The Welfare Effects Of A Government Policy Economics Essay

For the purpose of this paper demand and supply analysis is used to show how it can be applied to a wide variety of economic problems. In the first section consumer and producer surplus is better defined and explained to understand the welfare effects of a government policy. In other words, consumer and producer surplus can evaluate who gains and who loses from a given policy, and also by how much. Also note that these two concepts of surplus can also be used to demonstrate the efficiency of a competitive market.

In the sections to follow minimum prices, price supports, and related policies will be discussed in more detail. To assist the theory, demand-supply analysis will be used to understand and assess these policies.

Consumer and Producer Surplus

To understand consumer and producer surplus better the principles of price ceilings and floors will be discussed. As opposed to price floors, a government-imposed price ceiling means that the price is set at a lower level than the price in the prevailing market. Likewise, price ceilings will cause the quantity of a good demanded to rise. This happens because at lower prices consumers want to buy more. On the other hand, the quantity supplied will fall because producers are not willing to supply as much at lower prices. As a result of this a shortage will occur, which also indicates excess demand. Note that those consumers who can still buy the good will be better off because they now pay less. However, supply will fall, forcing producers to provide less of their goods.

The following section provides a more detailed explanation of the welfare gained or lost by both consumers and producers, should certain prices be imposed. For the purpose of this section the assumption follows that consumers and producers buy and sell at the prevailing market price in an unregulated, competitive market.

However, for some consumers the value of the good in question exceeds the prevailing market price. This also means that the consumer would be willing to pay more for the good if it was expected. Therefore, consumer surplus is the total benefit that consumers receive beyond what they pay for the good (Pindyck and Rubinfeld, 2005:300). For example if the market price of a product is R7, but the consumer is willing to pay R10 for it, then his net benefit will be R3.

Consumer surplus can also be explained with the assistance of demand and supply curves. In this respect consumer surplus can be interpreted as the area between the demand curve and the market price. Pindyck and Rubinfeld (2005:300) also states that consumer surplus measures the net benefit to consumers in the aggregate, therefore, this analysis can be used to better understand the gains or losses induced from government interventions.

On the other hand, producer surplus is the equivalent measure for producers (Pindyck and Rubinfeld, 2005:301). If goods were to be produced at a price lower than the market price, then more could be produced. Therefore, producers will enjoy a benefit, or rather a surplus, from selling those units. This surplus is the difference between the market price the producer receives and the marginal cost of producing the units. It can also be better explained as the area above the supply curve up to the market price.

Essentially consumer and producer surplus is used for economic analysis to evaluate the welfare effects of a government intervention in the market. It assists with anticipating who will gain or lose from the intervention, and also by how much. To do so the concepts of price ceilings and price floors will be explained in more detail.

Price Ceilings

Price ceilings occur when production (supply) is decreased and the quantity demanded is increased (Pindyck and Rubinfeld, 2005:301). Price ceilings tend to cause excess demand, or rather shortages, to occur. Figure 1: Graphical Presentation of a Price Ceiling

The following section provides a theoretical explanation of Figure 1 and the effects of price ceilings on consumers and producers respectively:

Consumer Surplus (Pindyck and Rubinfeld, 2005:302; and Perloff, 2005:274, 296, 297):

Consumers are better off as they can buy the good at a lower price.

Thus, the consumers that still buy the good enjoy an increase in consumer surplus, which is resembled by rectangle A.

On the other, those consumers who can no longer buy the good lose surplus. Their loss is represented by triangle B.

Therefore, the net change in consumer surplus which is a positive result is:

∆CS = A – B

Producer Surplus (Pindyck and Rubinfeld, 2005:303; and Perloff, 2005:278, 280, 297):

With price controls, some producers will stay in the market but will receive a lower price for their output. Thus, they have lost the producer surplus represented by rectangle A.

Other producers may however leave the market. This means that total production will also drop, which is represented by triangle C.

Therefore, the change in producer surplus, which is a negative result, is:

∆PS = (-A) – C

Deadweight Loss (Pindyck and Rubinfeld, 2005:304; and Perloff, 2005:280, 281):

Price controls will result in a net loss, which is also referred to as deadweight loss.

Therefore, combining the change in both consumer and producer surplus will bring along a total change in surplus as follows:

Deadweight Loss = (A – B) + [(-A) -C] = (-B) – C

In essence, deadweight loss results in an inefficiency caused by price controls.

In summation, a price ceiling is that price held below the prevailing market price. It merely means that too little is produced and, at the same time, that consumers and producers in the aggregate are worse off (Pindyck and Rubinfeld, 2005:306; and Mohr, 2004:162, 163).

Price Floors

In contrast to price ceilings, price floors indicate what happens when government requires for the price to be above the market price. Although producers would like to produce more at this higher price (indicated on the supply curve at P2) consumers will now buy less. If we assume that producers only produce what can be sold, then the market output level will be at Q1. Once again there is a noted net loss of total surplus (Pindyck and Rubinfeld, 2005:306, and Perloff, 2005:293):

Triangles B (a loss of consumer surplus) and C (a loss of producer surplus) represents the deadweight loss.

Rectangle D represents the transfer from consumers to producers, who now receive a higher price.

Figure 2: Graphical Presentation of a Price Floor

In fact, the deadweight loss gives an optimistic assessment of the efficiency cost of policies. The reason for this assumption is that some producers may still however increase prices after the price floor have been incorporated. This would, in turn, result in unsold output. However, should the producer receive more importance with regard to applicable policies, then government might buy up the unsold output to maintain production at Q0. In both cases, the total welfare loss will exceed the areas of triangles B and C (Pindyck and Rubinfeld, 2005:307).

The Efficiency of a Competitive Market

As discussed already, consumer and producer surplus can be used to evaluate economic efficiency in the aggregate. In the previous section it was shown how price controls create a deadweight loss. Thus, the policy imposes an efficiency cost on the economy (Pindyck and Rubinfeld, 2005:306). Both consumer and producer surplus are reduced by the amount of the deadweight loss. This does not mean that such a policy is bad. It may however achieve other objectives that policymakers and the public consider important.

Many researchers argue that if the only objective is to achieve economic efficiency, then a competitive market would be better left alone. This means that no interventions should occur. However, in some cases market failure will occur because prices fail to provide the proper signals to consumers and producers. Also, the unregulated, competitive market could be inefficient. These indications of market failure may occur because of two instances (Pindyck and Rubinfeld, 2005:306):

Externalities: Sometimes the actions of either consumers or producers will result in a cost/benefit that does not show up as part of the market price. Such a cost/benefit can also be referred to as externalities because they are ‘external’ to the market. An example of this is the cost to society of environmental pollution by a producer of industrial chemicals.

Lack of Information: When consumers lack information about the quality or nature of a product and can therefore not make a utility-maximising purchasing decision.

If these two instances (externalities and/or the lack of information) are absent in a market then that unregulated, competitive market will essentially have no obstacles, and an economically efficient output level can be reached.

Minimum Prices

For the purpose of this section we will refer back to Figure 2. From the graph we can see that if producers can correctly anticipate that they can sell only the lower quantity Q1, then the net welfare will be given by triangles B and C. However, as mentioned before, producers may not limit their output to Q1. Incorporating Figure 2 to illustrate minimum prices, the following notations has to be made (Pindyck and Rubinfeld, 2005:310):

P2 denotes a minimum price set by the government.

Q2 denotes the quantity supplied, and Q1 denotes the quantity demanded. The difference between Q1 and Q2 represents excess supply, or rather, unsold supply.

Therefore, Consumer Surplus (Pindyck and Rubinfeld, 2005:310):

Those consumers who still purchase the good must now pay a higher price (Rectangle D).

Some consumers will also drop out of the market (Triangle B).

Therefore, consumer surplus remains the same as before and indicates that consumers are actually worse off as a result of this policy:

∆CS = (-D) – B

Producer Surplus (Pindyck and Rubinfeld, 2005:311):

Producers, on the other hand, receive a higher price for the units they sell, which results in an increase of surplus (Rectangle D).

Rectangle D can also be better described as the transfer of funds between consumers and producers.

But, the drop in sales from Q0 to Q1 actually results in a loss of surplus which is represented by triangle C.

Also remember that the supply curve is a representation of the additional cost of producing each incremental unit. Thus, the area under the supply curve from Q1 to Q2 is the cost of producing quantity Q2 less Q1. This area is represented by trapezoid E. Unless producers respond to unsold output by cutting production, the total change in producer surplus will be:

∆PS = D – C – E

Minimum prices is merely one of the ways to raise prices above the prevailing market level through the direct intervention and regulation of the government – simply make it illegal to charge a price lower than a specific minimum level. As a result, this form of government intervention can reduce producer’s profits because of the cost of excess production. Another example of this is a minimum wage law. In other words, a wage rate at a level higher than the market price will result in those workers who can find jobs and earn a higher payoff. However, some people who want to work will be unable to, which will result in a policy that brings about unemployment (Pindyck and Rubinfeld, 2005:311).

Price Supports and Production Quotas

Besides imposing a minimum price, the government can also increase the price of a good in other ways. In agricultural policy the system is mostly based on price supports, but prices can also be increased by restricting production, either directly or through incentives to producers (Pindyck and Rubinfeld, 2005:314). In this section these policies will be examined in more detail as to show how consumers, producers and the government budget are affected.

Price Supports:

In general, price supports aim to increase the prices of dairy products, tobacco, peanuts, etc. This is done with the intention that the producers of these types of products earn higher incomes. This basically entails that the government sets the supporting price and then buys up whatever output is needed to keep the market price at this level. The resulting gains/losses will be as follows:

Figure 3: Government Price Supports

Consumers Surplus (Pindyck and Rubinfeld, 2005:315):

At price P2, the quantity demanded falls to Q1, and the quantity supplied increases to Q2.

To maintain this price and avoid inventories having to pile up, the government must buy the quantity Qg = Q2 – Q1.

Because the government adds its demand to the demand of the consumers, producers can sell all they want at price P2.

Therefore, the consumer surplus will be calculated in the same way as with minimum prices:

∆CS = (-D) – B

Producers Surplus (Pindyck and Rubinfeld, 2005:315):

Price support policies are implemented with the intention to increase the gains that producers receive because producers are now selling a higher quantity (Q2) at a higher price (P2).

Therefore producer surplus will be as follows:

∆PS = D + B + F

Government Welfare (Pindyck and Rubinfeld, 2005:315):

However, there is also a cost to government, which in essence is paid for by taxes.

Thus, ultimately this is actually a cost indirectly related to consumers.

This amount is represented by the rectangle that makes up BCEFG.

This cost may be reduced if the government can ‘dump’ some of its purchases, for example, selling them abroad at a low price. However, doing so hurts the ability of the domestic market to sell in foreign markets.

The total welfare cost of this policy could be defined as:

∆CS + ∆PS – Cost to Gov = D – (Q2 – Q1)P2

If the objective is to give producers an additional income equal to D + B + F, it is far less costly to society if government were to give them this money directly rather than via price supports. This can be supported by the fact that price supports are costing consumers D + B anyway. If government pay producers directly, then society will save the large rectangular area BCEFG less triangle F (Pindyck and Rubinfeld, 2005:316). However, price supports are in use most likely because they are a less obvious giveaway and, therefore, politically more correct.

Production Quotas:

The government can also cause the price of a good to rise by reducing supply. Government can do this by setting quotas on how much each firm can produce. With appropriate quotas, the price can then be forced up to any arbitrary level. An example of this could be the control of liquor licenses by the government. By requiring any bar or restaurant to have a liquor license and, at the same time limiting the number of licenses, will result in limited entrants into that market. This also allows those with licenses to earn higher prices and profit margins. The welfare effects of production quotas will be explained in the following section (Pindyck and Rubinfeld, 2005:317):

The government restricts the quantity supplied to Q1, rather than at the market level of Q0.

Thus the supply curve becomes the vertical line S’ at Q1.

As a result consumer surplus is reduced by rectangle D plus triangle B.

On the other hand, producers gain rectangle D less triangle C.

Thus, once again, there is a deadweight loss that occurs which is represented by B + C:

∆CS = (-D) – B

∆PS = D – C + (Payments for not producing)

However, the cost to the government is a payment sufficient enough to give producers an incentive to reduce output to Q1.

That incentive must be at least as large as (B + C + F), because that area represents the additional profit that could have been made if the quota was not applicable.

Also remember that the higher price (P2) give producers’ incentive to produce more even though the government is trying to get them to produce less.

Thus, the cost to government is at least B + C + F and the total change in producer surplus is:

∆PS = D – C + B + C + F = D + B + F

∆Welfare = (-D) – B + D + B + F – B – C – F = (-B) – C

Figure 4: Supply Restrictions via Production Quotas

This is the same change in producer surplus as with price supports therefore, producers should in essence be indifferent between the two policies because they end up gaining the same amount of money from each. Likewise, consumers end up losing the same amount of money (Pindyck and Rubinfeld, 2005:318). It can also be noted that, once again, the society will clearly be better off in efficiency terms if the government simply gave the producers (generally in the agricultural sector) D + B + C, leaving price and output alone. Producers would then gain D + B + C and the government would lose this profit for a total welfare change of zero, instead of a loss of B + C. However, economic efficiency is not always the objective of government policy.

Import Quotas and Tariffs

Many countries use import quotas and tariffs to keep the domestic price of a product above world levels and thereby enable the domestic industry to enjoy higher profits than it would under free trade. However, the cost to taxpayers from this protection can be relatively high. Without a quota or tariff, a country will import a good when its price is below the price that would prevail domestically, were there no imports (Pindyck and Rubinfeld, 2005:321, 322; and Perloff, 2005:298, 299).

Figure 5: The Affect of an Import Tariff/Quota on Imports

S and D represent the domestic supply and demand.

Because the world price (P1) is below domestic demand and supply, it gives domestic consumers an incentive to purchase from abroad if imports are not restricted.

If that is the case then domestic price will fall to the world price at P1.

At a lower price, domestic production will fall to Q1 and consumption will rise to Q2.

So imports will be the difference between domestic consumption and production (Q2 – Q1).

Now suppose the government, bowing to pressure from the domestic industry, eliminates imports by imposing a quota or a tariff at Q0.

This will forbid any importation of the good in question.

With no imports allowed the domestic price will rise to P0.

Consumer Surplus:

As a result, consumers who still purchase the good will now pay a higher price and will lose the surplus represented by trapezoid A and triangle B.

In addition, some consumers will no longer buy the good which results in a further loss represented by triangle C. Therefore, the total change in consumer surplus will be:

∆CS = (-A) – B – C

Producer Surplus:

In concern with producers, output is now higher (Q0 instead of Q1).

Output is also sold at a higher price (P0 instead of P1).

Producer surplus therefore increases by the amount of trapezoid A:

∆PS = A

∆Welfare = (-B) – C

Combining both ∆CS and ∆PS to obtain the total welfare effect merely indicates once again that there is a deadweight loss. This loss indicates that consumers lose more than what producers gain.

Imports could also be reduced to zero by imposing a sufficiently large tariff. The tariff would have to be equal to or greater than the difference between P0 and P1. With a tariff of this size there will be no imports and, therefore, no government revenue from tariff collections. Thus, the effect on consumers and producers would be the same as with a quota (Pindyck and Rubinfeld, 2005:323).

However, government policy is more often designed to reduce, but not eliminate, imports (as shown in Figure 6. Again, this can be done with either a tariff or a quota (Pindyck and Rubinfeld, 2005:323; and Perloff, 2005:300, 301):

When imports are reduced, the domestic price is increased from P1 to P0.

Trapezoid A is again the gain to domestic producers.

The loss to consumers is A + B + C + D.

Thus, if a tariff is used, the government will gain rectangle D, the revenue from the tariff.

Therefore, the net domestic loss will be B + C.

If a quota is used instead, then rectangle D becomes part of the profits of foreign producers, and the net domestic loss will be B + C + D.

Figure 6: The General Case with an Import Tariff or Quota

The Impact of a Tax or Subsidy

The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer. In this section it will become clear that the share of a tax accepted by consumers depends on the shapes of the demand and supply curves and, in particular, on the relative elasticities of demand and supply (Pindyck and Rubinfeld, 2005:326).

The Effects of a Specific Tax

A specific tax can be better defined as a tax of a certain amount of money per unit sold. This is in contrast to an ad valorem tax which is a proportional tax. However, the analysis of an ad valorem tax is roughly the same and yields the same qualitative results (Pindyck and Rubinfeld, 2005:326). Examples of specific taxes are sin taxes on cigarettes and liquor.

Suppose the government imposes a tax of t cents per unit. This means that the price the buyer pays must exceed the price the seller receives by t cents. Figure 7 illustrates this accounting relationship and its implications (Pindyck and Rubinfeld, 2005:326):

Figure 7: The Effects of a Specific Tax

Here, P0 and Q0 represent the price and quantity before the tax is imposed.

Pd is the price that buyers pay and Ps is the price that sellers receive after the tax is imposed.

Therefore, Pd – Ps = t.

Here the burden of a tax is split evenly between buyers and sellers. Buyers lose A + B, while sellers lose D + C.

On the other hand, the government earns A + D in revenue.

Thus, the deadweight loss is once again B + C.

The solution is therefore to find the quantity that corresponds to a price of Pd and Ps so that t = Pd – Ps. This quantity is shown as Q1. As seen from Figure 8, the burden of the tax is shared roughly evenly between buyers and sellers. It can also be stated that the price that buyers pay rises by half of the tax, and the price that sellers receive falls by roughly half of the tax. As Figure 7 and 8 shows, market clearing requires four conditions to be satisfied after the tax is in place (Pindyck and Rubinfeld, 2005:327, 328). These four conditions can also be written and distinguished as four different equations that must always be true:

The quantity sold and the buyer’s price must lie on the demand curve, because buyers are interested only in the price that they must pay. Qd = Qd(Pd)

The quantity sold and the seller’s price must both lie on the supply curve, because sellers are only concerned with the price they are to receive. Qs = Qs(Ps)

The quantity demanded must equal the quantity supplied (Q1). Qd = Qs

The difference between the prices of buyers and sellers must equal t. Pd – Ps = t

There is a change in consumer and producer surplus, as well as in government revenue can be summarised as follows (Pindyck and Rubinfeld, 2005:328; and Perloff, 2005:289, 290):

∆CS = (-A) – B

∆PS = (-C) – D

∆Welfare = (-A) – B – C – D + A + D = (-B) – C

From the above information we have seen that the burden of a tax is shared almost evenly between buyers and sellers, however, this is not always the case. If demand is inelastic and supply is relatively, then the burden of the tax will fall mostly on the buyer. Demand will work in the opposite way. It can also be determined if the burden of a tax falls more on the buyer or the seller (Pindyck and Rubinfeld, 2005:328):

Pass-through fraction (Buyer) = Ed / (Es – Ed)

This equation thus stipulates what fraction of the tax is ‘passed-through’ to consumers (buyers) and producers (sellers) in the form of higher prices. So, if the demand is totally inelastic (when Ed = 0) so that the pass-through fraction is 1, then all the tax is borne by the consumers (Pindyck and Rubinfeld, 2005:328). Similarly, when demand is totally elastic, the pass-through fraction is zero and producers bear all the tax. Therefore, the equation basically indicates that a tax falls on the buyer if Ed / Es is small, and on the seller if Ed / Es is large.

The Effects of a Subsidy

A subsidy can be analysed in much the same way as a tax. In fact, a subsidy can be better defined as a negative tax. With a subsidy, the sellers’ price exceeds the buyers’ price and the difference between the two is the amount of the subsidy. Thus, the effect of a subsidy on the quantity produced and consumed is the opposite of the effect of a tax, which also means that the quantity will increase (Pindyck and Rubinfeld, 2005:329).

Figure 8: The Effects of a Subsidy

In general, the benefit of a subsidy accrues mostlyto buyers if Ed / Es is small, and to sellers if Ed / Es is large. Also, the same four conditions needed for the market to clear, apply for a subsidy as it did for a tax. The only difference is that now the difference between the sellers’ price and the buyers’ price is equal to the subsidy (Pindyck and Rubinfeld, 2005:329):

Qd = Qd(Pd)

Qs = Qs(Ps)

Qd = Qs

Ps – Pd = s

Conclusion

From this paper the evidence shows that simple models of demand and supply can be used to analyse a wide variety of government policies. These include price controls, minimum prices, price supports, production quotas, import tariffs and quotas, and taxes and subsidies. In each case, consumer and producer surplus are used to evaluate the gains and losses to consumers and producers. These gains and losses can be quite large.

Evidence have also indicated that when the government imposes a tax or subsidy, price usually does not rise or fall by the full amount of the tax or subsidy. Also, the incidence of a tax or subsidy is usually split between consumers and producers. The fractions that each group ends up paying/receiving depend on the relative elasticities of demand and supply.

It is important to remember that government intervention generally leads to a deadweight loss, even if consumer and producer surplus is weighted equally. In some cases this deadweight loss will be small, but in other cases (price supports and import quotas) it is large. This deadweight loss is a form of economic inefficiency that must be taken into account when policies are designed and implemented.

In summation, government intervention in a competitive market is not always bad. Government, and the society it represents, might have objectives other than economic efficiency. There are also situations in which government intervention can improve economic efficiency. Examples are externalities and cases of market failure.