Goverment Intervension

First Pages
chapter 6
Government Intervention
LEARNING OBJECTIVES
LO 6.1
Calculate the effect of a price ceiling on the equilibrium price

andquantity.
LO 6.2
Calculate the effect of a price floor on the equilibrium price

andquantity.
LO 6.3
Calculate the effect of a tax on the equilibrium price and quantity.
LO 6.4
Calculate the effect of a subsidy on the equilibrium price and quantity.
LO 6.5
Explain how elasticity and time period influence the impact of a

market intervention.
FEEDING THE WORLD, ONE PRICE CONTROL AT A TIME

In the spring of 2008, a worldwide food shortage caused food prices to skyrocket. In just
a few months, the prices of wheat, rice, and corn shot up as much as 140 percent. In the
United States, the number of people living on food stamps rose to the highest level since
the 1960s. By June, low-income Americans were facing tough choices, as the prices of
basics like eggs and dairy products rose. Many reported giving up meat and fresh fruit;
others said they began to buy cheap food past the expiration date.1
Rising food prices caused trouble all over the world. The Economist magazine reported
on the political fallout:
In Haiti, protesters chanting Were hungry forced the prime minister to resign;
24 people were killed in riots in Cameroon; Egypts president ordered the army
to start baking bread; the Philippines made hoarding rice punishable by life
imprisonment. [In Cte dIvoire,] two days of violence persuaded the government to postpone planned elections.2
Faced with hunger, hardship, and angry outbursts, many governments felt obliged
to respond to the crisis. But what to do? Responses varied widely across countries.
When the poor rioted, many countries made it illegal to charge high prices for food.
Others subsidized the price of basic necessities. In the United States and Europe, policymakers tried to alleviate the shortage by paying farmers to grow more food. Were these
responses appropriate? What, if anything, should governments do in such a situation?
Food is a tricky issue for policy-makers because its a basic necessity. If prices rise too high,
people go hungry. If prices fall too low, farmers go out of business, which raises the risk of
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food shortages in the future. So, while policy-makers arent too concerned if the prices of
many goodslike digital cameras or lattesjump up and down, they often do care about
food prices. But attempts to lower, raise, or simply stabilize prices can backfire or create
unintended side-effects. Sometimes the cure ends up being worse than the problem itself.
FPO
In this chapter, well look at the logic behind policies that governments commonly use
to intervene in markets and their consequencesboth intended and unintended. We will
start with price controls, which make it illegal to sell a good for more or less than a certain
price. Then we will look at taxes and subsidies, which discourage or encourage the production of particular goods. These tools are regularly applied to a broad range of issues,
from unemployment to home ownership, air pollution to education. For better or worse,
they have a huge effect on our lives as workers, consumers, business people, and voters.
Why Intervene?
In Chapter 3, we saw that markets gravitate toward equilibrium. When markets
work well, prices adjust until the quantity of a good that consumers demand equals
the quantity that suppliers want to produce. At equilibrium, everyone gets what
they are willing to pay for. In Chapter 5, we saw that equilibrium price and quantity
also maximize total surplus. Thus, at equilibrium, there is no way to make some
people better off without harming others.
So, why intervene? Why not let the invisible hand of the market determine prices
and allocate resources? Some would argue thats exactly what should be done. Others believe the government has to intervene sometimesand the fact is that every
single government in the world intervenes in markets in some fashion.
Three reasons to intervene

The arguments for intervention fall into three categories: correcting market failures,
changing the distribution of benefits, and encouraging or discouraging consumption of certain goods. As we discuss different policy tools throughout the chapter,
ask yourself which of these motivations is driving the intervention.
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Correcting market failures. Our model of demand and supply has so far assumed
that markets work efficientlybut in the real world, thats not always true. For
example, sometimes there is only one producer of a good, who faces no competition and can charge an inefficiently high price. In other cases, one persons use of
a product or service imposes costs on other people that are not captured in prices
paid by the first person, such as the pollution caused by burning the gas in your car.
Situations in which the assumptions of efficient, competitive markets fail to hold
are called market failures. When there is a market failure, intervening can actually
increase total surplus. Well have much more to say about market failures in future
chapters. In this chapter, we will stick to analyzing the effect of government interventions in efficient, competitive markets.
Changing the distribution of surplus. Efficient markets maximize total surplus,
but an efficient outcome may still be seen as unfair. (Of course, the definition of
fairness is up for debate.) Another reason to intervene in the market, therefore, is to
change the distribution of surplus.
For example, even if the job market is efficient, wages can still drop so low that
some workers fall below the poverty line while their employers make healthy profits.
The government might respond by intervening in the labor market to impose a minimum wage. This policy will change the distribution of surplus, reducing employers
profits and lifting workers incomes. Reasonable people canand often doargue
about whether a policy that benefits a certain group (such as minimum-wage workers) is justified or not. Our focus will be on accurately describing the benefits and
costs of such policies. Economics can help us predict whose well-being will increase,
whose well-being will decrease, and who may be affected in unpredictable ways.
Encouraging or discouraging consumption. Around the world, many people
judge certain products to be good or bad based on culture, health, religion, or
other values. At the extreme, certain bad products are banned altogether, such as
hard drugs. More often, governments use taxes to discourage people from consuming bad products, without banning them altogether. Common examples are cigarettes and alcohol; many governments tax them heavily, with the aim of reducing
smoking and drinking. In some cases, minimizing costs imposed on others (such as
from pollution or second-hand smoke) is also part of the motivation for discouraging consumption.
On the other hand, governments use subsidies to encourage people to consume
good products or services. For instance, many governments provide public funding for schools to encourage education and for vaccinations to encourage parents to
protect their children against disease.
Four real-world interventions

In this chapter well look at four real-world examples of how governments have
intervened or could intervene in the market for food. For each, well consider the
motives for the intervention and what its direct and indirect consequences were or
could be. These four interventions are:
1. For many Mexican families, tortillas are an important food. What happened
when the Mexican government set a maximum price for tortillas, in an effort
to keep them affordable?
2. To ensure supplies of fresh milk, the U.S. government wanted to protect
dairy farmers. What happened when the government set a minimum price
for milk?
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3. Many Americans struggle with health problems caused by overeating and

poor nutrition. Several states have responded by banning the use of certain
fats in food products; others require that restaurants post nutritional information about the foods they serve. What would happen if governments
taxed high-fat or high-calorie foods?
4. What would happen if, instead of setting a maximum price for tortillas, the
Mexican government subsidized tortillas?
As we walk through these examples of real policies, we want you to apply both
positive and normative analysis. Remember the difference:
Positive analysis is about facts: Does the policy actually accomplish the original goal?
Normative analysis is a matter of values and opinions: Do you think the policy
is a good idea?
Few policies are all good or all bad. The key question is, What are the trade-offs
involved in the intervention? Do the benefits outweigh the costs?
CONCEPT CHECK
What are the three reasons that a government would want to intervene in
markets?
Price Controls
price control
a regulation that sets a
maximum or minimum
legal price for a
particular good
Suppose you are an economic policy advisor and food prices are rising. What should
you do? If you were living in a region with many low-income consumers, you might
want to take action to ensure that everyone gets enough to eat. One policy tool you
might consider using is a price controla regulation that sets a maximum or minimum legal price for a particular good. The direct effect of a price control is to hold
the price of a good up or down when the market shifts, thus preventing the market
from reaching a new equilibrium.
Price controls can be divided into two opposing categories: price ceilings and
price floors. We encountered this idea already in the chapter on surplus, when we
imagined an interfering eBay manager setting prices for digital cameras. In reality,
eBay would never do such a thing, but governments often do, particularly when
it comes to markets for food items. What are the effects of using price controls to
intervene in a well-functioning, competitive market?
Price ceilings
LO 6.1 Calculate the effect of a price ceiling on the equilibrium price and quantity.
price ceiling
a maximum legal price
at which a good can
be sold
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A price ceiling is a maximum legal price at which a good can be sold. Many countries have price ceilings on staple foods, gasoline, and electricity, as policy-makers
try to ensure everyone can afford the basic necessities.
Historically, the government of Mexico has set a price ceiling for tortillas, with
the intent of guaranteeing that this staple food will remain affordable. Panel A of
Figure6-1 illustrates a hypothetical market for tortillas without a price ceiling. The
equilibrium price is $0.50 per pound (in Mexico, prices are in pesos ($) and centavos;
here the equilibrium price is 50 centavos), and the equilibrium quantity is 50 million
pounds.
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FIGURE 6-1
A market with and without a price ceiling
(A) Market without price ceiling
(B) Market with price ceiling
Price (/lb.)
Price ( / lb.)
125
125
100
100
S
75
75
50
50
25
25
Consumers demand
a higher quantity.
Producers supply
a lower quantity.
Price
ceiling
Shortage
D
0
25
50
75
Quantity of tortillas (millions of lbs.)

Without government intervention, the market for
tortillas in Mexico would reach equilibrium at a
price of 50 centavos per pound and a quantity of
50 million pounds.
100
25
50
75
100

After government intervention, a price ceiling of
25 centavos keeps the price of tortillas below the
equilibrium point. At this new price, consumers
want to buy more tortillas (75 million pounds) than
producers want to supply (25 million pounds),
resulting in a shortage of tortillas.
In early 2007, the government of Mexico responded to rising tortilla prices by

setting a price ceiling of approximately $0.25 per pound, as shown in panel B of
Figure 6-1. How should we expect producers and consumers to respond to this
intervention? When price falls, consumers will want to buy more tortillas. In this
example, the price fell from $0.50 to $0.25, and as a result, quantity demanded
increased from 50 million to 75 million pounds.
Predictably, however, a lower price means fewer producers will be willing to
sell tortillas. When the price fell to $0.25, the quantity supplied dropped from
50 million to 25 million pounds. A lower price means higher quantity demanded
but lower quantity supplied. Supply and demand were no longer in equilibrium.
The price ceiling created a shortage of tortillas, equal to the 50 million pound difference between the quantities supplied and demanded.
Did the price ceiling meet the goal of providing low-priced tortillas to consumers? Yes and no. Consumers were able to buy some tortillas at the low price of
$0.25 a poundbut they wanted to buy three times as many tortillas as producers
were willing to supply. We can assess the full effect of the price ceiling by looking
atwhathappened to consumer and producer surplus. Without looking at the graph,
we already know that a price ceiling will cause producer surplus to fall: Sellers are
selling fewer tortillas at a lower price. We also know that total surplusthat is, producer and consumer surplus combinedwill fall, because the market has moved
away from equilibrium. Some trades that would have happened at the equilibrium
price do not happen, and the surplus that would have been generated by those
mutually beneficial trades is lost entirely. This area is known as deadweight loss and
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FIGURE 6-2
Welfare effects of a price ceiling
Price (/lb.)
125
Producer surplus
Consumer surplus
100
Deadweight loss
75
Surplus in area 2 is transferred

from producers to consumers
because tortillas are sold at a
lower price.
Surplus in area 1 is
deadweight loss incurred
because fewer transactions
happen at the lower price.
50
2
Price
ceiling
25
D
0
25
50
75
100

The price ceiling causes the total quantity of tortillas
traded to fall by 25 million relative to equilibrium. This
results in deadweight loss. The price ceiling also causes
surplus to be transferred from producers to consumers:
consumers win because they pay a lower price, and
producers lose because they sell at a lower price.
deadweight loss
a loss of total surplus
that occurs because
the quantity of a good
that is bought and sold
is below the market
equilibrium quantity
is represented by area 1 in Figure6-2. In general, deadweight loss represents the loss

of total surplus that occurs because the quantity of a good that is bought and sold is
below the market equilibrium quantity.
What we cant tell without looking at the graph is whether consumer surplus
will increase or decreasethat response depends on the shape of the supply and
demand curves. Consumers lose surplus from trades that no longer take place. But
for the trades that still do take place, consumers gain surplus from paying $0.25
instead of $0.50 (while producers lose the same amount of surplus from receiving
the lower price).
This direct transfer of surplus from producers to consumers is represented by
area 2 in Figure6-2. The fact that area 2 is larger than half of area 1 (the portion of
deadweight loss that would have gone to consumers at equilibrium) represents
the goal the price ceiling was intended to achieve: a net increase in the wellbeing of consumers. Was the policy worthwhile? On the one hand, consumers
gained surplus. On the other hand, the surplus lost by producers was greater
than that gained by consumers, meaning that total surplus decreased. Is it a price
worth paying? That is a normative question about which reasonable people can
disagree.
Another factor we may want to consider in our overall analysis of the price ceiling is how the scarce tortillas are allocated. Because a price ceiling causes a shortage,
goods must be rationed. This could be done in a number of ways. One possibility is
for goods to be rationed equally, with each family entitled to buy the same amount
of tortillas per week. This is what happened when food was rationed in the United
States during the World War II.
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Another possibility is to allocate goods on a first-come, first-served basis. This

forces people to waste time standing in lines. In still other cases, rationed goods
might go to those who are given preference by the government, or to the friends and
family of sellers. Finally, shortages open the door for people to bribe whoever is in
charge of allocating scarce supplies, which would mean even more deadweight loss
than in the example shown in Figure6-2. Economists call this rent-seeking behavior,
and it is often cited as an argument against imposing price ceilings.
Price ceilings are sometimes used with noble intentions, though. The What Do
You Think? box, Put a cap on payday lending? asks you to weigh the costs and
benefits of a controversial price ceiling on the interest rates of payday loans.
WHAT DO YOU THINK?

Put a cap on payday lending?
After the global financial crisis that began in 2008, policy-makers considered
many proposals to reform financial practices. Small loans to consumers got a lot of
attention, as some people felt that irresponsible borrowingthrough credit cards,
mortgages, and payday loanswas in part to blame for the crisis.
One of the most controversial types of borrowing is the payday loan, a short-term
cash loanusually for less than $1,000that is intended to be repaid with the borrowers next paycheck. Many borrowers like these loans because they can walk
out of the loan center with cash in their pockets in 30 minutes or less. Because payday loans are available to almost anyone with a paycheck, including people with
poor credit, lenders often charge high fees or interest rates. Payday loan centers
tend to be located in low-income neighborhoods, where people have few other
options for borrowing.
In 2008, the U.S. Congress considered putting a price ceiling of 36 percent per
year on the interest rates lenders could charge for payday loans. Since the interest rate is effectively the price of taking out a loan, this measure amounted to a
price ceiling on a certain sort of loan service. Supporters of the proposed price ceiling argued that limiting interest rates would protect vulnerable consumers from
predatory lenders who offer loans people cant afford, thus trapping borrowers
in a cycle of taking out loans simply to repay prior loans.
Critics of the price ceiling countered that capping interest rates would force
many payday lenders out of business. People who make informed decisions to
take out payday loans would be hurt by the resulting loss of credit. Those borrowers who have no other options could be driven to stop paying their bills or to
overdraw their checking accounts. Building up debt and penalties in these ways,
critics argued, could be even more expensive than a payday loan.
As we write this book, 15 states have banned payday loans or set a ceiling on the
interest rates that are charged for them. In 2008, for example, Ohio capped payday
loan rates at 28 percent per year. Other states still allow less restricted payday
loans. In Missouri, lenders can charge up to 75 percent over a short loan period.
You can learn about short-term loan regulations in your state by visiting http://
www.paydayloaninfo.org/lstatus.cfm.
What do you think?
1. An Internet search for payday loan turns up dozens of websites that promise
instant, easy, or no hassle loans. Whats the cheapest rate you can find in
your state? Would you consider borrowing at this price?
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2. Price ceilings hold down prices, but also cause shortages and transfer surplus
from payday-loan store owners to borrowers. Knowing that, would you support
a cap on payday loan interest rates?
3. What would you expect the outcome of such a policy to be for buyers (borrowers)
and sellers (lenders)?
4. Can you think of a way to protect potential victims of high interest rates without
hurting borrowers who make informed borrowing decisions?
Source: Payday loan consumer information, Consumer Federation of Americas PayDay Loan website, http://www.
paydayloaninfo.org.
A price ceiling does not always affect the market outcome. If the ceiling is set
above the equilibrium price in a market, it is said to be nonbinding. That is, the ceiling doesnt bind or restrict buyers and sellers behavior because the current equilibrium is within the range allowed by the ceiling. In such cases, the equilibrium
price and quantity will prevail.
Although price ceilings are usually binding when they are first implemented
(otherwise, why bother to create one?), shifts in the market over time can render
the ceilings nonbinding. Suppose the price of corn decreases, reducing the cost of
making tortillas. Figure6-3 shows how the supply curve for tortillas would shift to
the right in response to this change in the market, causing the equilibrium price to
fall below the price ceiling. The new equilibrium is 80 million pounds of tortillas at
$0.20 a pound, and the price ceiling becomes nonbinding.
FIGURE 6-3
Nonbinding price ceiling
Price (/lb.)
125
100
S1
75
1. Supply increases,
and the supply curve
shifts to the right.
50
S2
25
2. At the new equilibrium

point, the price is below
the price ceiling.
D
0
25
50
75
100

A price ceiling is intended to keep prices below the
equilibrium level. However, changes in the market can
reduce the equilibrium price to a level below the price
ceiling. When that happens, the price ceiling no longer
creates a shortage, because the quantity supplied
equals the quantity demanded.
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Price floors
LO 6.2 Calculate the effect of a price floor on the equilibrium price and quantity.
A price floor is a minimum legal price at which a good can be sold. The United
States has a long history of establishing price floors for certain agricultural goods.
The rationale is that farming is a risky businesssubject to bad weather, crop failure,
and unreliable pricesbut also an essential one, if Americans are to have enough to
eat. A price floor is seen as a way to guarantee farmers a minimum income in the face
of these difficulties, keeping them in business and ensuring a reliable supply of food.
The United States has maintained price floors for dairy products for over 60 years;
the Milk Price Support Program began with the Agricultural Act of 1949. What effect
has this program had on the market for milk? In panel A of Figure6-4, we show a
hypothetical unregulated market for milk in the United States, with an annual equilibrium quantity of 15 billion gallons and an equilibrium price of $2.50 per gallon.
Now suppose the U.S. government implements a price floor, so that the price of
milk cannot fall below $3 per gallon, as shown in panel B of Figure6-4. How will producers and consumers respond? At $3 per gallon, dairy farmers will want to increase
milk production from 15 to 20 billion gallons, moving up along the supply curve. At
that price, however, consumers will want to decrease their milk consumption from
15 to 10 billion gallons, moving up along the demand curve. As a result, the price
floor creates an excess supply of milk that is equal to the difference between the
quantity supplied and the quantity demandedin this case, 10 billion gallons.
Has the government accomplished its aim of supporting dairy farmers and providing them with a reliable income? As with price ceilings, the answer is yes and no.
price oora
minimum legal price
at which a good can
be sold
FIGURE 6-4
A market with and without a price floor
(A) Market without price floor
(B) Market without price floor
Price ($/gal.)
Price ($/gal.)
4.5
4.5
S
4
3.5
3.5
2.5
2.5
1.5
1.5
D
Excess supply
Price floor
Quantity supplied and
quantity demanded move
in opposite directions.
0.5
0.5
5
10
15
20
25
30
35
Quantity of milk (billions of gals.)

Without government intervention, the equilibrium
point in the market for milk would be 15 billion
gallons at a price of $2.50 per gallon.
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10
15
20
25
30
35

A price floor raises the price of milk above the
equilibrium point. At the new price of $3 per gallon,
consumers want to buy less than suppliers want to
produce, resulting in a 10 billion-gallon surplus.
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FIGURE 6-5
Welfare effects of a price floor
Price ($/gal.)
4.5
Surplus in area 2 is transferred

from consumers to producers
because milk is sold at a higher
price.
Producer surplus
Consumer surplus
3.5
Deadweight loss
Surplus in area 1 is
deadweight loss incurred
because fewer transactions
happen at the higher price.
2
1
2.5
2
1.5
1
0.5
0
10
15
20
25
30
35

The price floor causes the total quantity of milk
traded to fall by 5 billion gallons relative to equilibrium. This results in deadweight loss. The price
ceiling also causes surplus to be transferred from
consumers to producers: producers win because
they sell at a higher price, and consumers lose
because they pay a higher price.
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Producers who can sell all their milk will be happy, because they are selling more
milk at a higher price. However, producers who cannot sell all their milk because
demand no longer meets supply will be unhappy. Consumers will be unhappy
because they are getting less milk at a higher price.
Again, we can apply the concept of surplus to formally analyze how this change
in total surplus is distributed between consumers and producers. Before the price
floor, 15 billion gallons of milk were sold and bought; afterward, only 10 billion.
Five billion gallons of milk that could have been traded were not, reducing total
surplus. This deadweight loss is represented by area 1 in Figure6-5.
Like price ceilings, price floors change the distribution of surplus, but in this case
producers win at the expense of consumers. When the price floor is in effect, the only
consumers who buy are those whose willingness to pay is above $3. Their consumer
surplus falls, because they are buying the same milk at a higher price, and their lost
surplus is transferred directly to the producers who sell milk to them. This transfer
of surplus is represented by area 2 in Figure 6-5. Whether producers gain or lose
overall will depend on whether this area is bigger or smaller than their share of the
deadweight loss. The fact that area 2 is larger than the section of area 1 lost to producers shows that in this case the price floor policy increased well-being for producers.
Is the price of reduced total and consumer surplus worth paying to achieve increased
producer surplus? One factor to consider is how the extra surplus is distributed among
producers. Producers who are able to sell all their milk at the higher price will be
happy. But producers who do not manage to sell all of their goods will be left holding
an excess supply. They may be worse off than before the imposition of the price floor.
With excess supply, customers may choose to buy from firms they like based on familiarity, political preference, or any other decision-making process they choose.
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FIGURE 6-6
Nonbinding price floor
Price ($/gal.)
S2
2. At the new equilibrium

point, the price is above
the price ceiling.
5.5
5
1. Supply decreases,
and the supply curve
shifts to the left.
4.5
S1
4
3.5
Price floor
3
2.5
2
1.5
1
0.5
5
10
15
20
25
30
35

Although a price floor is usually set so as to raise
prices above the equilibrium level, changes in the
supply can raise the equilibrium price above the price
floor. When that happens, the surplus that was created
by the price floor disappears, and the quantity supplied
equals the quantity demanded.
To prevent some producers from being left in the lurch, the government may
decide to buy up all the excess supply of milk, ensuring that all producers benefit.
In fact, that is how the milk price support program works in the United States. The
Department of Agriculture guarantees producers that it will buy milk at a certain
price, regardless of the market price. Of course, paying for the milk imposes a cost
on taxpayers and is often cited as an argument against price floors. How much milk
will the government have to buy? The answer is the entire amount of the excess
supply created by the price floor. In the case of the hypothetical milk price floor, the
government will have to buy 10 billion gallons at a price of $3. The cost to taxpayers
of maintaining the price floor in this example would be $30 billion each year.
Price floors are not always binding. In fact, in recent years, the market prices
for dairy products in the United States have usually been above the price floor.
The price floor may become binding, however, in response to changes in the market. Consider the effect of the increased demand for ethanol in 2007 on the market
for milk. Ethanol is a fuel additive made from corn. The sudden rise in demand
for ethanol pushed up the price of corn, which in turn pushed up the cost of
livestock feed for dairy farmers. As a result, the supply curve for milk shifted to
the left, pushing the equilibrium price for milk above the $3 price floor to $3.50.
Figure6-6 shows how a hypothetical decrease in supply can render a price floor
nonbinding.
CONCEPT CHECK
Why does a price ceiling cause a shortage? [LO 6.1]
What can cause a price ceiling to become nonbinding? [LO 6.1]
Explain how a government can support a price floor through purchases. [LO 6.2]
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Taxes and Subsidies

Taxes are the main way that governments raise revenue to pay for public programs.
Taxes and subsidies can also be used to correct market failures and encourage or
discourage production and consumption of particular goods. As we will see, like
price floors and price ceilings, they can have unintended consequences.
Taxes
LO 6.3 Calculate the effect of a tax on the equilibrium price and quantity.
We began this chapter by discussing hunger, which is usually a minor problem in

wealthy countries. Indeed, the United States has the opposite problem: diseases
associated with overeating and poor nutrition, such as obesity, heart disease, and
diabetes.
How can policy-makers respond to this new type of food crisis? In 2008, the
state of California banned the use of trans fats in restaurants in an effort to reduce
heart disease and related problems. Trans fats are artificially produced (partially
hydrogenated) unsaturated fats. Used in many fried and packaged foods because
they extend products shelf lives, they are believed to be unhealthy if consumed in
excess. For decades, trans fats have been the key to making commercially produced
French fries crispy and pastries flaky.
Rather than banning trans fats, what would happen if California taxed them?
When a good is taxed, either the buyer or seller must pay some extra amount to
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FIGURE 6-7
Effect of a tax paid by the seller
Price ()
S2
80
2. The tax drives a wedge
between the buyers price
and the sellers price.
S1
E2
Buyers pay 60
60
Sellers receive 40 after

paying the tax
1. A new supply curve is

added 20 above the
original supply curve, the
amount of the tax.
E1
Tax
wedge
40
D
20
3. The equilibrium
quantity decreases from
30 million to 25 million.
10
15
20
25
30
35
40
45
Quantity of Whizbangs (millions)

A tax levied on the seller adds a new supply curve that is 20 cents higher
than the original, which is the amount of the tax. As a result, the equilibrium
quantity decreases and the equilibrium price increases. At the equilibrium
quantity, the price paid by buyers is now different from the amount received
by sellers after the tax is paid. This tax wedge is equal to the amount of the
tax, or $0.20.
the government on top of the sale price. How should we expect people to respond
to a tax on trans fats? Taxes have two primary effects. First, they discourage production and consumption of the good that is taxed. Second, they raise government revenue through the fees paid by those who continue buying and selling the
good. Therefore, we would expect a tax both to reduce consumption of trans fats
and to provide a new source of public revenue.
Figure6-7 illustrates this scenario by showing the impact of a trans-fat tax on the
market for Chocolate Whizbangs. A delicious imaginary candy, Chocolate Whizbangs are unfortunately rather high in trans fats. Suppose that, currently, 30 million
Whizbangs are sold every year, at $0.50 each.
A tax on sellers. Lets say that the government of California enacts a trans-fat tax
of $0.20, which the seller must pay for every Whizbang sold. How will buyers and
sellers respond? The impact of a tax is more complicated than the impact of a price
control, so lets take it one step at a time.
1.
Does a tax on sellers affect supply? Yes, supply decreases.

When a tax is imposed on sellers, they must pay the government $0.20 for
each Whizbang sold. At any market price, sellers will behave as if the price
they are receiving is actually $0.20 lower. Put another way, for sellers to be
willing to supply any given quantity, the market price must be $0.20 higher
than it was before the tax.
Figure 6-7 shows this change in supply graphically, by adding a new
supply curve (S2). (Technically, this shift isnt really a shift of the curve,
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but a way of showing the new equilibrium price; see the nearby Potentially
Confusing box, Taxes and Shifting Curves.) Note that the new supply
curve is $0.20 higher, the exact amount of the tax. At any given market
price, sellers will now produce the same quantity as they would have at
a price $0.20 lower before the tax. At $0.60 on curve S2, the quantity supplied will be the same as at a price of $0.40 on curve S1. At a price of $0.50
on curve S2, the quantity supplied will be the same as at a price of $0.30 on
curve S1, and so on.
POTENTIALLY CONFUSING
Taxes and shifting curves
In Chapter 3, Markets, we distinguished between a curve shifting to the left or right
and movement along the same curve. A shift represents a fundamental change in the
quantity demanded or supplied at any given price; a movement along the same curve
simply shows a switch to a different quantity and price point. Does a tax cause a shift
of the demand or supply curve or a movement along the curve?
The answer is neither, really. Heres why: When we add a tax, were not really
shifting the curve; rather, we are adding a second curve. The original curve is still
needed to understand what is happening. This is because the price that sellers receive
is actually $0.20 lower than the price at which they sell Whizbangs, due to the tax. So
we need one curve to represent what sellers receive and another curve to represent
what buyers pay. Notice in Figure6-7 that the price suppliers receive is on the original
supply curve, S1, but the price buyers pay is on the new supply curve, S2. The original
curve does not actually move, but we add the second curve to indicate that because of the
tax, buyers face a different price than what the sellers will get. In order for the market
to be in equilibrium, the quantity that buyers demand at $0.60 must now equal the
quantity that sellers supply at $0.40.
Does a tax on sellers affect demand? No, demand stays the same.
Demand remains the same because the tax does not change any of the nonprice
determinants of demand. At any given price, buyers desire to purchase Whizbangs is unchanged. Remember, however, that the quantity demanded may still
changedoes change, in factalthough the curve itself doesnt change.
3. How does a tax on sellers affect the market equilibrium? The equilibrium price
rises, and quantity demanded falls.
The new supply curve causes the equilibrium point to move up along the
demand curve. At the new equilibrium point, the price paid by the buyer
is $0.60. Because buyers now face a higher price, they demand fewer Whizbangs, so the quantity demanded falls from 30 million to 25 million. Notice
that at the new equilibrium point, the quantity demanded is lower and the
price is higher. Taxes usually reduce the quantity of a good or service that is
sold, shrinking the market.
2.
tax wedgethe
difference between
theprice paid by
buyers and the price
received by sellers in
the presence of a tax
kar11498_ch06_171-202.indd 184
Look at the new equilibrium price in Figure 6-7. The price paid by buyers to
sellers is the new market price, $0.60. However, sellers do not get to keep all the
money they receive. Instead, they have to pay the tax to the government. Since the
tax is $0.20, the price that sellers receive once they have paid the tax is only $0.40.
Ultimately, sellers do not receive the full price that consumers pay, because the tax
creates what is known as a tax wedge between buyers and sellers. A tax wedge is
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the difference between the price paid by buyers and the price received by sellers,
which equals the amount of the tax. In Figure6-7, the tax wedge is calculated as
shown in Equation 6-1.
Equation 6-1
Tax wedge 5 Pbuyers 2 Psellers 5 Tax
For each Whizbang sold at the new equilibrium point, the government collects
tax revenue, as calculated in Equation 6-2. Specifically, the government receives
$0.20 for each of the 25 million Whizbangs sold, or $5 million total. Graphically, the
government revenue equals the green-shaded area in Figure6-8.
Equation 6-2
Government tax revenue 5 Tax 3 Qpost-tax
Just like a price control, a tax causes deadweight loss and redistributes surplus. We can see the deadweight loss caused by the reduced number of trades in
Figure6-8. It is surplus lost to buyers and sellers who would have been willing to
make trades at the pre-tax equilibrium price.
The redistribution of surplus, however, is a little trickier to follow. Under a tax,
both producers and consumers lose surplus. Consumers who still buy pay more for
the same candy than they would have under equilibrium, and producers who still
FIGURE 6-8
Government revenue and deadweight loss from a tax
Deadweight loss
Price ()
S2
80
S1
Quantity sold 5 25 million
E2
60
E1
Tax revenue 5 5 million

($0.20 3 25 million)
Tax 5 $0.20
40
D
20
10
15
20
25
30
35
40
45

The revenue from a per-unit tax is the amount of the tax multiplied by
the number of units sold at the post-tax equilibrium point. The amount
of tax revenue directly corresponds to the surplus lost to consumers
and producers. The trades that no longer happen under the tax
represent deadweight loss.
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sell receive less for the same candy. The difference between this lost surplus and
deadweight loss, however, is that it doesnt disappear. Instead, it becomes government revenue. In fact, the area representing government revenue in Figure6-8 is
exactly the same as the surplus lost to buyers and sellers still trading in the market
after the tax has been imposed. This revenue can pay for services that might transfer
surplus back to producers or consumers, or both, or to people outside of the market.
A tax on buyers. What happens if the tax is imposed on buyers instead of sellers?
Surprisingly, the outcome is exactly the same. Suppose California enacts a sales tax
of $0.20, which the buyer must pay for every Whizbang bought. In this case the
demand curve, rather than the supply curve, moves by the amount of the tax, but
the resulting equilibrium price and quantity are the same (see Figure6-9).
To double-check this result, lets walk step by step through the effect of a tax
levied on buyers.
1.
Does a tax on buyers affect the supply curve? No, supply stays the same.
The supply curve stays the same because the tax does not change the incentives producers face. None of the nonprice determinants of supply are affected.
2. Does a tax on buyers affect the demand curve? Yes, demand decreases.
Demand decreases because the price buyers must pay per unit, including the
tax, is now $0.20 higher than the original market price. As Figure6-9 shows,
we take the original demand curve D1 and factor in the amount of the tax to
FIGURE 6-9
Effect of a tax paid by the buyer
Price ()
80
2. The tax drives a wedge
between the buyers price
and the sellers price.
Buyers pay 60, with 20

going to the government
60
E1
Tax
wedge
Sellers receive 40
1. The demand curve is

added 20 cents below the
original demand curve.
40
E2
D1
20
3. The equilibrium
quantity decreases from
30 million to 25 million.
10
15
20
D2
25
30
35
40
45

A tax levied on the buyer adds a new demand curve 20 cents below the
original curve. As a result, the equilibrium quantity decreases and the
equilibrium price paid by the buyer increases. These results are the
same as those of a tax levied on the seller.
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get a second demand curve D2, which represents the price buyers pay under
the tax. At any given price, buyers will now behave as if the price were actually $0.20 higher. For example, at $0.40 on curve D2, the quantity demanded
is as if the price were $0.60 on curve D1. At $0.30 on curve D2, the quantity
demanded is as if the price were $0.50.
3. How does a tax on buyers affect the market equilibrium? The equilibrium price
and quantity both fall.
As a result, the equilibrium point with the new demand curve is further down
the supply curve. The equilibrium price falls from $0.50 to $0.40, and the
quantity demanded and supplied falls from 30 million to 25 million. Although
the market equilibrium price goes down instead of up, as it does with a tax on
buyers, the actual amount that buyers and sellers pay is the same no matter
who pays the tax. When buyers pay the tax, they pay $0.40 to the seller and
$0.20 to the government, or a total of $0.60. When sellers pay the tax, buyers
pay $0.60 to the seller, who then pays $0.20 to the government. Either way,
buyers pay $0.60 and sellers receive $0.40.
As Figure6-9 shows, a tax on buyers creates a tax wedge just as a tax on sellers does.
At the new equilibrium point, the price sellers receive is $0.40. The buyer pays $0.40
to the seller and then the $0.20 tax to the government, so that the total effective price is
$0.60. Once again, the tax wedge is $0.20, exactly equal to the amount of the tax.
Equation 6-3
Tax wedge 5 $0.60 2 $0.40 5 $0.20
Furthermore, the government still collects $0.20 for every Whizbang sold, just as
under a tax on sellers. Again, the post-tax equilibrium quantity is 25 million, and the
government collects $5 million in tax revenue.
Equation 6-4
Tax revenue 5 $0.20 3 25 million 5 $5 million
What is the overall impact of the tax on Whizbangs? Regardless of whether a tax
is imposed on buyers or sellers, there are four effects that result from all taxes:
1. Equilibrium quantity falls. The goal of the tax has thus been achieved
consumption of Whizbangs has been discouraged.
2. Buyers pay more for each Whizbang and sellers receive less. This creates a
tax wedge, equal to the difference between the price paid by buyers and the
price received by sellers.
3. The government receives revenue equal to the amount of the tax multiplied
by the new equilibrium quantity. In this case, the California state government
receives an additional $5 million in revenue from the tax on Whizbangs
which could be used to offset the public health expenses caused by obesityrelated diseases.
4. The tax causes deadweight loss. This means that the value of the revenue the
government collects is always less than the reduction in total surplus caused
by the tax.
In evaluating a tax, then, we must weigh its goalin this case, reducing the consumption of trans fatsagainst the loss of surplus in the market.
Who bears the burden of a tax? Weve seen that the outcome of a tax does not
depend on who pays it. Whether a tax is levied on buyers or on sellers, the cost is
shared. But which group bears more of the burden?
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FIGURE 6-10
Tax incidence and relative elasticity
Sellers tax burden
In all figures, the supply curve shifts up and to the left by 20, the amount of the tax.
(A) Equal incidence

Price ()
(B) Sellers pay more

S2
Price ()
(C) Buyers pay more

S2
S1
60
Buyers tax burden
S1
Price ()
S2
66
S1
54
D
40
46
D
34
Buyers pay 60,

sellers receive 40.
Buyers pay 54,

sellers receive 34.
25
30
Buyers pay 66,

sellers receive 46.
25
30
When supply and demand have the

same relative elasticity, buyers and
sellers share the tax burden equally.
When demand is more elastic than

supply, sellers shoulder more of the
tax burden than buyers.
tax incidencethe
relative tax burden
borne by buyers and
sellers
188
kar11498_ch06_171-202.indd 188
22
30

When supply is more elastic than
demand, buyers shoulder more of
the tax burden than sellers.
In our example, the burden was shared equally. Buyers paid $0.50 for a Whizbang
before the tax; after the tax, they pay $0.60. Therefore, buyers bear $0.10 of the $0.20
tax burden. Sellers received $0.50 for each Whizbang before the tax; after the tax, they
receive $0.40. Therefore, sellers also bear $0.10 of the $0.20 tax burden. The shaded
rectangles in panel A of Figure6-10 represent graphically this 5050 split.
Often, however, the tax burden is not split equally. Sometimes one group carries
much more of it than the other. Compare the example just given to another possible
market for Whizbangs, represented in panel B of Figure6-10. In this case, buyers
paid $0.50 before the tax. After the tax, they pay $0.54, so their tax burden is $0.04
per Whizbang. Sellers, on the other hand, receive only $0.34 after the tax, so their
tax burden, at $0.16 per Whizbang, is four times as large as that of buyers. Panel
C shows the opposite case, in which buyers bear more of the burden than sellers.
Thus, buyers pay $0.66 and sellers receive $0.48. The relative tax burden borne by
buyers and sellers is called the tax incidence.
What determines the incidence of a tax? The answer has to do with the relative
elasticity of the supply and demand curves. Recall from Chapter 4 that price elasticity describes how much the quantity supplied or demanded changes in response to
a change in price. Since a tax effectively changes the price of a good to both buyers
and sellers, the relative responsiveness of supply and demand will determine the
tax burden. Essentially, the side of the market that is more price elastic will be more
able to adjust to price changes and will shoulder less of the tax burden.
Panel B of Figure6-10 imagines a market in which demand is more elastic: Many
consumers easily give up their Whizbang habit and buy healthier snacks instead. In
that case, Whizbang producers pay a higher share of the tax. Panel C imagines a market in which demand is less elastic: Consumers are so obsessed with Whizbangs that
they will buy even at the higher price. In that case, buyers pay a higher share of the tax.
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Recall that the market outcome of a taxthe new equilibrium quantity and price
is the same regardless of whether a tax is imposed on buyers or on sellers. Thus, the
tax burden will be the same no matter which side of the market is taxed. Note in panel
C of Figure6-10 that buyers bear the greater part of that burden, even though the tax
is imposed on sellers. The actual economic incidence of a tax is unrelated to the statutory incidencethat is, the person who is legally responsible for paying the tax.
This is an important point to remember during public debates about taxes. A
politician may say that companies that pollute should be held accountable for the
environmental damage they cause, through a tax on pollution. Regardless of how
you may feel about the idea of taxing pollution, remember that levying the tax on
companies that pollute does not mean that they will end up bearing the whole tax
burden. Consumers who buy from those producers will also bear part of the burden
of the tax, through higher prices. Policy-makers have little control over how the tax
burden is shared between buyers and sellers.
Subsidies
LO 6.4 Calculate the effect of a subsidy on the equilibrium price and quantity.
A subsidy is the reverse of a tax: a requirement that the government pay an extra
amount to producers or consumers of a good. Governments use subsidies to encourage the production and consumption of a particular good or service. They can also
use subsidies as an alternative to price controls to benefit certain groups without
generating a shortage or an excess supply.
Lets return to the Mexican dilemmawhat to do when hungry people cannot
afford to buy enough tortillas. What would happen if the government subsidized
tortillas rather than imposed a price ceiling on them?
Figure 6-11 shows the same tortilla market we discussed earlier in the chapter.
Before the subsidy, the market is in equilibrium at a price of $0.70 per pound and a
quantity of 50 million pounds. Now suppose the government offers tortilla makers a
subsidy of $0.35 per pound. How will buyers and sellers respond to the subsidy? They will
respond in the opposite way that they respond to a tax: With a tax, the quantity supplied and demanded decreases, and the government collects revenue. With a subsidy,
the quantity supplied and demanded increases, and the government spends money.
We can calculate the effect of a $0.35 tortilla subsidy by walking through the same
three steps we used to examine the effect of a tax.
1.
subsidya requirement
that the government
pay an extra amount to
producers or consumers
of a good
Does a subsidy to sellers affect the supply curve? Yes, supply increases.
When producers receive a subsidy, the real price they receive for each unit sold
is higher than the market price. At any market price, therefore, they will behave
as if the price were $0.35 higher. Put another way, for sellers to supply a given
quantity, the market price can be $0.35 lower than it would have to be without
the subsidy. As a result, the new supply curve is drawn $0.35 below the original.
In Figure6-11, S2 shows the new supply curve that is the result of the subsidy.
2. Does a subsidy to sellers affect the demand curve? No, demand stays the same.
The demand curve stays where it is, because consumers are not directly
affected by the subsidy.
3. How does a subsidy to sellers affect the market equilibrium? The equilibrium
price decreases and the equilibrium quantity increases.
The equilibrium quantity with the new supply curve increases as consumers move down along the demand curve to the new equilibrium point. At
the new, post-subsidy equilibrium, the quantity supplied increases from
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FIGURE 6-11
Effect of a subsidy to the seller
Price (/lb.)
3. Sellers receive the

equilibrium price plus
the subsidy, 88.
S1
1. A new supply curve

is added 35 below the
original, the amount of
the subsidy.
88
E1
70
2. Buyers pay the

equilibrium price,
53 . . .
S2
53
E2
4 .The equilibrium
quantity increases from
50 million lbs. to 62 million lbs.
D
50
62

A subsidy has the opposite effect of a tax. A new supply curve
is added 35 cents below the original supply curve. This decreases
the equilibrium price and increases the equilibrium quantity
supplied and demanded.
50 million pounds of tortillas to 62 million pounds. As with a tax, the price

buyers pay for tortillas differs from the price sellers receive after the subsidy, because the subsidy creates a wedge between the two prices. This time,
however, sellers receive a higher price than the pre-subsidy equilibrium of
$0.70, and buyers pay a lower one. Buyers pay $0.53 per pound and sellers
receive $0.88 per pound. The government pays the $0.35 difference.
A subsidy benefits both buyers and sellers, increasing total surplus within the market.
However, the subsidy imposes a cost on the government, and ultimately on taxpayers.
In this example, the government must pay $0.35 for each of the 62 million pounds of
tortillas produced, for a total expenditure of $21.7 million. Is the subsidy worth the
cost? That depends on how much we value the increased production of tortillas and the
reduced cost to consumers versus the opportunity cost of the subsidythat is, whatever other use the government or taxpayers might have made of that $21.7 million.
And as the Real Life box, The unintended consequences of bio-fuel subsidies, shows,
the obvious benefits of a subsidy can sometimes be swamped by unexpected costs.
REAL LIFE
The unintended consequences of bio-fuel subsidies
190
kar11498_ch06_171-202.indd 190
The United States subsidizes the production of bio-fuels such as ethanol, a cleaner
fuel than gasoline. The professed goal of the subsidy is to reduce pollutionand
as hoped, the subsidy has caused a huge increase in the production of ethanol.
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Unfortunately, it has also had some unintended effects. In Time magazine, Michael
Grunwald argues that, indirectly, bio-fuels can actually increase pollution:
[T]he basic problem with most bio-fuels is amazingly simple, given that
researchers have ignored it until now: using land to grow fuel leads to
the destruction of forests, wetlands and grasslands that store enormous
amounts of carbon. . . . More deforestation results from a chain reaction
so vast its subtle: U.S. farmers are selling one-fifth of their corn to ethanol
production, so U.S. soybean farmers are switching to corn, so Brazilian
soybean farmers are expanding into cattle pastures, so Brazilian cattlemen
are displaced to the Amazon.
Through a complex chain of market reactions that policy-makers probably didnt
anticipate, Grunwald argues, ethanol subsidies are having the opposite of the hopedfor reduction in air pollution. Unfortunately, unintended consequences arent always
just a postscript to market interventions. Sometimes, they can change the whole story.
Source: M. Grunwald, The clean energy scam, Time, March 27, 2008, http://www.time.com/time/magazine/article/
0,9171,1725975,00.html. The New York Times had a follow-up in its environmental blog: http://green.blogs.nytimes
.com/2008/11/03/the-biofuel-debate-good-bad-or-too-soon-to-tell/.
As with a tax, the effect of a subsidy is the same regardless of whether it is paid
to producers or consumers. If consumers received a $0.35 subsidy for every pound
of tortillas they bought, their demand curve would be $0.35 above the original, the
supply curve would remain unchanged, and the equilibrium outcome would be
the same as if producers received the subsidy: Quantity increases from 50 million
pounds to 62 million pounds, buyers pay $0.53 per pound, and sellers receive $0.88.
Also as with a tax, the way in which the benefits of a subsidy are split between
buyers and sellers depends on the relative elasticity of the demand and supply
curves. The side of the market that is more price elastic receives more of the benefit.
In our example, both have almost the same benefit: Buyers are better off by $0.17 per
pound of tortillas, and producers by $0.18. As with taxes, it is important to note that
who gets what share of benefit from the subsidy does not depend on who receives
the subsidy. Sometimes in debates about subsidies you will hear someone argue
that a subsidy should be given either to buyers or sellers because they deserve it
more. This argument doesnt make much sense in a competitive market (although it
might in a noncompetitive market).
In sum, a subsidy has the following effects, regardless of whether it is paid to
buyers or sellers:
1. Equilibrium quantity increases, accomplishing the goal of encouraging production and consumption of the subsidized good.
2. Buyers pay less and sellers receive more for each unit sold. The amount of
the subsidy forms a wedge between buyers and sellers prices.
3. The government has to pay for the subsidy, the cost of which equals the
amount of the subsidy multiplied by the new equilibrium quantity.
CONCEPT CHECK
What is a tax wedge? [LO 6.3]
How does a subsidy affect the equilibrium quantity? How does it affect the
price that sellers receive and the price that buyers pay? [LO 6.4]
Does it matter whether a subsidy is paid to buyers or sellers? Why or why
not? [LO 6.4]
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Evaluating Government Interventions

LO 6.5 Explain how elasticity and time period influence the impact of a market
intervention.
We began this chapter with a discussion of three reasons why policy-makers might
decide to intervene in a market. To decide whether policy-makers have achieved
their goals by implementing a price control, tax, or subsidy, we need to assess the
effects of each intervention, including its unintended consequences.
Weve established a few rules about the expected outcomes of market interventions. Table6-1 summarizes the key effects of price controls, taxes, and subsidies. In
general, we can say the following:
Price controls have opposing impacts on the quantities supplied and
demanded, causing a shortage or excess supply. In contrast, taxes and subsidies move the quantities supplied and demanded in the same direction,
allowing the market to reach equilibrium at the point where the quantity
supplied equals the quantity demanded.
Taxes discourage people from buying and selling a particular good, raise
government revenue, and impose a cost on both buyers and sellers.
Subsidies encourage people to buy and sell a particular good, cost the government money, and provide a benefit to both buyers and sellers.
TABLE 6-1 Government interventions: a summary

Intervention
Reason for
using
Price floor
To protect producers
income
Effect on
quantity
Who gains
and who loses?
Price cannot go
below the set
minimum.
Quantity demanded
decreases and quantity
supplied increases,
creating excess supply.
Producers who can sell all their

goods earn more revenue per
item; other producers are stuck
with an unwanted excess supply.
To keep consumer
costs low
Price cannot go
above the set
maximum.
Quantity demanded
increases and quantity
supplied decreases,
creating a shortage.
Consumers who can buy all the

goods they want benefit; other
consumers suffer from shortages.
Tax
To discourage an
activity or collect
money to pay for its
consequences; to
increase government
revenue
Price increases.
Equilibrium quantity
decreases.
Government receives increased

revenue; society may gain if the
tax decreases socially harmful
behavior. Buyers and sellers of
the good that is taxed share the
cost. Which group bears more of
the burden depends on the price
elasticity of supply and demand.
Subsidy
To encourage an
activity; to provide
benefits to a certain
group
Price decreases.
Equilibrium quantity
increases.
Buyers purchase more goods

at a lower price. Society may
benefit if the subsidy encourages
socially beneficial behavior. The
government and ultimately the
taxpayers bear the cost.
Price ceiling
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CHAPTER 6
In the following sections we will consider some of the more complicated details
of market interventions. These details matter. Often the details of an intervention
make the difference between a successful policy and a failed one.
How big is the effect of a tax or subsidy?

Regardless of the reason for a market intervention, its important to know exactly
how much it will change the equilibrium quantity and price. Can the effect of a tax
or subsidy on the equilibrium quantity be predicted ahead of time? The answer is
yes, if we know the price elasticity of supply and demand. The more elastic supply
or demand is, the greater the change in quantity. This rule follows directly from the
definition of price elasticity, which measures buyers and sellers responsiveness to
a change in priceand a tax or subsidy is effectively a change in price.
Figure6-12 shows the effect of a $0.20 tax on the quantity demanded under four different combinations of price elasticity of supply and demandagain, for Whizbangs.
In panel A, both supply and demand are relatively inelastic. In this case the tax
causes the equilibrium quantity to decrease, but not by much. Both buyers and
sellers are willing to continue trading, even though they now must pay the tax.
In panel B, demand is more elastic than supply, so when the supply curve is
$0.20 higher, the change in quantity is much larger than in panel A.
In panel C, supply is elastic but demand is relatively inelastic. Again, because
suppliers are highly responsive to the cost of the tax, the quantity changes
more than in panel A.
FIGURE 6-12
Price elasticity and the effect of a $0.20 tax
(A) Inelastic supply
and demand
(B) Inelastic supply

and elastic demand
(C) Elastic supply and

inelastic demand
(D) Elastic supply

and demand
The equilibrium quantity

decreases by 3 million.



Price ()
S2
80
S1
60
Price ()
S2
80
S2
60
D
40
20
Price ()
S1
60
40
Price ()
80
20
S1
40
20
80
S2
60
S1
40
20
10
20
30
40
10
20
30
40
10
20
30
40
10
20
30
40
Quantity of Whizbangs
(millions)
(millions)
(millions)
(millions)
When both supply and

demand are relatively
price-inelastic, the
equilibrium quantity
does not decrease
significantly because
of a tax.
When supply is inelastic

but demand is relatively
elastic, the equilibrium
quantity decreases more
than it does in panel A in
response to a tax.
When supply is relatively

elastic compared to inelastic
demand, the equilibrium
quantity decreases more
than it does in panel A in
response to a tax.
The greatest decrease

in the equilibrium quantity
occurs when both demand
and supply are relatively
elastic; both buyers and
sellers react strongly to
the change in price that is
caused by a tax.
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194
PART 2
Supply and Demand
Finally, panel D shows what happens if supply and demand are both elastic.
In this case, the quantity goes down even more than in the second and third
examples.
To predict the size of the effect of a tax or subsidy, then, policy-makers need to know
the price elasticity of both supply and demand. As we have seen, they can also use that
information to determine who will bear more of the burden or receive more of the benefit.
If you are interested in the role of government in the economy, read the Where
Can It Take You? box, Public economics, to learn more about the field.
WHERE CAN IT TAKE YOU?

Public economics
Are you more interested in elections and legislation than in how to run a business?
If so, we hope you are beginning to realize that understanding the economics behind
public policy is incredi3bly important. Although well-designed policies can accomplish great things, well-intentioned but poorly designed policies can backfire badly.
To learn more about the economics of public policy, consider taking a public economics course. We will discuss policy issues throughout this book, but there is a lot
more to learn, whether you want to be a politician, an analyst at a think tank, or
just an informed voter.
Long-run versus short-run impact

We have seen that in addition to changing the price of a good or service, price
controls cause shortages or excess supply. Because buyers and sellers take time to
respond to a change in price, sometimes the full effect of price controls becomes
clear only in the long run.
Suppose the U.S. government imposed a price floor on gasoline in an attempt to
reduce air pollution by discouraging people from driving. Panel A of Figure6-13
shows the short-run impact of a price floor in the market for gasoline. Note that in
the short run, the quantity of gas demanded might not change very much. Although
people would cut down on unnecessary driving, the greater part of demand would
still be based on driving habits that are difficult to change, such as commuting to
work or going to the grocery store. And unless gasoline producers have a lot of
unused oil wells sitting around, sellers might have trouble ramping up production
quickly. In the short run, demand and supply are not very elastic, and the price floor
results in only a small excess supply.
Recall that for both supply and demand, one of the determinants of price elasticity is the period over which it is measured. On both sides of the market, elasticity
is often greater over a long period than over a short one. Given time, both supply
and demand will become much more elastic than they are in the short run. On the
demand side, consumers might make small lifestyle changes over the medium term,
such as buying a bus pass or shopping closer to home. Over the long run, they might
make even bigger changes. When they need to buy a new car, for example, they will
be inclined to buy a model that offers high gas mileage. If they move to a new job or
home, they may place more weight than in the past on commuting distance.
Supply will also be more elastic over the long run. Because a higher price gives
suppliers an incentive to produce more, they may invest in oil exploration, dig
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FIGURE 6-13
Government intervention in the long and short run
(A) Short run
(B) Long run
Price ($)
Price ($)
Excess Supply
Excess Supply
S
S
Price floor
Price floor
D
Gasoline (bills. of gallons)
In the short run, neither the supply nor the demand

for gasoline is very elastic, so the effect of a price
floor on the quantity supplied is relatively small.
D
Gasoline (bills. of gallons)
In the long run, both the supply and the demand for
gasoline will change in response to price controls.
As a result, the long-run effect on the quantity
supplied is much greater than the short-run effect.
new wells, or take steps to increase the pumping capacity of existing wells. Panel
B of Figure6-13 shows the long run impact of a price floor in the market for gasoline. Because both supply and demand are more elastic in the long run than in the
short run, the excess supply of gasoline is much larger in the long run than in the
short run.
If the goal of the price floor was to reduce air pollution by giving consumers
an incentive to cut down on driving, the impact might look disappointing in the
short run: The quantity of gas burned will decrease very little. Over the long run,
however, the quantity of gas burned will decrease further, and the policy will look
more successful. If, on the other hand, the reason for the price floor was to support
gasoline suppliers, the short-run response would look deceptively rosy, because
suppliers will sell almost the same quantity of gas at a higher price. As the quantity
falls over the long run, however, more producers will be stuck with an excess supply and the policy will start to look less successful.
In the European Union and the United States, farmers are given very generous
subsidies. Without these subsidies, many farmers would be forced to quit farming.
Critics argue that subsides distort the market by keeping prices of certain foods
much higher than they would be without subsidies. Read the full debate in the
What Do You Think? box, Farm subsidies.
WHAT DO YOU THINK?

Farm subsidies
Many wealthy countries spend a lot of money on price floors and subsidies that
encourage domestic agricultural production. For instance, the costs associated
with Europes Common Agricultural Policy (CAP) currently account for almost
half the European Unions budget, or approximately $50 billion per year.
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CAP was established in 1957 with the following objectives:

1. To increase agricultural productivity by developing technical progress and by
ensuring the rational development of agricultural production and the optimum
utilization of the factors of production, particularly labor.
2. To ensure thereby a fair standard of living for the agricultural population,
particularly by the increasing of the individual earnings of persons engaged in
agriculture.
3. To stabilize markets.
4. To guarantee regular supplies.
5. To ensure reasonable prices in supplies to consumers.
Supporters believe that these are important and worthwhile policy goals. However, CAP has come under heavy criticism for many reasons. Critics accuse CAP of
imposing a huge cost on taxpayers; creating excess supplies of crops by distorting
farmers incentives; hurting farmers in poor countries, whose produce must compete
with Europes subsidized crops; and channeling public funds to big agri-businesses.
The European Union is not alone in its policies. Every year the United States
Farm Bill allocates many billions of dollars to crop price supports. Japan also intervenes heavily in agricultural markets.
What do you think?
1. Do you approve of the stated objectives of Europes Common Agricultural
Policy? Which, if any, do you think merit the market distortions they may create?
2. Do wealthy nations have a responsibility to consider the impact of their agricultural
policies on poorer countries, or are domestic farming interests more important?
Source: Cap explained, European Commission website, 2009, http://ec.europa.eu/agriculture/publi/capexplained/cap_en.pdf.
CONCEPT CHECK
If the demand for a good is inelastic, will a tax have a large or small effect on the
quantity sold? Will buyers or sellers bear more of the burden of the tax? [LO 6.5]
Would you expect a tax on cigarettes to be more effective over the long run or
the short run? Explain your reasoning. [LO 6.5]
Conclusion
If you listen to the news media, it might seem as if economics is all about business
and the stock market. To the contrary, many of the most important, challenging, and
useful applications of economic principles involve public policy. Dont underestimate
the effect that public policy can have on your everyday life, for better or for worse.
This chapter gives you the basic tools you need to understand government interventions in a competitive market, but as always, remember: The real world is complicated. Later, you will learn how to evaluate the benefits different people receive
from both markets and government policies. Further along in this book, you will
learn more about market failure and how to analyze the many policies you may
have heard about in the news.
FP
Mobile Window on the WorldUse this QR code to find more applications of the chapter content
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Key Terms
price control, p. xxx
price ceiling, p. xxx
deadweight loss, p. xxx
price floor, p. xxx

tax wedge, p. xxx
tax incidence, p. xxx

subsidy, p. xxx
Summary
LO 6.1 Calculate the effect of a price ceiling on the
equilibrium price and quantity.
Government usually intervenes in a market for

one or more of the following reasons: to correct
a market failure, to change the distribution of a
markets benefits, or to encourage or discourage
the consumption of particular goods and services.
Governments may also tax goods and services in
order to raise public revenues.
A price ceiling is a maximum legal price at
which a good can be sold. A binding price ceiling causes a shortage, because at the legally mandated price, consumers will demand more than
producers supply. This policy benefits some consumers, because they are able to buy what they
want at a lower price, but other consumers are
unable to find the goods they want. Producers
lose out because they sell less at a lower price
than they would without the price ceiling.
LO 6.2 Calculate the effect of a price floor on the
A price floor is a minimum legal price at which a

good can be sold. A price floor causes an excess
supply, because at the minimum price, sellers will
supply more than consumers demand. This policy
benefits some producers, who are able to sell their
goods at a higher price, but leaves other producers
with goods they cant sell. Consumers lose because
they buy less at a higher price. Maintaining a price
floor often requires the government to buy up the
excess supply, costing taxpayers money.
LO 6.3 Calculate the effect of a tax on the
A tax requires either buyers or sellers to pay some

extra price to the government when a good is
bought and sold. A tax shrinks the size of a market, discouraging the consumption and production of the good being taxed. The effect is the
same regardless of whether the tax is levied on
buyers or sellers. The tax burden is split between
consumers and producers, and the government

collects revenues equal to the amount of the tax
times the quantity sold.
LO 6.4 Calculate the effect of a subsidy on the
A subsidy is a payment that the government

makes to buyers or sellers of a good for each unit
that is sold. Subsidies increase the size of a market,
encouraging the consumption and production of
the good being subsidized. The effect is the same
regardless of whether the subsidy is paid to buyers
or sellers. Both consumers and producers benefit
from a subsidy, but taxpayers must cover the cost.
LO 6.5 Explain how elasticity and time period
influence the impact of a market intervention.
In evaluating the effects of a government intervention in the market, it is important to consider

both the intended and unintended consequences
of the policy. The size of the impact of a tax or subsidy and the distribution of the burden or benefit
will depend on the price elasticities of supply and
demand. Furthermore, the impact of a government intervention is likely to change over time, as
consumers and producers adjust their behavior in
response to the new incentives.
Review Questions
1. You are an advisor to the Egyptian government, which has placed a price ceiling on
bread. Unfortunately, many families still cannot buy the bread they need. Explain to government officials why the price ceiling has not
increased consumption of bread. [LO 6.1]
2. Suppose there has been a long-standing price
ceiling on housing in your city. Recently, population has declined, and demand for housing has decreased. What will the decrease in
demand do to the efficiency of the price ceiling? [LO 6.1]
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3. Suppose the United States maintains a

price floor for spinach. Why might this policy decrease revenues for spinach farmers?
[LO 6.2]
4. Suppose Colombia maintains a price floor

for coffee beans. What will happen to the
size of the deadweight loss if the price floor
encourages new growers to enter the market
and produce coffee? [LO 6.2]
5. Many states tax cigarette purchases. Suppose that smokers are unhappy about paying the extra charge for their cigarettes. Will
it help smokers if the state imposes the tax
on the stores that sell the cigarettes rather
than on smokers? Why or why not? [LO 6.3]
6. Consider a tax on cigarettes. Do you expect
the tax incidence to fall more heavily on buyers or sellers of cigarettes? Why? [LO 6.3]
7. In the Philippines, rice production is lower
than rice consumption, resulting in a need
to import rice from other countries. In this
situation, the Philippine government might
consider subsidizing rice farmers. What are
the potential benefits of such a policy? What
are the costs? [LO 6.4]
8. A subsidy will increase consumer and producer surplus in a market and will increase
the quantity of trades. Why, then, might a
subsidy (such as a subsidy for producing
corn in the United States) be considered
inefficient? [LO 6.4]
9. Suppose the government imposes a price
ceiling on gasoline. One month after the
price ceiling, there is a shortage of gasoline,
but it is much smaller than critics of the
policy had warned. Explain why the critics
estimates might still be correct. [LO 6.5]
10. A state facing a budget shortfall decides to
tax soft drinks. You are a budget analyst for
the state. Do you expect to collect more revenue in the first year of the tax or in the second year? Why? [LO 6.5]
Problems and
Applications
1. Many people are concerned about the rising
price of gasoline. Suppose that government
officials are thinking of capping the price of
gasoline below its current price. Which of
FIGURE 6P-1
Price ($)
22
20
18
16
S
14
12
10
8
6
4
2
0
D
1
6
7
Quantity
10
11
12
the following outcomes do you predict will

result from this policy? Check all that apply.
[LO 6.1]
a. Drivers will purchase more gasoline.

b. Quantity demanded for gasoline will
increase.
c. Long lines will develop at gas stations.
d. Oil companies will work to increase
their pumping capacity.
2. Figure6P-1 shows a market in equilibrium.
a. Draw a price ceiling at $12. What is
the amount of shortage at this price?
Draw and calculate the deadweight
loss. [LO 6.1]
b. Draw a price ceiling at $4. What is
the amount of shortage at this price?
Draw and calculate the deadweight
loss. [LO 6.1]
3. Decades of overfishing have dramatically
reduced the world supply of cod (a type of
whitefish). Farm-raised halibut is considered a close substitute for ocean-fished cod.
[LO 6.1]
a. On the graph in Figure6P-2, show the

effect of overfishing cod on the market
for farmed halibut.
A fast-food chain purchases whitefish for
use in its Fish n Chips meals. Already hurt
by the reduced supply of cod, the fast-food
chain has lobbied aggressively for price controls on farmed halibut. As a result, Congress
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FIGURE 6P-2
TABLE 6P-1
Market for farmed halibut

Market for farmed halibut
Price of halibut ($)
Price ($)
Quantity demanded
(thousands of lbs.)
Quantity supplied
(thousands of lbs.)
80
20
70
35
60
50
50
65
40
80
30
D
Q
has considered imposing a price ceiling on

halibut at the former equilibrium price
the price that prevailed before overfishing
reduced the supply of cod.
b. On your graph, show what will happen in the market for farmed halibut if
Congress adopts the price control policy.
Draw and label the price ceiling, quantity demanded, quantity supplied, and
deadweight loss.
4. The Organization for the Promotion of Brussels Sprouts has convinced the government
of Ironia to institute a price floor on the
sale of Brussels sprouts, at $8 per bushel.
Demand is given by P 59 2Q and supply
by P 5 2Q, where Q is measured in thousands of bushels. [LO 6.2]
a. What will be the price and quantity
of Brussels sprouts sold at market
equilibrium?
b. What will be the price and quantity
sold with the price floor?
c. How big will be the excess supply of
Brussels sprouts produced with the
price floor?
5. The traditional diet of the citizens of the nation
of Ironia includes a lot of red meat, and ranchers make up a vital part of Ironias economy.
The government of Ironia decides to support
its ranchers through a price floor, which it will
maintain by buying up excess meat supplies.

Table 6P-1 shows the supply and demand
schedule for red meat; quantities are given in
thousands of pounds. [LO 6.2]
a. How many thousands of pounds of meat
would you recommend that the government purchase to keep the price at $4/
pound?
b. How much money should the government budget for this program?
6. Suppose you have the information shown in
Table6P-2 about the quantity of a good that
is supplied and demanded at various prices.
[LO 6.3]
a. Plot the demand and supply curves on

a graph, with price on the y-axis and
quantity on the x-axis.
TABLE 6P-2
Price ($)
Quantity demanded
Quantity supplied
45
10
160
40
20
140
35
30
120
30
40
100
25
50
80
20
60
60
15
70
40
10
80
20
90
0
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b. What are the equilibrium price and

quantity?
c. Suppose the government imposes a
$15 per unit tax on sellers of this good.
Draw the new supply curve on your
graph.
d. What is the new equilibrium quantity?
How much will consumers pay? How
much will sellers receive after the tax?
e. Calculate the price elasticity of demand
over this price change.
f. If demand were less elastic (holding supply constant), would the deadweight loss
be smaller or larger? [LO 6.5]
7. The weekly supply and demand for fastfood cheeseburgers in your city is shown in
Figure 6P-3. In an effort to curb a looming
budget deficit, the mayor recently proposed
a tax that would be levied on sales at fastfood restaurants. [LO 6.3]
a. The mayors proposal includes a sales
tax of 60 cents on cheeseburgers, to be
paid by consumers. What is the new
outcome in this market (how many
b.
c.
d.
e.
cheeseburgers are sold and at what

price)? Illustrate this outcome on your
graph.
How much of the tax burden is borne by
consumers? How much by suppliers?
What are the deadweight loss associated with the proposed tax?
How much revenue will the government collect?
What is the loss of consumer surplus
from this tax?
8. Demand and supply of laptop computers

are given in Figure6P-4. The quantity of laptops is given in thousands. Suppose the government provides a $300 subsidy for every
laptop computer that consumers purchase.
[LO 6.4]
a. What will be the quantity of laptops bought and sold at the new
equilibrium?
b. What will be the price consumers pay
for laptops under the subsidy?
c. What will be the price that sellers
receive for laptops under the subsidy?
d. How much money should the government budget for the subsidy?
FIGURE 6P-3
Price ($)
1.80
FIGURE 6P-4
1.70
1.60
Price ($)
1.50
1.40
1,200
1.30
1,100
1.20
1,000
1.10
900
1.00
800
0.90
0.80
700
0.70
600
0.60
500
0.50
400
0.40
300
0.30
200
0.20
100
0.10
0
10
20
30 40 50 60 70 80 90
Thousands of fast-food cheeseburgers
D
100 110
D
0
12
18
Quantity of laptops
24
30
200
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9. Suppose government offers a subsidy to laptop sellers. Say whether each group of people gains or loses from this policy. [LO 6.4]
a. Laptop buyers.
b. Laptop sellers.
c. Desktop computer sellers (assuming
that they are different from laptop
manufacturers).
d. Desktop computer buyers.
10. Suppose that for health reasons, the government of the nation of Ironia wants to
increase the amount of broccoli citizens consume. Which of the following policies could
be used to achieve the goal? [LO 6.1, 6.4]
a. A price floor to support broccoli
growers.
b. A price ceiling to ensure that broccoli
remains affordable to consumers.
c. A subsidy paid to shoppers who buy
broccoli.
d. A subsidy paid to farmers who grow
broccoli.
increase consumption the most? Choose

only one. [LO 6.5]
a. Elastic demand, inelastic supply.
b. Inelastic demand, inelastic supply.
c. Elastic demand, elastic supply.
d. Inelastic demand, elastic supply.
12. The following scenarios describe the price
elasticity of supply and demand for a particular good. All else equal (equilibrium price,
equilibrium quantity, and size of the tax), in
which scenario will government revenues
be the highest? Choose only one. [LO 6.5]
a. Elastic demand, inelastic supply.
b. Inelastic demand, inelastic supply.
c. Elastic demand, elastic supply.
d. Inelastic demand, elastic supply.
Chapter 6 Endnotes
1. http://www.time.com/time/magazine/
article/0,9171,1727720,00.html; and http://www.
nytimes.com/2008/06/22/nyregion/22food.html.
2. The new face of hunger, The Economist, April 17, 2008.
11. The following scenarios describe the price

elasticity of supply and demand for a particular good. In which scenario will a subsidy
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Calculate the effect of a price ceiling on the equilibrium price

Calculate the effect of a price floor on the equilibrium price

Calculate the effect of a tax on the equilibrium price and quantity.

Calculate the effect of a subsidy on the equilibrium price and quantity.

Explain how elasticity and time period influence the impact of a

FEEDING THE WORLD, ONE PRICE CONTROL AT A TIME

Supply and Demand

Three reasons to intervene

Four real-world interventions

Supply and Demand

3. Many Americans struggle with health problems caused by overeating and

(B) Market with price ceiling

Quantity of tortillas (millions of lbs.)

Quantity of tortillas (millions of lbs.)

In early 2007, the government of Mexico responded to rising tortilla prices by

Surplus in area 2 is transferred

Quantity of tortillas (millions of lbs.)

is represented by area 1 in Figure6-2. In general, deadweight loss represents the loss

Another possibility is to allocate goods on a first-come, first-served basis. This

WHAT DO YOU THINK?

2. At the new equilibrium

Quantity of tortillas (millions of lbs.)

(B) Market without price floor

Quantity of milk (billions of gals.)

Quantity of milk (billions of gals.)

Surplus in area 2 is transferred

Quantity of milk (billions of gals.)

2. At the new equilibrium

Quantity of milk (billions of gals.)

Supply and Demand

Taxes and Subsidies

We began this chapter by discussing hunger, which is usually a minor problem in

Sellers receive 40 after

1. A new supply curve is

Quantity of Whizbangs (millions)

Does a tax on sellers affect supply? Yes, supply decreases.

Supply and Demand

Tax revenue 5 5 million

Quantity of Whizbangs (millions)

Supply and Demand

Buyers pay 60, with 20

1. The demand curve is

Quantity of Whizbangs (millions)

(A) Equal incidence

(B) Sellers pay more

(C) Buyers pay more

Buyers tax burden

Buyers pay 60,

Buyers pay 54,

Buyers pay 66,

Quantity of Whizbangs (millions)

Quantity of Whizbangs (millions)

When supply and demand have the

When demand is more elastic than

Quantity of Whizbangs (millions)

3. Sellers receive the

1. A new supply curve

2. Buyers pay the