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# Chapter 4 Markets in Action: Government Participation - PowerPoint PPT Presentation

Chapter 4 Markets in Action: Government Participation. Price Floors/Ceilings Tariffs/Quotas Sales Taxes. Welfare Analysis. Consumer and Producer Surplus. Welfare Analysis. To determine the impact on trade policies, we must determine how the participants in the economy are affected

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### Chapter 4Markets in Action: Government Participation

Price Floors/Ceilings

Tariffs/Quotas

Sales Taxes

### Welfare Analysis

Consumer and Producer Surplus

• To determine the impact on trade policies, we must determine how the participants in the economy are affected

• Participants include:

• Consumers (Households)

• Producers (Firms)

• Government

• Consumer Surplus (CS) is a method to determine the net benefit of consumption

• Definition: “extra amount consumers are willing to pay for an item compared to what they have to pay”

• Graphically, this is the area under the demand curve

At \$10, value to consumer is (a+b+c), but consumer must pay (b+c)

So CS = a

Consumer Surplus II

P

15

a

a

10

b

b

d

5

c

e

c

D

0

Q

15

10

If the price falls to \$5, then the total value of consumption is (a+b+c+d+e)

Consumer must pay (c+e)

So, CS= (a+b+d)

Consumer Surplus III

P

15

a

a

10

b

d

b

d

5

c

e

e

c

D

Q

0

15

10

Producer Surplus (PS) consumption is (a+b+c+d+e)

• “Extra benefit” to producers

• “What producers can charge” – “What producers willing to charge”

• Graphically: Area between market price and supply curve

Suppose the market price is \$5 consumption is (a+b+c+d+e)

Firm is willing to sell unit 8 at \$5, but for units 1-7, the firm is willing to sell each at a price less than \$8

PS = x

Producer Surplus II

P

S

10

y

z

5

x

1

0

15

8

Q

If the market price rises to \$10, the firm is willing to sell at most 15 units.

For units 1-14, the firm is willing to sell at a price lower than \$10

PS = (x+y+z)

Producer Surplus III

P

S

10

y

z

5

x

1

0

15

8

Q

Market Equilibrium sell at most 15 units.

• A nation’s welfare can then be determined by the sum of consumer surplus (CS) and producer surplus (PS) (plus any government revenue)

Welfare = CS + PS + GR

• Note that an increase in market price decreases CS yet increases PS

• So an increase in market price does not necessarily have a negative impact on the economy.

Government Intervention sell at most 15 units.

• What we have looked at before were cases where the "invisible hand" and market mechanism worked without interference from outside sources.

• Lets look now at what happens when there is government intervention in the market

Government Intervention sell at most 15 units.

• Cases where governments (Federal, State, Local) intervene:

• Price Ceilings

• Price Floors

• Sales Taxes

• Tariffs

• Quotas

Price Ceilings sell at most 15 units.

• Price Ceiling:A government regulation that limits how high a price can be charged for a good/service

• 2 possible situations :

1) ceiling set above the equilibrium price

2) ceiling set below the equilibrium price

Where do we see price ceilings in place?

Price Ceilings sell at most 15 units.

P

S

Ceilings create

shortages

P*

Ceiling

Price

D

Q

Price Floors sell at most 15 units.

Price Floors: A government regulation that limits how low a

price may be charged for a good/service

2 possible situations :

1) ceiling set above the equilibrium price

2) ceiling set below the equilibrium price

In what situations do we see price floors in place?

Price Floors sell at most 15 units.

P

S

Floor

Price

P*

Floors Create

Surpluses

D

Q

Quotas sell at most 15 units.

• Limit the quantity of imported goods that can enter a market

• 2 possible scenarios

1) Binding quota (*)

2) Non-binding quota

Why would the government ever use a quota rather than a tariff?

Quotas sell at most 15 units.

• Suppose the US autarky (no trade) price is \$10.00. Suppose also that the price that the rest of the world pays is \$5.00.

• If the US begins to trade, its own firms will supply 5 units at \$5.00, while demanding 20 units

• This means the US must import 15 units

Quotas sell at most 15 units.

P

S

10

5

Imports

D

Q

20

5

15

Quota sell at most 15 units.

• Suppose a quota is put in place that limits imports to 7 units. What will happen to:

• US production

2) US consumption

3) Price US consumers pay

Quotas sell at most 15 units.

P

S

Under the quota,

Consumers now

pay \$8 and import

less

10

8

Quota

5

D

Q

20

5

15

10

17

Sales Taxes sell at most 15 units.

While there are many different types of sales taxes,

we will focus on a specific tax.

A specific tax is a tax where for each unit of a good sold, a certain

amount of money is paid to the government.

One type of this tax is called an EXCISE TAX.

Taxes sell at most 15 units.

• NOTE:

• Sellers (Producers) only receive the price that excludes the tax.

• Buyers are faced with the price that includes the tax.

• Taxes have thus driven a wedge between the prices.

TAX INCIDENCE sell at most 15 units.

• This is the idea concerning "who bears the burden of the tax." Is it always the consumer who pays the full price of the tax??

Scenarios:

1) Perfectly inelastic demand

2) Perfectly elastic demand

3) Perfectly elastic supply

Modeling Taxes sell at most 15 units.

• Suppose that a \$10 per unit tax is placed on a good. The pre-tax price of the good is \$25.

Firms make supply decisions based on the price that they

receive, not the price that we pay.

Depending upon demand elasticity, consumers react by reducing

the amount consumed.

Depending upon supply elasticity, suppliers react by reducing

the amount produced.

P sell at most 15 units.

S + Tax

S

30

Tax raises price consumers

pay, but also reduces the amount

shared

Govnt. Rev.

25

20

D

0

Q

25

20

Taxes sell at most 15 units.

• In this case, the burden is shared.

What happens to the burden of the tax if demand and supply

elasticities are different?

P sell at most 15 units.

S + Tax

S

33

GR

25

23

D

Q

25

23

Taxes sell at most 15 units.

• What can we conclude from this???

• The more inelastic the demand and supply of a commodity,

• the smaller the decline in output from a given tax.

2) Relative burden of taxation among buyers and sellers follows

the "path of least resistance" ( i.e. tax is shifted in proportion to

where inelasticity is greatest)

3) Where is government revenue the highest? To which goods

does this relate?

Subsidies sell at most 15 units.

• Subsidies: a per unit payment on the purchase or sale of a commodity. Often called a “negative tax.”

Purchase =====> consumption subsidy

Sale =====> production subsidy