Government Intervention as

Implicit Taxation
• Government intervention in the form of price
controls can be viewed as a combination tax and
Taxation by another name subsidy.
• A price ceiling is an implicit tax on producers and
an implicit subsidy to producers that causes a
7-4 Price Control welfare loss identical to the loss from taxation.
• A price floor is a tax on consumers and a subsidy
for producers that transfers consumer surplus to
producers.

Price Ceilings Effect of a Price Ceiling

• A price ceiling is a government-set price Consumer
Price
below market equilibrium price. surplus
• It is an implicit tax on producers and an A Welfare loss S

implicit subsidy to consumers.

B C
P0
D E
P1 Price ceiling
F Transferred to
consumers
Producer D
surplus
Q1 Q0 Quantity

1
 Price Floors Effect of a Price Floor
• A price floor is a government-set price Consumer
Price
above equilibrium price. surplus
• It is a tax on consumers and a subsidy to A Price floor S
P1
producers.
B C
• Price floors transfer consumer surplus to P0
D E Welfare loss
producers. F Transferred to
producers
Producer D
surplus
Q1 Q0 Quantity

The Difference Between Taxes and A Price Ceiling with

Price Controls
• Price ceilings create shortages and taxes
do not unless people try to evade them.
• Taxes leave people free to choose how
much to supply and consume as long as
they pay the tax.
• Shortages also create black markets.
Forced Supply
• The draft is an example of a price ceiling
with forced supply.
• A draft must be imposed when the wage
offered by the army is below equilibrium and
the quantity of soldiers supplied is below the
quantity demanded.
• The surplus is transferred from the ones
drafted to the government.

2
 Rent Seeking, Politics,
Effect of a Draft on Surplus
and Elasticities
• Price controls reduce total producer and
Wage S consumer surpluses.
Deadweight loss • Governments institute them because
caused by draft people care more about their own surplus
We
Surplus transferred to than about total surplus.
the government
W0 • Individuals spend money to lobby
governments to institute policies that
D increase their own surplus.
surplus
QS QD=Draft
Quantity of soldiers

Rent Seeking, Politics, Inelastic Demand and Incentives to

and Elasticities
• Rent seeking – activities designed to transfer
surplus from one group to another.
• Public choice economists integrate economic
analysis of politics with their analysis of the
economy.
• They argue that when all rent seeking and
tax consequences are netted out, there is
often not a net gain to the public.
Restrict Supply
• When demand is inelastic, such as the demand
for food, producers have incentives to restrict
supply.
• Advances in farming productivity increase
supply, but decrease price.
• Since demand is inelastic, lower prices decrease
total revenue.
• Farmers have an incentive to restrict supply in
order to raise price and increase total revenue.

3
 Inelastic Demand & Producing Inelastic Demand and
more Incentives to Restrict Supply
Price S0 Price S0
P0 P0
Revenue lost S1
S1 Revenue gained
P1 Revenue gained P1
Revenue lost

Total Revenue Total Revenue

D Demand
Q0 Q1 Quantity Q0 Q1 Quantity

Inelastic Supplies and Incentives to Price Floors and Elasticity of

Restrict Prices Demand and Supply
• When supply is inelastic, consumers have • The surplus created by a price floor is larger
incentives to restrict prices. if demand and supply are elastic.
• When supply is inelastic and demand P surplus
increases, prices increase causing P S
surplus D
consumers to lobby for price controls. PF PF S
• Rent control in New York City is an PE PE
example.
D

QD QS Q QD QS Q

4
 The Long-Run/Short-Run
Problem of Price Controls
• The problem of price controls worsen from
the short run to the long run.
• In the long run, supply and demand tend
to be much more elastic than in the short
run.
The Long-Run/Short-Run
Problem of Price Controls
• In the face of price controls, potential new
competitors hate to enter the market
thereby strangling supply.
• Vacancy rates drop as potential new
renters scramble to find shrinking
affordable housing.
The Long-Run/Short-Run
Problem of Price Controls
• In the short run there will be small effects
from the price controls.
• There will be huge effects in the long run.
The Long-Run/Short-Run Problems
of Price Controls
• In the long-run
ong-run, supply and demand tend to be
much more elastic than in the short run.
run
• In the short run,
run when demand and supply are
more inelastic, the effects of price controls are
small.
small
• In the long run,
run with more elastic demand and
supply, the shortages or surpluses are larger.
large
5
 Long-Run and Short-Run
Elasticities Summary
• Consumer surplus is the net benefit a consumer gets
P Short run
supply from purchasing a good.
Long run • Producer surplus is the net benefit a producer gets
supply
P1 from selling a good.
P2 Larger long-run • Equilibrium maximizes the combination of consumer
elasticities result and producer surplus.
P0 in smaller price
increases when • Taxes create a loss of consumer and producer
D1 demand increases.
surplus known as deadweight loss, which is
D0 graphically represented by the welfare loss triangle.
Q0 Q1 Q2 Q3 Q

Summary
• The cost of taxation to consumers and producers
includes the actual tax paid, the deadweight loss,
and the costs of administering the tax.
• Government follows both the benefit principle and
the ability-to-pay principle when deciding on whom
to levy taxes.
• Relative elasticities determine who bears the
burden of the tax. The more inelastic one’s
demand or supply, the larger the burden of the tax.
Summary
• Price ceilings and floors, like taxes, result in loss of
consumer and producer surplus.
• Price ceilings transfer producer surplus to
consumers; they are a tax on producers and a
subsidy to consumers.
• Price floors transfer consumer surplus to
producers; they are a tax on consumers and a
subsidy to producers.
• The more elastic supply and/or demand is, the
greater the surplus with an effective price floor and
the greater the shortage is with an effective price
ceiling.

6
 Review Question 7-2 Given the following demand and
Review Question 7-1 Given the following demand and
supply of pizza, show the effects of a price floor at $8.
supply of pizza, find consumer and producer surplus.

$10 Consumer surplus: $10 Consumer surplus S

½ x ($10-6) x 100 = $200 S
$9 $9
$8
Price floor
$8
$7
Producer surplus: $7
$6 ½ x ($6-4) x 100 = $100 Deadweight loss
$6
$5
D $5
Producer surplus
$4
$4
D
50 100 150 200 250 300
50 100 150 200 250 300