Government Intervention Markets Lesson

In theory, when a market is left to function without interference, it will seek to attain equilibrium. At the equilibrium price, the market "clears" and no shortage or surplus will exist. The result is allocative efficiency - the amount consumers wish to buy exactly equals the amount producers are willing to supply. From time to time (and for a variety of reasons), the government intervenes in the market and the result is a deviation from allocative efficiency.

Effects of Government Invention in Markets

Some government policies, such as price floors, price ceilings, and other forms of price and quantity regulation, affect incentives and outcomes in all market structures. Governments use taxes and subsidies to change incentives in ways that influence consumer and producer behavior, shifting the supply and demand curves accordingly. Taxes and subsidies affect government revenues and costs. Government intervention in a market producing the efficient quantity through taxes, subsidies, price controls, or quantity controls can only decrease allocative efficiency. Deadweight loss represents the losses to buyers and sellers as a result of government intervention in an efficient market. The incidence of taxes and subsidies imposed on goods traded in perfectly competitive markets depends on the elasticity of supply and demand; we’ll deal more with this later.

Price Floors and Ceilings Video

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Price Floors

Occasionally, the government will intervene in a market to help the producers of a good by setting a price floor. In the market for gas established earlier in the module, the government may believe that the equilibrium price of $2.10 is too low. By setting a price floor at $2.20, which is a legal minimum price that can be charged for a good, the government is keeping the price of gas artificially high for the benefit of the producer.

However, at this high price, the QS is greater than the QD. Looking at either the schedule or the graph below, the QS is 95,000 gallons and the QD is 75,000 gallons. The price floor has created a surplus and reduced the allocative efficiency of the market. Before the price floor, the market only wanted 80,000 gallons. Now it is producing 95,000 (15,000 gallons more than the amount for allocative efficiency).

In a market without intervention, there would be a natural decrease in price to correct the surplus. Since it is illegal to charge less than the price floor, the market cannot correct the surplus.

The Market for Gasoline

Market for Gasoline Graph

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Market for Gasoline Graph
X-axis - Quantity
Y-axis - Price per Gallon
Graph shows the areas of surplus (above equilibrium) and shortage (below equilibrium) of gasoline. Equilibrium is at the center where the quantity demanded and supplied is equal. Equilibrium is at a quantity of 80,000 gallons and a price of $2.10.

Price Ceilings

Occasionally, the government will intervene in a market to help the consumers of a good by setting a price ceiling. Let's continue to consider the market for gas shown above. The government may believe that the equilibrium price of $2.10 is too high. By setting a price ceiling at $2.00, which is a legal maximum price that can be charged for a good, the government is keeping the price of gas artificially low for the benefit of the consumer.

However, at this low price, the QD is greater than the QS. Looking at either the schedule or the graph, the QD is 90,000 gallons and the QS is 70,000 gallons. The price ceiling has created a shortage and reduced the allocative efficiency of the market. Consumers can only purchase 70,000 gallons - the amount supplied - at the price ceiling (10,000 gallons less than what would have been purchased if the market had been left alone).

In a market without intervention, there would be a natural increase in price to correct the shortage. Since it is illegal to charge more than the price ceiling, the market cannot correct the shortage.

International Trade and Public Policy

Equilibria in competitive markets may be altered by the decision to open an economy to trade with other countries. Equilibrium price can be higher or lower than under autarky (economic independence), and the gap between domestic supply and demand is filled by trade. Opening an economy to trade with other countries affects consumer surplus, producer surplus, and total economic surplus.

Tariffs, which governments sometimes use to influence international trade, affect domestic price, quantity, government revenue, and consumer surplus and total economic surplus. Quotas can be used to alter quantities produced and therefore affect price, consumer surplus, and total economic surplus.

Review

Practice what you've learned with the review activity below.

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