Policy Implications

OIL AND PRICE CONTROL

• Estimated subsidy on LPG, 2011-12 : Rs 25,000 crores

• Government provides subsidy to - Kerosene: Rs 31/ltr- Diesel : Rs 13.64/ltr- One LPG cylinder (14.6kg): Rs 479

• Reduction in subsidy : average Rs 7.5/ltr

OIL AND PRICE CONTROL

• How does price control effect the society?

• Who benefits from this?

• Who looses?

• When is price control effective?

4

Price Controls and Natural Gas Shortages

• QS = 14 + 2PG + 0.25PO

– Quantity supplied in trillion cubic feet (Tcf)

• QD = -5PG + 3.75PO

– Quantity demanded (Tcf)

• PG = price of natural gas in $/mcf

• PO = price of oil in $/b

5

Price Controls and Natural Gas Shortages

• Using PO = $8/b and gives equilibrium values for natural gas

– PG = $2/mcf and QG = 20 Tcf

• Price ceiling was set at $1/mcf

GS

GD QQ

Chapter 9 6

B

A

C

SD

2.00

2.40

Price($/mcf)

Quantity (Tcf)0 5 10 15 20 25 3018

(Pmax)1.00

Price Controls and Natural Gas Shortages

No Regulation

• What is the consumer surplus?

• What is the producer surplus?

• What is the total surplus in the economy?

Price Control

• Price control will be effective only if the price is no higher than the equilibrium price

9

B

A

C

The gain to consumers is rectangle A minus triangle B, and the loss to producers is rectangle A plus triangle C.

SD

2.00

2.40

Price($/mcf)

Quantity (Tcf)0 5 10 15 20 25 3018

(Pmax)1.00

Price Controls and Natural Gas Shortages

Price Controls and Natural Gas Shortages

• What will be effect of price control of $1 on the amount traded?

• Will there be shortage or surplus?

• How will the producers get effected?

Price Controls

Effect on Producer Surplus

- Decrease in Producer Surplus- Value: A+C = (-)$18+1 billion- Loss due to lower per unit price :- Area A- Loss due to seller selling fewer units- Area C

Price Controls

Effect on Consumer Surplus

- Gain due to lower per unit price :- Area A- Loss due to seller selling fewer units- Area B- Net Change in consumer surplus:- A-B= $18-

0.4 = $17.6 bn

Price Control

• Net Effect = Change in Producer Surplus + Change in Consumer Surplus

• = (-) [Area A+ B] + Area A – Area C• Net Loss of Area B + C = $0.4+1 mn

• DEADWEIGHT LOSS

Price Control

• Can society ever benefit with a price control?

• When will the deadweight loss decrease?

• Lower subsidy • Lower demand and supply elasticity

15

Price Control

• Measuring effects of government price controls on the economy can be estimated by measuring these two triangles

• To measure the effect of government price control one needs information on elasticity of demand and supply

MARKET FOR HUMAN KIDNEYS

17

The Market for Human Kidneys

• The 1984 National Organ Transplantation Act prohibits the sale of organs for transplantation

• What has been the impact of the Act?

18

The Market for Human Kidneys

• We can measure this using the supply and demand for kidneys from estimated data– Supply: QS = 8,000 + 0.2P– Demand: QD = 16,000 - 0.2P

• Since the sale of organs is not allowed, the amount available depends on the amount donated– Supply of donated kidneys is limited to 8,000

19

D

A and D measure the total value of kidneys

when supply is constrained.

A

C

The loss to suppliersis seen in areas A & C.

The Market for Kidneys

Quantity

Price

4,0000

$10,000

$30,000

$40,000

8,000

S’

B

If kidneys are zero cost, consumer gain would

be A minus B.

S

D

12,000

$20,000

20

The Market for Human Kidneys

• Recipients:– Since they do not have to pay for the kidney, they

gain rectangle A ($140 million) since price is $0– Those who cannot obtain a kidney lose surplus

equal to triangle B ($40 million)– Net increase in surplus of recipients of $160 - $40

= $120 million

21

The Market for Human Kidneys

• Suppliers:– Those who supply them are not paid the market

price, estimated at $20,000• Loss of surplus equal to area A = $160 million

– Some who would donate for the equilibrium price do not donate in the current market

• Loss of surplus equal to area C = $40 million

– Total SUPPLIER loss of A + C = $200 million

The Market for Human Kidneys

• Net Effect = Change in Producer Surplus + Change in Consumer Surplus

• = (-) [Area A+ C] + Area A – Area B• Net Loss of Area B + C = $80 mn

• DEADWEIGHT LOSS

23

The Market for Human Kidneys

• Arguments in favor of prohibiting the sale of organs:

1. Imperfect information about donor’s health and screening

2. Unfair to allocate according to the ability to pay

MINIMUM PRICES

Support Price for Rice farmers

• Support price for common rice, 2012: Rs 1,250/kg

• Increase from 2011 : Rs 1,080/kg

Minimum Support Price

Minimum Support Price

• What is the effect of Minimum Support Price on the economy?

• Who benefits from it and who looses?

• When is Minimum Support Price effective?

28

Minimum Prices

• When price is set above the market clearing price.

• Effective minimum price only operates when minimum price support is above the equilibrium price.

29

BA

The change in producersurplus will be

A - C - D. Producersmay be worse off.

C

D

Minimum Prices

Quantity

Price

S

D

P0

Q0Q3 Q2

Pmin

If producers produce Q2, the amount Q2 - Q3

will go unsold.

D measures total cost of increased production

not sold.

30

Minimum Prices

• Losses in consumer surplus are– Increased price leading to decreased quantity

equals area A– Those priced out of the market lose area B

• Producer surplus– Increases from increased price for units sold equal

to A– Losses from drop in sales equal to C

Minimum Prices

• Net Effect of the price control on the society

• DEADWEIGHT LOSS OF B+C

• Deadweight loss decreases as- Subsidy is smaller- Elasticity of demand and supply is lower

32

Minimum Prices

• What if producers expand production to Q2 from the increased price?

33

BA

The change in producersurplus will be

A - C - D. Producersmay be worse off.

C

D

Minimum Prices

Quantity

Price

S

D

P0

Q0Q3 Q2

Pmin

If producers produce Q2, the amount Q2 - Q3

will go unsold.

D measures total cost of increased production

not sold.

34

Minimum Prices

• What if producers expand production to Q2 from the increased price?– Since they only sell Q3, there is no revenue to

cover the additional production (Q2-Q3)– Supply curve measures MC of production so total

cost of additional production is area under the supply curve for the increased production (Q2-Q3) = area D

– Total change in producer surplus = A – C – D

35

Supporting the Price of Wheat

• The supply and demand for wheat in 1981 was– Supply: QS = 1,800 + 240P

– Demand: QD = 3,550 - 266P– Equilibrium price and quantity was $3.46 and

2,630 million bushels

• Government raised the price to $3.70 through government purchases

36

D + Qg

By buying 122million bushels, the governmentincreased the

market-clearing price.

2,688

A BC

Qg

PS = $3.70

•AB consumer loss•ABC producer gain S

D

P0 = $3.46

2,6301,800

The Wheat Market in 1981

Quantity

Price

2,566

37

Supporting the Price of Wheat

• How much would the government have had to buy to keep price at $3.70?– QDTotal = QD + Qg = 3,550 - 266P + Qg

– QS = QDT

• 1,800 + 240P = 3,550 - 266P + Qg

• Qg = 506P - 1,750• At a price of $3.70, government would buy• Qg = (506)(3.70) - 175 = 122 million bushels

38

Supporting the Price of Wheat

• We can quantify the effects on CS – The change in consumer surplus = (-A -B)

• A = (3.70 - 3.46)(2,566) = $616 million• B = (1/2)(3.70 - 3.46)(2,630 - 2,566) = $8 million

– CS = -$624 million

39

Supporting the Price of Wheat

• Cost to the government:– $3.70 x 122 million bushels = $451.4 million– Total cost of program = $624 + 451 = $1,075

million• Gain to producers

– A + B + C = $638 million– Government also paid 30 cents/bushel = $806

million

44

Supporting the Price of Wheat

• In 1996, Congress passed the Freedom to Farm law– Goal was to reduce the role of government and

make agriculture more market-oriented– Eliminated production quotas, gradually reduced

government purchases and subsidies through 2003

45

Supporting the Price of Wheat

• In 2002, Congress and President Bush reversed the effects of the 1996 bill by reinstating subsidies for most crops– Calls for “fixed direct payments”– New bill would cost taxpayers almost $1.1 billion

in annual payments to wheat producers alone– 2002 farm bill expected to cost taxpayers $190

billion over 10 years• Estimated $83 billion over existing programs

MINIMUM WAGES

47

Minimum Wages

• Wage is set higher than market clearing wage

• Decreased quantity of workers demanded

• Those workers hired receive higher wages

• Unemployment results, since not everyone who wants to work at the new wage can

48

B

The deadweight lossis given by

triangles B and C.

C

A

L1 L2

Unemployment

wmin

Firms are not allowed topay less than wmin. This

results in unemployment.

S

D

w0

L0

The Minimum Wage

L

w

A is gain to workers who find jobs at higher

wage.

EFFECT OF TAX AND SUBSIDY

50

The Impact of a Tax or Subsidy

• The government wants to impose a $1.00 tax on movies. It can do it two ways:– Make the producers pay $1.00 for each movie

ticket they sell– Make consumers pay $1.00 when they buy each

movie

• In which option are consumers paying more?

51

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

• How the burden is split between the parties depends on the relative elasticities of demand and supply

52

The Effects of a Specific Tax

• For simplicity we will consider a specific tax on a good– Tax of a particular amount per unit sold

• For our example, consider a specific tax of $t per cigarette sold

53

Incidence of a Specific Tax

• Four conditions that must be satisfied after the tax is in place:

1. Quantity sold and buyer’s price, Pb, must be on the demand curve• Buyers only concerned with what they must pay

2. Quantity sold and seller’s price, PS, must be on the supply curve• Sellers only concerned with what they receive

54

Incidence of a Specific Tax

3. QD = QS

4. Difference between what consumers pay and what buyers receive is the tax

55

•Buyers lose A + B

Incidence of a Specific Tax

D

S

B

D

A

C

Quantity

Price

P0

Q0Q1

PS price producers get

Pb price buyers pay

Tax = $1.00 •Government gains A +

D in tax revenue.

•Sellers lose D + C

•The deadweightloss is B + C.

56

Incidence of a Specific Tax

• In the previous example, the tax was shared almost equally by consumers and producers

• If demand is relatively inelastic, however, burden of tax will fall mostly on buyers– Cigarettes

• If supply is relatively inelastic, the burden of tax will fall mostly on sellers

Impact of Elasticities on Tax Burdens

Quantity Quantity

Price Price

S

D S

D

Q0

P0 P0

Q0Q1

Pb

PS

t

Q1

Pb

PS

t

Burden on Buyer Burden on Seller

58

The Impact of a Tax or Subsidy

• We can calculate the percentage of a tax borne by consumers using pass-through fraction– ES/(ES - Ed)– Tells fraction of tax “passed through” to

consumers through higher prices– For example, when demand is perfectly inelastic

(Ed = 0), the pass-through fraction is 1 – consumers bear 100% of tax

59

A Tax on Gasoline

• The goal of a large gasoline tax is to:– Raise government revenue– Reduce oil consumption and reduce US

dependence on oil imports

• We will consider a gas tax in the market during mid-1990’s

60

A Tax on Gasoline

• Measuring the Impact of a 50 Cent Gasoline Tax

• QD = 150 - 50P• QS = 60 + 40P

– QS = QD at $1 and 100 billion gallons per year (bg/yr)

Chapter 9 61

A Tax on Gasoline

• With a 50 cent tax:QD = QS

150 - 50Pb = 60 + 40PS

150 - 50(PS+ 0.50) = 60 + 40PS

PS = .72

Pb = PS + 0.50 = $1.22

QD = QS = 89 bg/yr

62

A Tax on Gasoline

• With a 50 cent tax:– Q falls by 11%– Price to consumers increases by 22 cents per

gallon– Producers receive about 28 cents per gallon less

– Government revenue would be significant at $44.5 billion per year

Chapter 9 63

CD

A

The Impact of a 50 Cent Gasoline Tax

Quantity (billiongallons per year)

Price($ pergallon)

50 150100

P0 = 1.00

Pb = 1.22

PS = .72

89

11

The buyer pays 22 cents of the tax, and

the producer pays 28 cents.

SD

60

$0.50 Tax

Consumer Loss = A + B

Producer Loss = C + D

Government revenue = A + D = 0.50(89) = $44.5 billion.

B

64

The Effects of Subsidy

• A subsidy can be analyzed in much the same way as a tax– Payment reducing the buyer’s price below the

seller’s price• It can be treated as a negative tax• The seller’s price exceeds the buyer’s price• Quantity increases

Chapter 9 65

D

S

Effects of a Subsidy

Quantity

Price

P0

Q0 Q1

PS

Pb

Like a tax, the benefitof a subsidy is split

between buyers and sellers, depending

upon the elasticities ofsupply and demand.

Subsidy

66

Effects of a Subsidy

• The benefit of the subsidy accrues mostly to buyers if ED /ES is small

• The benefit of the subsidy accrues mostly to sellers if ED /ES is large