Islamic University in University:

Lecture Notes for ECQ 1101:

Introductory Microeconomics:

UNIT THREE
ECONOMIC EFFICIENCY, GOVERNMENT PRICE SETTING, AND
TAXES
Content Outline
3.0. Introduction
3.1. Consumer Surplus and Producer Surplus
3.1.1. Consumer Surplus
3.1.2. Producer Surplus
3.2. The Efficiency of Competitive Markets
3.2.1. Marginal Benefit Equals Marginal Cost in Competitive Equilibrium
3.2.2. Economic Surplus
3.2.3. Deadweight Loss
3.3. Government Intervention in the Market
3.3.1. Price Floors:
3.3.2. Price Ceilings:
3.3.3. The effect of Government Interreference: Black Markets and Peer-to-Peer Sites
3.3.4. Taxes and Their Economic Impact
3.3.5. Government Intervention Quotas

3.0. Introduction

We have seen that in a competitive market the price adjusts to ensure that the quantity
demanded equals the quantity supplied. Stated another way, in equilibrium, every consumer
willing to pay the market price is able to buy as much of the product as the consumer wants,
and every firm willing to accept the market price can sell as much as it wants. Even so,
consumers would naturally prefer to pay a lower price, and sellers would prefer to receive a
higher price. Normally, consumers and firms have no choice but to accept the equilibrium price
if they wish to participate in the market. Occasionally, however, consumers succeed in having
the government impose a price ceiling, which is a legally determined maximum price that
sellers may charge. Rent control is an example of a price ceiling. Firms also sometimes succeed
in having the government impose a price floor, which is a legally determined minimum price
that sellers may receive. In markets for farm products such as milk, the government has been
setting price floors that are above the equilibrium market price since the 1930s.

Another way the government intervenes in markets is by imposing taxes. The government
relies on the revenue raised from taxes to finance its operations. Unfortunately, whenever the
government imposes a price ceiling, a price floor, or a tax, there are predictable negative
economic consequences. It is important for government policymakers and voters to understand
the negative consequences when evaluating these policies. Economists have developed the
concepts of consumer surplus, producer surplus, and deadweight loss to analyse the economic
effects of price ceilings, price floors, and taxes.
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3.1 Consumer Surplus and Producer Surplus

Consumer surplus measures the dollar benefit consumers receive from buying goods or
services in a particular market. Producer surplus measures the dollar benefit firms receive from
selling goods or services in a particular market. Economic surplus in a market is the sum of
consumer surplus and producer surplus. As we will see, when the government imposes a price
ceiling or a price floor, the amount of economic surplus in a market is reduced; in other words,
price ceilings and price floors reduce the total benefit to consumers and firms from buying and
selling in a market. To understand why this is true, we need to understand how consumer
surplus and producer surplus are determined.

3.1.1. Consumer Surplus

Consumer surplus is the difference between the highest price a consumer is willing to pay for
a good or service and the actual price the consumer pays.

Suppose you are in need of a phone and you decide to buy one, so you go to the phone dealers.
As you walk to the phone shop, you think to yourself that UGX.1 million is the highest price
you would be willing to pay. At the phone shop, you find out that the price is actually UGX
900,000, so you buy the phone. Your consumer surplus in this example is UGX. 100,000: the
difference between the UGX 1 million you were willing to pay and the UGX. 900,000 you
actually paid.

We can use the demand curve to measure the total consumer surplus in a market. Demand
curves show the willingness of consumers to purchase a product at different prices. Consumers
are willing to purchase a product up to the point where the marginal benefit of consuming a
product is equal to its price. The marginal benefit is the additional benefit to a consumer from
consuming one more unit of a good or service.

With many consumers, the market demand curve for chai tea will have the normal smooth
shape shown in the Figure above. In this figure, the quantity demanded at a price of $2.00 is

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15,000 cups per day. We can calculate total consumer surplus by finding the area of a triangle.
Once again, we can draw an important conclusion: The total amount of consumer surplus in a
market is equal to the area below the demand curve and above the market price. Consumer
surplus is shown as the shaded area in the Figure and represents the benefit to consumers in
excess of the price they paid to purchase a product—in this case, chai tea.

3.1.2. Producer Surplus

Just as demand curves show the willingness of consumers to buy a product at different prices,
supply curves show the willingness of firms to supply a product at different prices. The
willingness to supply a product depends on the cost of producing it. Firms will supply an
additional unit of a product only if they receive a price equal to the additional cost of producing
that unit. Marginal cost is the additional cost to a firm of producing one more unit of a good or
service.

Consider the marginal cost to the firm Heavenly Tea of producing one more cup of tea: In this
case, the marginal cost includes the ingredients to make the tea and the wages paid to the
worker preparing the tea. Often, the marginal cost of producing a good increases as more of
the good is produced during a given period of time. Increasing marginal cost is the key reason
that supply curves are upward sloping.

In panel (b), the total amount

of producer surplus tea
sellers receive from selling
chai tea can be calculated by
adding up for the entire
market the producer surplus
received on each cup sold. In
the figure, total producer
surplus is equal to the shaded
area above the supply curve
and below the market price.

The market supply curve for chai tea will have the normal smooth shape shown in the Figure
above. The quantity supplied at a price of $2.00 is 15,000 cups per day. We can calculate total
producer surplus in by calculating the areas of the triangle. Therefore, the total amount of
producer surplus in a market is equal to the area above the market supply curve and below the
market price. The total producer surplus tea sellers receive from selling chai tea is shown as
the shaded area of the figure above.

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3.1.3. What Consumer Surplus and Producer Surplus Measure

We have seen that consumer surplus measures the benefit to consumers from participating in a
market, and producer surplus measures the benefit to producers from participating in a market.
It is important to be clear about what these concepts are measuring.

In a sense, consumer surplus measures the net benefit to consumers from participating in a
market rather than the total benefit. That is, if the price of a product were zero, the consumer
surplus in a market would be all of the area under the demand curve. When the price is not
zero, consumer surplus is the area below the demand curve and above the market price. So,
consumer surplus in a market is equal to the total benefit consumers receive minus the total
amount they must pay to buy the good or service.

Similarly, producer surplus measures the net benefit received by producers from participating
in a market. If producers could supply a good or service at zero cost, the producer surplus in a
market would be all of the area below the market price. When cost is not zero, producer surplus
is the area below the market price and above the supply curve. So, producer surplus in a market
is equal to the total amount firms receive from consumers minus the cost of producing the good
or service.

3.2. The Efficiency of Competitive Markets

Recall that a competitive market is a market with many buyers and many sellers. An important
advantage of the market system is that it results in efficient economic outcomes. But what does
economic efficiency mean? The concepts we have developed so far in this unit give us two
ways to think about the economic efficiency of competitive markets. We can think in terms of
marginal benefit and marginal cost. We can also think in terms of consumer surplus and
producer surplus. As we will see, these two approaches lead to the same outcome, but using
both can increase our understanding of economic efficiency.

3.2.1. Marginal Benefit Equals Marginal Cost in Competitive Equilibrium

In the Figure below, we show the market for chai tea. Recall from our discussion that the
demand curve shows the marginal benefit received by consumers, and the supply curve shows
the marginal cost of production. For this market to achieve economic efficiency, the marginal
benefit from the last unit sold should equal the marginal cost of production.

The figure below shows that this equality occurs at competitive equilibrium where 15,000 cups
per day are produced and marginal benefit and marginal cost are both equal to $2.00. Why is
this outcome economically efficient? Because every cup of chai tea has been produced where
the marginal benefit to buyers is greater than or equal to the marginal cost to producers.

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3.2.2. Economic Surplus

Economic surplus in a market is the sum of consumer surplus and producer surplus. In a
competitive market, with many buyers and sellers and no government restrictions, economic
surplus is at a maximum when the market is in equilibrium. To see this point, let’s look one
more time at the market for chai tea shown in the Figure below. The consumer surplus in this
market is the blue area below the demand curve and above the line indicating the equilibrium
price of $2.00. The producer surplus is the red area above the supply curve and below the price
line.

3.2.3. Deadweight Loss

Deadweight loss is the reduction in economic surplus resulting from a market not being in
competitive equilibrium.

To show that economic surplus is maximized at equilibrium, consider a situation in which the
price of chai tea is above the equilibrium price, as shown in Figure 4.7. At a price of $2.20 per
cup, the number of cups consumers are willing to buy per day falls from 15,000 to 14,000. At
competitive equilibrium, consumer surplus is equal to the sum of areas A, B, and C. At a price

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of $2.20, fewer cups are sold at a higher price, so consumer surplus declines to just the area of
A. At competitive equilibrium, producer surplus is equal to the sum of areas D and E. At the
higher price of $2.20, producer surplus changes to be equal to the sum of areas B and D. The
sum of consumer and producer surplus—economic surplus—has been reduced to the sum of
areas A, B, and D. Notice that this sum is less than the original economic surplus by an amount
equal to the sum of triangles C and E. Economic surplus has declined because at a price of
$2.20, all the cups between the 14,000th and the 15,000th, which would have been produced
in competitive equilibrium, are not being produced. These “missing” cups are not providing
any consumer or producer surplus, so economic surplus has declined.

The reduction in economic surplus resulting from a market not being in competitive
equilibrium is called the deadweight loss. In the figure, deadweight loss is equal to the sum of
the triangles C and E.

3.2.4. Economic Surplus and Economic Efficiency

Consumer surplus measures the benefit to consumers from buying a particular product, such
as chai tea. Producer surplus measures the benefit to firms from selling a particular product.
Therefore, economic surplus—which is the sum of the benefit to firms plus the benefit to
consumers—is the best measure we have of the benefit to society from the production of a
particular good or service. This gives us a second way of characterizing the economic
efficiency of a competitive market: Equilibrium in a competitive market will result in the
greatest amount of economic surplus, or total net benefit to society, from the production of a
good or service. Anything that causes the market for a good or service not to be in competitive
equilibrium reduces the total benefit to society from the production of that good or service.

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Now we can give a more general definition of economic efficiency in terms of our two
approaches: Economic efficiency is a market outcome in which the marginal benefit to
consumers of the last unit produced is equal to its marginal cost of production and in which
the sum of consumer surplus and producer surplus is at a maximum.

3.3. Government Intervention in the Market

Government intervention is when the government gets involved in the marketplace for the
purpose of impacting the economy. It can often be a very controversial topic and is known to
fuel political debate. Those that advocate for government intervention argue that the Law of
Supply and Demand is not enough to keep the economy running smoothly, and this intervention
will protect against abuses and guard the overall success of the economy. They argue that it is
a responsibility of the government to ensure the best interest of the people.

The government has a variety of ways to intervene in the economy.

• Price controls (minimum and maximum wage legislation),

• Taxes and subsidies, and
• Quotas
• Government bailouts

Price Controls: Price Floors and Price Ceilings

Notice that we have not concluded that every individual is better off if a market is at
competitive equilibrium. We have concluded only that economic surplus, or the total net
benefit to society, is greatest at competitive equilibrium. Any individual producer would rather
receive a higher price, and any individual consumer would rather pay a lower price, but usually
producers can sell and consumers can buy only at the competitive equilibrium price.

Producers or consumers who are dissatisfied with the competitive equilibrium price can lobby
the government to legally require that a different price be charged. Governments around the
world only occasionally override the market outcome by setting prices. When the government
does intervene, it can attempt to aid either sellers by requiring that a price be above
equilibrium—a price floor—or buyers by requiring that a price be below equilibrium—a price
ceiling. To affect the market outcome, the government must set a price floor that is above the
equilibrium price or set a price ceiling that is below the equilibrium price. Otherwise, the price
ceiling or price floor will not be binding on buyers and sellers. The preceding section
demonstrates that moving away from competitive equilibrium will reduce economic efficiency.
We can use the concepts of consumer surplus, producer surplus, and deadweight loss to
understand more clearly the economic inefficiency of price floors and price ceilings.

When the government intervenes, it can attempt to aid either:

a. sellers by requiring that a price be above equilibrium (minimum price or price

floor).

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 b. buyers by requiring that a price be below equilibrium (maximum price or price
ceiling)

3.3.1. Price Floors

During Economic recessions almost every sector of the economy is affected. However, the
agriculture sector is among those that are constantly affected by the general fall in prices.
Farmers are often tasked to sell their products only at very low prices. Farmers can be able to
convince the government to set price floors for many agricultural products.

In this case, A price floor or Minimum price is a price set by the government above the
equilibrium price set by the market. The Price floor is legally binding to all sellers of
that commodity and none is expected to sell below that price. Support for governments
setting price floors typically comes from sellers.

To understand how a price floor in an agricultural market works, suppose that the equilibrium
price in the wheat market is $6.50 per bushel, but the government decides to set a price floor
of $8.00 per bushel. As Figure 4.8 shows, the price of wheat rises from $6.50 to $8.00, and the
quantity of wheat sold falls from 2.0 billion bushels per year to 1.8 billion. Initially, suppose
that production of wheat also falls to 1.8 billion bushels.

The producer surplus received by wheat farmers increases by an amount equal to the area of
rectangle A and decreases by an amount equal to the area of triangle C. The area of rectangle
A represents a transfer from consumer surplus to producer surplus.

The total fall in consumer surplus is equal to the sum of the areas of rectangle A and triangle
B. Wheat farmers benefit from this program, but consumers lose. There is also a deadweight
loss equal to the areas of triangles B and C because economic efficiency declines as the price
floor reduces the amount of economic surplus in the market for wheat. In other words, the price
floor has caused the marginal benefit of the last bushel of wheat to be greater than the marginal
cost of producing it. We can conclude that a price floor reduces economic efficiency.

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We assumed initially that farmers reduce their production of wheat to the amount consumers
are willing to buy. In fact, as Figure 4.8 shows, a price floor will cause the quantity of wheat
that farmers want to supply to increase from 2.0 billion to 2.2 billion bushels. Because the
higher price also reduces the amount of wheat consumers want to buy, the result is a surplus of
0.4 billion bushels of wheat (the 2.2 billion bushels supplied minus the 1.8 billion demanded).

Price Floors in Labour Markets: The Minimum Wage Policy

The minimum wage may be the most controversial “price floor.” Supporters see the
minimum wage as a way of raising the incomes of low-skilled workers. Opponents argue that
it results in fewer jobs and imposes large costs on small businesses.

The following figure shows the effect of the minimum wage on employment in the market for
low-skilled labour.

Whatever the extent of employment losses from the minimum wage, because it is a price floor,
it will cause a deadweight loss, just as a price floor in the wheat market does. If price floors, in
the form of minimum wages, result in some workers going unemployed, why do governments
choose to put them in place? The excess supply in this case corresponds to unemployment –
more individuals are willing to work for the going wage than buyers (employers) wish to
employ. The answer really depends upon the magnitude of the excess supply

3.3.1. Price Ceilings (Maximum Price)

Ceilings mean that suppliers cannot legally charge more than a specific price. Limits on
apartment rents are one form of ceiling. In times of emergency – such as flooding or famine,
price controls are frequently imposed on foodstuffs, in conjunction with rationing, to ensure
that access is not determined by who has the most income. The problem with price ceilings,
however, is that they leave demand unsatisfied, and therefore they must be accompanied by
some other allocation mechanism
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 A Price Ceiling Price is the price set by the government below the equilibrium price.
It is also called the maximum price and it is the highest that any seller can charge to
consumers. Support for governments setting price ceilings typically comes from
consumers.

For example, when there is a sharp increase in Fuel prices, proposals are often made for the
government to impose a price ceiling on the market for gasoline. In a number of cities impose
rent control, which puts a ceiling on the maximum rent that landlords can charge for an
apartment. The Figure below shows the market for apartments in a city that has rent control.

Without rent control, the equilibrium rent would be $2,500 per month, and 2,000,000
apartments would be rented. With a maximum legal rent of $1,500 per month, landlords reduce
the quantity of apartments supplied to 1,900,000. The fall in the quantity of apartments supplied
can be the result of landlords converting some apartments into offices, selling some off as
condominiums, or converting some small apartment buildings into single-family homes. Over
time, landlords may even abandon some apartment buildings. At one time in New York City,
rent control resulted in landlords abandoning whole city blocks because they were unable to
cover their costs with the rents the government allowed them to charge. In London, when rent
controls were applied to rooms and apartments located in a landlord’s own home, the quantity
of these apartments supplied decreased by 75 percent.

In the Figure, with the rent ceiling of $1,500 per month, the quantity of apartments demanded
rises to 2,100,000, resulting in a shortage of 200,000 apartments. Consumer surplus increases
by rectangle A and falls by triangle B. Rectangle A would have been part of producer surplus
if rent control were not in place. With rent control, it is part of consumer surplus. Rent control
causes the producer surplus landlords receive to fall by rectangle A plus triangle C. Triangles
B and C represent the deadweight loss, which results from rent control reducing the amount of
economic surplus in the market for apartments.

Renters as a group benefit from rent controls—total consumer surplus is larger— but landlords
lose. Because of the deadweight loss, the total loss to landlords is greater than the gain to
renters. However, rent controls sometimes yield undesirable outcomes. Rent controls are
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widely studied in economics, and the consequences are well understood: Landlords tend not to
repair or maintain their rental units in good condition if they cannot obtain the rent they believe
they are entitled to. Accordingly, the residential rental stock deteriorates. In addition, builders
realize that more money is to be made in building condominium units than rental units, or in
converting rental units to condominiums. The frequent consequence is thus a reduction in
supply and a reduced quality. These outcomes are examples of what we call the law of
unintended consequences.

3.3.3. The Effect of Government Interreference: Black Markets and Peer-to-Peer Sites

To this point, our analysis of rent controls is incomplete. In practice, renters may be worse off
and landlords may be better off. We have assumed that renters and landlords actually abide
by the price ceiling, but sometimes they don’t. Because rent control leads to a shortage of
apartments, renters who would otherwise not be able to find apartments have an incentive to
offer landlords rents above the legal maximum. When governments try to control prices by
setting price ceilings or price floors, buyers and sellers often find a way around the controls.
The result is a black market. A Black market is a market in which buying and selling take
place at prices that violate government price regulations.

3.3.4. The Economic Impact of Taxes

Taxes are what we pay for a civilized society. When the government taxes a good or service,
however, it affects the market equilibrium for that good or service. Just as with a price ceiling
or price floor, one result of a tax is a decline in economic efficiency.
Analysing taxes is an important part of the field of economics known as public finance. In
this section, we will use the model of demand and supply and the concepts of consumer
surplus, producer surplus, and deadweight loss to analyse the economic impact of taxes.

The Effect of Taxes on Economic Efficiency

Whenever a government taxes a good or service, less of that good or service will be produced
and consumed. For example, a tax on cigarettes will raise the cost of smoking and reduce the
amount of smoking that takes place. We can use a demand and supply graph to illustrate this
point. Figure 4.10 shows the market for cigarettes.

Without the tax, the equilibrium price of cigarettes would be $5.00 per pack, and 4 billion packs
of cigarettes would be sold per year (point A). If the federal government requires sellers of
cigarettes to pay a $1.00-per-pack tax, then their cost of selling cigarettes will increase by $1.00
per pack. This increase in costs causes the supply curve for cigarettes to shift up by $1.00
because sellers will now require a price that is $1.00 greater to supply the same quantity of
cigarettes. In Figure 4.10, the supply curve shifts up by $1.00 to show the effect of the tax, and
there is a new equilibrium price of $5.90 and a new equilibrium quantity of 3.7 billion packs
(point B).

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The federal government will collect tax revenue equal to the tax per pack multiplied by the
number of packs sold, or $3.7 billion. The area shaded in green in Figure 4.10 represents the
government’s tax revenue. Consumers will pay a higher price of $5.90 per pack. Although
sellers appear to be receiving a higher price per pack, once they have paid the tax, the price
they receive falls from $5.00 per pack to $4.90 per pack. There is a loss of consumer surplus
because consumers are paying a higher price. The price producers receive falls, so there is also
a loss of producer surplus. Therefore, the tax on cigarettes has reduced both consumer surplus
and producer surplus. Some of the reduction in consumer and producer surplus becomes tax
revenue for the government. The rest of the reduction in consumer and producer surplus is
equal to the deadweight loss from the tax, shown by the yellow-shaded triangle in the figure.

We can conclude that the true burden of a tax is not just the amount consumers and producers
pay the government but also includes the deadweight loss. The deadweight loss from a tax is
referred to as the excess burden of the tax. A tax is efficient if it imposes a small excess burden
relative to the tax revenue it raises.

Tax Incidence: Who Actually Pays a Tax?

The answer to the question “Who pays a tax?” seems obvious: Whoever is legally required to
send a tax payment to the government pays the tax. But there can be an important difference
between who is legally required to pay the tax and who actually bears the burden of the tax.
The actual division of the burden of a tax between buyers and sellers is referred to as tax
incidence. For example, the federal government currently levies an excise tax of 18.4 cents per
gallon of gasoline sold. Gas station owners collect this tax and forward it to the federal
government, but who actually bears the burden of the tax?

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Determining Tax Incidence on a Demand and Supply Graph Suppose that currently the federal
government does not impose a tax on gasoline. In the Figure, equilibrium in the retail market
for gasoline occurs at the intersection of the demand curve and supply curve, S1. The
equilibrium price is $3.50 per gallon, and the equilibrium quantity is 144 billion gallons per
year. Now suppose that the federal government imposes a 10-cents-per-gallon tax. As a result
of the tax, the supply curve for gasoline will shift up by 10 cents per gallon. At the new
equilibrium, where the demand curve intersects the supply curve, S2, the price has risen by 8
cents per gallon, from $3.50 to $3.58.

Notice that only in the extremely unlikely case that demand is a vertical line will the market
price rise by the full amount of the tax. Consumers are paying 8 cents more per gallon. Sellers
of gasoline receive a new higher price of $3.58 per gallon, but after paying the 10-cents-per-
gallon tax, they are left with $3.48 per gallon, or 2 cents less than they were receiving in the
old equilibrium.

Although the sellers of gasoline are responsible for collecting the tax and sending the tax
receipts to the government, they do not bear most of the burden of the tax. In this case,
consumers pay 8 cents of the tax because the market price has risen by 8 cents, and sellers pay
2 cents of the tax because after sending the tax to the government, they are receiving 2 cents
less per gallon of gasoline sold. Expressed in percentage terms, consumers pay 80 percent of
the tax, and sellers pay 20 percent of the tax.

3.3.5. Government Intervention: Quotas

A quota represents the right to supply a specified quantity of a good to the market. It is a means
of keeping prices higher than the free-market equilibrium price. As an alternative to imposing
a price floor, the government can generate a high price by restricting supply.

Agricultural markets abound with examples. In these markets, farmers can supply only what
they are permitted by the quota they hold, and there is usually a market for these quotas. For
example, in several Canadian provinces it currently costs in the region of $30,000 to purchase
a quota granting the right to sell the milk of one cow. The cost of purchasing quotas can thus
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easily outstrip the cost of a farm and herd. Canadian cheese importers must pay for the right to
import cheese from abroad. Restrictions also apply to poultry. The impact of all of these
restrictions is to raise the domestic price above the free market price.

In Figure, the free-market equilibrium is at E0. In order to raise the price above P0, the
government restricts supply to Qq by granting quotas, which permit producers to supply a
limited amount of the good in question. This supply is purchased at the price equal to Pq. From
the standpoint of farmers, a higher price might be beneficial, even if they get to supply a smaller
quantity, provided the amount of revenue they get as a result is as great as the revenue in the
free market.

The government decides that

the equilibrium price P0 is
too low. It decides to boost
price by reducing supply from
Q0 to Qq. It achieves this by
requiring producers to have a
production quota. This is
equivalent to fixing supply at
Sq.

Useful techniques – demand and supply equations

The supply and demand functions, or equations, can be written in their mathematical form:

Demand: P = 10−Q

Supply: P = 1 + (1/2)Q

A straight line is represented completely by the intercept and slope. In particular, if the variable
P is on the vertical axis and Q on the horizontal axis, the straight-line equation relating P and
Q is defined by P = a + bQ. Where the line is negatively sloped, as in the demand equation, the
parameter b must take a negative value. By observing either the data in Table 3.1 or Figure 3.2
it is clear that the vertical intercept, a, takes a value of $10. The vertical intercept corresponds
to a zero-value for the Q variable. The slope (given by the rise over the run) is 10/10 and hence
has a value of −1. Accordingly the demand equation takes the form P = 10−Q.

On the supply side the price-axis intercept, from either the figure or the table, is clearly 1. The
slope is one half, because a two-unit change in quantity is associated with a one-unit change in

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price. This is a positive relationship obviously so the supply curve can be written as P = 1 +
(1/2)Q.

Where the supply and demand curves intersect is the market equilibrium; that is, the price-
quantity combination is the same for both supply and demand where the supply curve takes on
the same values as the demand curve. This unique price-quantity combination is obtained by
equating the two curves: If Demand=Supply, then

10−Q = 1+(1/2)Q.

Gathering the terms involving Q to one side and the numerical terms to the other side of the
equation results in 9 = 1.5Q. This implies that the equilibrium quantity must be 6 units. And
this quantity must trade at a price of $4. That is, when the price is $4 both the quantity
demanded and the quantity supplied take a value of 6 units.

Modelling Market Interventions Using Equations

To illustrate the impact of market interventions examined in Section 3.7 on our numerical
market model for natural gas, suppose that the government imposes a minimum price of $6 –
above the equilibrium price obviously. We can easily determine the quantity supplied and
demanded at such a price. Given the supply equation

P=1+(1/2)Q,

it follows that at P = 6 the quantity supplied is 10. This follows by solving the relationship 6
= 1 + (1/2)Q for the value of Q. Accordingly, suppliers would like to supply 10 units at this
price.

Correspondingly on the demand side, given the demand curve

P = 10−Q,

with a price given by P = $6, it must be the case that Q = 4. So buyers would like to buy 4 units
at that price: There is excess supply. But we know that the short side of the market will win
out, and so the actual amount traded at this restricted price will be 4 units.

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Summary

Although most prices are determined by demand and supply in markets, the government
sometimes imposes price ceilings and price floors. A price ceiling is a legally determined
maximum price that sellers may charge.

A price floor is a legally determined minimum price that sellers may receive. Economists
analyse the effects of price ceilings and price floors using consumer surplus, producer surplus,
and deadweight loss.

Marginal benefit is the additional benefit to a consumer from consuming one more unit of a
good or service. The demand curve is also a marginal benefit curve.

Consumer surplus is the difference between the highest price a consumer is willing to pay for
a good or service and the actual price the consumer pays. The total amount of consumer surplus
in a market is equal to the area below the demand curve and above the market price.

Marginal cost is the additional cost to a firm of producing one more unit of a good or service.
The supply curve is also a marginal cost curve.

Producer surplus is the difference between the lowest price a firm is willing to accept for a
good or service and the price it actually receives. The total amount of producer surplus in a
market is equal to the area above the supply curve and below the market price.

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EXERCISES:

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