Chapter 4
Markets in Action:
Government Participation
Price Floors/Ceilings
Tariffs/Quotas
Sales Taxes
Welfare Analysis
Consumer and Producer Surplus
Welfare Analysis
• To determine the impact on trade policies,
we must determine how the participants in
the economy are affected
– Participants include:
• Consumers (Households)
• Producers (Firms)
• Government
Consumer Surplus
• Consumer Surplus (CS) is a method to
determine the net benefit of consumption
• Definition: “extra amount consumers are
willing to pay for an item compared to what
they have to pay”
– Graphically, this is the area under the demand
curve
Consumer Surplus II
• Area under
demand curve is 15 P
the total value
of consumption
aa
• At $10, value to
10
consumer is
(a+b+c), but
b
b
consumer must
5
pay (b+c)
• So CS = a
d
e
c
0
10
15
D
Q
Consumer Surplus III
• If the price falls
P
15
to $5, then the
total value of
consumption is
aa
(a+b+c+d+e)
10
• Consumer must
b
pay (c+e)
b
• So, CS= (a+b+d) 5
dd
e
e
c
0
10
15
D
Q
Producer Surplus (PS)
• “Extra benefit” to producers
• “What producers can charge” – “What
producers willing to charge”
• Graphically: Area between market price and
supply curve
Producer Surplus II
P
S
10
z
y
5
x
• Suppose the
market price is $5
• Firm is willing to
sell unit 8 at $5,
but for units 1-7,
the firm is willing
to sell each at a
price less than $8
• PS = x
1
0
8
15
Q
Producer Surplus III
P
S
10
z
y
5
x
• If the market
price rises to
$10, the firm is
willing to sell at
most 15 units.
• For units 1-14,
the firm is
willing to sell at
a price lower
than $10
• PS = (x+y+z)
1
0
8
15
Q
Market Equilibrium
• A nation’s welfare can then be determined by the sum
of consumer surplus (CS) and producer surplus (PS)
(plus any government revenue)
Welfare = CS + PS + GR
• Note that an increase in market price decreases CS yet
increases PS
• So an increase in market price does not necessarily
have a negative impact on the economy.
Government Intervention
• What we have looked at before were cases
where the "invisible hand" and market
mechanism worked without interference
from outside sources.
• Lets look now at what happens when there
is government intervention in the market
Government Intervention
• Cases where governments (Federal, State,
Local) intervene:
–
–
–
–
–
Price Ceilings
Price Floors
Sales Taxes
Tariffs
Quotas
Price Ceilings
• Price Ceiling:A government regulation that limits
how high a price can be charged for a
good/service
• 2 possible situations :
1) ceiling set above the equilibrium price
2) ceiling set below the equilibrium price
Where do we see price ceilings in place?
P
Price Ceilings
S
Ceilings create
shortages
P*
Ceiling
Price
D
Q
Price Floors
Price Floors: A government regulation that limits how low a
price may be charged for a good/service
2 possible situations :
1) ceiling set above the equilibrium price
2) ceiling set below the equilibrium price
In what situations do we see price floors in place?
P
Price Floors
S
Floor
Price
P*
Floors Create
Surpluses
D
Q
Quotas
• Limit the quantity of imported goods that
can enter a market
• 2 possible scenarios
1) Binding quota (*)
2) Non-binding quota
Why would the government ever use a quota rather than a tariff?
Quotas
• Suppose the US autarky (no trade) price is
$10.00. Suppose also that the price that the
rest of the world pays is $5.00.
• If the US begins to trade, its own firms will
supply 5 units at $5.00, while demanding 20
units
• This means the US must import 15 units
Quotas
P
S
10
5
Imports
5
15
D
Q
20
Quota
• Suppose a quota is put in place that limits imports
to 7 units. What will happen to:
1) US production
2) US consumption
3) Price US consumers pay
Quotas
P
S
Under the quota,
Consumers now
pay $8 and import
less
10
8
Quota
5
D
Q
5
10 15
17
20
Sales Taxes
While there are many different types of sales taxes,
we will focus on a specific tax.
A specific tax is a tax where for each unit of a good sold, a certain
amount of money is paid to the government.
One type of this tax is called an EXCISE TAX.
Taxes
• NOTE:
• Sellers (Producers) only receive the price
that excludes the tax.
• Buyers are faced with the price that includes
the tax.
• Taxes have thus driven a wedge between
the prices.
TAX INCIDENCE
• This is the idea concerning "who bears the
burden of the tax." Is it always the
consumer who pays the full price of the
tax??
Scenarios:
1) Perfectly inelastic demand
2) Perfectly elastic demand
3) Perfectly elastic supply
Modeling Taxes
• Suppose that a $10 per unit tax is placed on a
good. The pre-tax price of the good is $25.
Firms make supply decisions based on the price that they
receive, not the price that we pay.
Depending upon demand elasticity, consumers react by reducing
the amount consumed.
Depending upon supply elasticity, suppliers react by reducing
the amount produced.
P
S + Tax
S
30
25
Tax raises price consumers
pay, but also reduces the amount
suppliers receive – tax burden
shared
Govnt. Rev.
20
D
0
20
25
Q
Taxes
• In this case, the burden is shared.
What happens to the burden of the tax if demand and supply
elasticities are different?
P
S + Tax
S
33
25
GR
23
D
23
25
Q
Taxes
• What can we conclude from this???
1) The more inelastic the demand and supply of a commodity,
the smaller the decline in output from a given tax.
2) Relative burden of taxation among buyers and sellers follows
the "path of least resistance" ( i.e. tax is shifted in proportion to
where inelasticity is greatest)
3) Where is government revenue the highest? To which goods
does this relate?
Subsidies
• Subsidies: a per unit payment on the
purchase or sale of a commodity. Often
called a “negative tax.”
Purchase =====> consumption subsidy
Sale =====> production subsidy