CHAPTER 3

GOVERNMENT
INTERVENTION
Government Intervention in Price
Determination
• In an unconstrained free market economy, market forces produce
equilibrium prices and exchange quantities.
• Even when equilibrium conditions are effective, it's likely that not
everyone is satisfied.
• Applying economic ideas to facilitate policy creation is one of
economists' tasks.
Controls on Prices
Price Ceiling
• A legal limit on how much a product can be sold for.
Price Floor
• A legal minimum price for a product that can be sold.
Price Ceilings
If the price ceiling is placed below the equilibrium price, a shortage will result.
• The price of a low-cost house in Malaysia is RM700,000 (market price)
(RM800,000).
• Food goods including cooking oil, wheat flour, and condensed milk, as well as
construction materials like cement and steel bar, have price ceilings set by the
government.
Objective of price ceiling
• To allow customers to receive some necessary items or services that they would
otherwise be unable to purchase at the equilibrium price.
• To control inflation if the government can set a price cap on a wide range of
goods
How Price Ceilings Affect
Market Outcomes
 
Because QD > QS, a legally
binding price ceiling causes •
shortages. For example, the
1970s gasoline shortage.
Long lines, discrimination by
merchants are examples of non-
price rationing.
Price Floors
There are two conceivable results when the government sets a price floor.
• If the price floor is set higher than the equilibrium price, a surplus will result.
• In the agriculture sector, the government uses a price floor (padi) to preserve
farmers' income if commodity prices are too low in the free market.
• The government establishes a minimum pay rate to assist low-skilled workers
and safeguard them from exploitation by employers.
Rationale:
• To ensure that specific groups of resource suppliers or producers have
sufficient revenue.
• To build up surpluses as a reserve.
• To maintain pricing stability
How Price Floors Affect Market Outcomes
• When the market price hits the floor, it can no longer decline and
equals the floor price, preventing supply and demand from progressing
towards a price and quantity equilibrium.
• A surplus results from a binding price floor because QS > QD.
• Non-price rationing is a method of limiting goods based on
discriminatory criteria rather than price.
• The minimum wage, for example, and agricultural price subsidies are
two examples.
CASE STUDY: The Minimum Wage
• The minimum wage is a good example of a price floor since it sets
the lowest feasible price for labour that any firm can pay.
Consumer surplus and producer surplus
• Market equilibrium results in maximum benefits and, as a result,
maximum total welfare for both the customers and the producers of the
commodity.
• Consumer surplus is a metric that assesses economic well-being from
the buyer's perspective.
• Producer surplus is a metric that reflects the economic well-being of
the seller.
• The minimum wage is a good example of a price floor.
• Minimum wage regulations mandate that any employer must pay the
lowest possible salary for workers.
Consumer Surplus
The difference between the maximum price purchasers are ready to
pay for each unit and the current market price is known as consumer
surplus. The area below the DD curve and above the market price is
equal to CS.
• Assume the good with the demand curve DD is available at RM2.50.
The initial unit's buyer would have been ready to pay up to RM4.00
for it.
• She obtains a consumer surplus of RM1.50 because the market price
is just RM2.50.
• The second unit's buyer is ready to pay less than RM4.00 in exchange
for a little smaller excess.
• The size of the triangle formed by the demand curve and the market
price is thus the total consumer surplus obtained by purchasers.
Producer surplus
The gap between a product's current market price and a firm's total
cost of production is known as producer surplus. (hint: a firm's SS curve
is the same as its MC curve)
• Some producers are willing to make the product for RM0.75 per unit.
They gain a producer surplus of RM1.75 because they are paid
RM2.50. Other producers are prepared to offer the commodity for
RM1.00; they will obtain a RM1.50 producer excess.
• The total producer surplus is the area of the triangle formed by the
market price and the supply curve, or the region above the SS curve
and below the market price, since the market price is RM2.50.
Total Producer and Consumer Surplus
Deadweight loss (or efficiency loss)
• Deadweight loss (or efficiency loss)
• Underproduction or overproduction causes a total loss of producer
and consumer surplus, which is known as deadweight loss
Price Floors & Economic surplus
Price Ceilings & Economic surplus
(without black market)
Price Ceilings & Economic surplus (there
is a black market)
Tax and subsidy effects
Taxes levied indirectly:
–Indirect tax = a government-imposed tax on manufacturers or sellers
that is paid by or passed on to end-users (consumers).
-Import tariffs, excise duties, sales taxes, service taxes, and export
duties are examples of indirect taxes that generate money for the
government.
• Subsidy:
-A government subsidy is a financial incentive for producers or sellers to
produce more.
The Consequences of a Tax
• A tax creates a gap between the price purchasers pay and the price sellers
receive, causing the amount sold to fall below what it would be if there were
no tax.
• The market for such product is shrinking.
• Revenue from taxesT = the size of the tax
• Q = the quantity of the good sold
• T  Q = the government’s tax revenue
How Does a Tax Affect Consumer and
Producer Surpluses?
   Without tax With tax Change

Consumer surplus A+B+C A -(B+C)

Producer surplus D+E+F F -(D+E)

Tax revenue None B+D +(B+D)

Total surplus A+B+C+ D+E+F A+B+D+F -(C+E)
 EFFECT OF TAXATION
How Does a Tax Affect Consumer and Producer Surpluses?

S1 4 INDIRECT TAX
R M
Price = Tax that is imposed by the
T ax S government on producers or sellers
but paid by or passed on to end-users

The equilibrium price is RM12 and the

14 quantity is 400
CONSUMER’S
SHARE The government imposes a sales tax
12
of RM4 per carton
PRODUCER’S
SHARE
10 SS curve shift to left from S to S1 and
new equilibrium is RM14 and 200 units

The tax amount of RM4 is shared

equally between buyer and seller
D
200 400 Quantity
Impact of Subsidy

Subsidy is an incentive from

government to encourage producers or
sellers to produce more. The impact of
subsidy on equilibrium price and
quantity is opposite with the tax effect.
Subsidy will lower the cost of
production and at the same time
encourage producer to increase the
quantity production.
 EFFECT OF SUBSIDIES
How Does a Subsidies Affect Consumer and Producer Surpluses

10
M
S R SUBSIDY
=
y
Price sid An incentive from the government to
b
Su encourage producers to produce more
S1
50 The equilibrium price is RM45 and the
PRODUCER’S SHARE quantity is 10
45 The government provides a subsidy of
CONSUMER’S SHARE RM10 per unit
40
SS curve shifts to the right from S to
S1 and new equilibrium is RM40 and
20 units

The subsidy amount of RM10 is shared

equally between buyer and seller
D
10 20 Quantity
REFER TEXT BOOK FOR THE APPLICATION OF TAX AND SUBSIDY
ANALYSIS