Other Forms of Government Intervention

Price Controls

The last type of government intervention is far more forceful than taxes and subsidies. Instead of changing the per-unit cost of a good paid by consumers or producers, price controls directly fix the market price. It does not change the amount different consumers are willing and able to pay or how much producers are willing and able to produce.

When price controls are introduced to a market, the equilibrium price and quantity no longer exist. Consumer and producers are forced to sell or buy goods at the prescribed price.

[Following image is a hand drawn diagram of a price floor]

Fig. 9 A price floor

Let’s take a price floor as the first example. This is when the government imposes a minimum price for which a good can be sold. For this to be effective, the price floor must be set above the equilibrium price, otherwise the market would just settle at equilibrium. This results in a surplus, as producers are willing to sell far more goods than consumers are willing to purchase. This results in a surplus as \(Q_s > Q_d\). Normally, without government intervention, the invisible hand would push prices down until \(Q_s = Q_d\). However, with the price floor, the market remains in a state of disequilibrium.

Minimum wages act as a price floor, keeping wages above a certain level. At this higher rate, more workers are willing to work than there is demand for, creating unemployment.

[Following image is a hand drawn diagram of a price ceiling ]

Fig. 10 A price ceiling

The other control is a price ceiling. This is when the government imposes a maximum price for which a good can be sold. This results in a shortage as consumers are to purchase more goods than producer are willing to sell: \(Q_d > Q_s\).

Rent control in Berkeley acts as a price ceiling, keeping rents from rising above a certain level.

Optional: World Trade vs. Autarky

Throughout the class so far, we have assumed that the economy is operating by itself, in isolation. Economists use the word “autarky” to represent the scenario when a country is economically self-sufficient. The key consequence of this is that the country’s economy is unaffected by global events, allowing us to conclude that any changes to equilibrium price or quantity are purely a result of shifts in domestic demand or supply.

We will now assume that the country is no longer in autarky, and is thus subject to world prices, demand and supply.

We now label our demand and supply curves as domestic demand and supply, respectively. Their intersection represents where the market would be if we were in autarky. However, as we are now open to world trade, the price where the market operates is now determined by the world price, which may be totally different from the equilibrium price.

Where the world price line intersects with domestic demand represents the total quantity demanded within the market. Where it intersects with the domestic supply curve is the total quantity supplied.

[Following image is a hand drawn diagram of a market with trade]

Fig. 11 Domestic supply and demand in the world market

Let’s first imagine a scenario where world price is lower than domestic price. From our graph, we find that \(Q_s < Q_d\). This is a shortage. Domestic producers are not willing to fully provide all goods demanded by consumers in the economy. The difference between what is produced domestically and the total quantity demanded will be fulfilled by international producers. Thus, \(Q_d - Q_s =\) imports. As prices are lower than what some consumers were willing to pay, there is a significant consumer surplus. Unfortunately for producers, as world prices are lower than what they would have been able to charge, they lose producer surplus. There is a net gain in the change in consumer surplus is greater than the loss in producer surplus. This is represented by the triangle between the curves and above the world price line.

Now, let’s imagine that world price is greater than domestic price. In this case, \(Q_s > Q_d\). We now have a surplus where the quantity demanded by consumers is far less than what domestic producers are willing to provide at this higher price. Thus, domestic producers will willingly sell goods to domestic customers and sell the rest on the global market. \(Q_s - Q_d =\) exports. As prices are higher than what some consumers were willing to pay, there is a significant decrease in consumer surplus. Producers however rejoice as world prices are higher than what they would have been able to charge. They gain producer surplus. There is a net gain in total surplus as the increase in producer surplus is greater than the loss in consumer surplus. This is represented by the triangle between the curves and above the world price line.