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Chapter 15
Market Interventions
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
The effect of a tax or subsidy
Policies designed to raise prices
Import tariffs and quotas
15-2
Taxes
A specific tax is a fixed dollar amount
that must be paid on each unit bought or
paid
An ad valorem tax is a tax that is stated
as a percentage of the good’s price
The incidence of a tax indicates how
much of the tax burden is borne by
various market participants
15-3
Taxes
In studying the effects of taxes it’s important to
distinguish between the amount a consumer
pays for a good and the amount a firm receives
Use Pb for the amount a consumer pays, Ps for the
amount a firm receives
If the tax is T per unit, then Ps = Pb – T
15-4
The Burden of a Tax
Consider the effect of a specific tax of T dollars
per gallon paid by gas stations on their sales of
gasoline
Graphically, there are three ways to determine
the tax’s effect:
Shift the supply curve up by T
Shift the demand curve down by T
Use a wedge between the amounts consumers pay
and firms receive
All three methods yield the same results
Makes no difference whether the tax is levied
on consumers or producers
15-5
Effects of a Specific Tax
 Shifting the supply curve is one way to determine a
specific tax’s effects
 Demand curve remains unchanged
 For any price paid by consumers, firms now receive
less than when there is no tax
 Won’t be willing to supply as much as before
 Supply curve with the tax is a distance T above the original
supply curve
 New equilibrium price paid by consumers is price at
which the demand curve and new supply curve cross
 Amount bought and sold falls
 Price paid by consumers rises; price received by firms falls
 In a competitive market the burden of a tax is shared
by consumers and firms
15-6
Price Paid by Consumers ($/gallon)
Figure 15.1: Effects of a Specific
Tax – Shifting the Supply Curve
ST
Increase in
Consumer Cost
per Gallon
S
Po + T
B
Pb
T
Po
A
Ps = Pb - T
Decrease in
Firms’ Receipts
per Gallon
D
QT
Qo
Gallons of Gas per Month
15-7
Tax Incidence
Incidence of a tax depends on the shapes of
the demand and supply curves
In general, the more elastic is demand and
less elastic is supply, the more of the tax is
borne by firms
Es
Consumers' share of tax  s
E  Ed
Consumers bear the larger share of the tax
when demand is less elastic than supply
15-8
Figure 15.2: Incidence of a
Specific Tax – Two Special Cases
Who bears the burden of the tax?
15-9
Figure 15.3: Effects of a Specific
Tax – Shifting the Demand Curve
15-10
Welfare Effects of a Tax
Use the no-tax demand and supply curve to
measure aggregate surplus in the absence of a
tax
The tax reduces the amount bought and sold to
the quantity at which the distance between the
supply and demand curves is T
Since quantity bought and sold is higher
without the tax, so is aggregate surplus
To see the welfare effect of the tax, compute
the difference in aggregate surplus at the
quantities with and without the tax
The deadweight loss of taxation is the lost
aggregate surplus due to a tax
15-11
Welfare Effects of a Tax
Welfare effects can be used to assess winners
and losers from a tax or other policy
Graphical analysis of a tax shows:
Consumers and producers both lose, government
gains tax revenue
Society overall loses (deadweight loss)
Taxation can be used to move resources from
the private sector to the government
But the government receives less than private
parties give up
Effect of a tax on welfare depends on what is done
with the revenue
Use algebra to compute the value of
deadweight loss from a tax
15-12
Figure 15.6: Welfare Effects of a
Specific Tax
15-13
Example Problem 15.1
Market demand for corn is Qd=15-2P and Mkt
supply is Qs=5P-2.5. What happens if the govt.
imposes a $.70 tax? What is
aggregate/consumer/producer surplus?
Step 1: Find mkt equil. without tax:
$2.50 and 10 bil. bushels with an agg. Surplus of
$35B, Consumer is $25B
Step 2: Find the new equil. with the tax:
Qs=5(Pb-.70)-2.5=5Pb-6
Find equil. with 15-2Pb=5Pb-6 = $3
What will the seller receive? What are the changes?
What is the govt. tax revenue?
Step 3: Calculate the new levels of surplus
15-14
Example Problem 15.1
15-15
Which Goods Should be Taxed?
 Size of the deadweight loss from taxation of a good
depends on the shapes of the demand and supply
curves
 If supply or demand is perfectly inelastic, for example, there is
no deadweight loss
 The tax doesn’t change the quantity bought and sold
 If either supply or demand is very inelastic, deadweight
loss caused by a tax will be low
 Implies the government should aim to tax goods for which the
deadweight loss from taxation will be low.
 If two goods have equal and constant marginal cost,
the good with less elastic demand should face a larger
tax
 Distributional considerations can also affect the choice
of goods to tax
 Why wouldn’t we want to tax milk?
 Why might we want to tax cigarettes?
15-16
Figure 15.8: Taxation with No
Deadweight Loss
Who bears the burden of the tax?
15-17
Subsidies and Their Effects
A subsidy is a payment that reduces the
amount that buyers pay for a good or increases
the amount that sellers receive
Subsidies can be either specific or ad valorem
(like taxes)
Often result from lobbying efforts
Unlike taxes, subsidies usually increase sales of the
affected goods
Cause deadweight loss…why?
15-18
Subsidies and Their Effects
Consider the effect of a government subsidy of
T dollars for each gallon of ethanol produced
Can find the equilibrium with the subsidy by:
Shifting supply curve down by T
Shifting demand curve up by T
Looking for the quantity at which the demand curve
lies a distance of T below the no-subsidy supply
curve
Consumers pay T dollars less than firms
receive (directly from the mkt)
Subsidy increases the amount bought and sold
15-19
Welfare Effects of Subsidies
Welfare analysis of a subsidy shows
consumers and producers both gain
The sum of the reduction in price to consumers
and the increase in price to firms exactly
equals the size of the subsidy
The side of the market whose demand or supply is
less elastic has a larger price change
Aggregate surplus falls
This is because the government incurs an expense,
the per-unit subsidy times the number of units sold
15-20
Figure 15.9: Deadweight Loss
of a Subsidy
15-21
Policies Designed to Raise Prices
 Governments often attempt to manipulate markets to
benefit a particular group
 When they want to help sellers in a market, they turn to
policies meant to raise prices
 A price floor establishes a minimum price that sellers
can charge
 A price support program raises the market price by
making purchases of the good, increasing demand
 Production quotas impose limits on the quantity that
individual firms can produce
 Voluntary production reduction programs offer firms
inducements to decrease their output voluntarily
15-22
Figure 15.12 (a): Price Floor
 A price floor establishes
a minimum price that
sellers can charge
 With minimum price of P,
quantity bought and sold
is Q1
15-23
Figure 15.12 (b): Price Support
 A price support
program raises the
market price by making
purchases of the good,
increasing demand
 Here, total sales are Q2:
 Government purchases
Q2-Q1
 Private buyers purchase
Q1
 Price is P
 Common Price Support
products
are….agricultural
goods…!
15-24
Figure 15.12 (c): Production Quota
 Production quotas
impose limits on the
quantity that individual
firms can produce
 Total sales of Q1 are
achieved through a
production quota
 Could also be achieved
through a voluntary
reduction program
 Can be either voluntary
or involuntary.
15-25
Welfare Effects of Policies for
Raising Prices
Compare all four policies, each raising the
price of milk from P0 to P1
All create deadweight loss
Price support program is least efficient
Causes unused milk to be produced
Other three policies create equal deadweight
loss
Price floor and production quota have same
effects
15-26
Figure 15.13: Welfare Effects of
Policies for Raising Prices
15-27
Figure 15.13: Welfare Effects of
Policies for Raising Prices
15-28
In-Text Problem 15.2
 Market demand for corn is Qd=15-2P and Mkt
supply is Qs=5P-2.5. What happens if the govt.
wants to raise the price per bushel to $3? How
could it do this with a price ceiling, a price
support program, a quota and a voluntary
production reduction program?
15-29
In-Text Problem 15.2
Price ceiling:
State that corn cannot be old for less than $3
Price support program:
Govt. purchase a great quantity that will drive the
price up to $3
Quota:
Dist. X amount of quotas to the farmers and prohibit
them from producing more.
Voluntary production reduction program:
Pay farmers to reduce production to the equil. Level
required for $3.
Which is the best? Worst?
15-30
Policies that Lower Prices
Sometimes governments adopt policies that
are designed to lower prices
To improve the well-being of buyers
Example: rent control laws
Reduces amount of the good available for
purchase
Creates deadweight loss
Because buyers can’t purchase all they want at
the ceiling price, they may behave inefficiently
Increases deadweight loss
Example: extreme searching for rent-controlled
apartments
Sellers have an incentive to inefficiently
degrade the quality of their products
15-31
Figure 15.16: Price Ceiling
If the govt. imposes a price ceiling on apt. equal to P
(line), the # of avail. Apts and # rented falls to Q1.
15-32
Import Tariffs and Quotas
Many countries use tariffs or quotas to
discourage imports
Example: the U.S. imposes a tariff on frozen orange
juice
A tariff is a tax on imports
A tariff is a tax on sellers in a market
But only on foreign sellers
A quota directly limits the total quantity of a
good that can be imported
In some cases governments use a mix of tariffs
and quotas
15-33
Tariffs
Analyzing the effects of a tariff, T, assume that
the country consumes a small share of the
world’s production of the good
Doesn’t affect world price, Pw
Import supply curve is horizontal at Pw
Tariff shifts the import supply curve upward by
the distance T
Foreign firms must now sell their goods for Pw + T
Price to domestic consumers rises, domestic
consumption falls
Amount sold by domestic producers increases
Imports decline
15-34
Figure 15.17: Effects of a Tariff
15-35
Welfare Effects of Tariff
 The domestic government is concerned with domestic
aggregate surplus: the sum of consumer surplus,
domestic producer surplus, and government revenue
 Under the tariff:
 Consumers are worse off
 Domestic consumers are better off
 Government receives revenue equal to the quantity of imports
times the amount of the tariff
 Domestic deadweight loss arises from reduction in total
consumption
 The tariff allocates production inefficiently away from
foreign producers to domestic producers
15-36
Figure 15.18: Welfare Effects
of a Tariff
15-37
Quotas
 A quota limits the supply of imports to some maximum
quantity
 The government can use either a quota or a tariff to
achieve a desired outcome of imports and domestic
price
 Consumers and domestic firms are both as well off with the
quota as with the tariff
 Difference is that government revenue is zero under the quota
 Instead, revenue is earned by foreign firms lucky enough to
import their goods
 Quota has lower domestic aggregate surplus than tariff
 If government allocates import rights to domestic firms,
domestic firm’s producer surplus would increase
 Domestic aggregate surplus would be the same for quota and
tariff
15-38
Figure 15.19: Effects of a Quota
15-39
Beneficial Trade Barriers…?
Although we have talked
about the effects of
deadweight loss, can a
trade barrier bring about
positive results?
(Assumes non-perfectly
elastic supply…upward
sloping supply cure)
Consider a situation with
no domestic producers
Domestic Agg. Surplus =
C+D+ without a tariff and
C+D+F with a tariff.
Can also work even if there
are some domestic
producers. The key point is
that there is an upwards
sloping supply curve.
15-40