Government Intervention

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1 Government Intervention Deadweight Loss à the loss in economic surplus due to the market being prevented from reaching the equilibrium price and quantity where marginal benefit (MB) equals marginal cost (MC) 1. PRICE CEILING (When price is unfairly high for consumers) Price Ceiling à a maximum allowable price imposed by the government Ceiling Price less than market price otherwise there are no winners By lowering price you are increasing the quantity the consumers want to buy and decreasing the quantity the suppliers want to produce, hence some consumers don t buy anything because it is not produced. The winners of the policy are the consumers with high reservation price, and high willingness to pay à The rich Solution à help low- income households through a direct lump sum transfer to the poor 2. PRICE FLOOR (When price is unfairly low for suppliers) à Minimum allowable price imposed by the government à When governments believe that P is unfairly low for producers à Opposite of price ceiling Price Ceiling à below Market equilibrium Price Floor à above Market Equilibrium, Due to increase in price, suppliers want to produce more that the consumers no longer want to buy; therefore they have an excess of what they produce Solutionà consumers willing to pay the suppliers the exact amount they gained from the intervention in exchange for cancelling the price floor

2 3. TAXATION (Improves the distribution of Income and Opportunities across different opportunity groups) à Tax, generate Tax revenue à Tax revenue used to redistribute wealth in a society When we tax producers Implementing a tax, increases the MC for suppliers Increase the P for the good, which shifts supply curve up New market equilibrium price, is the quantity they produce at The Consumers receive a quantity of Q* and they pay the Price at the new Equilibrium, when tax was added P* The suppliers produce a quantity of Q*, but they only receive a Price of P=P*- tax So where does the extra money go when the consumers pay P* but suppliers only receive P*- tax The money in between goes to the government as tax And the Dead weight loss, is the original quantity we produce before tax final quantity produced after tax See Panel B Tax Revenue à Government receives it à Provide public goods à Subsidizes or reduce taxes on other markets To increase Tax Revenue à Tax people with the lowest elasticity

3 Losers of the policy Consumers and the producers Consumers à D=inelastic, S=perfectly elastic Producers à S=inelastic, D=perfectly elastic Chapter 7 In an imperfect market one of the following assumptions are violated; Consumers/Suppliers are Price Takers Goods are homogenous There are no Externalities Goods are excludable and rival Full Information Free Entry and Exit Monopolists violate the following assumptions; Consumers/Suppliers are Price Takers Goods are homogenous Free Entry and Exit A Firm is a Price Maker à if it has the ability to set its own prices A Firm has Market Power à if it has the ability to set its own prices If a firm in a perfectly competitive market increased its price it would lose all their sales. Therefore the demand curve for a price taker firm is a straight line à Demand curve is perfectly elastic

4 However if a monopolist increased its prices it would not lose all its sales, as it is the only firm in the market. It would lose some customers but not all. Therefore the demand curve would look like a negative sloping line as the price increases the quantity decreases. A price maker firms demand curve looks like the demand curve for an economy A market composed of firms that are price- setters is said to a perfectly competitive market. There are 3 main forms imperfectly competitive markets; Monopoly à Only one firm in the market (i.e. market curve = individual demand curve) e.g. Microsoft Monopolistic Competition à Large number of firms, à Each producing slightly differentiated goods, (almost perfect substitutes) à E.g. restaurants, different food and petrol station, different station Oligopolistic Competition à Small number of firms selling goods that are close substitutes Free Entry or Exit Invisible Hand Principle suggests a mechanism that eliminates market power à Whenever firms make a profit, some new firms will be willing to enter the market and commence production of the same good à This entry process will continue till the firms in the market make zero profit and are essentially left with no market power

5 à But if no one is able to enter the market, the market power for the monopolist will begin to arise again Barriers to Entry; Control over Scarce Resources If a firm has exclusive control over key inputs of production, it might be impossible for others to enter the market e.g. a mine Government created barriers to entry Patents, copyrights, licenses, etc. Increasing Returns to Scale See below Network Economies Emerge when customer satisfaction with a given product increases with the number of users e.g. Facebook à Similar to increasing returns to scale, because on both cases market power gets stronger as it expands its production Increasing Returns to Scale (Economies of Scale) à When the average cost of producing a certain good decreases with the amount of the good produced à Firms experiencing IRS become more profitable with size à A single firm producing a large quantity of the good can do so more efficiently than a large number of firms each producing a small quantity (natural monopoly) Natural Monopoly à denotes a monopoly that occurs because of increasing returns to scale Monopoly à is a market structure where there is only one firm operating in the market

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