2.7.2 Main forms of government intervention in markets Notes

1. Governments intervene in markets using different methods to influence demand and supply, thereby shaping market outcomes.
2. The main forms of government intervention are:
   1. Price controls:
      1. Price ceilings.
      2. Price floors.
   2. Indirect taxes and subsidies
   3. Direct provision of services
   4. Command and control regulation and legislation
   5. Consumer nudges (HL only)

Price controls: price ceilings (maximum prices) and price floors (minimum prices)

1. Governments set price controls to not allow markets to reach their natural equilibrium.
2. By setting price controls, governments force disequilibrium in the market, thus creating:
   1. Shortages (excess demand)
   2. Surpluses (excess supply)

Price ceilings (maximum prices)

1. The imposition of a price ceiling ensures that the price at which sellers are allowed to sell a good cannot exceed the maximum price set by the ceiling.
2. This government-imposed limit prevents prices from rising above a specific level for the good or service in question.

1. As it can be seen in Figure 1, at the initial equilibrium price ($P_1$) there is a quantity of $Q_1$ bread demanded. After the price ceiling ($P_{ceiling}$) is imposed:
   1. The quantity demanded increases to $Q_3$, while the quantity supplied decreases to $Q_2$.
   2. Meaning that the market demand is higher than the market supply, hence a shortage of $Q_3-Q_2$.

As it can be seen in Figure 2:

1. Before the price ceiling:
   1. Consumer surplus = $a+d$
   2. Producer surplus = $b+c+e$
2. After the price ceiling
   1. Consumer surplus = $a+b$
   2. Producer surplus = $c$

Therefore there is a welfare loss (WL) of the areas $d+e$.

1. This is the amount of social welfare (surplus) lost due to resource misallocation arising from the price ceiling.
2. Remember allocative efficiency is achieved when Marginal benefits (MB) = Marginal Costs (MC).

Calculating the welfare impacts of price ceilings (HL only)

In order to calculate the change in welfare impacts due to price ceiling, we need to look at Figure 3:

Looking at Figure 3 we can see that that the equilibrium price ($P_e$) and quantity ($Q_e$) are both equal to 6. Using the information in Figure 3 we can calculate:

1. Consumer expenditure
   1. Consumer expenditure is equal to the number of units purchased ($Q_e$) multiplied by the price per unit paid ($P_e$).
      1. So at equilibrium the consumer expenditure is $6 \times 6=36$
      2. After the price ceiling the consumer expenditure is $4 \times 4=16$
2. Producer revenue
   1. Producer revenue is equal to consumer expenditure
      1. So at equilibrium producer revenue is $36\$$.
      2. After price ceiling producer revenue is $16\$$.
3. Consumer surplus (CS)
   1. Consumer surplus is represented by the area below demand curve, and above the price paid (up to the quantity purchased).
      1. So at equilibrium $CS = a+d = \frac{(10 - 6) \times 6}{2} = 12\$$
      2. After price ceiling $CS = a+b = \frac{((8 - 4) \times 4) + ((10 - 8) \times 4)}{2} = 20\$$
4. Producer surplus (PS)
   1. Producer surplus is represented by the area above the supply curve, and below the price received by the producers.
      1. So at equilibrium $PS = b+c+e = \frac{((6 - 2) \times 6)}{2} = 12\$$
      2. After the price ceiling $PS = c = \frac{((4 - 2) \times 4)}{2} = 4\$$
5. Welfare loss(WL)
   1. Welfare loss is equal to the difference between social surplus before and after the price control. In Figure 3, this is the area marked $WL$.
      1. $WL = d+e = \frac{((8 - 4) \times (6 - 4))}{2} = 4\$$

Price floors (minimum prices)

1. The imposition of a price floor ensures that the price at which sellers are allowed to sell a good cannot fall below the minimum price set by the floor.
2. This government-imposed limit prevents prices from dropping below a specific level for the good or service in question.

1. As it can be seen in Figure 4, at the initial equilibrium price ($P_e$) there is a quantity $Q_e$ being demanded.
2. After the price floor ($P_{floor}$) is imposed:
   1. The quantity demanded decreases to $Q_d$, while the quantity supplied increases to $Q_s$.
   2. This creates a situation where the market supply is higher than the market demand, hence a surplus of $Q_s-Q_d$.
3. This spare surplus that consumers are not willing and able to buy is then bought by the government. Then, the government either:
   1. Stores the surplus.
   2. Exports the surplus.
4. When the government buys the excess supply, the demand for the good/service increases, shifting the demand curve to the right ($D → D_{gov}$).

The welfare impacts of price floors

In order to calculate the change in welfare impacts due to price ceiling, we need to look at Figure 6:

As we can see in the diagram:

1. Before the price floor:
   1. Consumer surplus= $a+b+c$.
   2. Producer surplus= $d+e$.
2. After the price floor:
   1. Consumer surplus loses areas $b+c$.
      1. Therefore, new Consumer surplus = $a$
   2. Producer surplus gains areas $b+c+f$.
      1. Therefore, new Producer surplus = $d+e+b+c+f$.
   3. The government pays for the excess supply, which equals to the price per unit times the surplus amount, hence $P_f \times (Q_s-Q_d)$.
   4. To buy the surplus, the government uses the money collected from tax revenue, which has an opportunity cost for other uses in society.
   5. Therefore all the money spent by the government ($P_f \times (Q_s-Q_d)$) translates into welfare loss.
   6. However, while government spending loses area $f$ to society, this area $f$ is gained by producers' surplus.
   7. Therefore, the welfare loss ($WL$) after the price floor is represented by the areas $c+e+g$.
      1. Welfare loss = $c+e+g$.