Divergence from market equilibrium
Price ceilings, price floors and excise taxes
Dr. Amy McCormick Diduch
The interaction of market supply and market demand determine a uniquely efficient equilibrium price and quantity as long as markets are highly competitive and no groups of buyers or sellers have the power to alter outcomes. When markets are highly competitive, prices adjust so that the last people to purchase the good pay exactly what it costs for the last suppliers to provide the good and the market quantity supplied exactly equals the market quantity demanded.
In these highly competitive markets, prices and quantities may diverge from equilibrium due to government intervention in the market. We’ll look at two scenarios: price controls and excise taxes.
Price controls take one of two forms (ceilings or floors) and may be binding or non-binding.
Price ceilings are maximum legal prices. They are instituted with two primary purposes: to hold inflation in check, and to keep the price of certain items within reach of those with lower incomes. When a binding price ceiling is in effect, the actual price of the product will be lower than the market equilibrium price, resulting in excess demand for the product. (Imagine that price is represented by a helium-filled balloon. The price can rise until it hits the ceiling but cannot go above it).
Price floors are minimum legal prices. The intent of the government in setting a price floor is to increase the incomes of those who sell that good. When a binding price floor is in effect, the actual price of the product will be above the market equilibrium price, resulting in excess supply of the product. (Imagine that price is represented by a rubber ball. The price can fall until it hits the floor but cannot go below it).
1. Effects of a price ceiling in a competitive market
Suppose you have the following information about the market for novels:
Price ceilings, price floors and excise taxes
Dr. Amy McCormick Diduch
The interaction of market supply and market demand determine a uniquely efficient equilibrium price and quantity as long as markets are highly competitive and no groups of buyers or sellers have the power to alter outcomes. When markets are highly competitive, prices adjust so that the last people to purchase the good pay exactly what it costs for the last suppliers to provide the good and the market quantity supplied exactly equals the market quantity demanded.
In these highly competitive markets, prices and quantities may diverge from equilibrium due to government intervention in the market. We’ll look at two scenarios: price controls and excise taxes.
Price controls take one of two forms (ceilings or floors) and may be binding or non-binding.
Price ceilings are maximum legal prices. They are instituted with two primary purposes: to hold inflation in check, and to keep the price of certain items within reach of those with lower incomes. When a binding price ceiling is in effect, the actual price of the product will be lower than the market equilibrium price, resulting in excess demand for the product. (Imagine that price is represented by a helium-filled balloon. The price can rise until it hits the ceiling but cannot go above it).
Price floors are minimum legal prices. The intent of the government in setting a price floor is to increase the incomes of those who sell that good. When a binding price floor is in effect, the actual price of the product will be above the market equilibrium price, resulting in excess supply of the product. (Imagine that price is represented by a rubber ball. The price can fall until it hits the floor but cannot go below it).
1. Effects of a price ceiling in a competitive market
Suppose you have the following information about the market for novels:
What is the equilibrium quantity of novels? 100
What is the equilibrium price of novels? $12
Suppose the City Council decides that novel prices are too high -- they want to encourage more summer reading in town. They impose a price ceiling on novels of $9. At this price, there is excess demand for novels. People want to purchase 110 novels at this new price but only 80 are offered for sale. The difference – the excess demand - is 110-80, or 30 novels.
The graph below illustrates the impact of this price ceiling. The law requires that the price of novels be equal to or below the price ceiling of $9. Thus, merchants may choose any price in the “green” zone in the graph but may not choose a price in the “red” zone of the graph. Notice that the graph also marks the quantity demanded and the quantity supplied at the ceiling price of $9.
What is the equilibrium price of novels? $12
Suppose the City Council decides that novel prices are too high -- they want to encourage more summer reading in town. They impose a price ceiling on novels of $9. At this price, there is excess demand for novels. People want to purchase 110 novels at this new price but only 80 are offered for sale. The difference – the excess demand - is 110-80, or 30 novels.
The graph below illustrates the impact of this price ceiling. The law requires that the price of novels be equal to or below the price ceiling of $9. Thus, merchants may choose any price in the “green” zone in the graph but may not choose a price in the “red” zone of the graph. Notice that the graph also marks the quantity demanded and the quantity supplied at the ceiling price of $9.
Imposing a price ceiling in a competitive market has several other important implications. First, given the new problem of excess demand (i.e. the shortage of novels), we cannot be certain that we have actually succeeded in helping those who could not previously afford to buy them. Second, there is now incentive to create an “illegal market” in which novels are exchanged at prices above the legal limit. A more effective means of making novels more affordable could be creation of incentives to increase their supply (resulting in lower prices).
What if city council had set the price ceiling on novels at $16? First, note that a price ceiling does not mandate that merchants charge a specific price. It simply sets a limit on how high the price can go. Thus, merchants do not raise their prices to $16 because the equilibrium market price is still only $12.
The graph below illustrates this situation. The green zone again marks allowable prices and the red zone marks illegal prices. Notice that the market price of $12 is now in the green zone and is thus compliant with the law. This is an example of a non-binding price ceiling. The allowable maximum price is above the market equilibrium price.
What if city council had set the price ceiling on novels at $16? First, note that a price ceiling does not mandate that merchants charge a specific price. It simply sets a limit on how high the price can go. Thus, merchants do not raise their prices to $16 because the equilibrium market price is still only $12.
The graph below illustrates this situation. The green zone again marks allowable prices and the red zone marks illegal prices. Notice that the market price of $12 is now in the green zone and is thus compliant with the law. This is an example of a non-binding price ceiling. The allowable maximum price is above the market equilibrium price.
2. Effects of a price floor in a competitive market
Assume the regional market for milk is represented in the following table:
Assume the regional market for milk is represented in the following table:
The equilibrium price is $2/gallon and the equilibrium quantity is 12,000.
Local dairy owners argue that the price is too low to cover their costs. They successfully lobby for a price floor of $2.50/gallon. What happens in this market?
At $2.50 / gallon, quantity demanded is 11,000 gallons and quantity supplied is 15,000 gallons. There is excess supply of 4,000 gallons (15,000 – 11,000). The graph below illustrates this outcome. Note that a price floor does not mandate a specific price for milk; it simply makes illegal any price below the floor. The green zone in the graph depicts allowable prices and the red zone shows illegal prices. The price floor is “binding” as long as it is set above the market equilibrium price (as it is here).
Local dairy owners argue that the price is too low to cover their costs. They successfully lobby for a price floor of $2.50/gallon. What happens in this market?
At $2.50 / gallon, quantity demanded is 11,000 gallons and quantity supplied is 15,000 gallons. There is excess supply of 4,000 gallons (15,000 – 11,000). The graph below illustrates this outcome. Note that a price floor does not mandate a specific price for milk; it simply makes illegal any price below the floor. The green zone in the graph depicts allowable prices and the red zone shows illegal prices. The price floor is “binding” as long as it is set above the market equilibrium price (as it is here).
The difficulty with a binding price floor is deciding what to do with the resulting surplus. In the case of agricultural products, the government sometimes buys the surplus. If this doesn’t happen, the surplus might be destroyed if it cannot easily be stored and sold at some future date when supply and demand conditions might have changed.
If a price floor is set below the market equilibrium price, it is “non-binding.” At market equilibrium, the quantity supplied exactly equals the quantity demanded; no dairy would benefit from lowering its price to the price floor level. There is no excess supply (or excess demand) in this situation.
If a price floor is set below the market equilibrium price, it is “non-binding.” At market equilibrium, the quantity supplied exactly equals the quantity demanded; no dairy would benefit from lowering its price to the price floor level. There is no excess supply (or excess demand) in this situation.
3. Effects of an excise tax on price and quantity
Excise taxes are taxes placed on specific goods or services. Examples: taxes on cigarettes, alcohol, gasoline, telephone service, some luxury goods. (Most of us are more familiar with sales taxes, which are assessed as a percentage of the total sales price. The theory behind sales taxes is the same but it is easier to illustrate an excise tax on a graph).
It does not matter whether an excise tax is levied on the consumer or on the producer; the outcome is identical. Therefore, we will focus solely on the impact of a tax levied on the supplier of a product.
Let’s assume that Staunton City Council adopts a “ticket tax” of $2 per ticket to any entertainment venue in the city (this would include movie theaters and concerts as well as the American Shakespeare Theater's Blackfriars Playhouse). What impact will this have on the quantity of tickets purchased, the prices consumers pay for the tickets, the amount received by the sellers and the revenue raised by city council?
The impact of a tax on suppliers is to shift the supply curve up vertically by exactly the amount of the tax. Does this mean that the equilibrium price will increase by the same amount as the tax? NO! Why not?
The ticket tax does several things:
The file below contains problems (with answers) on price ceilings, floors, and excise taxes.
- It reduces the quantity of entertainment purchased in the city (from 2500 to 2300 in this example).
- It increases the total cost to purchasers of entertainment. In this example, consumers originally paid $15 per event but now pay $16 per event.
- It decreases the total amount received by sellers. In this example, sellers originally received $15 per event but now receive $14 per event. (Consumers pay $16 but $2 of this is sent to the government as tax payment).
- NOTE: the difference in the price paid by the consumer ($16) and the price received by the producer ($14) is exactly the amount of the excise tax.
- The city government gets revenue of $2 on each ticket sold; the total revenue generated for the city in this example is $2 * 2300 = $4600.
- The tax does create deadweight loss, which is a reduction in the efficiency of the market. This occurs because there are people willing to pay more for a ticket than it costs for producers to provide them but these tickets are not sold due to the extra burden of the tax. One general principle of taxation is to levy taxes on goods for which the deadweight loss is relatively small.
The file below contains problems (with answers) on price ceilings, floors, and excise taxes.
practice_problems_on_price_ceilings_price_floors_and_excise_taxes.pdf |