Market changes and government intervention
Real markets are constantly shifting. Governments also intervene with price controls, taxes, and subsidies, with predictable side effects.
Analysing shifts
To analyse a change, ask: does it affect demand, supply, or both? Which direction? Then find the new equilibrium. An increase in demand raises both price and quantity. An increase in supply lowers price and raises quantity. A fall in demand lowers both; a fall in supply raises price and lowers quantity.
Both curves shifting
When both shift, one variable's change is certain and the other's is ambiguous. If demand and supply both rise, quantity definitely rises, but price could go either way depending on which shift is bigger. Economists say the effect on price is indeterminate without more information.
Consumer and producer surplus
Consumer surplus is the difference between what buyers are willing to pay and what they actually pay: the area below the demand curve and above the price. Producer surplus is the difference between the price and sellers' minimum acceptable price: above supply and below price. Their sum, total surplus, measures the gains from trade.
Price ceilings
A price ceiling is a legal maximum price, such as rent control. If set below equilibrium, it causes a shortage: more people want apartments at the low rent than landlords supply. Side effects include waiting lists, black markets, and lower quality as landlords skimp on maintenance.
Price floors
A price floor is a legal minimum price, such as a minimum wage or agricultural price support. If set above equilibrium, it causes a surplus: in labour markets, more people want to work at that wage than employers want to hire. The size of the effect on employment is debated and depends on market conditions.
Taxes
A tax on a good drives a wedge between what buyers pay and what sellers receive, reducing the quantity traded. Who really bears the tax (its incidence) does not depend on who legally pays it, but on elasticities: the less responsive side bears more. The lost surplus from trades that no longer happen is called deadweight loss.
Subsidies
A subsidy is a payment to producers or consumers, shifting supply or demand outward. It increases quantity and lowers the price buyers pay. Subsidies for solar panels and electric cars aim to encourage adoption; their costs fall on taxpayers, and they can create deadweight loss if they encourage too much production.
Worked example
Rent control sets apartment rents at 1,000 dollars when equilibrium is 1,400. At 1,000, 50,000 households want apartments but landlords offer only 35,000. The shortage of 15,000 shows up as long waiting lists and informal side payments, while landlords have less incentive to build new housing.
Key takeaways
Shifts in demand and supply change equilibrium price and quantity predictably; when both shift, one effect is ambiguous. Consumer plus producer surplus measures gains from trade. Binding price ceilings cause shortages; binding floors cause surpluses. Taxes create a wedge and deadweight loss, with incidence set by elasticities. Subsidies raise quantity at taxpayers' expense.
Flashcard
Price and quantity both rise
Check your understanding
A frost destroys much of the orange crop. What happens in the orange juice market?