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Section 2

Intervention in Markets
2.1
2.2
2.3
2.4

Price controls
Taxes and subsidies
Similarity of price controls and taxes
Illegal goods

2.1
Price controls
2.1.1
2.1.2
2.1.3

Price ceilings
Price floors
Commodity price stabilisation
schemes

2.1.1

Price ceilings (e.g. rent


controls, usury laws)

price

Supply with
price ceiling

1
p2
p0
p1 = pmax

2
4

S = MC
3
5

D = MB
q1

q0

q2

Price ceiling
(maximum
legal price)

quantity

Effects:
price decreases from p0 to pmax
quantity supplied decreases from q0 to q1
desired quantity demanded increases from
q0 to q2
excess demand of q2 - q1 units

How to allocate the quantity supplied q1 ?


ration coupons
value of coupons
= (p2 - p1) q1
= areas (2) + (4)
how to distribute?
what is equitable?
are coupons tradeable?
black markets
queues
search cost

Welfare analysis
No intervention:
CS0 = (1) + (2) + (3)
PS0 = (4) + (5) + (6)
Intervention:
CS1 = (1) + (2) + (4)
PS1 = (6)

Welfare effects of intervention:


CS
= CS1- CS0
= (1)+(2)+(4)-(1)-(2)-(3)
= +(4)-(3)
PS

= PS1- PS0
= (6)-(4)-(5)-(6)
= -(4)-(5)

Welfare =
=
=
=

CS + PS
+(4)-(3)-(4)-(5)
-(3)-(5)
deadweight loss

There is a welfare gain if gainers can


compensate losers, i.e. can make the
losers no worse off, while leaving
themselves better off.
off
But with a price ceiling this is not the case
and there is a welfare loss.
The welfare loss is larger if part or all of the
coupon value is dissipated through search
cost or rent-seeking (i.e. the use of
resources to obtain transfers).

2.1.2

Price floors (e.g. taxis,


eggs, wages)
Restricted
supply with
price floor

price
1
p1 = pmin
p0
p2

2
4

S = MC
3

Price floor
(minimum
legal price)

D = MB
q1

q0

q2 quantity

Effects:
price increases from p0 to pmin
desired quantity supplied increases from q0
to q2
quantity demanded decreases from q0 to q1
excess supply or surplus of q2 - q1 units
How to limit the quantity supplied to q1 ?
production licences or quotas
value of licences = (p1 - p2) q1
= areas (2) + (4)
how to distribute?
what is equitable?
are licences tradeable?

Welfare analysis
Welfare effects:
CS
= - (2) - (3)
PS
= + (2) - (5)
Welfare = CS + PS
= -(2)-(3)+(2)-(5) = -(3)-(5)
= deadweight loss
The welfare loss is larger if there is
rent-seeking
ki
to obtain
b i li
licences.

Note on licences:
1. Licences are often given out and apply
permanently, e.g. taxi licences, irrigation
water rights etc.
2. If such rights are tradeable they can give
the initial recipients a valuable asset.
3. Subsequent holders dont benefit; they
only earn a normal return on their
investment.
investment

2.1.3

Commodity price
stabilisation with buffer
stocks
price

buy

p0

sell
D1
D2

q2

D0

q0

q1

quantity

Price stabilisation band:


price

ceiling
floor

sell

buy

D1
D2

D0
quantity

2.2
Taxes and subsidies
2 2 1 Buyer and seller prices and
2.2.1
tax/subsidy 'wedges'
2.2.2 Production and consumption taxes
2.2.3 Production and consumption
subsidies
2.2.4 Tax incidence
2.2.5 Elasticity and the magnitude of
distortion
2.2.6 Tax rates, tax revenue and
deadweight loss

2.2.1

Buyer and seller prices


and tax/subsidy 'wedges'

Taxes ((either ad valorem or specific)


p
)
form a wedge between
pb = buyer price
ps = seller price
for example
if there is a specific tax of t $ per unit then
pb = ps + t
quantity demanded depends on pb
quantity supplied depends on ps

Subsidies
are a negative tax
if there is a specific subsidy of s $ per
unit then
ps = pb + s

2.2.2

Production and
consumption taxes
Production taxes

what
buyers
pay

price

S with tax
S w/o tax

pb = ps + t
tax wedge

what
sellers
get

ps

quantity

Effects:
buyer price increases from p0 to p1b
seller price decreases from p0 to p1s
quantity supplied and quantity demanded
decrease from q0 to q1
tax revenue collected = tq1 = areas (2)+(4)
S with tax

price

S w/o tax

p1b = p1s + t
2

p0
p1s

4
D
q1

q0

quantity

Welfare effects:
CS
= - (2) - (3)
PS
= - (4) - (5)
Rev
= + (2) + (4)
Welfare = CS + PS + Rev = -(3)-(5)
(3) (5)
S with tax

price
1
p1b = p1s + t

p0
p1

S w/o tax
3
5

D
q1

q0

quantity

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Consumption taxes

what
buyers
pay

price
pb = ps + t
tax wedge
ps

what
sellers
get

D w/o tax
D with tax
q

quantity

Effects:
exactly the same as a production tax
(on output, buyer & seller prices, revenue)
Welfare effects:
exactly
tl the
th same as a production
d ti
tax
t
price
1
p1b = p1s + t

p0
p1

S
3
5

6
D with tax
q1

q0

D w/o tax
quantity

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2.2.3

Production and
consumption subsidies
Production subsidy
price

p1s = p1b + s

S w/o subsidy

1
2

p1b

S with subsidy

p0
4

5 6
D
q0

q1

quantity

Effects:
buyer price decreases from p0 to p1b
seller price increases from p0 to p1s
quantity supplied and quantity demanded
increase from q0 to q1
subsidy paid
= s q1
= areas (2)+(3)+(4)+(5)+(6)+(7)
Welfare analysis:
CS
= +(4)+(5)+(6)
PS
= +(2)+(3)
Rev
= -(2)-(3)-(4)-(5)-(6)-(7)
Welfare
= CS + PS + Rev
= -(7)

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Consumption subsidy
Effects:
exactly the same as a production subsidy
(on output, buyer & seller prices, revenue)
Welfare effects:
exactly the same as a production subsidy
price

p1s = p1b + s

1
3

p1b

D with subsidy

p0
4

5 6
D w/o subsidy
q0

2.2.4

q1

quantity

Tax incidence

Who bears the burden of the tax?


(i.e. by how much does the buyer price
increase and the seller price decrease?)
price
S

p1b = p1s + t

part of t paid
p
p
by
y consumers
p0
part of t paid by producers

p1s
D
q1

q0

quantity

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Tax incidence:
depends on the
demand elasticity
supply elasticity s
the more inelastic the demand, the more
the buyer pays
price
p1b

p0
p1s
D
quantity

the more inelastic the supply, the more


the seller pays
price

p1b
p0

p1s

quantity

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2.2.5

Elasticity and the


magnitude of distortion

the greater the elasticity of supply and


demand the greater the deadweight loss of
a tax
price

deadweight loss

D
quantity

thus it is generally better to tax goods


which have inelastic supply and/or demand

Inelastic S or D
p

when supply
is relatively
inelastic the
deadweight
loss is small

Elastic S or D
p
S

quantity

quantity

when demand
is relatively
inelastic the
deadweight
loss is small
quantity

when supply
is relatively
elastic the
g
deadweight
loss is large

S
D

when demand
is relatively
elastic the
deadweight
loss is large
quantity

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2.2.6

Tax rates, tax revenue


and deadweight loss

the larger the tax rate, the larger the


distortion but not necessarily larger tax
revenue
price

D
tax
revenue

quantity

deadweight
loss
tax rate

thus it is generally better to spread taxes


uniformly across more goods
taxing one good
p

taxing two goods


p

D
q

q
p

revenue on
one good =
sum of
revenue on
two goods

D
q

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2.3
Similarity of price controls and taxes
Note the similarity between the effects of
price
i ceilings,
ili
price
i fl
floors, ttaxes ((and,
d as will
ill
be seen in Section 4, monopoly).
price

deadweight
loss
S = MC

transfer
D = MB
quantity

The only difference is who receives the


transfer
Distortion
pmax
pmin
tax
monopoly

Transfer recipient
consumers with coupons
producers with licences
government
monopolist

As noted earlier, part or all of the transfer


may be dissipated through rent-seeking
which is an additional deadweight loss of the
intervention.

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2.4
Illegal goods
Imposing penalties on
- sellers increases the costs of p
production ((cs)
- buyers decreases the benefits of
consumption (cb)
price

S = MC + cs
S = MC

D = MB
D = MB - cb
quantity

The effect is
a decreased equilibrium quantity supplied
and demanded
uncertain on equilibrium price (depends on
the size of cs and cb )

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