Effects of Government Intervention – Price Controls
Topic 3

 Some

cases market forces are not allowed to determine equilibrium price and quantity authorities (Govt.)

Price Controls

 Intervention by

Price Ceilings  Price Floors  Taxes

 on  on

Producers Consumers

“A price ceiling is the maximum legal price a seller may charge for a good or service”


Maximum price




6/3/2013 • Govt.  To help the poor & the disadvantaged  During What are the results? P S Pe maximum price shortage D fig O Qs Qd Q 2 . Price Ceilings • Why would they do this? • What is the result? • Who benefits? Who loses? • What is likely to happen? Why would they do it?  To keep the price down to an acceptable level. rice etc. wartime price controls may be imposed on essential items such as petrol. sets the price LOWER than the equilibrium.

6/3/2013 What are likely to happen? Effects: dealing with resulting shortages => rationing  black markets  Effect of price control on black-market prices P Pb Blackmarketeers’ profits S Pe Price ceiling Pg D O Qs Qd fig Q Gainers  Consumers who are able to obtain supplies at the price ceiling Gainers & Losers? Losers:  Consumers who cannot obtain supplies (even though they are willing to purchase at the equilibrium price ) 3 .

minimum wages) Why does the government do it? 4 .  To protect workers (eg. sets the price floor HIGHER than the equilibrium • Why would they do this? • What is the result? • Who benefits? Who loses? • What is likely to happen?  To support prices (income) in important sectors of the economy (eg. Agriculture).6/3/2013 Price Controls.Consumer Surplus & Producer Surplus • Originally • CS = A+B • PS = C+E+F • After Price ceiling • CS = A+C • PS = F • What about B & E? • net loss in total surplus Price Floors A price floor is the minimum price set by the gov’t for a good or service • Govt.

higher income.6/3/2013 What is the impact? P S minimum price surplus Pe D O Qd Qs fig Q Losers: Gainers  Consumers who have to  Suppliers who receive higher price per unit and pay higher prices for the probably. CS & PS (contd.  Workers Gainers & Losers? who are in job receive a higher wage  Workers who were previously working. are now unemployed Price Controls.) • Originally • CS = A+B+C • PS = E+F • After Price floor • CS = A • PS = C+F • What about B & E? • net loss in total surplus 5 . goods.

6/3/2013 Taxes on Producers • Supply curve shifts up • vertical shift = amount of tax • Equilibrium price increases. the burden changes Taxes on Producers  Effects of imposing tax on producers: P Tax S1 E1 Consumers’ tax burden Producers’ tax burden So E0 D Q1 Q0 Consumers’ tax burden > Producers’ tax burden if Demand is relatively inelastic Q Taxes on Producers 6 . equilibrium quantity decreases • Notice the difference in amount of tax and increase in price. • As elasticity of demand and supply vary.

6/3/2013 Taxes on Producers Taxes on producers Taxes on Producers 7 .

Pw+ T Pw At a domestic price Pw + T. Ddom A tariff can stimulate domestic supply and restrict imports.6/3/2013 Taxes on Consumers • Demand curve shifts down • vertical shift = amount of tax • Equilibrium price decreases. the burden changes Elasticity and Tax burden . the burden of tax is not affected by who it is levied on (producer or consumer). quantity of domestic supply rises to Qs' and imports fall. equilibrium quantity decreases • Notice the difference in amount of tax and decrease in price. • As elasticity of demand and supply vary. and there is free trade. If the world price is Pw. domestic demand is Qd and the difference is imported.Summary Deman d Supply Elastic Producer Consumer Inelastic Consumer Producer • So. Qs Qs' Qd' Qd Quantity domestic firms supply Qs. 8 . • It is affected by the elasticities of demand & supply 24 The Effect of a Tariff Sdom Ddom & Sdom show the domestic demand and supply for a good. where T is the size of the tariff. quantity of domestic demand falls to Qd'.

27 International Free-trade Equilibrium Husted/Melvin. Pw and D. 26 Optimal Tariff  Let’s assume that country A is an economically large country (a large world importer of a product L)  Country B exports product L. Pw+ T Pw D Qs Qs' Qd' Qd Quantity There is also dead-weight loss from consumption inefficiency. © 2001.e. there is a transfer to the government. Inc. Addison Wesley Longman. 9 . Consumer surplus is decreased by the area between Pw+T. and there is a transfer in the form of extra profits to producers. S The government raises revenue – i. There is a social deadweight cost from production inefficiency. All rights reserved. given that the good could be imported at Pw.6/3/2013 The Welfare Costs of a Tariff 25 The tariff leads both to transfers and net social losses.  Let’s consider the situation under free trade and after an import tariff is imposed by country A.

$(b + d) Comparison of the Effects of Import Tariffs and Production Subsidies 30  Domestic production can also be increased and imports reduced through the use of a production subsidy  Actually . Inc. 29  Welfare Cost of a tariff Imposed by a large Country -$a -$b -$c -$d  in CS  in PS  in G revenue $a $c -$b +$e -$d +$e Net welfare change Optimal tariff would max $e .6/3/2013 28 Illustration of a Tariff for a Large Country Husted/Melvin. temporary production subsidies rather than import tariffs are sometimes suggested by economists WHY? 10 . All rights reserved. © 2001. Addison Wesley Longman.

 Area CGA shows the social cost of restricting consumption when marginal benefits exceeds the world price of the good 11 .  With a subsidy on exports alone.6/3/2013 31  Let's compare the effects of these two trade restrictions on the welfare of the society = dead weight loss (a) Tariff (b) Subsidy Price Sdom Sdom Sdom+ s Price P’ P Sw + t Sw P’+ s P Sw Ddom Qs’ Ddom Qs Qsd’ Qd Quantity Qs Qd Quantity 32 Export subsidies  "commercial policy to boost exports" Exports Price Sdom B Sw+ s F Sw P’ P C A G E Ddom Qd’ Qd Qs Qs’ Quantity 33 Export subsidies cont’d  Under free trade. and exports AB. and exports are GE.  Area EFB shows the social cost of producing goods whose marginal cost exceeds the world price for which they are sold. Total output is Qs’. domestic producers will restrict supply to the home market to Qd’ so that home consumers pay P’. the same as producers can earn by exporting. consumers demand Qd. production is Qs.