Price Controls, Taxes + Subsidies and Applications with Elasticity

Question 1

market intervention

Answer 1

as we have said previously, the best way to achieve efficiency and maximise welfare is to let markets operate freely and let the ‘invisible hand’ take care of resource allocation

however, governments do intervene in markets

• they might do this because they are worried about fairness, and they want to protect or help consumers or producers, for one reason or another
• governments also intervene under the specific conditions of market failure

governments can intervene in markets by:

• placing restrictions on prices
• placing restrictions on quantities = prohibition, quotas and permits
• implementing taxes and subsidies

Question 2

price ceilings (diagram)

Answer 2

when the government legally decrees that the price of a cannot rise above a specified level
- generally provides some “insurance” for consumers

problems

• potential for prices to be too low
• this can create a shortage

Question 3

price floors (diagram)

Answer 3

when the government legally decrees that the price of a cannot fall below a specified level
- generally provides some “insurance” for producers

problems

• potential for prices to be too high
• this will likely create a surplus

Question 4

definition: quantity restrictions

Answer 4

means the government intervenes by placing restrictions on the quantity produced/sold and/or consumed/purchased of a particular good

Question 5

common ways of restricting quantity (quota diagram)

Answer 5

prohibition = the government prohibits the purchase, consumption, production or sale of a good or service
- typically drugs, prostitution, gambling

quotas = the government tells producers how much they are allowed to produce

permits = the government issues permits which allows an agent to operate in the market or produce/consume a particular amount

• can be issued and managed by the government or a government approved organisation
• can be issued for free or at a cost
• can be non-transferrable or tradable in the market at either a regulated price, or in a freely operated separate market

examples include property, taxi industry, fishing and hunting, carbon emissions, doctors

Question 6

taxes and subsidies

Answer 6

price ceilings, price floors and quotas are all highly inflexible means or market intervention = the government imposes a particular price or quantity upon the market

taxes and subsidies are more flexible means of market intervention these tools essentially impose an adjustment to observed prices = they drive a wedge in between the price producers receive for the goods and the price consumers pay that way the government can “tweak” the market

• a tax typically means the consumer will observe a higher price and the producers will observe a lower price
• this means less will be produced and consumed so, a tax will unambiguously reduce Q
• a subsidy typically means the producer will observe a higher price and the consumer will consumer will observe a lower price
• this means more will be produced and consumed so a subsidy will unambiguously increase Q

Question 7

taxes (diagram)

Answer 7

in reality a proportional tax is more realistic, but the flat tax assumption works just as well to get the point across

the tax is charged directly from the producer when a good is produced

• such taxes are often charged only when the good is sold
• taxes can appear to be charged directly from the consumer at the point of sale
• it doesn’t matter whether taxes are levied on consumers or producers = a tax has the same economic implications for sellers and buyers regardless, and we get the same market outcome consequently, we make this simplifying assumption

this is modelled by treating the tax as an added cost of production

• the cost of producing each quantity therefore increases by $t
• this effectively shifts the supply upwards by $t
• this change in supply will then increase the price which buyers observe while simultaneously decreasing the price which sellers receive after tax = leads to a decrease in both QD and QS

Question 8

subsidies (model)

Answer 8

you might think of a subsidy as a ‘negative tax’

like taxes, subsidies can be implemented in a variety of ways = in order to keep things simple, we will restrict ourselves to a simplified “flat subsidy” situation

• a subsidy of $s is implemented
• it can be given directly to the consumer, but again we assume we give it directly to the producer because this is a little bit easier to model and the implications are the same
• this is modelled by treating the subsidy as a rebate to the costs of production
• the cost of producing each quantity therefore decreases by $s
• this effectively shifts the supply downward by $s
• this change in supply will then then decrease price and therefore increase QD and QS

Question 9

elasticity and market intervention

Answer 9

elasticity measures the relative responsiveness between two variables, so information about elasticity is important to producers
- a price elasticity of demand X means that a 1% change in the price leads to an X% change in the quantity demanded for that good

this information is also important when determining the welfare effects of government controls on prices and quantities

the price elasticity of demand and supply changes across the demand and supply curves = elasticity falls along with price
- but in general, a relatively steep demand/supply curves indicate relatively inelastic demand/supply and vv

the relative “steepness” (gradients) of demand and supply has consequences for how controls on prices and quantities affects buyers, sellers and the government

hence, understanding elasticity is important for understanding the welfare effects of such controls

Question 10

elasticity and tax incidence

Answer 10

taxes increase the price of a good, and a tax drives a wedge between the price the buyer pays and the price the seller receives

if the gradients of the demand and supply curves are the same, then the tax incidence will be divided equally between buyers and sellers

if the demand curve is steeper than the supply curve, then more of the tax will be passed on to the buyers and less to the sellers, because buyers are less sensitive to price changes than sellers and will absorb more of the tax

if the supply curve is steeper than the demand curve, then more of the tax will be passed on to the sellers and less to the buyers, because sellers are less sensitive to price changes than buyers and will absorb more of the tax

Question 11

important points to note

Answer 11

these examples have demonstrated how elasticity matters in determining the effectiveness of government market intervention

• the elasticities of demand and supply determine how price controls will affect quantities and how quantity controls will affect prices
• the relative elasticities of demand and supply determine the tax or subsidy incidence = how the burden of a tax or the benefit of a subsidy gets divided between buyers and sellers
• if demand is highly price inelastic, the government will have a large incentive to impose a tax
• if these tax policies are implemented with a primary objective of reducing consumption & production, should we really buy this type of argument?

why and when are we willing to accept the deadweight losses implied by price and quantity restrictions, taxes and subsidies?

• the production/consumption of some goods carry welfare effects which aren’t captured in these simple model = external costs and benefits, via broader effects on health and wellbeing
• when we build these effects into our model, we can show that such market interventions actually help reduce or remove existing deadweight losses, rather than creating them