Perloff 2.5, 3.5. WB 4.
Here we examine government interventions in competitive markets. The Krugman-Wells chapter linked below offers an excellent discussion of the issues.
All the skills used in analyzing the supply-and-demand model are needed here: graphing the model, computing equilibria, and predicting the effects of shifts in supply and demand curves. In addition, you will need to understand elasticities for the per-unit tax part.
Out of equilibrium, cont.
- How much is traded when QD>QS? Is this a shortage or a surplus?
- How much is traded when QS>QD? Is this a shortage or a surplus?
An effective price restriction forces the market away from the equilibrium price. This creates a shortage or a surplus since quantities respond to price (the price-taking assumption).
A price ceiling keeps the market price below PC; a price floor keeps the market price above PF. A ceiling or floor is binding (or effective) if it moves the market away from the equilibrium price; and it is ineffective if it does not.
- Can a price ceiling/floor lead to a shortage? When?
- Can a price ceiling/floor lead to a surplus? When?
- Given a price ceiling/floor and formulas for supply and demand, calculate the shortage/surplus (if any) and the quantity traded.
- Given a price ceiling/floor and formulas for supply and demand, graph the curves, and identify the shortage/surplus (if any) and the quantity traded on the graph.
Under a maximum quota, no more than QC can be traded. The quota is binding if it moves the market away from the equilibrium quantity.
- Can this lead to a shortage or a surplus? When?
- What are quota rents?
- Given a quota and formulas for supply and demand, calculate the price when the quota is binding?1
What's so great about equilibrium?
Scarce products are all somehow rationed — distributed to those who want them.2
In competitive markets, the equilibrium price rations the product by giving it to those willing to pay the most for it. This rationing is efficient — no one can be made better off without making someone else worse off. When there is a shortage or a surplus, the product must be rationed by other means. This leads to some negative side effects.
Side-effects of shortages
In a shortage, the product itself is rationed.
- Inefficient rationing — The people who get the good may not be those who value it most.
- Frictions — Even if resale leads to efficient rationing, resources are wasted on the process.3
- Inefficiently low quality — Producers are not “disciplined” by competition.
- Illegal activities — Underground resale markets lead to worse things.
Side-effects of surpluses
In a surplus, the opportunity to supply the product is rationed.
- Inefficiency — The firms that produce the good may not be those with the lowest costs.
- Frictions — Even if the low-cost firms find buyers, resources will be wasted.
- Inefficiently high quality — Producers must compete on “non-price dimensions.”
- Illegal activity
So, policies that induce shortages and surpluses are bad for competitive markets. However, real-world markets in which price restrictions are used are typically not competitive to begin with (rent controls, minimum wages). Comparing these to our supply-and-demand model of price-rationing is perhaps unfair. The supply-and-demand model only applies when
- No one has enough market power to change the price; consumers and suppliers act as price-takers.
- Consumers and suppliers act in their own best interests; they are rational.
- Everyone observes the same price, and there are no frictions.
- Everything traded is identical, and there are no quality differences.
Per-unit taxes and subsidies
How much of a tax on producers is “passed through” to consumers via higher prices? How much do producers lose when a tax is applied directly on the consumption of their product? For answers, we need (own-price) elasticities of Demand and Supply.
Given a per-unit tax on consumers/producers, and formulas for demand and supply…
- Calculate the no-tax equilibrium, and the equilibrium when the tax is applied.
- Calculate the elasticity of demand $\varepsilon$ and the elasticity of supply $\eta$ at the no-tax equilibrium price.
- What fraction of the tax is borne by consumers/producers?
- How would your answer be changed if the tax were on producers/consumers instead?
Subsidies are analogous. If producers are granted a per-unit subsidy, some of that benefit is “passed through” to consumers via lower prices; how much depends again on elasticities.
Losses to consumers and producers from a per-unit tax (as well as the other interventions described above) can also be measured another way, as we will see later.
- Perloff, Chapter 3 ``Applying the Supply-and-Demand Model''
- Stiglitz and Walsh, Chapter ``Using Demand and Supply''
- Narrated lecture with graphs
- FAQs and pitfalls
- Krugman and Wells, Chapter 4 “The Market Strikes Back”
- Sloman's tax incidence graphs4
- Price and quantity restrictions
- Taxes and subsidies