Chapter 4Markets 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– Participants include:

• Consumers (Households)

• Producers (Firms)

• Government

Consumer Surplus• 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

Consumer Surplus II

• Area under demand curve is the total value of consumption

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

• So CS = a

QD

15

0

10

5

10 15

a

b d

c e

a

b

c

P

Consumer Surplus III• 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)

15

10

5

a

b d

c e

a

b

c

P

d

e

1510

DQ0

Producer Surplus (PS)

• “Extra benefit” to producers

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

• Graphically: Area between market price and supply curve

Producer Surplus II• Suppose the

market price is $5

• 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

0

1

S

Q

P

5

10

8 15

x

yz

Producer Surplus III• 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)0

1

S

Q

P

5

8 15

x

yz

10

Market Equilibrium• 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

• 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

• Cases where governments (Federal, State, Local) intervene:– Price Ceilings– Price Floors– Sales Taxes– Tariffs– Quotas

Price Ceilings• 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

Q

P

D

S

P*

CeilingPrice

Ceilings create shortages

Price FloorsPrice Floors: A government regulation that limits how low aprice 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

Q

P

D

S

P*

FloorPrice

Floors CreateSurpluses

Quotas

• 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• 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

Q

P

D

S

10

5

15 205

Imports

Quota

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

1) US production

2) US consumption

3) Price US consumers pay

Quotas

Q

P

D

S

10

5

15 205

Quota

10 17

8

Under the quota, Consumers now pay $8 and importless

Sales Taxes

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

• 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

• 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

• 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 reducingthe amount consumed.

Depending upon supply elasticity, suppliers react by reducingthe amount produced.

D

S

P

Q0

25

S + Tax

30

20

2520

Tax raises price consumerspay, but also reduces the amountsuppliers receive – tax burdenshared

Govnt. Rev.

Taxes

• In this case, the burden is shared.

What happens to the burden of the tax if demand and supplyelasticities are different?

D

S

Q

S + Tax

25

P

23

25

23

33

GR

Taxes

• What can we conclude from this???

1) 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

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

Purchase =====> consumption subsidy Sale =====> production subsidy