Economics Lecture Notes – Chapter 4

GOVERNMENT INTERVENTION IN THE MARKETS will be taught in economics tuition in the sixth and seventh weeks of term 1.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

In the free market, the equilibrium of a market is determined by the market forces of demand and supply. However, the equilibrium price and the equilibrium quantity may not be the optimal price and the optimal quantity. For example, the price of food may be too high especially in times of war, the quantity of education will be too low and the quantity of tobacco will be too high in the absence of government intervention. Therefore, there is a role for the government in the markets. This chapter provides an exposition of government intervention in the markets through tax, subsidy, maximum price and minimum price.

2          TAX

2.1       Effects of an Indirect Tax on Price and Quantity

A tax is a levy imposed on a good, service, income or wealth by the government. Taxes are often classified into direct taxes and indirect taxes. A direct tax is a tax imposed on income or wealth. Examples include personal income tax and corporate income tax. An indirect tax is a tax imposed on a good or service. Examples include goods and services tax and excise tax.

There are two types of indirect taxes: specific tax and ad valorem tax. A specific tax is an indirect tax of a certain amount per unit sold. An example is the excise tax on cigarettes in Singapore which is $0.427 per cigarette. An ad valorem tax is an indirect tax of a certain percentage of the price of the good. An example is the goods and services tax in Singapore which is 7 per cent of the price of a good or service.

An indirect tax will lead to a rise in the cost of production. When this happens, firms will increase price by the amount of the tax at each quantity supplied to maintain profitability. In other words, they will decrease quantity supplied at each price which will lead to a decrease in supply.

Specific Tax

In the above diagram, a specific tax leads to a vertical/parallel upward shift in the supply curve (S) from S0 to S1 as the amount of the tax is the same at each quantity supplied.

Ad Valorem Tax

In the above diagram, an ad valorem tax leads to a pivotal upward shift in the supply curve (S) from S0 to S1 as the amount of the tax increases when the quantity supplied increases, and this is because a higher quantity supplied corresponds to a higher price on the supply curve.

Consider the demand and the supply schedules of wine and the effect of a specific tax of $3 per bottle.

Price

Quantity   demanded

Quantity   supplied

(before   tax)

Quantity   supplied

(after   tax)

12

6

15

9

11

7

13

7

10

8

11

5

9

9

9

3

8

10

7

1

7

11

5

6

12

3

5

13

1

In the above diagram, the initial price and quantity are $9 and 9 bottles. Firms pay a tax of $3 to the government for each bottle sold and this induces them to increase the price by $3 at each quantity supplied to maintain profitability. However, the new price is $11 instead of $12 as the quantity supplied exceeds the quantity demanded at the price of $12. The tax revenue of $21 ($3 × 7) collected by the government is represented by the shaded area.

Note:   Direct taxes affect disposable income (i.e. after-tax income). Therefore they affect demand. Disposable income will be explained in greater detail in Chapter 8. Indirect taxes affect the cost of production. Therefore, they affect supply. 

A progressive tax is a tax that increases more than proportionate with income. Direct taxes are progressive taxes. A regressive tax is a tax that increases less than proportionate with income. Indirect taxes are regressive taxes.

Note:   The effects of an indirect tax on price and quantity will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

2.2       Tax Incidence

Tax incidence is the distribution of the burden of tax between firms and consumers.

When the government imposes a tax on a good, firms and consumers will each pay a proportion of the tax. A tax on a good will lead to a rise in the cost of production. When this happens, firms will pass on the rise in the cost of production to consumers in the form of a higher price in order to maintain profitability. However, as the demand for a good is not perfectly price inelastic, the rise in the price will be less than the rise in the unit cost of production which is the amount of the tax. Therefore, consumers will pay the tax in the form of a higher price and firms will pay the tax as the rise in the price will be less than the amount of the tax. In the previous example, the tax of $3 leads to a vertical upward shift in the initial supply curve (S0) by the amount of the tax to the new supply curve (S1). The vertical distance between S0 and S1 is the tax of $3. Consumers pay a higher price of $11 and firms receive a lower effective price of $8 after paying the tax of $3 to the government. Therefore, consumers pay two-thirds [($11 – $9)/$3] of the tax and firms pay one-third [($9 – $8)/$3] of the tax. In this case, consumers pay a larger proportion of the tax.

In general, whether consumers or firms will pay a larger proportion of a tax on a good depends on the price elasticity of demand relative to the price elasticity of supply. The side of the market which is less responsive to a change in the price will pay a larger proportion of the tax. If the demand is more price elastic than the supply, firms will pay a larger proportion of the tax. When consumers are more responsive to a change in the price than firms, firms will not be able to pass on a larger proportion of the tax to consumers in the form of a large increase in the price without causing a large decrease in the quantity demanded. Conversely, if the demand is less price elastic than the supply, consumers will pay a larger proportion of the tax. When consumers are less responsive to a change in the price than firms, firms will be able to pass on a larger proportion of the tax to consumers in the form of a large increase in the price without causing a large decrease in the quantity demanded.

Demand is more Price Elastic than Supply

In the above diagram, the demand is more price elastic than the supply and hence the demand curve (D) is flatter than the supply curve (S). The proportion of the tax (t) paid by firms, which is [P0 – (P1 – t)]/t or B/(A + B), is greater than the proportion paid by consumers, which is (P1 – P0)/t or A/(A + B).

Demand is less Price Elastic than Supply

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D) is steeper than the supply curve (S). The proportion of the tax (t) paid by consumers, which is (P1 – P0)/t or A/(A + B), is greater than the proportion paid by firms, which is [P0 – (P1 – t)]/t or B/(A + B).

Note:   Tax incidence will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

3          SUBSIDY

3.1       Effects of a Subsidy on Price and Quantity

A subsidy is a payment made by the government to a firm to lower the cost of production and therefore increase supply.

A subsidy will lead to a fall in the cost of production. When this happens, firms will decrease price by the amount of the subsidy at each quantity supplied to maintain competitiveness. In other words, they will increase quantity supplied at each price which will lead to an increase in supply.

In the above diagram, a subsidy leads to a vertical/parallel downward shift in the supply curve (S) from S0 to S1 as the amount of the subsidy is the same at each quantity supplied.

Consider the demand and the supply schedules for wheat and the effect of a subsidy of $3 per sack.

Price

Quantity   demanded

Quantity   supplied

(before   subsidy)

Quantity   supplied

(after   subsidy)

12

6

15

11

7

13

10

8

11

9

9

9

15

8

10

7

13

7

11

5

11

6

12

3

9

5

13

1

7

In the above diagram, the initial price and quantity are $9 and 9 sacks. Firms receive a subsidy of $3 from the government for each sack sold and this allows them to decrease the price by $3 at each quantity supplied to maintain competitiveness. However, the new price is $7 instead of $6 as the quantity demanded exceeds the quantity supplied at the price of $6. The expenditure of $33 ($3 x 11) on the subsidy incurred by the government is represented by the shaded area.

Note:   The effects of a subsidy on price and quantity will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

3.2       Subsidy Incidence

Subsidy incidence is the distribution of the benefit of subsidy between firms and consumers.

When the government gives a subsidy on a good, firms and consumers will each receive a proportion of the subsidy. A subsidy on a good will lead to a fall in the cost of production. When this happens, firms will pass on the fall in the cost of production to consumers in the form of a lower price in order to maintain competitiveness. However, as the demand for a good is not perfectly price inelastic, the fall in the price will be less than the fall in the unit cost of production which is the amount of the subsidy. Therefore, consumers will receive the subsidy in the form of a lower price and firms will receive the subsidy as the fall in the price will be less than the amount of the subsidy. In the previous example, the subsidy of $3 leads to a vertical downward shift in the initial supply curve (S0) by the amount of the subsidy to the new supply curve (S1). The vertical distance between S0 and S1 is the subsidy of $3. Consumers pay a lower price of $7 and firms receive a higher effective price of $10 after getting the subsidy of $3 from the government. Hence, consumers receive two-thirds [($9 – $7)/$3] of the subsidy and firms receive one-third [($10 – $9)/$3] of the subsidy. In this case, consumers receive a larger proportion of the subsidy.

In general, whether consumers or firms will receive a larger proportion of a subsidy on a good depends on the price elasticity of demand relative to the price elasticity of supply. The side of the market which is less responsive to a change in the price will receive a larger proportion of the subsidy. If the demand is more price elastic than the supply, firms will receive a larger proportion of the subsidy. When consumers are more responsive to a change in the price than firms, firms will not need to pass on a larger proportion of the subsidy to consumers in the form of a large decrease in the price to induce them to increase the quantity demanded substantially. Conversely, if the demand is less price elastic than the supply, consumers will receive a larger proportion of the subsidy. When consumers are less responsive to a change in the price than firms, firms will need to pass on a larger proportion of the subsidy to consumers in the form of a large decrease in the price to induce them to increase the quantity demanded substantially.

Demand is more Price Elastic than Supply

In the above diagram, the demand is more price elastic than the supply and hence the demand curve (D) is flatter than the supply curve (S). The proportion of the subsidy (s) received by firms, which is [(P1 + s) – P0]/s or A/(A + B), is greater than the proportion received by consumers, which is (P0 – P1)/s or B/(A + B).

Demand is less Price Elastic than Supply

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D) is steeper than the supply curve (S). The proportion of the subsidy (s) received by consumers, which is (P0 – P1)/s or B/(A + B), is greater than the proportion received by firms, which is [(P1 + s) – P0]/s or A/(A + B).

Note:   Subsidy incidence will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

4          MAXIMUM PRICE (PRICE CEILING)

4.1       Effects of a Maximum Price on Price and Quantity

A maximum price, or a price ceiling, is the highest price that firms are legally allowed to charge.

The government may set a maximum price on a good to prevent the price from rising above a certain level in order to ensure the affordability to consumers. An example is the rent control in Canada. A non-binding maximum price is a maximum price set above the equilibrium price. A binding maximum price is a maximum price set below the equilibrium price. A binding maximum price will lead to a fall in the price resulting in an increase in the quantity demanded and a decrease in the quantity supplied. Therefore, a binding maximum price will lead to a shortage.

In the above diagram, the initial price (P) and quantity (Q) are P0 and Q0. A binding maximum price (PMAX) leads to a fall in the price from P0 to PMAX. The quantity demanded increases from Q0 to QD and the quantity supplied decreases from Q0 to QS. Therefore, the quantity demanded (QD) is greater than the quantity supplied (QS) resulting in a shortage. When a shortage occurs, a black market may emerge. In other words, the good may be illegally sold at prices above the price ceiling which will render it ineffective. In the extreme case where black marketeers buy up the quantity supplied at PMAX, the price will rise from P0 to PBM.

To solve the shortage problem, the government can draw on its buffer stock, assuming it has a buffer stock of the good. However, this can only be a short-term measure if the shortage problem is persistent as the government will deplete its buffer stock in time to come. In this case, the government can only solve the shortage problem by decreasing the demand or increasing the supply. The government can decrease the demand by developing substitutes for the good or increase the supply by direct government production or by giving a subsidy to firms to induce them to increase output.

4.2       Effects of a Maximum Price on Consumers, Firms and the Government

Firms

A binding maximum price will lead to a fall in the price and the quantity. A fall in the price and the quantity will both lead to a decrease in the producer surplus. Therefore, firms will be worse off.

In the above diagram, the initial price (P) and quantity (Q) are P0 and Q0 and the initial producer surplus is represented by the sum of area D, area E and area F. A binding maximum price leads to a fall in the price from P0 to PMAX and a fall in the quantity from Q0 to QS resulting in a lower producer surplus represented by area F.

Consumers

A binding maximum price will lead to a fall in the price and the quantity. Although the fall in the price will lead to an increase in the consumer surplus for consumers who can continue to buy the good, the fall in the quantity will lead to a decrease in the consumer surplus for consumers who can no longer buy the good. Therefore, consumers may be better off or worse off. If the supply is price inelastic, which means that the fall in the quantity will be small, the consumer surplus will increase. In the previous diagram, the initial consumer surplus is represented by the sum of area A, area B and area C. A binding maximum price leads to the new consumer surplus represented by the sum of area A, area B and area D. As area D is greater than area C, the consumer surplus increases. However, if the supply is price elastic, which means that the fall in the quantity will be large, the consumer surplus will decrease. In this case, area D will be less than area C. If the shortage leads to a black market, in the extreme case where black marketeers buy up the quantity supplied at PMAX, the price will rise from P0 to PBM resulting in a lower consumer surplus represented by area A.

Government

A binding maximum price will lead to a fall in the quantity. If the initial quantity is allocatively efficient, the fall in the quantity will be undesirable for the government as it will lead to the problem of under-production resulting in a deadweight loss represented by the sum of area C and area E. However, if the initial quantity is above the allocatively efficient level due to external costs, the fall in the quantity will be desirable for the government as it will solve or reduce the problem of over-production. In this case, instead of creating deadweight loss, a binding maximum price will eliminate or reduce deadweight loss.

Note:   Students should understand that apart from the price elasticity of supply, the effect of a price ceiling on the consumer surplus also depends on the price elasticity of demand, but to a lesser extent. Due to the examination time constraint, a discussion of the concept of price elasticity of demand is not necessary.

The effects of a maximum price on consumers, firms and the government will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

5          MINIMUM PRICE (PRICE FLOOR)

5.1       Effects of a Minimum Price on Price and Quantity

A minimum price, or a price floor, is the lowest price that firms are legally allowed to charge.

The government may set a minimum price on a good to prevent the price from falling below a certain level in order to protect the producers’ income. An example is the minimum price on rice in Thailand. The government may also set a minimum price on a good to decrease the consumption. An example is the minimum price on vodka in Russia. A non-binding minimum price is a minimum price set below the equilibrium price. A binding minimum price is a minimum price set above the equilibrium price. A binding minimum price will lead to a rise in the price resulting in an increase in the quantity supplied and a decrease in the quantity demanded. Therefore, a binding minimum price will lead to a surplus.

In the above diagram, the initial price (P) and quantity (Q) are P0 and Q0. A binding minimum price (PMIN) leads to a rise in the price from P0 to PMIN. The quantity supplied increases from Q0 to QS and the quantity demanded decreases from Q0 to QD. Therefore, the quantity supplied (QS) is greater than the quantity demanded (QD) resulting in a surplus. When a surplus occurs, a black market may emerge. In other words, firms may illegally sell the good at prices below the price floor to reduce their stocks which will render it ineffective.

To solve the surplus problem, the government can buy the surplus and keep it as buffer stock. However, this can be a costly measure if the surplus problem is persistent as it will lead to an over-accumulation of the buffer stock. In this case, the government may want to solve the surplus problem by increasing the demand or decreasing the supply. The government can increase the demand by finding alternative uses for the good or decrease the supply by imposing an output quota.

Note:   An output quota, or a production quota, is a limit imposed on the quantity of a good that can be produced.

5.2       Effects of a Minimum Price on Consumers, Firms and the Government

Consumers

A binding minimum price will lead to a rise in the price and a fall in the quantity. A rise in the price and a fall in the quantity will both lead to a decrease in the consumer surplus. Therefore, consumers will be worse off.

In the above diagram, the initial price (P) and quantity (Q) are P0 and Q0 and the initial consumer surplus is represented by the sum of area A, area B and area C. A binding minimum price leads to a rise in the price from P0 to PMIN and a fall in the quantity from Q0 to QD resulting in a lower consumer surplus represented by area A.

Firms

Assume that the government does not buy up the excess supply created by the binding minimum price. A binding minimum price will lead to a rise in the price and a fall in the quantity. Although the rise in the price will lead to an increase in the producer surplus for firms who can continue to sell the good, the fall in the quantity will lead to a decrease in the producer surplus for firms who can no longer sell the good. Therefore, firms may be better off or worse off. If the demand is price inelastic, the fall in the quantity is likely to be small. Therefore, the producer surplus is likely to increase. However, if the demand is price elastic, the fall in the quantity is likely to be large. Therefore, the producer surplus is likely to decrease. In the previous diagram, the initial producer surplus is represented by the sum of area D and area E. A binding minimum price leads to the new producer surplus represented by the sum of area B and area D. If the demand is price inelastic, area B is likely to be greater than area E and hence the producer surplus is likely to increase. However, if the demand is price elastic, area B is likely to be less than area E and hence the producer surplus is likely to decrease. To prevent a black market from occurring, the government may buy up the excess supply. In this case, the quantity will rise which will lead to an increase in the producer surplus from the sum of area D and area E to the sum of area D, area E, area B, area C and area F.

Government

If the government buys up the excess supply, there will be a loss in surplus as the expenditure incurred by the government on buying the excess supply can be used to produce goods which generate surplus. In the previous diagram, the expenditure incurred by the government on buying up the excess supply is represented by the sum of area C, area F, area G, area H, area I and area E. Other things being equal, this will be the deadweight loss, assuming the initial quantity is at the allocatively efficient level. Furthermore, as discussed earlier, the consumer surplus will decrease by the sum of area B and area C. Therefore, the deadweight loss will be the sum of the expenditure incurred by the government on buying up the excess supply and the decrease in the consumer surplus, other things being equal. However, as discussed earlier, the producer surplus will increase by the sum of area B, area C and area F. Therefore, the deadweight loss is the sum of area C, area G, area H, area I and area E.

Note:   Students should understand that apart from the price elasticity of demand, the effect of a price floor on the producer surplus also depends on the price elasticity of supply, but to a lesser extent. Due to the examination time constraint, a discussion of the concept of price elasticity of supply is not necessary.

The effects of a minimum price on consumers, firms and the government will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

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