EPS1Lecture5(1)

8/11/2019 EPS1Lecture5(1)

1/25

Economic Principles I

Lecture 5:

Government Intervention in Marketsand its Welfare Impact


2/25

Policies that Control Prices

Governments sometimes

regulate prices to protect

consumers against being

exploited by monopolysuppliers, or to ration goods

in extreme times

Very occasionally they use

price floors to protect

producersagricultural

markets are the main

example

(A World War 2 ration book)


3/25

A Price Ceiling

Supply

Quantity0

Price

Demand

Quantity0

Price Supply

Demand

a) Non-binding b) Binding

Sellers must ration goods

12

Price

ceiling

12

100

Equilibrium

quantity

70 130

Shortage

Quantity

supplied

Quantity

demanded

Price

ceiling8


4/25

Another ExampleControlled

Rents for Low Income Families

Quantity

of houses0

Weekly

rent

Demand

a) short-runSupply

Rent

control50

Shortage

Quantity

of houses0

Weekly

rent

Demand

b) long-run

Supply

Rent

control50

Shortage


5/25


6/25

Taxes

Governments raise taxes to finance public

expenditure

But taxes affect market equilibrium When government levies a tax, who bears the

burden of the tax?

Farmers and road hauliers claim they bear the burden

of high fuel taxes. Is this true or is it consumers?

Tax incidence


7/25

Taxes on Buyers or Sellers

Taxes on buyers are unusual

If you buy a good you must send a certain

additional sum to the government Taxes on sellers are common

If you sell a good you must send a proportionof the selling price to the government

(although in the case of VAT you can net offany tax you have paid buying raw materials tomake the good)


8/25

A Tax Levied on Sellers (e.g. VAT)

15

12.77

tax

90

Equilibrium

with tax

Suppose a CD costs14 without VAT

VAT is levied at 17.5%tax

S2

Because equilibriumchanges the new pricebefore tax falls to (say)12.77

Adding VAT (17.5% of12.77) gives a price toconsumers of 15

Price

Quantity

14

100

Equilibrium

without tax

D

S1

0


9/25

Effects of Taxes on Buyers or

Sellers

A tax levied on sellers shifts the supply curvewhereas a tax levied on buyers shifts the demandcurve Both have the same effect

So the government can decide who is responsiblefor paying a tax but it cannot influence whoactually pays the tax

In the previous example the price the sellers receivefalls and the price the consumers pay rises

The relative size of these effects depends on therelative price elasticity of demand and supply


10/25

Elasticity and TaxIncidence

(1)Elastic supply and

inelastic demand

D

Price buyers

pay

Price sellers

receive

tax

Price without

tax

S

Tax incidence fallsheavily on

consumers

and only lightly on

producers.

Price

Quantity0


11/25

Elasticity and Tax Incidence(2)

Price buyers

pay

Price sellers

receive

tax

Price without

tax

S

Tax incidence fallslightly on

consumers

but heavily on

producers.

Price

Quantity

D

0

Inelastic supply and

elastic demand


12/25

Implications

If demand is less elastic than supply then more ofthe tax is paid by consumers than producers

If supply is less elastic than demand then more ofthe tax is paid by producers than consumers

So taxing luxury goods as a way of taxing the rich maybe counterproductiveif demand is very elasticproducers will bear the tax

Labour taxes (such as national insurance contributions)tend to be borne by workers (suppliers) becausesupply is very inelastic


13/25

Welfare Economics

Looks at the benefits that buyers and

sellers obtain from market participation

Consumer surplus

Producer surplus

Conclusion: only in equilibrium, where

supply equals demand, are total benefits ata maximum


14/25

Consumer Surplus

Willingness to pay: amount individual

would be prepared to pay (reservation

price)

Consumer surplus = (willingness to pay

amount actually paid)


15/25

5

100

Cheryl

150

Sarah

4

200

Nicola

3

250

2

Kimberley300

1

Nadine

Price of

Ferrari k

Buyers Quantity

>300 Nadine 1

250-300 + Kimberley 2

200-250 + Nicola 3

150-200 + Sarah 4


16/25

What does Consumer Surplus

Measure?

The benefit that buyers receive from the

good or service, as they perceive it

Economists use it as a measure of

economic well-being


17/25

Producer Surplus

Willingness to sell: amount at which firm is

prepared to sell

Producer surplus = (amount good is sold at

cost of producing good) = profit


18/25

Producer Surplus in Practice

Ricky

200

30 40

250

Barrie

50

300

Roy

Price of

Ferrari k

Sellers Quantity

300 + Roy 50

The area above the supply curve up

to the current price: e.g., willingness

to sell Ferraris

Raising the price adds

producer surplus

100

Ken

10

150

Arthur

20

price

0

50


19/25

Market Efficiency

What might a central planner do?

Maximise total surplus (i.e. consumer +

producer)

What price and output combination should

the planner announce to achieve this?


20/25

Maximising Total Surplus

TS = CS + PS

CS = value to buyersamount paid by buyers

PS = amount received by sellerscost to sellers TS = value to buyersamount paid by buyers +

amount received by sellerscost to sellers

So TS = value to buyerscost to sellers (because

amount paid must equal amount received)


21/25

Efficient Market Allocation

Producer

surplus

C

D Consumers AE buy,

because they valuethe good more than

the price Consumers EB dont

buyConsumer

surplus

A

E

B

Equilibrium

price

Equilibrium

quantity

Supply

price

quantity

Demand

0

Producers CE sell

because price isabove cost

Producers ED dontsell


22/25

If Economies were Perfect

Free markets allocate supply to buyers who value

them most highly

Free markets allocate demand to sellers whoproduce at least cost

Free market equilibrium maximises total surplus,

and is therefore efficient

But economies are not perfect


23/25

Efficient Market Equilibrium

Equilibrium

quantity

Supply

Value to

buyers is

greater

than cost

to sellers

Value to

buyers is

less than

cost to

sellers

Value to buyers

Cost to sellers

At quantities to the

left of market

equilibrium

producing morewould increasetotal

surplus

At quantities to the

right of market

equilibrium

producing more

would reducetotal

surplus

price

quantity

Demand

0


24/25

Conclusions

Governments intervene in markets by controllingprices and levying taxes

The effects of these interventions depends on the

price elasticities of demand and supply Tax incidence depends on the relative size of the

elasticities.

In a free market, equilibrium is where total

surplus is maximised In Lecture 6 we shall use these tools to analyse

the gains and losses from international trade.


25/25

Economic Principles I

Lecture 5:

Government Intervention in Marketsand its Welfare Impact

Documents

EPS1Lecture5(1)