(4) Market Equilibrium and Policy

Total Video Time: 74 minutes

Note that the information in this blog is part of Module 4 (Market Equilibrium and Policy) and part of Module 5 (Market Efficiency). The Module 4 material on Connect goes through the effects on output and prices when there is government intervention, while the material in Module 5 works through the concepts of Consumer Surplus, Producer Surplus, and Economic Surplus (a.k.a Social Welfare). I recommend that while watching this in Module 4, don’t worry too much about it, and then when you get to Module 5, refer back to these videos.

Introduction

In the last two modules, we examined supply and demand and what shifts each curve. Now, we put them all together to find the market equilibrium. We’ll also explore what happens when the government intervenes to keep the price higher or lower than the equilibrium price, or and what happens when the government either imposes taxes on a product or subsidizes it.

We’ll see, generally speaking, that government intervention results in a less efficient outcome, since (with the exception of a subsidy) the result is to decrease the amount of output traded in the market. So why do it? Because by intervening, the government is changing the distribution of benefits in a market so that one group of people is favored. Whether you individually are one of the people who benefits or one of the people who loses will likely affect whether you support the government policy. That’s the normative part of the analysis. For now, on to the positive economics!

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Video 4.1: Market Equilibrium and Efficiency (15 min)

This video explains the outcome we expect to find in a market when the government does not intervene, and discusses how that can be an efficient outcome.

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Video 4.2: Changes in Supply and Demand (13 min)

This video walks through a few different changes in supply and demand so that students gain a better understand of how markets adjust to sudden shocks.

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Video 4.3: Price Ceilings (19 min)

This video provides a few examples of price ceilings and discusses the good and bad that can result from them. After you watch the video, read the news article here about the unintended consequences of price ceilings in Venezuela: efforts to keep prices down have caused quantity supplied to fall, resulting in illegal markets for items that sell at much more than the legal price.

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Video 4.4: Price Floors (14 min)

This video looks at minimum wages as an example of price floors, explaining who benefits and who loses as a result.

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Video 4.5: Taxes (13 min)

This video explains how we can model a simple per-unit tax (a $1 tax on music downloads), and how it affects both consumers and producers.

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Subsidies

A subsidy is the exact opposite of a tax, so the way we analyze it is similar but the effect is the exact opposite. When you pay producers to make a good (ethanol) or you pay consumers to buy a good (hybrid cars), you’re going to increase the amount of the good in the market. With taxes, there are two reasons to do it: to raise revenues or to discourage behavior. With subsidies, there is only one reason: to encourage behavior. (I’ll give the government enough of a break to assume they don’t spend money just to spend mony.)

Suppose the government subsidizes ethanol production by paying suppliers every time they produce and sell a unit of ethanol. This basically reduces their cost of production (it’s like a rebate for them), so they’re going to want to produce more ethanol. Graphically, the supply curve shifts down by the amount of the subsidy: if the government is giving them $1 for every unit of ethanol they produce, they’re willing to charge $1 less for their ethanol. (They won’t like it if the price falls by the entire $1, as they wouldn’t really get any benefit from the subsidy — but as we’ll see, the price will likely fall by less than $1 so they’re better off.) The graph below shows what happens in a competitive market. Supply shifts down by the amount of the tax, moving the line from the orange supply line to the green one.

The equilibrium quantity in the market will increase — the effect is similar to a decrease in costs, so the resulting increase in supply forces prices down, and that increases quantity demanded. People buy more of the product because it’s cheaper; that’s the goal of the subsidy.

But is it really cheaper? That’s the key question here. It’s cheaper for consumers — that’s why we buy more of it. And firms are obviously happy about the situation because they’re getting paid every time they produce. But the actual cost of production has increased because firms have increased production. And taxpayers have to pay for all of the subsidy payments. How can we show that? Consider the graph below.

The total cost of the subsidy program = subsidy per unit*number of units sold. The new equilibrium quantity is where the green supply line crosses the blue demand line — that part is pretty easy. But how do we determine the amount of the subsidy per unit? It’s the difference between the orange and green supply lines. After all, the way that we got the green line was by shifting the orange line down by the amount of the subsidy. So if the subsidy is $1 per unit, the vertical distance between the orange and green lines is $1. So if we start at the intersection of green and blue and go up to the orange supply line, that tells us the actual cost of producting that last unit of output for the firm. (Then, it gets the subsidy, and ends up only really paying the amount shown on the green supply line). Thus, the total cost of the subsidy program to taxpayers is the shaded rectangle in the graph above. Remember: somebody always has to pay for this stuff, and in the case of subsidies, it’s the taxpayer.

Who do subsidies benefit? The producers and consumers of the good. Consumers pay a lower price (where green and blue intersect). Producers actually get a higher price for their good. The price they sell the good for to consumers goes down, but they’re getting an extra $1 for the government so they’re better off than before. So how can we evalute the changes? With the graph below.

The orange area is an increase in profits for firms. They sell more output at higher prices (including the subsidy) than they used to. The blue area is an increase in benefit to consumers. We pay lower prices than we used to and we get to buy more of the product than before. But as you can see if you compare this graph to the previous one, the total cost of the program is more than the total benefit to firms and consumers. The difference is the red triangle in the graph above. That’s the deadweight loss of the subsidy program. So idea is simple: a subsidy program that costs $2 billion is going to create less than $2 billion in benefits for people in the market, and the difference is still paid by taxpayers, so that’s a net loss.

Just as with a tax, a subsidy results in less total benefit in the market. So why do we have them? Because the government wants to encourage certain behavior. Ethanol is subsidized so that we can be less dependent on foreign oil, so there’s a benefit there that we’re not capturing in this graph. Hybrid cars are subsidized for the same reason. Many subsidies are justified based on the idea that there is some other benefit not captured by the market that justifies paying to have more of the good produced. And of course there’s always the more cynical, political argument: ethanol is subsidized because Iowa corn farmers want it to be and they hire lobbyists to pay off congressmen and senators so they’ll vote for subsidies. John Q. Taxpayer might be worse off overall, but is unlikely to hire a lobbyist to argue that subsidies are bad because they create deadweight loss. So the Iowa farmers win and get their subsidy.

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