Transcript Government Intervention & Market Failure

Government Intervention &
Market Failure
AP Micro
Module 4
Objectives
• By the end of this module, SWBAT
– Define and graph consumer and producer surplus
– Define and graph price floors and price ceilings
– Explain how the elasticity of demand and supply
curves affects surplus and tax burden
– Explain and graph taxes and tariffs and define
deadweight loss
– Contrast subsidies and their effects to taxes and
tariffs
SLOs
• Social Responsibility
– At times, Smith’s invisible hand can create
conditions that are unduly harsh for some
consumers and producers
– These groups lobby the government to step in and
provide a “safety net”
– The question as America moves forward is should
the government continue to play this role and if
not, what can ordinary actors in the market do to
protect themselves?
Efficiency
• Markets that operate at
equilibrium price are at
max efficiency
• The large triangle formed
by the P axis, demand
curve and supply curve
represents TOTAL
SURPLUS
• TOTAL SURPLUS is the
total number of
transactions that takes
place between consumers
and producers
Efficiency
• The smaller triangle
inside total surplus
above the equilibrium
price is the CONSUMER
SURPLUS
• The smaller triangle
inside total surplus
below the equilibrium
price is the PRODUCER
SURPLUS
Elasticity and Surplus
• Changes to the elasticity of demand and
supply curves allocate different shares of total
surplus to producers and consumers
Elasticity and Surplus
When Equilibrium Fails…
• Sometimes, market forces move equilibrium
price (aka market price) to an undesirable
amount
• Governments have two options
– Price controls
– Taxes/Subsidies
Price Floors
• Must be placed ABOVE
equilibrium to be
“binding”
• Prices want to fall
toward equilibrium but
they cannot
• Creates extra surplus
goods because Q
supplied > Q demanded
at the price floor
Price Ceiling
• Prices want to rise to
equilibrium but cannot
• Create shortages
because Q demanded >
Q supplied at price
ceiling
• Must be placed BELOW
equilibrium to be
“binding”
Taxes
• From a liberal economic point of view, taxes
are always inefficient – artificially inflate prices
and negate business transactions
• Society needs them, however, since tax
revenue is used to:
– Provide services which are common goods that
are hard to privatize (i.e. street lights, sewers)
– Undo the negative externalities caused by
economic activity (i.e. EPA to fight pollution)
Taxes
• On a graph, any tax price
must be ABOVE equilibrium
price to be binding
• Draw a line at the tax price
from the P axis to the right
until you reach the demand
curve
• Then draw a perpendicular
line down to the Q axis
• The segment of this vertical
line between the demand
and supply curves is called
the TAX INCIDENCE
Taxes
• On a graph, the TAX
REVENUE is area of the
rectangle that is formed by
the tax incidence (height)
times the quantity
demanded or supplied at
the tax price (base)
• The purple triangle to the
right of the tax incidence is
the DEADWEIGHT LOSS, or
transactions that no longer
take place because of the
tax
Taxes and Elasticity
• Just like in the surplus example before,
different elasticity of each curve will cause the
tax burden to shift from the producer to the
consumer or vice versa
Taxes and Elasticity
Determinants of Elasticity of Supply
• Supply curves might change elasticity due to
– availability of materials - The limited availability of raw
materials could limit the amount of a product that can
be produced.
– length and complexity of product - If the product is
complex to manufacture, it becomes more inelastic
– time to respond - If the producer has more time to
respond to price changes, the product is more elastic
– excess capacity - A producer with unused capacity will
quickly respond to price changes
International Trade
• Consider any supply and demand curve situation
and locate the equilibrium price
• This price is also the domestic price
• Also represented are domestic consumer surplus
and domestic producer surplus
• When we introduce an international price or
“world price” to the situation, any particular
nation becomes an importer or exporter of that
particular good based on the difference between
the domestic price and the world price
Exports
• A nation is an exporter IF
the domestic price of a
good is LESS than the
world price
• The triangle above
equilibrium and between
demand and supply
curves represents the
“foreign consumer
surplus” which is equal to
the added producer
surplus of all of the
exporters in the nation
Imports
• A nation is an importer IF
the domestic price is
MORE than the world
price
• The triangle below
equilibrium and between
the supply and demand
curves is the “imported
consumer surplus” which
is equal to the added
producer surplus of the
exporter nation
Tariffs
• Although less popular these days than in the late 19th
and early 20th centuries, tariffs (or taxes on imports)
can effectively increase domestic producer surplus in
importer nations
• They will, however, cause a deadweight loss because
they are taxes but…
• They will, however, generate revenue because they are
taxes
• In order to be binding, tariffs must create a higher
world price in order to make the domestic price
(equilibrium price) more competitive and boost
domestic producer surplus
Tariffs
• Shown here, the tariff
price is in the middle,
between equilibrium
and the world price
• The blue box is the tax
revenue it generates
• The orange triangle of
producer surplus has
now added a
substantial trapezoid to
its area
Tariffs
• The green triangle,
consumer surplus, has
shrunk a bit but is still
substantial
• The two pink triangles,
however, are deadweight
losses of the tariffs,
representing the import
transactions that will no
longer happen due to the
influence of the tariff
Important Reminder
• Tax revenue boxes will ALWAYS be rectangular
• Deadweight losses will ALWAYS be triangular
Subsidies
• Artificial boosts to mostly supply but also
sometimes demand in order to protect and
support producers in certain industries
• Work in an “opposite” way as taxes
– Will provide more surplus for consumers and
producers instead of hand revenue to government
– Will create more transactions to offset the
“deadweight loss effect”
Subsidies
• Literally, subsidies are
the best of both worlds
so to speak
– Create lower prices for
consumers
– Generate quantity
supplied levels as if
market price was higher
for producers
Subsidies
• Region “a” in the figure to
the right represents all of
the new transactions that
the subsidies create
• In most cases, subsidies are
used when prices of a
certain key good in the
marketplace drop too low
• Much like a price floor in
this way, keep prices
artificially high but with the
benefit of not making
consumer pay higher prices
directly at the market
Subsidies
• In this example, what
would the subsidy’s
revenue be?
Summary
• Remember that although classical liberal
economists would love to convince you that
Smith’s invisible hand is enough to prevent
market failure and promote efficiency, the
government must still act from time to time to
ensure prosperity
Summary
• Prices that are too low can be combated with
price floors and supply subsidies (think
agriculture)
• Prices that are too high can be regulated with
price ceilings and demand subsidies (think rent
control apartments and electric cars)
• Unbalanced international trade scenarios can be
normalized with tariffs, although most of the
world is moving toward free trade and less trade
boundaries
Summary
• Taxes are inherently inefficient and should be
crafted to minimize deadweight loss in the
economy
– Taxes that are too low not worth having 
generate too little tax revenue
– Taxes that are too high too disruptive  generate
too little tax revenue AND create massive
deadweight loss
Summary
Summary
• The best taxes are like
Goldilocks – just right
• A visual representation
of this concept is the
Laffer Curve
• Compromise between
tax revenue and the
surpluses of the
consumer and producer
to promote economic
growth
Summary
• Government intervention in the economy is
inevitable
• The tools used by a federal government to
conduct this intervention are collectively called
“fiscal policy” tool
– Taxes
– Spending programs
• Economic tools used by financiers to regulate an
economy are called “monetary policy” tools and
they are distinct from this section and will be
discussed separately