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Econ 200 Week 5 Notes

by: Drew Herring

Econ 200 Week 5 Notes ECON200

Drew Herring

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These notes extensively cover chapter 6, which has to do with government intervention in the market.
Principles of Micro-Economics
Hossein Abbasi Alikamar
Class Notes
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This 3 page Class Notes was uploaded by Drew Herring on Monday September 26, 2016. The Class Notes belongs to ECON200 at University of Maryland taught by Hossein Abbasi Alikamar in Fall 2016. Since its upload, it has received 162 views. For similar materials see Principles of Micro-Economics in Microeconomics at University of Maryland.


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Date Created: 09/26/16
Chapter 6 Notes Government Intervention 6.0 ​Introduction Every single government in the world intervenes in markets in some way. There are typically three reasons for this: 1. Correction of market failure -- Markets don’t always work efficiently in the real world. When the assumption of an efficient competitive market fails to hold, a ​market failure​ is said to have occurred. Examples include a monopolized product with an inefficiently high price, or imposing prices on others from pollution caused by burning gasoline from your car. 2. Changing the distribution of surplus -- Efficiency can still be unfair. When a market situation is efficient but blatantly unfair, the government may intervene. The point here is to evenly distribute the surplus, or profit. Example - A regulated minimum wage. 3. Encouraging/discouraging consumption of certain goods -- Governments can pose taxes on products that have negative effects. Examples include cigarettes, alcohol, and tobacco. Conversely, governments can subsidize (financially support) producers of positive things, such as farmers, educators, and doctors. Here are four examples from the book on real cases of government interventions, all of which are either an encouragement or a discouragement to consume certain goods: 1. The Mexican government set a maximum price for tortillas, a common food. 2. The U.S. government set a minimum price on milk, an effort to protect dairy farmers. 3. The U.S. government is considering taxing high-calorie/high-fat foods in the hopes of getting Americans to eat healthier. 4. The Mexican government is considering subsidizing tortillas. As we look at these p​ olicie​ , remember ​ o​sitive (facts)​ a​ ormative (ideals/opinions) ​ analysis. Positive analysis answers the question, “Does the policy accomplish its goal?” Normative analysis asks the question, “Is the policy a good/ethical/wise idea?” Few policies are all good or all bad. There are always trade-offs involved. The real question is: ​ o​ the benefits outweigh the costs? The first two examples of government intervention listed above are examples of ​price controls​: regulations that set maximum/minimum prices for particular goods. There are two kinds of price controls: Price ceilings and price floors. 6.1 ​Price Ceilings​ are maximum legal prices at which goods can be sold. Most goods that have price ceilings are necessities. Some goods that are often hit with price ceilings are basic foods, gasoline, and electricity. Let’s look at that first example: ​The Mexican government set a maximum price for ​ tortillas, a common food. The Mexican government set the max price at 25¢, while the equilibrium was 50¢. While the government was trying to do good by making tortillas more accessible (and it did, consumer surplus went up), producer surplus went down. The number of producers of tortillas went down, thus cutting the supply in half. This meant that there were fewer tortillas for the public to buy and consume. Total surplus went down, resulting in deadweight loss​. This price ceiling was still effective, because consumers saved money, which they could’ve used on different food. Effective price ceilings do sometimes cause a shortage. This just means that goods mu ​ st be rationed. A situation that can result in even m when people bribe the individual in charge of allocating the rationed good. ​ If the price ceiling is ​set ​above the equilibrium price, it’s said to be ​nonbinding. 6.2 ​Price Floors​ are minimum legal prices at which goods can be sold. The U.S. gov’t has imposed a price floor on milk since 1949. Right now, the price floor is $3.00. The equilibrium ​ price is $2.50. What happens if the price floor is m ​ ore than the equilibrium price? There is an excess supply in the product. This excess supply is equal to the difference between quantity supplied and quantity demanded. If the price floor is set below the equilibrium price in the market, it is said to be non-binding. Vice versa, if the price floor is above the equilibrium market price, it is called ​ binding. In order to raise revenue to pay for public programs, governments will institute taxes. Taxes and subsidies are actually really useful when used to correct market failures. And, as we’ve seen, they are used to encourage/discourage consumption of certain goods. 6.3 ​Taxes Taxes have two primary effects. First, they discourage consumption and production of the taxed good. Second, they raise gov’t revenue. Taxes have many effects on sellers. First, they decrease the supply that sellers produce. This makes sense. If production of a good costs extra due to taxes, the amount that producers can make with the same amount of money will go down. When a good is taxed, demand does stay the same. This is because taxes don’t change the non-price determinants of demand. Lastly, taxes on sellers cause equilibrium price to rise and quantity demanded to fall. Essentially, taxes cause the market to shrink. When a good is taxed, sellers no longer receive the full price of the good. This difference between amount paid and amount received is called the ​tax wedge​. The tax wedge is equal to the amount of tax. Tax Wedge = (price paid by buyers) - (price received by sellers) = Tax Taxes cause deadweight loss and redistribute surplus. This deadweight loss is equal to the lost buyers and sellers who would have traded at the pre-tax price. Under a tax, both consumers and producers lose surplus. What happens when buyers are taxed? The outcome is the same. None of the non-price determinants of supply are affected. Supply stays the same, demand decreases, and equilibrium price/quantity both fall. A tax on buyers creates a tax wedge just like a tax on sellers. When supply and demand both have the same relative elasticity, buyers and sellers share the tax burden equally. When demand is more elastic, sellers take more of the burden. When supply is more elastic, buyers shoulder more of the burden. Unless demand is perfectly (in)elastic, tax cost is shared by buyers and sellers. The tax burden taken by buyers and sellers is called the ​tax incidence​. The incidence of the tax has to do with the elasticity of the supply and demand curves. Tax incidence is unrelated to ​Statutory Incidence​: the person/corporation who is legally ​ bound to the tax. Statutory incidence refers to who’s ​supposed to pay the tax. Tax incidence ​ refers to who actually ​does pay the tax. Because of this ambiguity, policy makers have little control over who pays the tax. 6.4 ​Subsidies​ are the reverse of taxes. They are requirements for the government to pay an extra amount to producers (or consumers) of a good. Gov’ts use subsidies to encourage the production or consumption of certain goods. They are also good alternatives to price controls. When the gov’t gives subsidies to sellers, supply increases. This is obvious. Demand/the demand curve stays the same, because buyers aren’t really affected. The equilibrium price ​ decreases, while the equilibrium quantity increases. A subsidy benefits both buyers a therefore increasing total surplus in the market. What they make up for to buyers/sellers, they take away from the government and taxpayer dollars. To sum things up, subsidies have the following effects on buyers/sellers: 1. Equilibrium quantity increases, which encourages production and consumption of the good. 2. Buyers pay less and sellers receive more of the good. 3. The gov’t has to pay for the subsidy. This cost is equal to the amount of the subsidy multiplied by the new equilibrium quantity.


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