Aim for FiveMicroeconomics

Unit 2 · Topic 2.8

2.8 The Effects of Government Intervention in Markets

Governments step into markets with price ceilings, price floors, taxes and subsidies. When the market was efficient to begin with, each of these moves quantity away from equilibrium and creates deadweight loss. Who actually pays a tax depends on elasticity, not on who sends the money to the government.

Key terms

  • price ceiling
  • price floor
  • per-unit (excise) tax
  • tax incidence
  • subsidy
  • deadweight loss

Price ceilings

A price ceiling is a legal maximum price, like rent control. It's binding (it has an effect) only when it's set below the equilibrium price. Then quantity demanded is greater than quantity supplied, so there's a shortage.

Only the quantity sellers supply at the ceiling price gets traded. Some consumers gain because they pay less, but producer surplus falls, and the units between the new quantity and the equilibrium quantity are never traded. The surplus those units would have created is the deadweight loss: the triangle between the demand and supply curves, from the quantity traded out to the equilibrium quantity.

A ceiling set above equilibrium is non-binding: the market just stays at equilibrium.

Price floors

A price floor is a legal minimum price, like a minimum wage or a guaranteed crop price. It's binding only when set above equilibrium. Then quantity supplied is greater than quantity demanded, so there's a surplus. Only the quantity buyers demand at the floor gets traded, which again creates deadweight loss. A floor set below equilibrium is non-binding.

Governments can also limit quantity directly, for example by capping the number of taxi licenses. A binding quantity limit (set below the equilibrium quantity) cuts the amount traded to the limit and raises the price buyers pay. The units between the limit and the equilibrium quantity are never traded, so there's deadweight loss here too.

Per-unit taxes and tax incidence

A per-unit (excise) tax charges a fixed amount on each unit sold. A tax on sellers shifts the supply curve up by the full amount of the tax (a decrease in supply). The new equilibrium has a higher price paid by buyers, a lower price kept by sellers (the buyers' price minus the tax), and a smaller quantity.

On the graph, the tax creates a vertical gap equal to the tax at the new quantity, between the buyers' price on the demand curve and the sellers' price on the original supply curve. Government revenue is the rectangle: tax per unit × new quantity. Deadweight loss is the triangle between demand and the original supply, from the new quantity to the old equilibrium quantity.

Tax incidence is how the burden is split. Whichever side is less elastic pays more of the tax, because it can't easily walk away. If demand is perfectly inelastic, buyers pay the entire tax and there's no deadweight loss because quantity doesn't change. If supply is perfectly inelastic, sellers pay all of it. It doesn't matter whether the law puts the tax on buyers or sellers; the outcome is the same.

Per-unit subsidies

A per-unit subsidy is a payment to sellers for each unit. It shifts supply down (right) by the amount of the subsidy. Buyers pay less, sellers receive more (the buyers' price plus the subsidy), and quantity rises past the efficient amount. The government's cost is subsidy per unit × new quantity. That cost is bigger than the combined gain in consumer and producer surplus, and the difference is deadweight loss: a triangle between the original supply and demand curves, from the equilibrium quantity out to the new, larger quantity. Those extra units cost more to make than buyers value them.

Worked examples

Try each one yourself first, then open the solution.

  1. Example 1Calculator allowed

    A per-unit tax: prices, revenue and deadweight loss

    Demand runs from $12 at zero quantity down to zero at 120 units. Supply starts at $2 and rises $1 for every 15 units. Equilibrium is $6 and 60 units. The government places a $2.50 per-unit tax on sellers, and the new quantity is 45. Find the price buyers pay, the price sellers keep, tax revenue, deadweight loss and how the burden is split.

    Show the solution
    1. Step 1: Buyers' price: read demand at 45 units: $12 − 45 ÷ 10 = $7.50.
    2. Step 2: Sellers keep the buyers' price minus the tax: $7.50 − $2.50 = $5.00. Check on the original supply curve: $2 + 45 ÷ 15 = $5.00.
    3. Step 3: Tax revenue = $2.50 × 45 = $112.50.
    4. Step 4: Deadweight loss = ½ × (60 − 45) × $2.50 = $18.75.
    5. Step 5: Burden: buyers pay $7.50 − $6 = $1.50 more per unit; sellers get $6 − $5 = $1.00 less. Buyers bear more, so demand is less elastic than supply here.

    Answer: Buyers pay $7.50, sellers keep $5.00; revenue $112.50; deadweight loss $18.75; buyers bear $1.50 of the tax and sellers $1.00.

  2. Example 2Calculator allowed

    A binding price ceiling

    In the same market (equilibrium $6 and 60 units, where quantity demanded = 120 − 10P and quantity supplied = 15P − 30), the government sets a price ceiling of $4. Find the shortage, the quantity traded and the deadweight loss.

    Show the solution
    1. Step 1: $4 is below $6, so the ceiling is binding.
    2. Step 2: At $4: quantity demanded = 80 and quantity supplied = 30, so the shortage is 80 − 30 = 50 units.
    3. Step 3: Only 30 units are traded, because sellers supply only 30.
    4. Step 4: At 30 units, the demand curve's price is $12 − 30 ÷ 10 = $9 and the supply curve's price is $4. Deadweight loss = ½ × (60 − 30) × ($9 − $4) = $75.

    Answer: Shortage of 50 units; 30 units traded; deadweight loss $75.

  3. Example 3

    Is the control binding? (classic trap)

    In the same market, the government sets a price floor of $5. What happens?

    Show the solution
    1. Step 1: A floor is a minimum price. The market price is $6, which is already above $5.
    2. Step 2: The floor doesn't stop the market from reaching equilibrium, so it's non-binding.
    3. Step 3: Price stays $6, quantity stays 60, and there's no surplus or deadweight loss. The trap is assuming every floor causes a surplus.

    Answer: Non-binding: price stays at $6 and quantity at 60, with no deadweight loss.

Common mistakes

  • Putting a binding ceiling above equilibrium or a binding floor below it. Ceilings bind below equilibrium; floors bind above it.
  • Using quantity demanded as the amount traded under a ceiling. With a shortage, only the quantity supplied gets sold.
  • Saying the side the law taxes pays the tax. The less elastic side bears more, whoever writes the check.
  • Measuring tax deadweight loss with the new supply curve. The triangle sits between demand and the original supply curve.

On the exam

  • Free-response questions often ask you to describe a graph with a tax or price control and identify the areas: tax revenue (a rectangle), deadweight loss (a triangle), and the new consumer and producer surplus.
  • Expect questions that link elasticity to incidence: 'If demand is perfectly inelastic, who pays the tax?' Buyers pay all of it, and there's no deadweight loss.

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Check yourself

4 questions on 2.8 The Effects of Government Intervention in Markets. Pick an answer to see if you got it, and why.

Before any tax, the straight-line supply and demand curves for a product cross at a price of $10 and a quantity of 100 units. Price is on the vertical axis and quantity on the horizontal axis.

The government then places a tax of $4 per unit on sellers, which shifts the supply curve up by $4 at every quantity.

After the tax, 80 units are sold and buyers pay $12.50 per unit. At a quantity of 80 units, the original supply curve is at a price of $8.50.

Hypothetical market described in words

Question 1 of 4Calculator allowed

How much tax revenue does the government collect?

Question 2 of 4Calculator allowed

What is the deadweight loss caused by the tax?

Question 3 of 4

Which of the following correctly describes who bears the burden of the tax?

Question 4 of 4

A city sets a maximum rent for apartments that is below the equilibrium rent. Which of the following is the most likely result?

0 of 4 answered