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Price ceilings, price floors, taxes, subsidies, consumer/producer surplus, and deadweight loss
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Even a perfectly competitive market can produce outcomes that policymakers want to alter — usually because the equilibrium price is considered too high (hurting consumers) or too low (hurting producers). The standard tools are price controls (price ceilings and floors), excise taxes, subsidies, and quotas. Each creates predictable winners and losers and almost always reduces total surplus.
A price ceiling is a legal maximum price. To matter, it must be set BELOW equilibrium (). The result is a persistent shortage: . Examples include rent control and gasoline price caps. Side effects include long lines, black markets, and reduced supplier incentive to maintain quality.
In a competitive market for apartments, equilibrium rent is $1,200. The city imposes a rent ceiling of $900. (a) Will this cause a shortage or surplus, and why? (b) Identify two non-price effects you might expect.
(a) The ceiling is BELOW equilibrium, so it is binding. At P = \900Q_d > Q_s$ ⇒ shortage of apartments. The artificially low price raises quantity demanded and reduces quantity supplied.
(b) Possible non-price effects: long waiting lists, key-money / under-the-table side payments, reduced maintenance and quality (landlords have less incentive to invest), illegal sublets / black market.
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A price floor is a legal minimum price. To matter, it must be set ABOVE equilibrium (). The result is a persistent surplus: . Examples include the minimum wage (a floor in the labor market that creates excess supply of labor — i.e., unemployment) and agricultural support prices.
An excise tax shifts the supply curve UP by the amount of the tax. The new equilibrium quantity is lower, the price paid by consumers () rises, and the price received by sellers () falls. Tax revenue equals tax × . The wedge between and creates a triangular deadweight loss (DWL) — mutually beneficial trades that no longer occur.
Tax incidence depends on relative elasticities: the more inelastic side of the market bears the bigger share of the tax.
A subsidy is the mirror image of a tax: it shifts supply DOWN by the per-unit subsidy, raising equilibrium quantity, lowering the price consumers pay, and raising the price sellers effectively receive. Subsidies cost the government money and, when applied to a competitive market with no externalities, also create deadweight loss because they push output beyond the socially optimal quantity.
Quotas (legal quantity limits) and tariffs (taxes on imports) both restrict supply — they raise prices for domestic consumers and shrink consumer surplus while transferring some of that loss to producers and (for tariffs) the government.
Every AP Microeconomics exam includes graphs of taxes or price controls. You will be asked to identify changes in CS, PS, government revenue, and deadweight loss, and to label tax incidence by area on a diagram.
The federal minimum wage is set above the market-clearing wage in a low-skill labor market. Use a labor-market diagram (verbally) to predict the effect on (a) the wage actually paid, (b) the quantity of labor employed, and (c) the quantity of labor supplied. What gap does this create?
(a) The wage rises to the legal floor — above equilibrium.
(b) Quantity demanded of labor (employment) FALLS — firms hire fewer workers at the higher wage.
(c) Quantity supplied of labor RISES — more people want to work at the higher wage.
The gap at the floor wage is the surplus of labor, observed as unemployment caused by the binding minimum wage.
A market in equilibrium at P^* = \10Q^* = 100. A \2 per-unit excise tax is imposed on producers. After the tax, P_c = \11Q_{\text{new}} = 90P_p (price producers receive net of tax). (b) Compute government tax revenue. (c) Identify how the \2 tax burden splits between consumers and producers.
(a) P_p = P_c - \text{tax} = \11 - $2 = \boxed{$9}$.
(b) \text{Revenue} = \text{tax} \times Q_{\text{new}} = (\2)(90) = \boxed{$180}$.
(c) Consumers' burden: P_c - P^* = \11 - $10 = $1P^* - P_p = $10 - $9 = $11/$1** (50/50 here, which implies roughly equal elasticities of demand and supply).
On a supply-and-demand graph, an excise tax raises from $10 to $13 and lowers to $8, with quantity falling from 100 to 80. Compute the deadweight loss.
Tax wedge = P_c - P_p = \13 - $8 = $5$.
DWL is a triangle with base = tax wedge = $5 and height = reduction in quantity = :
DWL = \tfrac{1}{2}(\5)(20) = \boxed{$50}.$
Two markets each receive a $3 per-unit subsidy paid to producers. Market A has highly elastic demand and elastic supply. Market B has highly inelastic demand and inelastic supply. (a) In which market will the subsidy cause a larger increase in quantity? (b) In which market will more of the subsidy "stay" with consumers (lower price)? (c) Which market generates a larger deadweight loss from the subsidy?
(a) Market A — both curves are elastic, so the supply shift produces a much larger change in equilibrium .
(b) The benefit of a subsidy goes mostly to the side of the market that is more INELASTIC. In market B both sides are inelastic, but the comparison the question wants is "consumers vs producers": the more inelastic side keeps more of the subsidy. If demand is more inelastic than supply in market B, consumers benefit more there. In market A both sides being elastic means the subsidy is shared more evenly.
(c) Market A — DWL from a subsidy is proportional to the change in quantity beyond the socially optimal . Elastic curves produce a much larger for the same subsidy ⇒ much larger DWL. Subsidies (like taxes) cause more efficiency loss when the market is more elastic.