Unit-4
Application of Supply & Demand
4.2 Impact of government intervention on Price &
Quantity – Taxation and Price
Control
4.3 Willingness to Pay and Consumer Surplus
4.4 Willingness to Sell and Producer Surplus
4.5 Market Efficiency and Deadweight Loss
4.6 Deadweight Loss of Taxation.
MAXIMUM PRICE(Price MINIMUM PRICE(Price
ceiling ) flooring)
GOVERNMENT INTERVENTION
IN THE MARKET
SUBSIDIES
TAXES
CONSUMER SURPLUS
Price of concert ticket CONSUMER SURPLUS
Difference between what a consumer is
willing to pay and what is actually paid.
A
80
The area of the triangle ABC which is the
area under the demand curve and above
60 the equilibrium price of Rs 40 is the
CONSUMER
CONSUMER SUPRLUS.
SURPLUS
40 C Consumer Surplus = ½ * (80-40)*2=Rs 40
B
20
DD
0
1 2 3 4 Quantity of concert ticket
PRODUCER SURPLUS
Price of concert ticket
PRODUCER SURPLUS
Difference between what a producer is
paid and what he/she is willing to sell.
SS
80 The area of the triangle DEF which is
the area above the supply curve and
60 below the equilibrium price of Rs 40 is
the PRODUCER SUPRLUS.
40
E F Producer Surplus = ½ * (40)*2=Rs 40
PRODUCER
SURPLUS
20
0
D 1 2 3 4 Quantity of concert ticket
MARKET EFFICIENCY
Price of concert ticket ECONOMIC EFFICIENCY
The allocation of resources maximizes
total surplus (consumer surplus plus
SS producer surplus) which received by
80 the society.
Consumer Surplus (CS) = area above
60 equilibrium price and below demand
curve
CONSUMER
SURPLUS Producer Surplus (PS) = area below
40 equilibrium price and above supply curve
PRODUCER
SURPLUS
Total Surplus (TS) = CS + PS
20
0
1 2 3 4 Quantity of concert ticket
The Efficiency Loss From an Indirect Tax
S1
S
Price
Tax
E1
p1
Deadweight loss
p0
E0
p2
0 q1 q0
Quantity
The Efficiency Loss From an Indirect Tax
The original curves are S and D.
Equilibrium is at E0 with price p0 and quantity q0.
The tax shifts the supply curve to ST.
Equilibrium moves to E1 .
Market price is p1, and quantity q1.
Consumers pay p1, while the after-tax receipts of producers
are p2.
The Efficiency Loss From an Indirect Tax
The government gains tax revenue equal to the light yellow
area, which is p1 minus p2 multiplied by q1.
Part of this revenue comes from producers and part from
consumers.
Consumers also lose surplus of the dark yellow area.
Producers also lose surplus of the medium shaded area.
Since no one gets the surpluses that consumers and
producers lose, they are the deadweight losses of the tax.
The impact of a tax
Impact of a tax is its first point of contact with
tax payers. It is upon those who bear the first
responsibility of paying it to the authorities ,that
is those who have statutory responsibility of
paying it to the govt.
Incidence of tax
Incidence of tax is defined as final resting place.
It is upon those economic units which finally
bear the money burden of it and which are not
able to pass it on to others.
Incidence lies upon that final source from which
the tax money comes.
Effects of Taxation
When a tax is imposed and collected ,it involves
certain responses from the tax-payers and the
economy. Such responses can be of great
variety and can profoundly influence the
working of the economy in terms of
production,growth,savings,investement,choice
of techniques of production and so on.
Factors affecting tax shifting
Type of tax
Long usage
Size of the tax and the market
Availability of close and effective substitute
Geographical coverage
EQUILIBRIUM PRICE AND
OUTPUT
6 SURPLUS (QSS > QDD)
5
4
Price
E
3
P* SS
2 DD
1
SHORTAGE (QDD > QSS)
0
Q*
2 4 6 8 10
Quantity
GOVERNMENT
INTERVENTION IN MARKETS
MAXIMUM PRICE/CEILING PRICE
Price Government-imposed regulations that
Advantage:
S prevent prices from rising above a
•Consumers purchase maximum level
at lower price
Suppliers reduce the amount offered to Q1 but
demand would rise to Q2 creating a shortage
The equilibrium price is
P* and the quantity is Q*
P*
The government imposes
a maximum price of P1
P1 Price Disadvantages:
ceilin • Emergence of black market
Shortages occur g • Reduction in quantity produced
• Producers tend to receive illegal
D payments from consumers
Q1 Q* Q2 Quantity
GOVERNMENT INTERVENTION IN
MARKETS (cont.)
MINIMUM PRICE/FLOOR PRICE
Price Government-imposed regulations
S that prevent prices from falling
Surplus occurs below a minimum level
Advantages:
P1 • Protects the producer’s income
Floor Price
• Higher wage rate
P* Disadvantages: Suppliers increase the amount
• Consumers pay more offered to Q2 but demand drop to
• Waste of resources of
Q1 creating a surplus
production
• Creates unemployment The equilibrium price is
P* and the quantity is Q*.
The government imposes
a minimum price of P1
D
Q1 Q* Q2 Quantity
MARKET FAILURE
Market failure exists when a free market is unable to
deliver an efficient allocation of resources which leads to
a loss of economic efficiency.
Causes of market failure
– Externalities(Positive & Negative)
– Existence of monopoly power
– Public goods
– Incomplete information
