Government intervention in markets
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A government sets a minimum price for wheat above the equilibrium price. What is the most likely result?
Which measure is most suitable for making sure a public good such as street lighting is provided?
Worked problems
Show your working.
Reading a shortage from a demand and supply schedule. The monthly rental market for flats in a city is shown below. Rent $800: quantity demanded 6,000, quantity supplied 2,000. Rent $1,000: quantity demanded 5,000, quantity supplied 3,000. Rent $1,200: quantity demanded 4,000, quantity supplied 4,000. Rent $1,400: quantity demanded 3,000, quantity supplied 5,000. The government sets a maximum rent of $1,000. Identify the equilibrium, then calculate the effect of the maximum rent.
Diagrams
Draw a demand and supply diagram for rented flats. Mark the equilibrium rent and quantity. Draw a horizontal line for a maximum rent below the equilibrium, and label the quantity demanded, the quantity supplied and the shortage.
Draw two demand and supply diagrams side by side. On the first, show an indirect tax on cigarettes shifting supply to the left, and mark the old and new price and quantity. On the second, show a subsidy on bus travel shifting supply to the right, and mark the old and new price and quantity.
Answers
Mixed economic system: An economy in which resources are allocated partly by the price mechanism and partly by the government, with both a private sector and a public sector.
Maximum price: A legal upper limit on the price of a good, set below the equilibrium price to make it more affordable.
Minimum price: A legal lower limit on the price of a good, set above the equilibrium price to raise producers' incomes or to discourage consumption.
Indirect tax: A tax on spending, collected from the seller, which raises firms' costs and therefore the price of the good.
Subsidy: A payment by the government to producers that lowers their costs, so that more of a good is supplied at a lower price.
B. Above equilibrium, farmers want to supply more and buyers want to buy less, so quantity supplied exceeds quantity demanded. The surplus has to go somewhere, which is why minimum price schemes for farm products usually require the government to buy it.
C. A public good is non-excludable, so a private firm cannot make people pay for it and the market provides none. Taxing or capping the price of something that is not being supplied changes nothing, and privatisation hands it to firms that cannot charge for it. The government has to provide it and pay for it through taxation.
Step 1. Find the equilibrium rent and quantity. Equilibrium is where quantity demanded equals quantity supplied. That happens at $1,200, where 4,000 flats are demanded and 4,000 are supplied.
Step 2. Check whether the maximum rent has any effect. $1,000 is below the equilibrium of $1,200, so the maximum rent binds. A maximum set above $1,200 would change nothing.
Step 3. Read the quantities at the maximum rent. At $1,000, 5,000 flats are demanded but only 3,000 are supplied.
Step 4. Calculate the shortage. Shortage = quantity demanded minus quantity supplied = 5,000 - 3,000 = 2,000 flats.
Step 5. State who gains and who loses. The 3,000 households who find a flat pay $200 a month less. But 1,000 fewer flats are rented than at equilibrium (3,000 against 4,000), and 2,000 households who want a flat at $1,000 cannot find one. The policy helps some tenants and harms others.
Step 5 is where the marks are. A maximum price does not make the good more available; it makes it cheaper for those who get it and less available overall. Say both halves.
The maximum price line must be drawn below equilibrium. Drawn above it, the control does nothing, and examiners mark the diagram as showing no understanding of when a maximum price binds.
Always label the new supply curve (S + tax, or S + subsidy) and show both equilibrium points. A diagram with only the shifted curve and no change marked on the axes earns little.