Gov’t Intervention: Price Floors & Price Ceilings / Taxes & Subsidies
Price Floor: Regulated price, cannot charge below this price. A price floor will be binding if it is set above the
true equilibrium price. A binding price floor will lead to surplus because the price is too high (Qs > Qd).
**Examples include farm price support policies and minimum wage laws.
Price Ceiling: Regulated price, cannot charge above this price. A price floor will be binding if it is set below the
true equilibrium price. A binding price ceiling will lead to shortage because the price is too low (Qd > Qs).
**Examples include rent control and gasoline price controls.
In each case, the quantity transacted will be determined by the short side of the market.
Price Floor: Qd = quantity transacted (Qt)
Price Ceiling: Qs = quantity transacted (Qt)
A Price Floor is designed to benefit producers by raising the price they receive, while hurting consumers as they
must pay a higher price.
CS will fall
PS will rise/fall
BUT
The quantity transacted (Qt) will be less than Q* leading to a dead-weight-loss from units that are not transacted
for which the benefit exceeds the cost.
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Because there are many sellers willing to provide this product to only a few buyers, the sellers will potentially
engage in competitive behavior leading to an additional loss of any PS gain that remains.
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A Price Ceiling is designed to benefit consumers by lowering the price they must pay, while hurting producers as
they receive a lower price.
PS will fall
CS will rise/fall
BUT
The quantity transacted (Qt) will be less than Q* leading to a dead-weight-loss from units that are not transacted
for which the benefit exceeds the cost.
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Because there are many buyers willing to buy this product from only a few sellers, the buyers will potentially
engage in competitive behavior leading to an additional loss of any CS gain that remains.
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1
Tax Levied on Seller: Sellers must pay a tax of $ t for every unit sold. Buyers pay new equilibrium price
(listed price) and then sellers pay tax to gov’t and therefore receive a net price after the tax of the listed price
minus the tax (per unit).
Tax Levied on Buyer: Buyers must pay a tax of $ t for every unit purchased. Buyers pay new equilibrium price
(listed price) and then they pay tax to gov’t and therefore pay the listed price plus the tax in total, while sellers
receive the listed price (per unit).
A tax on sellers raises the supply schedule upwards by the amount of the tax as they must account for the fact that
they must pay the tax on top of there existing costs of production.
The new equilibrium price (listed price) will be higher (Pt > P*). Consumers pay Pc = Pt and sellers end up
receiving Ps = Pt – t after they pay the tax.
With normal upward sloping D & S curves, the burden of the tax will be split.
Consumers pay more than initially
Pc = Pt > P*
Producers receive less than initially
Ps = (Pt – t) < P*
PS
CS
The quantity transacted (Qt) will be less than Q* leading to a dead-weight-loss from units that are not transacted
for which the benefit exceeds the cost.
*The tax revenue collected falls short of the combined hurt to consumers and producers
A tax on buyers lowers the demand schedule downwards by the amount of the tax as they must account for the fact
that they must pay the tax on top of their existing willingness to pay.
The new equilibrium price (listed price) will be lower (Pt < P*). Consumers pay Pt and sellers receive Ps = Pt and
therefore consumers end up paying Pc = Pt + t after they pay the tax.
With normal upward sloping D & S curves, the burden of the tax will be split.
Consumers pay more than initially
Pc = (Pt + t) > P*
Producers receive less than initially
Ps = Pt < P*
PS
CS
The quantity transacted (Qt) will be less than Q* leading to a dead-weight-loss from units that are not transacted
for which the benefit exceeds the cost.
*The tax revenue collected falls short of the combined hurt to consumers and producers
**Note: A subsidy is just the opposite of a tax, but also leads to a dead-weight-loss**
2
Steps to Welfare Analysis of Gov’t Intervention
In General………
1. Identify initial equilibrium (P*, Q*, CS, PS)
2. State desired goal and policy to meet this goal
3. Implement the policy
4. Find new outcome with policy in place (price, quantity, CS, PS)
5. Policy Incidence: Look at net changes in welfare ( CS, PS, DWL, tax revenue)
Price Floor (Pf)……..
1. Identify initial equilibrium (P*, Q*, CS, PS)
2. State desired goal and policy to meet this goal (binding Pf to help sellers)
3. Implement the policy (horizontal line at Pf, above equilibrium price)
Qd < Q* < Qs surplus
4. Find new outcome with policy in place (price, quantity, CS, PS)
shortside of the market
Qt = Qd < Q*
Pf > P*
5. Policy Incidence: Look at net changes in welfare ( CS, PS, DWL)
CS
, PS & PS
helps sellers if PS > PS
DWL due to Qt < Q*
Price Ceiling (Pc)……..
1. Identify initial equilibrium (P*, Q*, CS, PS)
2. State desired goal and policy to meet this goal (binding Pc to help buyers)
3. Implement the policy (horizontal line at Pc, below equilibrium price)
Qs < Q* < Qd surplus
4. Find new outcome with policy in place (price, quantity, CS, PS)
shortside of the market
Qt = Qs < Q*
Pc < P*
5. Policy Incidence: Look at net changes in welfare ( CS, PS, DWL)
PS
, CS & CS
helps buyers if CS > CS
DWL due to Qt < Q*
3
Tax on buyers……….
1. Identify initial equilibrium (P*, Q*, CS, PS)
2. State desired goal and policy to meet this goal (tax to paid by buyers)
3. Implement the policy (D shifts downward vertically by the amount of the tax)
4. Find new outcome with policy in place (price, quantity, CS, PS)
Qt < Q*
Pt < P*
5. Transaction and payment of the tax (Pc, Ps)
Ps = Pt < P*
Pc = (Pt + tax) > P*
6. Policy Incidence: Look at net changes in welfare ( CS, PS, DWL, tax revenue)
PS
CS
tax rev = tax*Qt
DWL due to Qt < Q*
tax rev < PS + CS
Tax on sellers……….
1. Identify initial equilibrium (P*, Q*, CS, PS)
2. State desired goal and policy to meet this goal (tax to paid by sellers)
3. Implement the policy (S shifts upward vertically by the amount of the tax)
4. Find new outcome with policy in place (price, quantity, CS, PS)
Qt < Q*
Pt > P*
5. Transaction and payment of the tax (Pc, Ps)
Ps = (Pt - tax) < P*
Pc = Pt > P*
6. Policy Incidence: Look at net changes in welfare ( CS, PS, DWL, tax revenue)
PS
CS
tax rev = tax*Qt
DWL due to Qt < Q*
tax rev < PS + CS
Gov't Intervention (Policy)
P
P*
Q*
Welfare Analysis
CS , PS , DWL , Tax Rev
4
Q
A tax on the Buyer leads to the same outcome as a tax on the Seller
$2 per unit tax
to be paid by sellers
$2 per unit tax
to be paid by buyers
5
Tax on Sellers
P
S
10
10
6
Q
P
Tax on Buyers
10
D
10
7
Q
Gov’t Intervention: Price Floor/Price Ceiling
Price Floor: Regulated price, firms cannot charge below this price. A price floor will be binding if it is set above the
true equilibrium price. A binding price floor will lead to surplus because the price is too high (Qs > Qd).
The quantity that is actually bought and sold will be determined by the amount that buyers are willing to purchase at
the regulated price
Qd is bought & sold at Pf
Surplus = Qs – Qd
P
10
S
Pf = 7
P* = 5
Prs = 3
D
3
Qd
5
Q*
7
Qs
Initial Equil: consumers & producers buy & sell Q* = 5 units at P* = 5 per unit
With Price Floor:
Qd = 3 units are purchased by consumers at Pf = 7 per unit
Consumers pay more per unit and buy less units
CS = (7-5)*3 + = 6 *transfer to sellers
CS = 1/2*(5-3)*(7-5) = 2
Overall: CS = 6 + 2 = 8
Qs = 3 units are sold by farmers at Pf = 7 per unit
Producers sell less units at a higher price per unit
PS = (7-5)*3 = 6 *transfer from buyers
PS = 1/2*(5-3)*(5-3) = 2
Overall: PS = 6 – 2 = 4
CS of 6 is just a transfer from consumers to producers.
This policy results in a net loss of 4 (DWL)
8
10
Q
Price Ceiling: Regulated price, firms cannot charge above this price. A price floor will be binding if it is set below
the true equilibrium price. A binding price ceiling will lead to shortage because the price is too low (Qd > Qs).
The quantity that is actually bought and sold will be determined by the amount that sellers are willing to supply at
the regulated price
Qs is bought & sold at Pc
Shortage = Qd – Qs
P
S
Prs = 700
P* = 500
Pc= 300
D
300
Qs
500
Q*
700
Qd
Initial Equil: renters and landlords buy and sell Q* = 500 units at R* = 500 per unit
With PriceCeiling:
Qs = 300 units are purchased by consumers at Pc = 300 per unit
Consumers pay less per unit but buy less units
CS = (500-300)*300 = 60,000 *transfer from sellers to buyers
CS 1/2*(700-500)*(500-300) = 20,000
Overall: CS = 40,000
Qs = 300 units are sold by producers at Pc = 300 per unit
Producers sell less units at a lower price per unit
PS = (500-300)*300 = 60,000 *transfer from sellers to buyers
PS = 1/2*(500-300)*(500-300) = 20,000
Overall: PS = 80,000
PS of 60,000 is just a transfer from producers to consumers
This policy results in a net loss of 40,000 (DWL)
9
1000 Q
Example 2.3
If soybeans are one of the main ingredients in cattle feed, how would a price support program in the soybean market
affect the market for beef.
P
Beef
S
D
Q
10