Economic Principles I

Lecture 5:
Government Intervention in Markets
and its Welfare Impact
Policies that Control Prices
Governments sometimes
regulate prices to protect
consumers against being
exploited by monopoly
suppliers, or to ration goods
in extreme times
Very occasionally they use
price floors to protect
producers agricultural
markets are the main
example
(A World War 2 ration book)
A Price Ceiling
Supply
Quantity 0
Price
Demand
Quantity 0
Price Supply
Demand
a) Non-binding
b) Binding
Sellers must ration goods
12
Price
ceiling
12
100
Equilibrium
quantity
70 130
Shortage
Quantity
supplied
Quantity
demanded
Price
ceiling
8
Another Example Controlled
Rents for Low Income Families
Quantity
of houses
0
Weekly
rent
Demand
a) short-run
Supply
Rent
control
50
Shortage
Quantity
of houses
0
Weekly
rent
Demand
b) long-run
Supply
Rent
control
50
Shortage
A Price Floor the EU Common
Agricultural Policy
Quantity 0
Price per tonne
D
Quantity 0
Price
Demand
S
1

100
100
Equilibrium
quantity
60
support
price
S
2

40
a) Non-binding b) Binding
150 200
Surplus
Quantity
supplied
Quantity
demanded
support
price
60
Taxes
Governments raise taxes to finance public
expenditure
But taxes affect market equilibrium
When government levies a tax, who bears the
burden of the tax?
Farmers and road hauliers claim they bear the burden
of high fuel taxes. Is this true or is it consumers?
Tax incidence
Taxes on Buyers or Sellers
Taxes on buyers are unusual
If you buy a good you must send a certain
additional sum to the government
Taxes on sellers are common
If you sell a good you must send a proportion
of the selling price to the government
(although in the case of VAT you can net off
any tax you have paid buying raw materials to
make the good)
A Tax Levied on Sellers (e.g. VAT)
15
12.77
tax
90
Equilibrium
with tax
Suppose a CD costs
14 without VAT
VAT is levied at 17.5%
tax
S
2

Because equilibrium
changes the new price
before tax falls to (say)
12.77
Adding VAT (17.5% of
12.77) gives a price to
consumers of 15
Price
Quantity
14
100
Equilibrium
without tax
D
S
1

0
Effects of Taxes on Buyers or
Sellers
A tax levied on sellers shifts the supply curve
whereas a tax levied on buyers shifts the demand
curve
Both have the same effect
So the government can decide who is responsible
for paying a tax but it cannot influence who
actually pays the tax
In the previous example the price the sellers receive
falls and the price the consumers pay rises
The relative size of these effects depends on the
relative price elasticity of demand and supply
Elasticity and Tax Incidence (1)
Elastic supply and
inelastic demand
D
Price buyers
pay
Price sellers
receive
tax
Price without
tax
S
Tax incidence falls
heavily on
consumers
and only lightly on
producers.
Price
Quantity
0
Elasticity and Tax Incidence (2)
Price buyers
pay
Price sellers
receive
tax
Price without
tax
S
Tax incidence falls
lightly on
consumers
but heavily on
producers.
Price
Quantity
D
0
Inelastic supply and
elastic demand
Implications
If demand is less elastic than supply then more of
the tax is paid by consumers than producers
If supply is less elastic than demand then more of
the tax is paid by producers than consumers
So taxing luxury goods as a way of taxing the rich may
be counterproductive if demand is very elastic
producers will bear the tax
Labour taxes (such as national insurance contributions)
tend to be borne by workers (suppliers) because
supply is very inelastic
Welfare Economics
Looks at the benefits that buyers and
sellers obtain from market participation
Consumer surplus
Producer surplus
Conclusion: only in equilibrium, where
supply equals demand, are total benefits at
a maximum
Consumer Surplus
Willingness to pay: amount individual
would be prepared to pay (reservation
price)
Consumer surplus = (willingness to pay
amount actually paid)
5
100
Cheryl
150
Sarah
4
200
Nicola
3
250
2
Kimberley
300
1
Nadine
Price of
Ferrari k
Buyers Quantity
>300 Nadine 1
250-300 + Kimberley 2
200-250 + Nicola 3
150-200 + Sarah 4
<150 + Cheryl 5
The area under the demand curve
down to the current price; e.g.
willingness to pay for Ferraris
price
0
Reducing the price adds
consumer surplus
Consumer Surplus in Practice
What does Consumer Surplus
Measure?
The benefit that buyers receive from the
good or service, as they perceive it
Economists use it as a measure of
economic well-being
Producer Surplus
Willingness to sell: amount at which firm is
prepared to sell
Producer surplus = (amount good is sold at
cost of producing good) = profit
Producer Surplus in Practice
Ricky
200
30 40
250
Barrie
50
300
Roy
Price of
Ferrari k
Sellers Quantity
<150 Ken 10
150-200 + Arthur 20
200-250 + Ricky 30
250-300 + Barrie 40
>300 + Roy 50
The area above the supply curve up
to the current price: e.g., willingness
to sell Ferraris
Raising the price adds
producer surplus
100
Ken
10
150
Arthur
20
price
0
50
Market Efficiency
What might a central planner do?
Maximise total surplus (i.e. consumer +
producer)
What price and output combination should
the planner announce to achieve this?
Maximising Total Surplus
TS = CS + PS
CS = value to buyers amount paid by buyers
PS = amount received by sellers cost to sellers
TS = value to buyers amount paid by buyers +
amount received by sellers cost to sellers
So TS = value to buyers cost to sellers (because
amount paid must equal amount received)
Efficient Market Allocation
Producer
surplus
C
D
Consumers AE buy,
because they value
the good more than
the price
Consumers EB dont
buy
Consumer
surplus
A
E
B
Equilibrium
price
Equilibrium
quantity
Supply
price
quantity
Demand
0
Producers CE sell
because price is
above cost
Producers ED dont
sell
If Economies were Perfect
Free markets allocate supply to buyers who value
them most highly
Free markets allocate demand to sellers who
produce at least cost
Free market equilibrium maximises total surplus,
and is therefore efficient
But economies are not perfect
Efficient Market Equilibrium
Equilibrium
quantity
Supply
Value to
buyers is
greater
than cost
to sellers
Value to
buyers is
less than
cost to
sellers
Value to buyers
Cost to sellers
At quantities to the
left of market
equilibrium
producing more
would increase total
surplus
At quantities to the
right of market
equilibrium
producing more
would reduce total
surplus
price
quantity
Demand
0
Conclusions
Governments intervene in markets by controlling
prices and levying taxes
The effects of these interventions depends on the
price elasticities of demand and supply
Tax incidence depends on the relative size of the
elasticities.
In a free market, equilibrium is where total
surplus is maximised
In Lecture 6 we shall use these tools to analyse
the gains and losses from international trade.
Economic Principles I
Lecture 5:
Government Intervention in Markets
and its Welfare Impact