Government Intervention - Subsidies/Price Floor/Price Ceiling

It eliminates allocative efficiency and generates welfare loss

As a greater amount of the good is produced, 'Q2', than the socially optimum amount determined by the market equilibrium, 'Qe', there is an over-allocation of resources to the production of the good from the society's point of view. Allocative inefficiency causes the society to be worse off. When the price floor is set, consumers only consume the quantity 'Q1'. Therefore, the consumer surplus is area 'a' (all of the area below the demand curve and above the price paid by consumers, 'Pmin', for the units consumed). If the government buys the excess supply, producer surplus is now 'b + c + d + e + f' (all of the area above the supply curve and below the price received by producers, 'Pmin', for the units sold). This means that the consumer plus producer surplus increases after the price control. This happens because producers gain the area 'b + c' lost by consumers, in addition to 'f'. The government has a cost of Pmin × (Q2 - Q1), which is a loss of social welfare. Because part of this loss is compensated by the gain in producer surplus represented by 'f', the net deadweight loss for society is the yellow shaded area shown in the diagram.

It eliminates allocative efficiency and generates welfare loss

As a smaller amount of the good is produced and consumed ('Q1') than the socially optimum amount determined by the market equilibrium ('Qe'), there becomes an under-allocation of resources to the production of the good from the society's point of view. This allocative inefficiency results in society being worse off. with no price controls the market equilibrium is at price Pe and quantity Qe. Consumer surplus is equal to area a + b and producer surplus is equal to c + d + e. When the price ceiling is set, consumers only consume the quantity Q1, therefore the consumer surplus is area a + c (all of the area below the demand curve and above the price paid by consumers Pmax, for the units consumed). Producer surplus is now only e (all of the area above the supply curve and below the price received by producers, Pmax, for the units sold). The total community surplus is the area 'a + c + e' after the maximum price control is set. Thus, by comparing to the total social welfare before the maximum price we can see that society suffers a deadweight loss of 'b + d', as shown by the shaded area in the diagram.

To make basic necessities and merit goods more affordable to low-income consumers.

As explained in the previous section, one of the market outcomes of granting subsidies is a reduction in the price of goods for consumers, thus making them more affordable. Subsidies are used to lower the price of essential goods, such as milk, to encourage their consumption for low-income consumers. This is usually done for basic necessities and food staples such as bread and rice, and for certain merit goods like healthcare and education.

It generates a rationing problem

As not all of the interested consumers will be able to purchase the good because of the generated shortage, the problem of who gets to consume the good and how to ration the available amount arises. Because the price is no longer the method used to distribute the good, non-price rationing methods have to be used: People line up and wait their turn to buy the good, and only those who arrive first will be able to do so. Coupons are distributed between the interested buyers so that they can purchase a fixed amount of the good in a given time period. Sellers use favouritism to choose who they sell the good to; the sellers can sell the good to their preferred clients.

​To support growth of a particular industry

As subsidies have the effect of reducing the cost of production for firms and increasing the amount produced of a certain good when granted to firms or specific industries, they support the growth of those industries. Granting these subsidies might be part of a government's strategic objectives and can be observed in many areas; for example, power suppliers, the defence industry, an industry that creates a lot of jobs in the country, and so on.

price ceiling diagram description

At the lower price, consumers would now be willing and able to consume a greater amount, 'Q2', while producers, on the other hand, would be willing and able to supply less, 'Q1'. This would create an excess of demand from 'Q1' to 'Q2' and the consumption of tomatoes would actually fall to 'Q1' even though those consumers would pay a lower price for them. If the government does not intervene further, then both original policy objectives would not be achieved. The price has been reduced but only for those who get to consume the good. The amount consumed has not increased because of the maximum price, it has actually now fallen.

It produces shortages

At the price ceiling 'Pmax' the quantity supplied, 'Q1', is much lower than the quantity demanded, 'Q2', therefore not all of the consumers who are willing and able to buy the good at that price will be able to do so. Producers will cut production in response to the lower price, and a shortage of Q2 - Q1 is created. If the price is kept at 'Pmax' there will be many consumers that at the previous price 'Pe' would have purchased the good, 'Qe', plus all of the new entrants to the market attracted by the low price, who will not have access to it now.

the effect subsidies have on consumers

Consumers' expenditure on the good changes from P* × Q* to Pc × Qsb. Consumers are better off after the subsidy because they pay a lower price (Pc < P*) and consume a greater amount of the good (Qsb > Q*).

There are consequences for market stakeholders

Consumers. Consumers of the good are worse off as they end up consuming a smaller amount of the good at a higher price. Producers. If the government purchases the surplus, producers will sell a greater amount of the good than before (Q2 > Qe) and receive a higher price for it. Their total revenue increases after the price floor is imposed, therefore they are better off. Workers. As the size of the market increases, it is probable that more workers will be hired in this market and consequently employment will rise; workers will be better off. Government. If the government buys the surplus it will incur a cost and have less funds to spend on other public goods and services, which is an opportunity cost. Additionally, if it has to store the product or subsidise it to export it to other countries, the cost will be even higher.

Consequences for market stakeholders

Consumers. Some consumers of the good are better off and some are worse off. Those who get to buy the good at a lower price than before are better off. Those who don't get to consume it at any price at all because of shortages or rationing are worse off. Producers. Producers now sell a smaller amount of the good than before (Q1 < Qe) and receive a lower price for it. Their total revenue falls after the price ceiling is imposed, therefore they are worse off. Workers. As the size of the market is reduced and fewer units of the good are sold, it is probable that workers will be fired in this market and unemployment will increase. Thus, those workers will be worse off. Government. Government does not have a revenue or a cost from this specific policy. However, it may gain political popularity from those consumers who get to consume the good at a lower price than before.

reason for solution

Doing so would mean that both of the original objectives are accomplished: The quantity consumed of the good would increase from Qe to Q2 The price of the good is made more accessible for low-income consumers, reducing it from Pe to Pmax

To increase revenues of producers

Governments tend to grant subsidies to producers whose revenues they might want to protect. As we have seen in previous sections, agricultural goods tend to have highly volatile prices because of their inelastic demand and supply curves, and the nature of their business that needs to deal with climatic and natural anomalies. Therefore, incomes tend to be very unstable.

Effect on society as a whole

However, assuming that the free market equilibrium, with no government intervention, is the socially optimum amount of the good in the absence of externalities, then society as a whole is worse off because there is an over-allocation of resources to the production of the subsidised good. Additionally, the higher price received by producers allows relatively inefficient producers to keep producing as they are protected by the subsidy. In this sense the society is worse off too.

It might create firm inefficiency

If firms know they will receive a higher price no matter how inefficient they are in their production process, they will not be motivated to reduce costs and use more efficient methods of production. Higher prices than the equilibrium price may lead to production inefficiency, because the high prices protect the firms from lower-cost competitors.

It promotes the creation of black markets.

If producers cannot sell all of their product at the regulated price 'Pmin', they may try to sell it at a lower price on the informal (or black) market. This practice is illegal and will go against the original objective of the policy by selling the good at a lower price nearer to the original equilibrium price.

price floor diagram describtion

If the government set a minimum price on corn, it would be set above the equilibrium price at 'Pmin', as shown in the diagram. At the higher price, producers would be willing and able to supply a greater amount, 'Q2', while consumers would be willing and able to buy less, 'Q1'. This would create an excess of supply from 'Q1' to 'Q2'. If the government does not intervene further then the original policy objective of protecting producers of corn by increasing their revenue might not be achieved. The price has been increased but only for those who will still be willing and able to consume the good at the higher price, so the quantity sold has fallen.

To correct positive externalities, improving the allocation of resources

If there is a situation where the market is producing a lower amount of a good than the socially optimum amount, because there is a positive effect on third parties or the society that is not included within the product's supply or demand curve, then the government can intervene in such a market to try to solve the problem. Granting a subsidy to these firms reduces their costs of production, shifting the supply curve outwards by the amount of the subsidy, making the equilibrium quantity produced increase. More of the good being produced results in more workers needed to be trained, and a greater positive effect on society.

price floors

In this case the government sets a minimum price above the equilibrium price, preventing producers from selling their product below it. This is done to protect producers. This is usually done in the case of commodities and in the labour market.

price ceiling

In this situation the government sets a maximum price below the equilibrium price preventing producers to sell their product above it. This is done to protect consumers and is usually applied to necessity and/or merit goods.

consequences of price floor

It produces shortages. It generates a rationing problem. It promotes the creation of parallel (black) markets. It eliminates allocative efficiency and generates welfare loss. There are consequences for market stakeholders.

consequences of imposing a price floor

It produces surpluses. It promotes the creation of black markets. The government needs to dispose of the surplus. It might create firm inefficiency. It eliminates allocative efficiency and generates welfare loss. There are consequences for market stakeholders.

it produces surplus

Looking at Figure 1, at the price floor, 'Pmin', the quantity supplied, 'Q2', is much higher than the quantity demanded, 'Q1', therefore not all of the produced crop will be bought by consumers. Consumers will purchase less in response to the higher price and a surplus of Q2 - Q1 is created. If the price is kept at 'Pmin' there will be many consumers who at the previous price 'Pe' would have purchased the good, ,Qe,, plus all of the new entrants to the market attracted by the low price, who will not have access to it now.

The government needs to dispose of the surplus

Once it has bought the surplus, the government needs to decide what to do with it: The government can store the good, which will generate additional costs. The government can sell the surplus abroad (export), but it would be difficult to sell it at the higher imposed price, 'Pmin'. The government would have to subsidise the good to be able to compete internationally, and this has a cost too. The government can send the surplus as aid to developing countries, but this usually causes problems to these countries (an issue that will be explored later in the Development topic). The government could burn the excess good, but burning food (as in this example) is seen as being extremely wasteful and unethical given that so many people in the world are starving.

subsidy diagram description

Once the subsidy is granted the supply curve shifts downwards from 'S1' to 'S2' by the amount of the subsidy. Producers are willing and able to supply a greater amount of the good to the market at the previous equilibrium price, 'P*', because their cost of production has fallen due to the subsidy they received from the government per unit of output sold. As the supply increases, the equilibrium price in the market falls from 'P*' to 'Pc'. At lower prices, because of the law of demand, consumers will demand more of the good, and therefore the new equilibrium price and quantity will be established at 'Pc' and 'Qsb'.

It promotes the creation of parallel (black) markets

Parallel markets, also called black markets, are markets where buying and selling transactions are unrecorded, and are usually illegal. In this case, many consumers that were willing and able to purchase the good at a higher price than the one set by the government will not be able to purchase the good through the legal market because of the shortage produced by the maximum price. Also, many producers who could have sold more units of the good at a higher price than 'Pmax' before setting the price control will not be able to sell that higher amount through the legal market either. This creates motivation for a black market of the good to emerge. Producers will try to sell the extra units at a higher price than 'Pmax' as there will be consumers willing to buy them. Then the real price for the product being sold and consumed would be somewhere between 'Pmax' and 'Pe'. This means that government would not accomplish either of the objectives of the maximum price control policy.

the effect subsidies have on producers

Producers' revenue rises from P* × Q* to Pp × Qsb, where Pp = Pc + subsidy per unit. Producers are better off as they sell a greater amount of the good (Qsb > Q*) and receive a higher final price (Pp > Pc) after receiving the subsidy from the government.

To encourage exports and protect national industry from foreign competition

Since subsidies reduce the price of goods for consumers, they are used to support industries that produce goods which compete internationally and are sold abroad. Goods that are sold to other countries are called exports. Foreign consumers buy more of these goods when they are relatively cheaper than other countries' goods. Lower export prices increase the quantity of exports. On the other hand, when national firms have to compete with foreign goods sold within the country (imports), governments tend to grant subsidies to domestic producers to protect them and allow their product to compete with the imported ones.

Solutions to price ceilings consequences

The basic problem created by the maximum price is the excess demand or shortage of the product in the market. Grant subsidies to the producers to encourage them to increase supply by producing more of the good. The government could increase supply by producing the shortfall quantity of the good itself to meet total demand. The government could store some of the product (as long as it isn't a perishable good) before setting the price ceiling, then increase supply when needed by releasing some of its stocks on to the market.

the effect subsidies have on government

The government is now worse off, as it has a cost because of the subsidy. The cost of the subsidy is equal to (Pp - Pc) × Qsb, which is the difference between the two supply curves at the new equilibrium level of output in the market. The government has an opportunity cost as the funds granted in subsidies cannot be used to provide public goods and services or for any other government expenditure.

the effect subsidies have on employment

The market has become bigger because more units of output are consumed and produced after the subsidy (Qsb > Q*). If a greater amount of goods are sold, then more workers are needed to produce them. Therefore, the subsidy may lead to higher employment in this market. Workers are better off if more people are employed.

two common scenarios for price ceilings

To ensure low-cost food for low-income earners. To ensure affordable housing for low-income families.

the aims of price ceiling

To increase consumption of the good or service. To reduce the price of the good or service for low-income consumers.

reasons to grant subsidies

To increase revenues of producers. To make basic necessities and merit goods more affordable to low-income consumers. To encourage the consumption of a good or service that is considered beneficial to consumers. To support growth of a particular industry. To encourage exports and protect national industry from foreign competition. To correct positive externalities, improving the allocation of resources.

aims of price floors

To increase the income of producers of goods and services that the government considers important, such as agricultural products, which are subject to large price fluctuations or great foreign competition. To protect workers by setting a minimum wage that ensures they earn enough to have a reasonable standard of living.

subsidy

an amount granted by the government to a certain firm or industry. It is usually given per unit of output, decreasing the firm's costs of production and therefore shifting the supply curve downwards by the amount of the subsidy.

The change in consumer expenditure ('CE') is

ΔCE = CE2 - CE1

The change in the firm's total revenue ('TR') is:

ΔTR = TR2 - TR1