This Economics HL talks about how the intervention of the government plays a huge role in the Supply-Demand Curve and how the prices are affected.
Table of Contents
1.3 Government intervention
1.3.1 Indirect taxes
Indirect taxes are taxes imposed on certain goods to discourage the consumption of goods that can create externalities (demerit goods).
Let’s look at what happens to the equilibrium when the government decides to install a specific tax on a certain good:
Changes in price elasticity of demand and supply
In general, we can say that if the general elasticity of demand and supply changes the slope of the demand and supply curve also changes. In this section, we will look at what will happen to the changes in welfare when these elasticities change.
Supply becomes more elastic
When supply becomes more elastic, the supply curve will become less steep because a change in price will have a larger effect on the quantity supplied.
This results in the following general rule: the higher the elasticity of supply, the higher the tax incidence (welfare loss caused by the tax) will be on consumers and the lower it will be on
Of course, exactly the opposite of the above will be the case when supply becomes less elastic (and the supply curve has an increased slope).
Demand becomes more elastic
When demand becomes more elastic, the demand curve will become less steep because a change in price will have a larger effect on the quantity supplied.
This results in the following general rule: the higher the price elasticity of demand, the lower the tax incidence (welfare loss caused by the tax) will be on consumers, and the higher it will be on producers.
Of course, exactly the opposite of the above will be the case when demand becomes less elastic (and the demand curve has an increased slope).
A subsidy is an amount of money paid by the government to a firm per unit of output.
Possible goals of the government for setting the subsidy may include:
• To lower the price of essential goods: producers of essential goods can lower the price when receiving a subsidy.
• Guarantee the supply of certain goods: more producers will want to produce certain goods if they can get a subsidy to do so.
• Enable producers to compete with foreign competitors: domestic companies stand stronger on the international market if they get money in the form of subsidies from their government.
Whether the subsidy will result in a welfare loss or gain depends on the size of the areas involved. If f + g + i > c + c + d + j + k, there will be a welfare gain. If the opposite is the case, there will be a welfare loss.
1.3.3 Price controls
Price control is a measure by the government that forces producers to sell goods for a fixed price or a price within a certain range. In this section, we will discuss two price controls: (1) the maximum price (price ceiling) and (2) the minimum price (price floor).
Price ceiling (maximum price)
With a price ceiling, the government sets a maximum price, which lies below the equilibrium price, beyond which producers are not allowed to raise the price.
The government can do so to protect consumers against high prices.
As you can see in the diagram, in the case of a price ceiling the demand will be greater than the supply. Excess demand will thus exist.
Possible consequences of setting a price ceiling may include:
Shortage: production falls short of demand.
Underground parallel markets: due to the excess demand some consumers who want to buy the good cannot do so. They may go on the black market to still buy the good in question.
Welfare loss: the market won’t be at equilibrium, consumer and producer surplus are not maximized.
Inefficient resource allocation: the market won’t be at equilibrium, resources are not used most efficiently.
Non-price rationing: producers may start deciding who may buy and who may not buy. They may do so by queuing: consumers who are willing to wait for the longest in a queue may buy the good.
Price floor (minimum price)
With a price floor, the government sets a minimum price which lies above the equilibrium price. Below, producers are not allowed to lower the price.
The government can do so to protect producers against large fluctuations in prices (e.g. agricultural products) or to protect workers (e.g. setting a minimum wage).
As you can see in the diagram, in the case of a price floor supply will be greater than demand. Excess supply will thus exist.
Possible consequences of setting a price floor may include:
• Surpluses and government measures. As explained above in the case of a price floor, there will be excess supply and the government often sets a minimum price while promising producers to buy the stock that they can’t sell on the market for a higher price.
• Welfare loss. The market won’t be at equilibrium, consumer and producer surplus are not maximized.
• Inefficient resource allocation. The market won’t be at equilibrium, resources are not used most efficiently.