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3 Government Intervention
Government Intervention
Indirect taxes
Subsidies
Price Controls
Unit Overview
Government
Intervention
Online:
Price controls
Taxes
Subsidies
Market failure
Externalities
Taxes
Coase Theorem
Environment
Public goods
Government
Intervention
Video Lessons
Practice Activities
Microeconomics G
lossary
Indirect Taxes
Indirect Taxes
An indirect tax is one placed by the government on the producers of a
particular good.
Consumers will pay the tax indirectly through producers
An indirect tax will be shared by both consumers and producers
Pencil
The effect of an indirect tax on
S+tax
P
market
the market for a good: Examine
the market for pencils.
Assume the government decides 1.55
$0.5
to place a $0.50 tax on pencil
0
production to raise revenue to
1.25
support the pen industry.
1.05
The tax is an additional cost for
pencil producers, so the supply of
pencils decreases.
Supply will shift UP by $0.50
The price of pencils increases from
Qtax Qe
$1.25 to $1.55.
Indirect Taxes
Pencil market
S+tax
$0.5
0
D
Qtax Qe
Indirect Taxes
Indirect Taxes
Good A
S+tax
2.90
$1
2.2
0
2.00
Good B
S+tax
$1
2.00
1.90
1.20
D
D
Qtax
Qe
QtaxQe
Indirect Taxes
Good A
S+tax
Observations:
The $1 tax on Good A (highly elastic
demand):
0
$0.80 is paid by produces, and only $0.20 by
1.2
consumers
0
Quantity falls dramatically.
The loss of welfare (gray triangle) is large
Revenue raised is small due to the large decrease in
P
Q
$1
2.2
0
2.0
D
Qe
Qtax
Good B
S+tax
2.90
$1
2.00
1.90
D
Q
Indirect Taxes
Indirect Taxes
After the
tax:the
After
tax:
Subsidies
Per-unit Subsidies
A subsidy, in contrast to a tax, is a payment from the government to
producer for each unit produced
The effect of a per-unit subsidy
on the market for a good: Assume
P
the government places a $0.50
subsidy on the production of pens.
Supply shifts down by $0.50,
since the subsidy reduces the
2.20
marginal costs of pen producers. 2.00
The price consumers pay falls from
1.70
$2 to $1.70.
The price producers receive for
each pen is the $1.70 consumers
pay plus the $0.50 subsidy, or
$2.20
There is a greater quantity of pens
Pen market
S
S+subsidy
$0.5
0
D
Qe Qsubsidy
Subsidies
1.70
Pen market
S
S+subsidy
$0.5
0
Subsidies
The
Subsidies
The
After the
subsidy:
After the
subsidy:
After the
subsidy:
After the
subsidy:
Price Controls
Price Controls
Another form government intervention might take in a market is price
controls.
Price Ceiling: This is a maximum
Price Floor: This is a minimum price,
price, set below the equilibrium
set below the equilibrium price,
price, meant to help consumers of
meant to help producers of a product
a product by keeping the price low.
by keeping the price high.
P
Gasolin
e
Market
Corn
Market
Pf
Pe
Pe
Pc
D
QS
Qe
QD
D
QD
Qe
QS
Price Controls
Gasoline
Market
Shortag
e
QS
Qe
D
QD
Price Controls
On Producers:
Market
Pf
Pe
Surplus
D
QD
Qe
QS
Price Controls
Equations
As with taxes and subsidies, we can use linear supply and demand equations
to calculate the effects of price ceilings and price floors. Once again, assume
demand and supply for bread is:
and
As we have already shown, the current equilibrium price is $4 and the
quantity is 400 loaves.
Assume the government wishes to help households afford bread, so
imposes a price ceiling of $3 on bread. To determine the impact on the
market, we must simply put $3 into both equations.
The $3.00 price ceiling will create a shortage of 200 loaves of bread.
Producers will reduce their output of bread and more consumers will wish
Price Controls
Equations
Next, assume that the government determines that $4 is too cheap for bread,
and producers need the price to be higher. The government imposes a price
floor of $5 in the market. To determine the impact on the market, we must
simply put $3 into both equations.
The $5.00 price floor will create a surplus of 200 loaves of bread.
Producers will increase their production of bread to take advantage of the
now higher prices it is commanding in the market.
Consumers will reduce the quantity of bread they demand due to the now
higher price.
The price floor took an efficient market and made it allocatively inefficient.
Too many resources are now being allocated towards bread production!
Price Controls
Government Intervention
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