Test your understanding 4.

5 (b) The government grants a subsidy of £20

per unit. Derive the new supply function
1 Why does a subsidy create a welfare
and calculate the price paid by consumers,
(deadweight) loss?
the price received by producers and the new
2 (a) Using a diagram showing the cheese market, equilibrium quantity. (c) Calculate the change
show equilibrium price and quantity, and in consumer expenditure, the change in firm
consumer and producer surplus that arise in a revenue, government expenditure, the change in
free market equilibrium. (b) The government consumer surplus, the change in producer surplus
decides to grant a £0.50 subsidy per kilogram of and welfare (deadweight) loss.
cheese. Drawing a new diagram showing the pre-
subsidy and after-subsidy equilibrium, identify
the price paid by consumers, the price received
by producers and the quantity bought and sold.
4.5 Price controls
(c) Using your diagram, illustrate the increase
in consumer surplus and producer surplus,
Introduction to price controls
government expenditure and deadweight loss at
the after-subsidy market equilibrium. (d) Explain The third type of intervention we will consider
the changes in consumer surplus, producer involves price controls.
surplus, government revenue, deadweight
loss and allocative efficiency. (e) How does Price controls refer to the setting of minimum
the relationship between marginal benefit or maximum prices by the government (or
and marginal cost at the new (after-subsidy) private organisations) so that prices are unable to
equilibrium relate to allocative efficiency (or adjust to their equilibrium level determined by
inefficiency)? demand and supply. Price controls result in market
3 In the market for good alpha the P intercept of disequilibrium, and therefore in shortages (excess
the demand curve is at the point (0,7), and the P demand) or surpluses (excess supply).
intercept of the supply curve is at the point (0,1).
The point of intersection of the demand curve
Price controls differ from indirect taxes and subsidies
and the supply curve at free market equilibrium
in a fundamental way. When a tax is imposed or a
is at (6,4). (a) Plot the demand and supply
subsidy granted, the market settles at a new equilibrium.
curves, and identify the equilibrium price and
The new equilibrium differs from the pre-tax or pre-
quantity. (b) Suppose that price is measured in
subsidy equilibrium, but it is still a new equilibrium,
£, and quantity in tonnes per day, and that a
because there is a balance of demand with the new
subsidy of £2 per tonne is granted. Plot the new
supply. Price controls differ because, once they are
supply curve, and find (through your graph) the
imposed, they do not allow a new equilibrium to be
price paid by consumers, the price received by
established, and instead force a situation where there
producers and the new equilibrium quantity.
is persisting market disequilibrium.
(c) Using your results, calculate the change
Market disequilibrium means that the market is
in consumer expenditure, the change in firm
prevented from reaching a market-clearing price,
revenue, government expenditure, the change
and there emerge shortages (excess demand) or
in consumer surplus, the change in producer
surpluses (excess supply) (see page 30). Shortages
surplus and deadweight loss. (d) The demand
and surpluses involve a misallocation of resources
function for this market is Qd = 14 – 2P and the
and welfare losses.
pre-subsidy supply function is Qs = −2 + 2P. Find
In the discussion that follows, it is important to
the post-subsidy supply function, and using the
bear in mind that the term surplus has two different
demand function, calculate the post-subsidy
meanings. In one sense it refers to excess supply
price paid by consumers, the price received by
resulting when quantity supplied is greater than
producers and the new equilibrium quantity. Do
quantity demanded (see page 30). In the second sense
your results match your graph?
it refers to the benefits that consumers or producers
4 A market is defined by the following equations: receive from buying or selling (see pages 42–3). This
1 1 is not as confusing as it may sound, because surplus in
Q d = 10 − P , and Q s = − 2 + P , where P is in
10 10 the second sense is referred to as ‘consumer surplus’,
£. (a) Find the equilibrium price and quantity. or ‘producer surplus’ or ‘social surplus’.

88 Section 1: Microeconomics
Price ceilings: setting a legal maximum price is less than the equilibrium quantity Qe that suppliers
would supply at price Pe.
 Explain why governments impose price ceilings, and In addition, the price ceiling, Pc, gives rise to a
describe examples of price ceilings, including food price larger quantity demanded than at the equilibrium
controls and rent controls. price: the quantity consumers want to buy at price Pc
is given by Qd, which is greater than quantity Qe that
they would buy at price Pe.
What is a price ceiling? A price ceiling does not allow the market to clear;
A government may in some situations set a legal it creates a situation of disequilibrium where there is a
maximum price for a particular good; this is shortage (excess demand).
called a price ceiling. It means that the price
that can be legally charged by sellers of the good Consequences for the economy
must not be higher than the legal maximum price.
Figure 4.12 shows how this works. The equilibrium  Examine the possible consequences of a price ceiling,
price is Pe, determined by the forces of demand including shortages, inefficient resource allocation,
and supply. The price ceiling, Pc, is set by the welfare impacts, underground parallel markets and
government at a level below the equilibrium price, non-price rationing mechanisms.
leading to a shortage (excess supply), since quantity
demanded, Qd is greater than quantity supplied, Shortages
Qs. If the market were free, the forces of demand A price ceiling, Pc, set below the equilibrium price of a
and supply would force price up to Pe. However, good creates a shortage. At Pc, not all interested buyers
now this cannot happen, because the price hits the who are willing and able to buy the good are able to
legally set price ceiling. do so because there is not enough of the good being
Note that to have an effect, the price ceiling must supplied. In Figure 4.12, the shortage is equal to Qd − Qs.
be below the equilibrium price. If it were higher than
the equilibrium price, the market would achieve Non-price rationing
equilibrium, and the price ceiling would have no The term ‘rationing’ refers to a method of dividing up
effect. something among possible users. In a free market, this
is achieved by the price system: those who are willing
Impacts on market outcomes and able to pay for a good will do so, and the good
is rationed among users according to who buys it;
 Draw a diagram to show a price ceiling, and analyse the this is called price rationing. However, once a shortage
impacts of a price ceiling on market outcomes. arises due to a price ceiling, the price mechanism is
no longer able to achieve its rationing function. Some
By imposing a price that is below the equilibrium demanders willing and able to buy the good at Pc in
price, a price ceiling results in a lower quantity Figure 4.12 will go unsatisfied. How will the quantity
supplied and sold than at the equilibrium price. This Qs be distributed among all interested buyers? This
is shown in Figure 4.12, where the price ceiling, Pc, can only be done through non-price rationing
corresponds to quantity Qs that firms supply, which methods, which include the following:

• waiting in line and the first-come-first-served

principle: those who come first will buy the good
P S • the distribution of coupons to all interested
buyers, so that they can purchase a fixed amount
of the good in a given time period
Pe • favouritism: the sellers can sell the good to their
preferred customers.
Pc
shortage = Underground (or parallel) markets
D Underground (or parallel) markets involve
excess demand
0 buying/selling transactions that are unrecorded, and
Qs Qe Qd Q
are usually illegal. In the case of price ceilings, they
are a special kind of price rationing. They involve
Figure 4.12 Price ceiling (maximum price) and market outcomes buying a good at the maximum legal price, and

Chapter 4 Government intervention 89

then illegally reselling it at a price above the legal
A price ceiling creates a welfare (deadweight) loss,
maximum. Underground markets can arise when there
indicating that the price ceiling introduces allocative
exist dissatisfied people who have not succeeded in
inefficiency due to an underallocation of resources
buying the good because there was not enough of it,
to the production of the good, seen by Qs < Qe.
and are willing to pay more than the ceiling price to
MB > MC, indicating that society is not getting
get it. If there were no shortage, the price of the good
enough of the good.
would be at its equilibrium price, and no one would
be interested in paying a higher than equilibrium
price for it. Underground markets are inequitable,
and frustrate the objective sought by the price ceiling, Consequences for various stakeholders
which is to set a maximum price.
 Discuss the consequences of imposing a price ceiling
Underallocation of resources to the good on the stakeholders in a market, including consumers,
and allocative inefficiency producers and the government.
Since a lower than equilibrium price results in
a smaller quantity supplied than the amount
determined at the free market equilibrium, there Consumers
are too few resources allocated to the production of Consumers partly gain and partly lose. They
the good, resulting in underproduction relative to lose area b but gain area c from producers (see
the social optimum (or ‘best’). Society is worse off Figure 4.13). Those consumers who are able to buy
due to underallocation of resources and allocative the good at the lower price are better off. However,
inefficiency. some consumers remain unsatisfied as at the ceiling
price there is not enough of the good to satisfy all
Negative welfare impacts demanders.
In Figure 4.13, with no price control, the market
determines price Pe and quantity Qe at equilibrium. Producers
Consumer surplus, or the area under the demand Producers are worse off, because with the price ceiling
curve and above Pe, is equal to areas a + b. Producer they sell a smaller quantity of the good at a lower
surplus, the area under Pe and above the supply curve, price; therefore, their revenues drop from Pe × Qe to Pc
is equal to areas c + d + e. Consumer plus producer × Qs. This is clear also from their loss of some producer
surplus is maximum, and is equal to a + b + c + d + e. surplus, area c, (which is transferred to consumers), as
Also, MB = MC, and there is allocative efficiency. well as area d (welfare loss) in Figure 4.13.
If a price ceiling, Pc, is imposed, only the quantity
Qs is produced and consumed. Consumer surplus is Workers
now the area under the demand curve and above Pc, The fall in output (from Qe to Qs) means that
but only up to Qs, since that is all that is consumed. some workers are likely to be fired, resulting in
Therefore, consumer surplus becomes a + c. Producer unemployment; clearly these workers will be
surplus is the area above the supply curve and below worse off.
Pc, also only up to Qs since that is all that is produced.
Producer surplus therefore falls to area e. Total social
surplus after the subsidy is a + c + e. Comparing with P
total social surplus before the subsidy, we see that the
shaded areas b and d have been lost and represent
welfare loss (deadweight loss), or lost social benefits
welfare loss S = MC
due to the price ceiling.Welfare loss represents
a
benefits that are lost to society because of resource b
Pe
misallocation. c d
We can see there is allocative inefficiency also Pc
because MB > MC at the point of production, Qs: the e
benefit consumers receive from the last unit of the D = MB
good they buy is greater than the marginal cost of
0 Qs Qe Qd Q
producing it. Therefore, society is not getting enough
of the good, as there is an underallocation of resources
to its production. Figure 4.13 Welfare impacts of a price ceiling (maximum price)

90 Section 1: Microeconomics
Government Figure 4.12, at price Pc, the quantity Qs is lower
There will be no gains or losses for the government than Qe
budget, yet the government may gain in political • long waiting lists of interested tenants waiting for
popularity among the consumers who are better off their turn to secure an apartment/flat
due to the price ceiling. • a market for rented units where tenants sublet their
apartments at rents above the legal maximum (an
The examples of rent controls and food underground market)
price controls
• run-down and poorly maintained rental housing
Price ceilings are for the most part set in order to
because it is unprofitable for landlords to maintain
make certain goods considered to be necessities more
or renovate their rental units since low rents result
affordable to low-income earners.
in low revenues.

Rent controls
Rent controls consist of a maximum legal rent on Food price controls
housing, which is below the market-determined Some governments use food price controls as a
level of rent (the price of rental housing). It is method to make food more affordable to low-income
undertaken by governments in some cities around earners, especially during times when food prices are
the world to make housing more affordable to rising rapidly (for example, in the period 2008−9).
low-income earners. Consequences of rent controls The results of food price controls follow the same
include: patterns as discussed above: lower food prices and
greater affordability; food shortages as quantity
• housing becomes more affordable to low-income
demanded is greater than quantity supplied; non-
earners
price rationing methods (such as queues) to deal
• a shortage of housing, as the quantity of housing with the shortages; development of underground
demanded at the legally maximum rent is greater markets; falling farmer incomes due to lower
than the quantity available revenues; more unemployment in the agricultural
• a smaller quantity of housing at the legally sector; misallocation of resources; possible greater
maximum rent than at the free market rent, since popularity for the government among consumers
owners of housing supply a smaller quantity; in who benefit.

Real world focus

Price controls in Vietnam

Due to high rates of inflation (a rising general price level), businesses. It is feared that Vietnam may be moving away
the Vietnamese government is considering the imposition from its freer market orientation of recent years and
of price controls, namely price ceilings on numerous back toward the ways of a command economy. Foreign
products, including chemical fertilisers, salt, milk powder, diplomats are warning the government that price controls
rice, sugar, animal feeds, coal, cement, paper, textbooks will damage business confidence in the country.
and many more. If it goes ahead with these measures, the
pricing rules will apply not just to domestic government- Source: Adapted from The Economist Intelligence Unit, ‘Vietnam
owned businesses but also private firms and foreign-owned economy: reform roll-back?’ in ViewsWire News Analysis, 21 Sep-
tember 2010.

Applying your skills

1 What does it mean to move toward the ways of government moves forward with the price
a ‘command economy’? controls.
2 Discuss the consequences for the economy 3 Why do you think that price controls may
and stakeholders that may arise if the damage business confidence?

Chapter 4 Government intervention 91

Test your understanding 4.6 P (£)
1 Using a diagram, explain why price controls 14
S = MC
lead to disequilibrium market outcomes. 12
2 Define a price ceiling, and providing examples, 10
explain some reasons why governments impose Pe 8
them. 6
3 Draw a diagram illustrating a price ceiling, Pc 4.5
4
and analyse its effects on market outcomes shortage =
2 excess demand D = MB
(price, quantity demanded, quantity supplied,
market disequilibrium) and consequences for 0 5 10 15 20 25 30 35 40 45
the economy (shortages, non-price rationing, Qs Qe Qd Q
allocative inefficiency, deadweight loss). (thousand units per week)
4 (a) Explain the difference between price
rationing and non-price rationing. (b) Under Figure 4.14 Calculating effects of price ceilings
what circumstances does non-price rationing
arise? (c) What are some forms of non-price Change in consumer expenditure
rationing? (d) In what way are underground Consumer expenditure is given by the price per unit
markets a form of price rationing? of the good times the number of units purchased. At
5 (a) Draw a diagram showing producer and equilibrium, prior to the price ceiling, consumers spend
consumer surplus in a free market competitive Pe × Qe = £8 × 20 000 units = £160 000. After the price
equilibrium. (b) Assuming a price ceiling is ceiling is imposed, consumers spend Pc × Qs = £4.50
imposed in this market, draw a new diagram Qs × 10 000 units = £45 000. The change is therefore £160
showing the new consumer surplus, producer 000 − £45 000 = £115 000, meaning that consumers now
surplus and welfare (deadweight) loss. spend £115 000 less than at equilibrium.
(c) Comparing your diagrams for parts (a) and
(b), what can you conclude about consumer Change in producer (firm) revenue
surplus, producer surplus and deadweight Firm revenue is the same as consumer expenditure
loss? (d) What is the relationship between both before and after the imposition of the price
marginal benefits and marginal costs in the ceiling. This is because revenue is equal to price
new equilibrium? What does this reveal about per unit times quantity of units sold, and both the
allocative efficiency (or inefficiency)? price (Pc) and the quantity (Qs) are the same for both
6 Examine the consequences of price ceilings for consumers and producers. Therefore, before the price
different stakeholders in the case of (a) rent ceiling is imposed, firm revenue is £160 000, and after
controls, and (b) food price controls. the price ceiling, firm revenue is reduced to £45 000.
Therefore, firm revenues fall by the amount £115 000.

Calculating effects of price ceilings

(higher level topic) Test your understanding 4.7
1 In the example of the market illustrated in
 Calculate possible effects from the price ceiling diagram,
Figure 4.14, what would be the effect of a price
including the resulting shortage, and the change in consumer
ceiling set at £10?
expenditure (which is equal to the change in firm revenue).
2 Suppose a price ceiling is set at £4 per unit (Figure
Figure 4.14 provides us with a numerical example of a 4.14). Calculate (a) the shortage (excess demand),
price ceiling. At equilibrium, price is equal to £8 and (b) the change in consumer expenditure, and
quantity demanded and supplied is 20 000 units of (c) the change in producer revenue.
the good per week. When a price ceiling is imposed at
Pc = £4.50 per unit, quantity demanded becomes Qd =
30 000 units, and quantity supplied Qs = 10 000 units. Price floors: setting a legal minimum price
Shortage (excess demand) What is a price floor?
The shortage, or excess demand, is equal to Qd − Qs, which A legally set minimum price is called a price floor.
in this case is 30 000 − 10 000 = 20 000 units per week. The price that can be legally charged by sellers of
the good must not be lower than the price floor, or
92 Section 1: Microeconomics
 excess supply =
P surplus
excess supply = S P
surplus S

Pf
Pf
Pe D+
Pe
government
purchases
D
D
0 Qd Qe Qs Q
0 Qd Qe Qs Q

Figure 4.15 Price floor (minimum price) and market outcomes Figure 4.16 An agricultural product market with price floor and
government purchases of the surplus
minimum price. In Figure 4.15, a price floor, Pf, is set
above the equilibrium price, Pe. At Pe, consumers are
willing and able to buy Qd of the good, but firms are or too low. Some important reasons for both instability
willing and able to supply Qs of the good. Therefore, and low incomes were considered in Chapter 3.
a surplus, or excess supply, equal to the difference Unstable incomes arise from unstable agricultural
between Qs and Qd, arises. If the market were free, the product prices, which are due to low price elasticities
forces of demand and supply would force the price of demand and low price elasticities of supply for
down to Pe. However, now this cannot happen. agricultural products (see pages 56–7 and 70). Low
Note that to have an effect, the price floor must income elasticities of demand are an important factor
be above the equilibrium price. If it were below accounting for low farmer incomes (see page 64).
the equilibrium price, the market would achieve One method governments use to support farmers’
equilibrium and the price floor would have no effect. incomes is to set price floors for certain agricultural
products, the objective being to raise the price above
Why governments impose price floors their equilibrium market price; such price floors are
called price supports. Figure 4.16 illustrates the
 Explain why governments impose price floors, and market for an agricultural product with a price floor,
describe examples of price floors, including price support Pf, set above the equilibrium price, Pe. The price
for agricultural products and minimum wages. floor results in a larger quantity supplied, Qs, than
the quantity supplied at market equilibrium, Qe. In
Price floors are commonly used for two reasons: (a) addition, the price floor, Pf, leads to a smaller quantity
to provide income support for farmers by offering demanded and purchased than at the equilibrium
them prices for their products that are above market- price: the quantity consumers want to buy at Pf is
determined prices; and (b) to protect low-skilled, low- Qd, which is smaller than the quantity Qe that they
wage workers by offering them a wage (the minimum bought at price Pe.
wage) that is above the level determined in the market. A price floor does not allow the market to clear;
Note that the first of these involves price control in it results in disequilibrium where there is a surplus
product markets, while the second concerns price (excess supply). A common practice is for the
control in a resource market. While market outcomes government to buy the excess supply, and this causes
are similar, each type of price control has different the demand curve for the product to shift to the
consequences for the economy and stakeholders. We right to the new demand curve ‘D plus government
will therefore consider each one separately. purchases’. By buying up the excess supply, the
government is able to maintain the price floor at Pf.
Price floors for agricultural products
Consequences of agricultural price floors
Impacts of price floors on market outcomes
for the economy
 Draw a diagram of a price floor, and analyse the impacts
of a price floor on market outcomes.  Examine the possible consequences of a price floor, including
surpluses and government measures to dispose of the
Farmers’ incomes in many countries, resulting from the surpluses, inefficient resource allocation and welfare impacts.
sale of their products in free markets, are often unstable

Chapter 4 Government intervention 93

Surpluses The effect of a price floor set above the
equilibrium price of a good is to create a surplus P excess supply =
surplus
(excess supply) equal to Qs − Qd, shown in Figure 4.16,
since the quantity consumers demand is given by Qd, S = MC
a
while the quantity farmers want to supply is given Pf
by Qs. b f
c
Pe
e D+
Government measures to dispose of surpluses d government
welfare
The government must make a decision about what purchases
loss
to do with the surplus (excess supply) it purchases.
One option is store it, giving rise to additional D = MB
costs for storage above the costs of the purchase. 0 Qd Qe Qs Q
Another method is to export the surplus (sell it
abroad); this often requires granting a subsidy to
lower the price of the good and make it competitive Figure 4.17 Welfare impacts of a price floor (minimum price) for
in world markets, since the price floor has increased agricultural products and government purchases of the
the price of the good above the market price surplus
(foreign countries would not want to buy it at the
high price). Clearly, subsidies involve additional
costs for the government. A third option is for the supply curve and below Pf, up to the quantity
the government to use it as aid sent to developing produced, Qs, and so becomes d + e + b + c + f. This
countries, which often poses problems for the means that the sum of consumer plus producer
developing countries intended to benefit from the surplus increases by the area f after the price floor
aid (see page 513). In general, any course chosen is imposed. (This happens because producers gain
by the government to get rid of the surpluses is the area b and c lost by consumers, and in addition
problematic. gain f.)
Government spending to buy the excess supply
Firm inefficiency Higher than equilibrium product is equal to the price paid per unit, P f, times the
prices can lead to inefficient production; inefficient surplus quantity it purchases: P f × (Qs − Q d),
firms with high costs of production do not face corresponding to the rectangle outlined in bold.
incentives to cut costs by using more efficient Since government spending is financed out of
production methods, because the high price offers taxes with alternative uses (opportunity costs),
them protection against lower-cost competitors. This government spending to maintain the price floor
leads to inefficiency. involves losses for society.
We therefore have a gain in surplus of f and a
Overallocation of resources to the production of loss equal to the rectangle shown in bold. If we
the good and allocative inefficiency Too many subtract the loss from the gain we are left with the
resources are allocated to the production of the good, green shaded area, which is welfare (deadweight)
resulting in a larger than optimum (or ‘best’) quantity loss, representing loss of benefits due to allocative
produced. Whereas the optimum quantity is Qe, inefficiency caused by overallocation of resources to
actually Qs is produced. the production of the good. This is also shown by
MB < MC at the point of production, Qs , indicating
Negative welfare impacts In Figure 4.17 (which that society would be better off if less of the good were
is similar to Figure 4.16), price Pe and quantity Qe produced.
represent market equilibrium with no price floor, and
where social surplus is maximum; consumer surplus is
A price floor creates welfare (deadweight) loss,
given by a + b + c and producer surplus by
indicating that the price floor introduces allocative
d + e. Also, MB = MC.
inefficiency due to an overallocation of resources to
After a price floor, Pf, is imposed, consumer surplus
the production of the good, seen by Qs > Qe. MB <
becomes the area under the demand curve and above
MC, indicating that society is getting too much of
Pf, up to the quantity consumers buy, Qd, and so
the good.
falls to a. Producer surplus becomes the area above

94 Section 1: Microeconomics
Consequences of price floors for various developed countries (this topic will be discussed in
stakeholders Chapters 13 and 17).
If excess supplies of agricultural products are used
as aid to developing countries, they are sold at low
 Discuss the consequences of imposing a price floor on the
(below-market) prices in local markets. Consumers of
stakeholders in a market, including consumers, producers
those countries gain, as they buy the good at a lower
and the government.
than market price, but producers lose as they have to
compete with lower-priced foreign goods, and some
Consumers Consumers are worse off, as they of them may go out of business, losing their only
must now pay a higher price for the good (Pf > Pe), source of income (see the Real world focus feature on
while they buy a smaller quantity of it (Q d < Qe). page 513).
This is clear also from their loss of some consumer Overall, a global misallocation of resources can
surplus. result, as price floors cause high-cost producers to
produce more and low-cost producers to produce
Producers Producers gain as they receive a higher less than the social optimum, resulting in a waste of
price and produce a larger quantity, and since the resources.
government buys up the surplus, they increase their
revenues from Pe × Qe to Pf × Qs. Remember, this
is the main rationale of agricultural price floors.
Also, producers become protected against low-cost Test your understanding 4.8
competition and do not face as strong incentives to 1 Define a price floor, and providing examples,
become efficient producers; they are therefore less explain some reasons why governments impose
likely to go out of business if they are producing them.
inefficiently (with higher costs).
2 Draw a diagram illustrating a price floor
that is imposed in a product market, and
Workers Workers are likely to gain as employment
analyse its effects on market outcomes (price,
increases on account of greater production of the
quantity demanded, quantity supplied, market
good.
disequilibrium) and consequences for the
economy (excess supply, firm inefficiency,
Government When the government buys the excess
possible illegal sales, allocative inefficiency,
supply, this is a burden on its budget, resulting in
welfare (deadweight) loss).
less government funds to spend on other desirable
activities in the economy. The costs to the government 3 What are some measures governments can
are paid for out of taxes (and therefore by taxpayers). take to dispose of surpluses that result from the
In addition, there are further costs of storing the imposition of a price floor in an agricultural
surplus or subsidising it for export (sale to other product market? What are some problems
countries). associated with these measures?
4 Assuming a price floor is imposed in a market
Stakeholders in other countries The European for an agricultural product, and that the
Union, the United States and many other more government purchases the entire excess supply
developed countries rely on price floors for agricultural that results in order to maintain the price,
products to support their farmers. The surpluses (a) draw a diagram illustrating welfare
are sometimes exported (sold to other countries), (deadweight) loss. (b) What is the relationship
leading to lower world prices due to the extra supply between marginal benefits and marginal costs
made available in world markets. Countries that in the new equilibrium? What does this reveal
do not have price supports are forced to sell their about allocative efficiency (or inefficiency)?
agricultural products at low world prices. The low 5 Examine the consequences for different
prices in these countries signal to local farmers that stakeholders of a price floor for an agricultural
they should cut back on their production, resulting product whose excess supply is purchased by
in an underallocation of resources to these products. the government.
These events often work against the interests of less

Chapter 4 Government intervention 95

Calculating effects of price floors floor is £1.2 million per week. Once the price floor is
(higher level topic) imposed and the government purchases the surplus
(excess supply), firms receive revenues of Pf × Qs, and so
 Calculate possible effects from the price floor diagram, producer revenue increases to £25 × £80 000 =
including the resulting surplus, the change in consumer £2 million per week. Therefore, the change is £800 000,
expenditure, the change in producer revenue, and or additional producer revenue of this amount per week.
government expenditure to purchase the surplus.
Government expenditure
Figure 4.18 provides a numerical example of a price In order to purchase the excess supply of the
floor on an agricultural product. At equilibrium, price agricultural product, the government spends an
is equal to £20 and quantity is equal to 60 000 kg amount equal to the price of the good at the price floor
per week. When a price floor is imposed at Pf = £25, times the number of kg purchased, or Pf × (Qs − Qd) =
quantity demanded is Qd = 40 000 kg per week and £25 × 40 000 = £1 million.
quantity supplied is Qs = 80 000 kg per week. Note that government expenditure (£1 million) is
equal to total producer revenue (£2 million) minus
Surplus (excess supply) total consumer expenditure (£1 million) per week.
The surplus, or excess supply is equal to Qs − Qd, which
in this case is 80 000 − 40 000 = 40 000 kg per week.
Test your understanding 4.9
Change in consumer expenditure
Consumer expenditure is given by the price per kg 1 In the example of the market illustrated in
of the good times the number of kg purchased per Figure 4.18, what would be the effect of a price
week. At equilibrium, before the price floor, consumers floor set at £15?
spend Pe × Qe = £20 × 60 000 kg = £1.2 million per 2 Suppose a price floor is set at £30 per unit
week. After the price floor is imposed, consumers (Figure 4.18). Calculate (a) the surplus
spend Pf × Qs = £25 × 40 000 kg = £1 million per week. (excess supply), (b) the change in consumer
Therefore, consumers spend £200 000 less on the good expenditure, (c) the change in producer
per week. revenue, and (d) government expenditure
needed to purchase the surplus (excess supply)
Change in producer revenue and maintain the price floor.
Before the price floor, producer revenue is the same as
consumer expenditure, since revenue is equal to price
per kg times quantity sold, and both the price (Pe) Minimum wages
and the quantity (Qe) are the same for consumers and
producers. Therefore producer revenue before the price Impacts of minimum wages on market
outcomes

£P  Draw a diagram of a price floor, and analyse the impacts

40 of a price floor on market outcomes.
surplus =
35 excess supply
30 Many countries around the world have minimum
S = MC
Pf 25 wage laws that determine the minimum price of
Pe 20 labour (the wage rate) that an employer (a firm)
D+
government must pay. The objective is to guarantee an adequate
15
purchases income to low-income workers, who tend to be mostly
10
D = MB unskilled. (The market-determined wages of skilled
5 workers are usually higher than the minimum wage.)
0 Figure 4.19 shows the market for labour. The demand
10 20 30 40 50 60 70 80 90 100 110
Qd Qe Qs Q for labour curve shows the quantity of labour that
firms are willing and able to hire at each wage, and the
(thousand kg per week)
supply of labour curve shows the quantity of labour
that workers supply at each wage. Supply and demand
Figure 4.18 Calculating effects of a price floor on an agricultural determine the equilibrium ‘price’ of labour, which is
product with government purchases of the surplus the wage, We, where the quantity of labour demanded
is equal to the quantity of labour supplied, Qe.
96 Section 1: Microeconomics
 excess supply of labour involves illegal immigrants who may be willing to
= labour surplus supply

price of labour (wage)

of supply their labour at very low wages.
= unemployment
labour
Wm
Misallocation of labour resources The minimum
We wage affects the allocation of labour resources, as it
prevents the market from establishing a market-
demand clearing price of labour. In Chapter 2, page 41, we saw
for how the wage acts as a signal and incentive to workers
labour (the suppliers of labour) and firms (the demanders of
0 Qd Qe Q s Q labour) to determine the optimal allocation of labour
quantity of labour resources. The imposition of a minimum wage changes
these signals and incentives for unskilled labour,
Figure 4.19 Labour market with minimum wage (price floor) whose wage is affected by the price floor. Therefore,
industries that rely heavily on unskilled workers are
The minimum wage, Wm, lies above the equilibrium more likely to be affected, and will hire less unskilled
wage, We. Therefore, at Wm, the quantity of labour labour.
supplied, Qs, is larger than the quantity of labour
supplied when the labour market is in equilibrium Misallocation in product markets Firms relying
(Qe). The quantity of labour demanded, Qd, is less heavily on unskilled workers experience an increase
than the quantity demanded at equilibrium, Qe. There in their costs of production, leading to a leftward shift
results a surplus of labour in the market equal to the in their product supply curve (see Chapter 2, page 28),
difference between Qs and Qd. The labour market does resulting in smaller quantities of output produced.
not clear when there is a minimum wage. Therefore, the misallocation of labour resources leads
also to misallocation in product markets.
Consequences of minimum wages
for the economy Negative welfare impacts (supplementary
material) Figure 4.20 shows the labour market,
 Examine the possible consequences of a price floor, with the market-clearing wage at We, and
including surpluses, inefficient resource allocation and equilibrium quantity of labour demanded and
welfare impacts.3 supplied at Qe. The imposition of a minimum wage,
Wm, creates a labour surplus (excess labour supply),
or unemployment of Qs − Qd. To examine the welfare
Labour surplus (excess supply) and impacts of the minimum wage, note that we are
unemployment The imposition of a minimum wage
in the labour market creates a surplus of labour equal
P
to Qs − Qd in Figure 4.19, which is unemployment, as
it corresponds to people who would like to work but
are not employed. The unemployment is due partly
to the decrease in quantity of labour demanded by S
a welfare loss
firms (the difference between Qe and Qd) and partly Wm
to an increase in the quantity of labour supplied b c
We e
(the difference between Qs and Qe) which occurs
d
because the higher wage makes work more attractive,
causing a movement up the labour supply curve. This
D
unemployment is likely to involve unskilled workers.
0 Qd Qe Qs Q
Illegal workers at wages below the minimum
wage Illegal employment of some workers at wages
below the legal minimum may result; this often Figure 4.20 Welfare impacts of a minimum wage

3
The phrase ‘government measures to dispose of the surpluses’
has been deleted because it does not apply to the minimum wage.

Chapter 4 Government intervention 97

dealing with employer surplus (the area under the Price floors and minimum wages in the
demand curve) and worker surplus (the area above the real world
supply curve). Economists agree that price floors for agricultural
In the free market, with no minimum wage, products lead to surpluses (excess supplies) and are
employer surplus consists of areas a + b + c, and highly inefficient for the reasons discussed above. Yet
worker surplus consists of areas d + e, making a they continue to be used in many countries because of
total social surplus of a + b + c + d + e. After the strong political pressures exerted by farmers who claim
imposition of the minimum wage, employer surplus to need these for income support.
is reduced to area a, and worker surplus becomes The effects of minimum wages, on the other hand,
areas d + b, so that total social surplus is a + b + tend to be controversial, as it is uncertain whether
d. Therefore, the minimum wage has resulted in a they produce an increase in unemployment to
loss of social surplus equal to c and e, representing the extent that economic theory predicts. There is
welfare (deadweight) loss. The deadweight loss agreement that if a minimum wage is set at a high
arises because there is an underallocation of labour level relative to the free market equilibrium wage, it is
resources (usually unskilled labour) relative to the likely to create some unemployment. Yet some studies
social optimum, since Qd < Qe. have shown that a minimum wage in some situations
(The reason why the welfare analysis of the may have no effect or even a positive effect on total
minimum wage differs from that of price floors for employment. Some firms respond to the minimum
agricultural products with government purchases of wage by maintaining the same number of workers
the excess supply is that the government does not but cutting non-wage benefits (such as paid holidays
‘buy’ the excess labour supply that results from the or sick leave); or they may hire fewer unskilled
minimum wage by offering the excess workers jobs.) workers and more skilled workers. Also, it is possible
that labour productivity (defined as the amount of
Consequences of minimum wages for output produced per worker) may increase due to the
various stakeholders minimum wage, as workers feel motivated to work
harder, with the result that some firms hire more
 Discuss the consequences of imposing a price floor on the unskilled labour in response to minimum wages.
stakeholders in a market, including consumers, producers While the effects of minimum wages remain
and the government. controversial, there is generally strong political
support for their continued use on the grounds of
Firms (employers of labour) Firms are worse off as greater equity in income distribution.
they face higher costs of production due to the higher
labour costs. This is reflected in the loss of employer Setting fixed prices
surplus. Sometimes prices may be fixed at a particular level,
such as with ticket prices for theatres, movies and
Workers (suppliers of labour) The impacts on sports events, where prices are usually fixed ahead of
workers are mixed. Some gain, as they receive a higher time by the organising body (which may be private or
wage than previously (Wm > We), but some lose as public), and cannot increase or decrease according to
they lose their job. Note that the workers who lose supply and demand.
their job are those represented by Qe − Qd. This is not Figure 4.21 shows the market for tickets for a sports
the full amount of unemployment created by the event. The supply curve is vertical because there is a
minimum wage, because the minimum wage leads fixed supply of tickets (due to a fixed number of seats;
to additional unemployment of Qs − Qe, since more see page 27). The ticket price is fixed at Pfx by the
workers supply their labour in the market when the organising body. Figure 4.21(a) illustrates an event for
wage increases. which there is large demand, given by D1. If the price
The mixed effects on workers are reflected in the could respond to market forces, it would rise to Pe,, but
gain in worker surplus of area b, and the loss of area e. since it is fixed at Pf a shortage of tickets arises equal
to the horizontal difference between points a and b.
Consumers Consumers are negatively affected, Figure 4.21(b) illustrates an event for which there is
because the increase in labour costs leads to a decrease low demand, given by D2. Here, the equilibrium price
in supply of products (a leftward shift in firm supply would have been Pe, however price is fixed at the
curves) causing higher product prices and lower higher level Pfx, resulting in a surplus of tickets equal
quantities. to the horizontal difference between points c and d.

98 Section 1: Microeconomics
 (a) Price fixing resulting in a shortage (b) Price fixing resulting in a surplus

P P
P of tickets S S

P of tickets
Pe
c d
Pfx Pfx
a b
Pe
D1
D2
0 Q 0 Q

Figure 4.21 Price fixing and surpluses and shortages

Test your understanding 4.10

1 Define a minimum wage. Why do many
governments around the world impose them? in employer surplus, (b) the gain and the loss
2 Draw a diagram illustrating the imposition of in worker surplus, and (c) welfare (deadweight)
a minimum wage, and analyse its effects on loss. (d) What is the impact of the minimum
market outcomes (the wage, quantity of labour wage on allocative efficiency?
demanded and supplied, market disequilibrium) 4 Examine the consequences of a minimum wage
and consequences for the economy for different stakeholders.
(unemployment of labour, illegal work, resource 5 Using diagrams show how excess demand or
misallocation, welfare (deadweight) loss). excess supply of tickets results when ticket
3 (Optional) Assuming a minimum wage is prices are set at a level that is (a) lower than
imposed, draw diagrams to illustrate (a) the loss equilibrium, or (b) higher than equilibrium.

Theory of knowledge

Allocative efficiency: is it really value-free?

Throughout this chapter, we have used the competitive ‘Scientific’ meant economics should get rid of any value
market model, explained in Chapter 2, as the basis for making judgements about things that ‘ought to be’ and base itself
assessments about government intervention in the economy. entirely on positive thinking (see page 11). The famous
According to this model, when there is competition in the classical economists of earlier times (Adam Smith, Robert
sense of many buyers and sellers who act according to Malthus, David Ricardo, John Stuart Mill, Karl Marx and
their best self-interest, and when market forces are free to many others) openly discussed their ideas about what
determine equilibrium prices, a situation is reached where ought to happen in society (normative ideas) together
there is allocative efficiency and maximum social welfare. with their positive ideas of things that ‘are’ or ‘will be’.
Scarce resources are allocated in the best possible way, Yet by the late 19th century, it was believed that a true
producing the most of what people mostly want, and it is not science is value-free, and economists set out to imitate
possible to make anyone better off without making someone the methods of the natural sciences, especially physics.
worse off, a condition called Pareto optimality (see page 42). The concept of Pareto optimality, developed by
The concept of Pareto optimality emerged in the Vilfredo Pareto (an Italian engineer, sociologist, economist
late 19th century after a period when economists were and philosopher), was welcomed as being truly free of
trying to make economics more scientific in its approach. normative aspects. It simply stated that under certain
(continued over)

Chapter 4 Government intervention 99