Government

Intervention in Markets
Chathuranga Adhikari
B.com (Sp)(Hons), M.com (Reading)
Upon the successful completion of this lecture,
you’ll be able to,

• Understand Market equilibrium and disequilibria

• Describe types of Government Intervention
• Describe types of Goods, Buffer Stocks Income Guarantee
Schemes and Price Controls
• Explain Market failures
 Market Equilibrium
• The operation of the market depends on
the interaction between buyers and
sellers.
• An equilibrium is a condition that
exists when the quantity supplied and
quantity demanded are equal.
• At equilibrium, there is no tendency for
the market price to change.
Market Equilibrium
• Only in equilibrium is
the quantity supplied
equal to the quantity
demanded.

• At any price level

other than P0, the
wishes of buyers and
sellers do not coincide.
Market Disequilibria
• Excess demand, or shortage, is the
condition that exists when the
quantity demanded exceeds the
quantity supplied at the current price.

• When the quantity demanded

exceeds the quantity supplied, the
price tends to rise until equilibrium
is restored.
Market Disequilibria
• Excess supply, or surplus, is the
condition that exists when the
quantity supplied exceeds the
quantity demanded at the current
price.
• When the quantity supplied exceeds
the quantity demanded, the price
tends to fall until equilibrium is
restored.
Methods of Government Intervention
• Buffer Stocks
• Price Ceilings (Maximum price and Minimum Price)
• Taxations
• Subsidies
• State provision
• Regulation
Government Intervention in Markets
1. Buffer Stocks
A buffer stock is a system;
-buys and stores stocks at times of good harvests to prevent prices from falling below a price
level
-releases stocks during bad harvests to prevent prices from rising above a price level
• Influencing market supply through holding or releasing stocks to stabilize prices or incomes
• Short term measure
• Used in agriculture where supply can be volatile
• Assumption: supply is perfectly inelastic in the short run
• Only useful where goods can be stored
Government Intervention in Markets
S (Bad harvest) S (Good Harvest) Buffer Stock
Price to stabilise price:
After a good
harvest the
government ‘buys
up’ 60 units and
puts it into store
Target Price TP
After a bad
harvest,
Government
government
sets a target
releases
price (TP)50 onto
market

D
50 100 160 Quantity Bought and Sold
Government Intervention in Markets
Income stabilization Schemes:
• Buffer stocks do not guard against volatile incomes
• Aim to ensure farm incomes remain relatively constant
– manipulate price through releasing stocks or adding
to stores
Government Intervention in Markets
Problems of such schemes:
• Farmers do not respond to market signals – the market becomes
distorted
• Overproduction if incomes guaranteed
• Issues in storing food
• Cost of storage
• Farmers’ moral issues – constant income
• Long-term sustainability, international effects – LDCs, World Trade
Organisation
 Assume the equilibrium The government imposes
price is £10 and the a maximum price of £6 (P
amount bought and sold is 100 Max)
2. Price Ceilings
Price Controls:
Price Maximum Prices
S
below normal equilibrium
Black Market
Price
£18
Suppliers reduce the
amount offered to 60 but
Shortages £10 demand would rise to 140
may lead to creating a shortage of 80
black market – rationing might have to
prices way £6 P Max be introduced
above the
equilibrium
free market D
level
60 100 140 Quantity Bought and Sold
Question 01
• Qd = 100 – 5P
• Qs = 5P
• Maximum Price Rs. 8
 P

20
S

C/S A

12
B E
10
C F

8 Max/P
D
P/S
D

40 50 60 100 Q
 Government
Price Ceilings imposes minimum
price of £9 (Min P)
Price Controls:
Price S Minimum Prices set
above normal equilibrium

£9 Min P
Assume initial
equilibrium price = £5
£5 and amount bought and
sold = 200

At the higher price,

demand would fall
whereas supply
D would rise – a
surplus would
170 200 240 Quantity Bought and Sold exist.
Question 02
• Qd = 100 – 5P
• Qs = 5P
• Minimum Price Rs. 12
 P

20
S

C/S
A
12 Min/P
B L
E
10 K
C F
G J
8
D H I
P/S
D

40 50 60 100 Q
Consumer and Producer Surplus
• When government controls price, some people are better off.
• May be able to buy a good at a lower price
• But, what is the effect on society as a whole?
• Is total welfare higher or lower and by how much?
• A way to measure gains and losses from government policies
is needed.
Consumer and Producer Surplus
Consumer surplus is the total benefit or value that
consumers receive beyond what they pay for the good.
• Assume the market price for a good is $5
• Some consumers would be willing to pay more
than $5 for the good
• If you were willing to pay $9 for the good and pay
$5, you gain $4 in consumer surplus
Consumer and Producer Surplus
• The demand curve shows the willingness to pay for all
consumers in the market
• Consumer surplus can be measured by the area
between the demand curve and the market price
• Consumer surplus measures the total net benefit to
consumers
Consumer and Producer Surplus
Producer surplus is the total benefit or revenue that
producers receive beyond what it cost to produce a
good.
• Some producers produce for less than the market
price and would still produce at a lower price
• A producer might be willing to accept $3 for the
good but get a $5 market price
• Producer gains a surplus of $2
Consumer and Producer Surplus
• The supply curve shows the amount that a producer is
willing to take for a certain amount of a good
• Producer surplus can be measured by the area between
the supply curve and the market price
• Producer surplus measures the total net benefit to
producers
Consumer and Producer Surplus
Price
9 Consumer
Surplus
S

Between 0 and Q0
consumer A receives a
net gain from buying the
product-- consumer
5 surplus
Producer
Surplus
3 Between 0 and Q0
producers receive
a net gain from
selling each product--
D producer surplus.

QD QS Q0 Quantity
Consumer and Producer Surplus
• To determine the welfare effect of a governmental
policy we can measure the gain or loss in consumer
and producer surplus.
• Welfare Effects
• Gains and losses to producers and consumers.
Consumer and Producer Surplus
• When government institutes a price ceiling, the price
of a good can’t to go above that price.
• With a binding price ceiling, producers and consumers
are affected
• How much they are affected can be determined by
measuring changes in consumer and producer surplus
Consumer and Producer Surplus
• When price is held too low, the quantity demanded increases
and quantity supplied decreases
• Some consumers are worse off because can no longer buy the
good.
• Decrease in consumer surplus
• Some consumers better off because can buy it at a lower
price.
• Increase in consumer surplus
Consumer and Producer Surplus
• Producers sell less at a lower price
• Some producers are no longer in the market
• Both of these producer groups lose and producer
surplus decreases
• The economy as a whole is worse off since the surplus
that used to belong to producers or consumers are
simply gone.
Consumer and Producer Surplus

Price

Consumer S
Surplus

Po Producer Surplus

Qo
Quantity
Price Control and Surplus Changes
Price
Consumers that can Consumers that cannot
buy the good gain A buy, lose B
S

The loss to producers is

the sum of rectangle A
B and triangle C.

P0
A C Triangles B and C are
losses to society – dead
Pmax weight loss

Q1 Q0 Q2
Quantity
Price controls and Welfare Effects

• The total loss is equal to area B + C.

• The deadweight loss is the inefficiency of the price controls –

the total loss in surplus (consumer plus producer)
The Efficiency of a Competitive Market

• In the evaluation of markets, we often talk about

whether it reaches economic efficiency
• Maximization of aggregate consumer and producer
surplus
• Policies such as price controls that cause dead weight
losses in society are said to impose an efficiency cost
on the economy
The Efficiency of a Competitive Market

• If efficiency is the goal, then you can argue leaving

markets alone is the answer
• However, sometimes market failures occur
• Prices fail to provide proper signals to consumers
and producers
• Leads to inefficient unregulated competitive market
Types of Market Failures
1. Externalities
• Costs or benefits that do not show up as part of the market price (e.g. pollution)
• Costs or benefits are external to the market
2. Public Goods- National Defense
3. Monopolies
4. Lack of Information
• Imperfect information prevents consumers from making utility-maximizing
decisions.
Government intervention may be desirable in these cases
The Efficiency of a Competitive Market

• Other than market failures, unregulated competitive

markets lead to economic efficiency
• What if the market is constrained to a price higher than
the economically efficient equilibrium price?
Price Control and Surplus Changes
Price

Pmin
When price is regulated
A B to be no lower than
Pmin, the deadweight
P0 loss given by triangles B
C and C results.

Q0 Quantity
Q1 Q2
The Efficiency of a Competitive Market

• Deadweight loss triangles, B and C, give a good

estimate of the efficiency cost of policies that force
price above or below the market clearing price.
• Measuring effects of government price controls on the
economy can be estimated by measuring these two
triangles
 Qd = a - bP

03. Taxations Qs = a + bP

Qst = a + b(P-t)
Loss in Efficiency
Taxation
STax

Price
Tax
S
New Consumer
Surplus Lost Consumer
Surplus Deadweight Loss
PD

Tax
Revenues
Po Lost Producer Surplus

PS
New Producer
Surplus
D

QL Qo
Quantity
Question 03
• Qd = 200 - 10P
• Qs = -100 + 20P
• Tax = Rs. 3
 P
St
20
C/S
Gov. Tax S
Revenue

12
10
D/W/L
9
P/S
8

D
-100 80 100 200 Q
 Qd = a - bP

04. Subsidies Qs = a + bP

Qss = a + b(P+s)
Loss in Efficiency
Subsidy

Price

Gain in Producer Surplus S

New
Consumer
Surplus PS SSub
Subsidy

Gain in Consumer Po
Surplus
PD Deadweight Loss

New Producer D
Subsidy Cost
Surplus

Qo QH
Quantity
Question 04
• Qd = 100 – 5P
• Qs = -20 + 5P
• Subsidy = Rs. 4
Thank you
Any Questions?