzed in this? ?chapter Intervention Price floor Reason for using... U.S. milk prices and the? ?government? ?setting a minimum price – U.S. fatty foods and the? ?government? ?taxing high fat and high calorie foods – Mexican tortilla prices and the? ?government? ?subsidizing