ęBruce Domazlicky

  Chapter Five:

Government and the

Market

 

As we have seen in Chapter 3, competitive markets work automatically to set equilibrium prices and quantities.  In addition, markets adjust automatically to changing conditions.  If consumer demand for a product wanes, the demand curve shifts to the left, price soon falls, causing sellers to reduce their quantity supplied and to divert their resources to the production of other more profitable products. If consumer demand for a product increases,  the demand curve shifts to the right, price increases, giving sellers an incentive to devote more resources of the production of the good.

Despite the somewhat self-regulating qualities of a market, the equilibrium in a market is sometimes influenced by the intervention of the government. Through intervention, the government can change the price consumers will have to pay or the price sellers will receive. The quantity that is ultimately purchased will also be influenced by government intervention.

Four types of government intervention are considered in this chapter. The first two are price controls: price ceilings and price floors. The latter two examples of government intervention are less direct: they consist of taxes and subsidies, which may be placed on goods; however, they, too, affect the equilibrium price and quantity of the good in question.

PRICE CEILINGS

A price ceiling is simply a maximum price that may be charged for a good. It has the force of law behind it in that sellers who charge more than the price ceiling can be arrested and be subjected to fines or even prison sentences. Therefore, sellers, in order to remain within the confines of the law, must charge a price equal to or less than the price ceiling.

What is the government's purpose in placing a price ceiling on a good? Clearly, a price ceiling is meant to help the buyer by reducing the price that must be paid for a good. Why would the government want to reduce the price charged to buyers of a particular good? There is no obvious economic answer to this question. It is mostly a political decision to enact a price ceiling on a good.  The good may be deemed one that is particularly important and that everyone needs.  For example, it may be felt that a price ceiling on gasoline is necessary so that lower-income families will still be able to purchase the good.  Or buyers may have the political power to get legislation passed that benefits them.  Whatever the reason, price ceilings have very predictable effects.

Consider for a moment Figure 5.1 which represents the market for gasoline. As can be seen, the equilibrium price of gasoline is $1.50 per gallon and the equilibrium quantity is 500 million gallons per week. If the government were to place a price ceiling of $2.00 per gallon on gasoline (as shown by line Pc), what effect would this have on the market? Since gasoline must be sold at or below the price ceiling of $2.00, there is no effect. The equilibrium price and quantity will remain at their present levels. Therefore, a price ceiling that is above the current equilibrium price will have no effect on the market.

Figure 5.2 reproduces 5.1 with the same equilibrium price and quantity. Suppose now the government places a price ceiling of $1.25 per gallon on gasoline (as shown by line Pc). At that price, the quantity supplied will fall to 400 million gallons of gasoline per week while the quantity demanded increases to 600 million gallons per week. There is a shortage of gasoline at the price ceiling equal to 200 million gallons per week. Normally, when there is a shortage of a good at the current market price, that price will rise and eliminate the shortage. But because of the government's price ceiling, that will not occur in this case. There is a permanent shortage. So, in general, a price ceiling that is below the equilibrium price will cause a shortage of the good.

 

Now that there is a shortage, what happens next? How will the limited quantity supplied (400 million in this case) be rationed among the buyers who want to purchase 600 million gallons? That is, how will it be decided who gets the gasoline which is available? There are several possibilities. The gasoline may be sold on a first-come, first-serve basis. Whoever gets to the station first gets the gasoline. Those who prefer to sleep late may find there is no gasoline when they get to the station. This type of approach may lead to long lines and excessive waiting by buyers. If you are willing to wait in line for, say, an hour or two, you will get gasoline at $1.25 a gallon. But the true cost of buying the gasoline is much higher than that since you incur an opportunity cost from waiting in line. The value of your time spent waiting in line has to be added to the price of the gasoline to get the true cost of the gas to you.

Stations may resort to rationing by selling to their best customers, however they determine who their best customers are. If the station owner doesn't know you, you may not get gas. Also notice that this allows station owners to discriminate against certain groups if they so desire. In a competitive market, discrimination by a seller in the form of not selling to particular groups has a price: lost sales. But in a shortage situation, sellers can choose not to sell to particular groups and still be able to sell all of their goods. This is because at the price ceiling, quantity demanded exceeds quantity supplied. So if sellers decide to discriminate against blue-haired economists with green glasses, they can do so. (I'm not one of them, however, so I'll get gasoline.)

A final possibility for rationing the scarce gasoline that is available is for the government to ration it. That's right, the same group that caused the shortage in the first place by implementing a price ceiling, is now going to attempt to fix the problem that it caused. The government would print up coupons (equal to the quantity supplied at the price ceiling, which is 400 million gallons in our example) and distribute them among the buyers. The big question is, of course, how does the government decide which buyers get gasoline and which do not? How about each licensed driver gets the same amount (say 5 gallons each per week)? But some people need more gasoline than others as the long-distance commuter, the traveling salesperson, etc. They clearly should get more while the retiree engaged mostly in pleasure driving should get less. That seems reasonable, perhaps, but notice the difficulty of actually determining priorities of need. Some type of government agency will be necessary to handle all of this-determining need, distributing coupons, enforcing it, etc. Note that scarce resources will be needed to implement the government rationing.

Another possibility exists: people will basically ignore the government and buy and sell gasoline at the equilibrium price ($1.50). This is what is meant by a black market-a good is bought and sold for higher than the legal ceiling price. While we don't like to encourage people to break the law, it is difficult to see why the government should prevent transactions in which people willingly engage. As long as the market is competitive and a buyer is willing to pay more than the legal price ceiling in order to have gasoline, should the government object?

Notice that the rationing and signaling functions of price are hampered by the use of a price ceiling. Because there is a shortage of the good, it needs to be rationed in some other way besides price and we have mentioned some possibilities. Also note that the good is not necessarily rationed to those buyers who have the highest-valued uses for the good. Someone who is willing to pay only $1.25 per gallon may get gasoline while someone else who values the good at $1.50 per gallon or more may not get any gasoline. This is inefficient. Relatedly, note that the efficient level of gasoline is not produced. At the price ceiling, 400 million gallons of gasoline are produced. But at that quantity, someone is willing to pay $1.75 for a gallon of gasoline while the marginal cost of the last gallon of gasoline is $1.25. Therefore, the marginal benefit exceeds the marginal cost at 400 million gallons per week. More gasoline should be produced. Also notice the signal that is being sent to sellers of gasoline. Since the price is being held down by the ceiling, we are, in effect, telling sellers to produce less gasoline even though there is a shortage of it.

 You probably realize that I am not in favor of price ceilings and you are right. There is very little to recommend them. Perhaps in time of war or some other national emergency, a case can be made for them. Otherwise, it's probably best to forget about them.

PRICE FLOORS

Government may also intervene in markets to help the sellers by setting a price floor for a good. The idea of a price floor is that there is a minimum price for which a good will sell. The government will take steps to insure that the good does not sell for less than the price floor.

Figure 5.3 is a depiction of the market for corn. The current equilibrium price is $2.50 per bushel while the equilibrium quantity is 400 million bushels per month. Suppose the government places a price floor of $2.00 per bushel on corn (as shown by line Pf). This means that corn is not to be sold for less than this amount. What effect will the $2.00 price floor have on the market in Figure 4.4? Clearly none, since the current equilibrium price of corn is $2.50, which is above the price floor. So a price floor that is below the current equilibrium price has no effect on the market.

Figure 5.4 effectively reproduces the market for corn as depicted in Figure 5.3, where the equilibrium price of corn is $2.50 per bushel and the equilibrium quantity is 400 million bushels per month. Let the government set a price floor of $3.00 per bushel for corn, which, of course, is above the current equilibrium price of corn (this is shown by line Pf). At that price, the quantity demanded of corn is 350 million bushels per month while the quantity supplied is 450 million bushels per month. There clearly is an excess supply of corn at the price floor. Sellers wish to sell an additional 100 million bushels of corn per month over what buyers wish to buy. Suppose the government did nothing else at this point but pass a law saying it was illegal to sell or buy corn for less than $3.00 per bushel. Would the sellers be better off? As a group they clearly would be. Their total revenue from selling corn has increased from $1000 million per month ($2.50 times 400 million bushels) to $1050 million ($3.00 times 350 million bushels). This is because the demand for corn is inelastic so a price increase leads to more revenue.

 

While farmers as a group are better off because they have more revenue, some farmers would be worse off because they have corn that they are unable to sell. Instead of receiving $2.50 per bushel as before, some farmers now get nothing. They would not be very happy. Politically, it is evident that the government would not be able to enact the price floor and then do nothing else. So what will be done in practice is the government purchases the excess supply of corn at the price ceiling (100 million bushels per month in our example for a total of $300 million). This allows farmers to sell their entire quantity supplied at $3.00 per bushel-either in the market or to the government.

The government is now in the corn business. What could it do with all of the corn that it buys up? There are several possibilities. One is that it could store the corn. The corn could be saved for future use as, for example, in a drought. In such a time when market supplies would be low, the government could release corn from its own stocks to add to the market supply. This sounds prudent, though in practice, the government has only rarely been required to draw upon its surplus stocks. A second possibility is for the government to sell the surplus corn to other countries. We may not need it, but perhaps other countries will. That is quite possible, but at what price is the government going to be able to export the corn? Clearly not $3.00, the price it paid for the corn. Most likely, the government will sell the corn to other countries at $2.50 per bushel, the equilibrium price. So now the government is buying up corn at $3.00 per bushel and selling it to other countries for $2,50 per bushel. Who makes up the loss? Most likely, taxpayers will be required to pick up the tab. A third possibility is for the government to give the surplus away. This is a common way to dispose of surplus stocks. Various government giveaway programs and reduced price sales of food exist.

What kinds of signals are being sent to producers and consumers when price floors are used? Because the price is being held above equilibrium, consumers are being told to use less of the good while the higher price is a signal to producers to produce more of the good. Yet there is a surplus of the good at the price floor! Clearly, the reactions of buyers and sellers to a price floor are really opposite of what is efficient. To encourage sellers to produce more of a surplus good is a waste of resources. To induce buyers to economize on their use of a surplus good also makes little sense. Too much corn is being produced. At the price floor, buyers are willing to pay only $2.25 for the last bushel of corn, which has a marginal cost of $3.00 to produce. This is clearly inefficient. Therefore, most economists do not support price floors. Such floors may be well intentioned (to help certain groups which may need assistance), but their effects on markets are undesirable. If the goal is to help some group by increasing its members' income, it would be better to give direct cash assistance to the members than to cause inefficiency in markets by placing price floors on some goods. This is basically the approach the government takes now to the farm program. Target prices are set for various farm products and then deficiency payments are made directly to farmers equal to the difference between the actual price of a farm product (such as corn) and the target price.

Alternatives to a price floor would include either to try to increase the demand for the good or reduce the supply or some combination of the two. It can be seen that if either supply decreases or demand increases, the equilibrium price of the good will rise and perhaps lead to a situation where a price floor is no longer necessary. The government has tried to reduce the supply of farm products through various types of acreage allotment programs, soil bank conservation, etc. However, these have had limited effectiveness in reducing supply. Through advertising, farmers have attempted to increase the demand for various products-milk, beef, pork, etc. It is difficult to discern how effective these campaigns have been.

Subsidies

An additional way in which the government may affect the outcome of a market is through the use of a subsidy on a good. The purpose of a subsidy would be to increase the amount of a good that is purchased. If the government believed that some good is particularly meritorious or beneficial for consumers, it could use a subsidy on that good to induce buyers to purchase more of the good.

One way to subsidize a good would be for the government to send a check to buyers for every unit of a good that they purchase. Or it could give the subsidy to sellers in the form of a check for every unit that they sell. While there may be some slight differences in the final results, subsidizing the buyer or the seller gives a similar outcome. Since, typically, sellers are less numerous than buyers, it is usually easier for the government to give the subsidy to the seller.

Suppose the government decides to place a subsidy on compact disks (CD's). Since CD's give such clear, true sound, it is felt that consumers' ears will be better protected if they listen to CD's rather than other music modes. Therefore, the government decides to give a subsidy of $1.00 to sellers for each CD that they sell.

This situation is depicted in Figure 5.5 where S1 and D1 are the original supply and demand curves and $12.00 is the original equilibrium price of CD's and 1 million CD's per week is the original equilibrium quantity. A subsidy of $1.00 per CD is now given to sellers, how will this affect them? Basically, they are willing to offer more CD's at each price or, alternatively, they will accept a lower price for each amount sold than before. For example, at the equilibrium price of $12.00, sellers had been willing to sell 1 million CD's per week. If they now receive $1.00 from the government for each CD they sell, they would be willing to sell 1 million CD's per week at a price of $11.00 in the market since they would still get $11.00 + $1.00 (from the government) = $12.00 for the CD's. This would be true at each price so that the entire supply curve shifts down by the amount of the subsidy ($1.00) to S2.

 

It can be seen from Figure 5.5 that with the new supply curve, S2, the equilibrium price is $11.60 while the equilibrium quantity is 1.1 million CD's per week. Note, however, that the sellers of CD's now receive $12.60 (equal to the price of $11.60 plus the $1.00 from the government). Also note that the government pays out $1.1 million in subsidies each week for the purchase of CD's. We should also consider how the $1.00 subsidy was split between sellers and buyers. While the $1.00 per CD subsidy is given to the sellers, buyers receive part of the subsidy in the form of a lower price for CD's ($11.60 vs $12.00). Therefore, in effect, the sellers keep $.60 of the subsidy for themselves and pass on $.40 of the rest to buyers in the form of a lower price for CD's.

How should this subsidy be evaluated? Has it been effective? In this case, the answer is "yes." The consumption of CD's rose by 10% per week, which is in line with our desire to induce consumers to purchase more CD's. Note, however, in Figure 5.6, what would happen if the demand for CD's were rather inelastic at the current price of CD's. The equilibrium price and quantity are the same as before and we place a $1.00 subsidy on CD's as before. Now the equilibrium price falls by close to the full amount of the subsidy (down to $11.20 or by $.80) but the equilibrium quantity only increases by 20,000 CD's per week to 1.02 million. Therefore, quantity demanded increased by only two percent in response to a price decline of 6 2/3%. This is a rather extreme case, but it points up the fact that if a good with inelastic demand is subsidized, the subsidy will not be very effective in causing the quantity purchased to increase. But note that the government still is obligated to pay out $1.02 million per week ($1.00 per CD) in subsidies to CD sellers. Also note that the seller keeps only $.20 of the subsidy in this case and passes on the remaining $.80 to the buyers. So when demand is inelastic, the buyers get more of the subsidy through lower prices.

 

Furthermore, even if the subsidy is effective in increasing purchases of CD's (as in the first case), there are still some considerations relating to the desirability of the policy. First, resources are needed to implement and enforce the policy just as in the above cases of price floors and ceilings. But, perhaps more important, we should be concerned about using subsidies to encourage the purchase of goods. In our case, more resources will be needed to produce the additional CD's that are demanded. Those resources, of course, cannot then be used to produce other goods and services. This may or may not be desirable. Supply curve S1 in Figure 5.5 represents the marginal cost of producing CD's. Therefore, at the new equilibrium, consumers buy CD's for $11.60 each, yet the CD's cost $12.60 each to produce. This means $12.60 worth of resources are used to produce a good that some consumers value at only $11.60. That is inefficient. What it does mean is that the government should have some very good reasons before deciding to subsidize a good (e.g., saving people's ears). This would apply to our first case where demand is fairly elastic. When demand for a good is inelastic as in Figure 5.6, it is futile to even attempt to subsidize the good.

Subsidies are frequently given in our country through the tax system.  For example, if you buy a home, most likely you will borrow the money from a financial institution (such as a bank) and pay thousands of dollars in interest over the life of the mortgage.   However, any interest you pay for your home loan is deductible from your income tax and so can save you thousands of dollars in taxes.  This amounts to a subsidy to you from the government for buying your home.  Why should the government subsidize your purchase of a home?  We will explore that and other questions on the bulletin board this week.

EXCISE TAXES

As will be explained in a later chapter, there are many types of taxes that are levied by government. One type of tax is considered in this chapter: excise taxes. These are taxes on specific goods. Excise taxes may be expressed as a percent of the price of the good (e.g., 10% of the purchase price) or per unit of the good ($5.00 per unit). Both types are used in the United States. For simplicity it is easier to consider excise taxes expressed per unit of a good. As before, an excise tax could be placed on either the buyer or the seller. For simplicity, excise taxes are usually placed on the sellers because there are fewer of them, making administration of the tax easier. However, while sellers may have the responsibility of handing over the tax revenue to the government, they may not necessarily pay the tax. That is, they may be able to shift the burden of the tax to the buyer.

There are two principal reasons for imposing an excise tax on a good. One is to raise revenue for the government. The second reason is to discourage the purchase of a good. To a certain extent, these two purposes are in conflict with each other.

Consider Figure 5.7 where S1 and D1 are the original supply and demand curves of CD's and $12.00 and 1 million CD's per week are the equilibrium price and quantity. Starting from the same equilibrium in the previous section, let's now impose a $1.00 per unit excise tax on CD's. For every CD they produce and sell, sellers must now pay the government $1.00. For now, presume that the primary goal of the tax is to raise revenue.

The $1.00 per CD excise tax has the effect of raising the costs of the sellers since they must now pay this tax in addition to their normal production costs. The effect of the tax is to cause the supply curve to shift upward to S2 by the amount of the tax, $1.00. The reason is that at the equilibrium price, e.g., of $12.00, sellers were willing to sell 1 million CD's per week. When the tax is imposed, they must now receive $13.00 if they are going to be willing to supply 1 million CD's as before ($13.00 minus $1.00 gives $12.00). So the supply curve has shifted up by $1.00 at that point and, for similar reasons, it shifts up by $1.00 at every other point on the curve.

This results in a new equilibrium at a price of $12.40 and a quantity of .9 million CD's (or 900,000) per week. Note that the sellers, however, only receive $11.40 after paying the tax to the government. This means that the consumers paid $.40 of the tax in the form of a higher price while sellers absorbed the other $.60. So part of the tax is shifted forward to consumers and part of it is paid by the sellers. Also note that the government receives tax revenue of $900,000 per week ($1.00 times 900,000 CD's). If the equilibrium quantity had remained the same, the government's revenue would have been $1 million per week.

Contrast the results in Figure 5.7 with the situation in Figure 5.8. Here the demand for CD's is quite inelastic at the current price. Starting from a price of $12.00 and quantity of 1 million CD's per week and original demand and supply curves of D1 and S1, it is seen that the $1.00 excise tax in this case causes price to rise to $12.80 while the quantity demanded falls only to .98 million CD's per week (or 980,000). Consumers pay most of the excise tax ($.80) and government revenue is greater than in the above case, $980,000 per week. Therefore, when demand is inelastic, more of the excise tax is passed onto consumers in the form of higher prices and government receives more revenue than when demand is more elastic as in the first case.

 

From the two cases, we see that if the major purpose of an excise tax is to raise revenue for the government, the tax will be more effective if it is placed on goods with inelastic demand. If the major purpose of the excise tax is to discourage consumption, the tax will be more effective if the demand for the good is elastic.

How to evaluate excise taxes? If the purpose is to raise revenue, then the taxation of goods with inelastic demand is appropriate. The tax will be fairly effective and it will not significantly affect the consumption of the taxed good. The only issue that might arise is fairness. Why should the buyers of a particular good (e.g., CD's) bear the burden of financing government? Should not the tax burden be spread more fairly among the general population such as through a tax on income? There is validity in such an argument.

As a means of reducing consumption, the use of an excise tax leads to a variety of questions. Will the tax be effective? As seen above, it will not be very effective if the good currently has inelastic demand. Should the government even try to reduce the consumption of a good? That is not an easy question to answer. So-called "sin" taxes are popular with some segments of the population. Examples would include excise taxes on cigarettes and alcohol. Many people believe that it is appropriate for government to try to reduce the consumption of such goods because of the harmful side effects from consuming them (poor health, drunken driving, etc.). Yet the purchasers of alcohol and cigarettes do get satisfaction from the use of such goods. Does society have the right to stand in judgment and tell individuals they should consume fewer cigarettes and less alcohol?

In our first example of excise taxes, there are people willing to pay $12.40 for another record album. An additional album costs only $11.40 to produce so efficiency would demand that more records be produced. But the imposition of the excise tax means no more albums are produced beyond the new equilibrium at 900,000.

Summary

In general, when government intervenes in a market, efficiency is usually sacrificed in favor of whatever goal the government is pursuing (more revenue, lower prices for buyers, etc.) The fact that efficiency is reduced by such intervention means government should have some very good reasons for changing market results through the use of price floors, excise taxes, etc. Otherwise, the benefits of government intervention are likely to be outweighed by the costs.

VOCABULARY REVIEW

Price Ceilings
Price Floors(Supports)
Surplus

Shortage
Rationing
Subsidy
Excise Tax

CHAPTER REVIEW QUESTIONS AND PROBLEMS

1. Identify the gainers and losers from the imposition of a price ceiling on gasoline. Be as specific as you can.

2. Who are the gainers and losers when a price floor is placed on a good such as corn?  Be as specific as you can.

3. Explain why a price ceiling will cause a shortage of a good if the ceiling is below the equilibrium price of the good.

4. Explain why a price floor will cause a surplus of a good if the floor is above the equilibrium price of the good.

5. Why does an excise tax on good X raise less revenue for the government if the demand for good X is elastic rather than inelastic?

6. From the standpoint of efficiency, why are price ceilings and price floors bad?

7. From the standpoint of efficiency, why are excise taxes and subsidies undesirable?

8. Suppose the state legislature decided to impose a price ceiling on fees at state universities in an attempt to keep the price of attending college low in Missouri.  What might be the anticipated results of such a decision? How would a price ceiling affect the ability of state universities to provide education services? Be as specific as you can. Do you think this would be a good idea? 

9. After the tragic events of Sept. 11, 2001, tourism fell dramatically in the US as people tended to stay home, partly out of fear and uncertainty and partly due to a recession.  One proposal that was suggested at the time to help the tourism industry was to give people up to $1,000 tax credit for tourism related expenditures.  This would be the same as giving people a subsidy for purchasing tourism services (hotels, transportation, dining at restaurants, etc.).  Evaluate such a proposal. Do you think it would have been a good idea?