The Welfare Effects Of A Government Policy Economics Essay

The Wel furthermoste Effects Of A Government Policy Economics EssayFor the purpose of this paper affect and cater outline is utilise to show how it great deal be applied to a wide variety of sparing problems. In the first section consumer and maker surplus is crack defined and explained to translate the offbeat effects of a regime form _or_ system of organisation. In other words, consumer and producer surplus hindquarters evaluate who gains and who slips from a given insurance policy, and also by how much. Also none that these two concepts of surplus set up also be employ to demonst regulate the efficiency of a militant market.In the sections to follow minimum equipment casualtys, harm supports, and related policies ordain be discussed in much detail. To assist the theory, demand-supply analysis pull up stakes be used to understand and assess these policies.Consumer and Producer SurplusTo understand consumer and producer surplus better the principles of val ue ceilings and floors result be discussed. As opposed to footing floors, a government-imposed toll ceiling elbow room that the hurt is set at a tear down level than the expense in the prevailing market. Likewise, price ceilings will cause the cadence of a good demanded to rise. This happens because at lower prices consumers want to deal more. On the other hand, the standard supplied will fall because producers are not willing to supply as much at lower prices. As a government issue of this a shortage will occur, which also indicates excess demand. Note that those consumers who heap even so buy the good will be better off because they now pay less. However, supply will fall, forcing producers to provide less of their goods.The following section provides a more detailed explanation of the well-being gained or lost by both consumers and producers, should certain prices be imposed. For the purpose of this section the assumption follows that consumers and producers buy and cuckold at the prevailing market price in an unregulated, competitive market.However, for well-nigh consumers the value of the good in question exceeds the prevailing market price. This also means that the consumer would be willing to pay more for the good if it was expected. Therefore, consumer surplus is the jibe benefit that consumers win beyond what they pay for the good (Pindyck and Rubinfeld, 2005300). For typeface if the market price of a product is R7, but the consumer is willing to pay R10 for it, therefore his net benefit will be R3.Consumer surplus commode also be explained with the helper of demand and supply curves. In this respect consumer surplus can be interpreted as the area among the demand curve and the market price. Pindyck and Rubinfeld (2005300) also states that consumer surplus measures the net benefit to consumers in the aggregate, at that placefore, this analysis can be used to better understand the gains or terminationes induced from government hitchs.On the other hand, producer surplus is the equivalent measure for producers (Pindyck and Rubinfeld, 2005301). If goods were to be produced at a price lower than the market price, then more could be produced. Therefore, producers will enjoy a benefit, or rather a surplus, from interchange those units. This surplus is the difference between the market price the producer receives and the marginal greet of producing the units. It can also be better explained as the area in a higher place the supply curve up to the market price.Essentially consumer and producer surplus is used for economic analysis to evaluate the welfare effects of a government intervention in the market. It assists with anticipating who will gain or lose from the intervention, and also by how much. To do so the concepts of price ceilings and price floors will be explained in more detail. determine Ceilings impairment ceilings occur when production (supply) is decreased and the metre demanded is gaind (Pind yck and Rubinfeld, 2005301). Price ceilings tend to cause excess demand, or rather shortages, to occur. Figure 1 graphic Presentation of a Price CeilingThe following section provides a theoretical explanation of Figure 1 and the effects of price ceilings on consumers and producers respectivelyConsumer Surplus (Pindyck and Rubinfeld, 2005302 and Perloff, 2005274, 296, 297)Consumers are better off as they can buy the good at a lower price.Thus, the consumers that mollify buy the good enjoy an increase in consumer surplus, which is resembled by rectangle A.On the other, those consumers who can no prolonged buy the good lose surplus. Their difference is cope with by triangle B.Therefore, the net change in consumer surplus which is a positive result isCS = A BProducer Surplus (Pindyck and Rubinfeld, 2005303 and Perloff, 2005278, 280, 297)With price controls, round producers will stay in the market but will receive a lower price for their widening. Thus, they have lost the produ cer surplus represented by rectangle A.Other producers may however leave the market. This means that total production will also drop, which is represented by triangle C.Therefore, the change in producer surplus, which is a negative result, isPS = (-A) CDeadweight Loss (Pindyck and Rubinfeld, 2005304 and Perloff, 2005280, 281)Price controls will result in a net loss, which is also referred to as deadweight loss.Therefore, combining the change in both consumer and producer surplus will bring along a total change in surplus as followsDeadweight Loss = (A B) + (-A) -C = (-B) CIn essence, deadweight loss results in an inefficiency caused by price controls.In summation, a price ceiling is that price held infra the prevailing market price. It merely means that too little is produced and, at the like time, that consumers and producers in the aggregate are worse off (Pindyck and Rubinfeld, 2005306 and Mohr, 2004162, 163).Price FloorsIn contrast to price ceilings, price floors indicate what happens when government requires for the price to be above the market price. Although producers would like to produce more at this higher(prenominal) price (indicated on the supply curve at P2) consumers will now buy less. If we assume that producers only produce what can be sold, then the market output level will be at Q1. Once again on that point is a noted net loss of total surplus (Pindyck and Rubinfeld, 2005306, and Perloff, 2005293)Triangles B (a loss of consumer surplus) and C (a loss of producer surplus) represents the deadweight loss.Rectangle D represents the transfer from consumers to producers, who now receive a higher price.Figure 2 Graphical Presentation of a Price FloorIn fact, the deadweight loss gives an optimistic assessment of the efficiency cost of policies. The reason for this assumption is that some producers may still however increase prices after the price floor have been incorporated. This would, in turn, result in unsold output. However, should the p roducer receive more importance with respect to applicable policies, then government might buy up the unsold output to maintain production at Q0. In both cases, the total welfare loss will exceed the areas of triangles B and C (Pindyck and Rubinfeld, 2005307).The Efficiency of a Competitive MarketAs discussed already, consumer and producer surplus can be used to evaluate economic efficiency in the aggregate. In the previous section it was shown how price controls create a deadweight loss. Thus, the policy imposes an efficiency cost on the preservation (Pindyck and Rubinfeld, 2005306). Both consumer and producer surplus are reduced by the amount of the deadweight loss. This does not mean that such a policy is bad. It may however turn over other objectives that policymakers and the public consider important.Many researchers argue that if the only objective is to achieve economic efficiency, then a competitive market would be better left alone. This means that no interventions shoul d occur. However, in some cases market failure will occur because prices fail to provide the proper signals to consumers and producers. Also, the unregulated, competitive market could be inefficient. These indications of market failure may occur because of two instances (Pindyck and Rubinfeld, 2005306)Externalities Sometimes the actions of either consumers or producers will result in a cost/benefit that does not show up as bulge of the market price. Such a cost/benefit can also be referred to as outerities because they are external to the market. An example of this is the cost to society of environmental pollution by a producer of industrial chemicals.Lack of Information When consumers lack information about the tint or nature of a product and can thence not make a utility-maximising purchasing decision.If these two instances (externalities and/or the lack of information) are indifferent in a market then that unregulated, competitive market will essentially have no obstacles, a nd an economically efficient output level can be reached.Minimum PricesFor the purpose of this section we will refer back to Figure 2. From the graph we can see that if producers can correctly anticipate that they can sell only the lower quantity Q1, then the net welfare will be given by triangles B and C. However, as mentioned before, producers may not limit their output to Q1. Incorporating Figure 2 to illustrate minimum prices, the following notations has to be made (Pindyck and Rubinfeld, 2005310)P2 denotes a minimum price set by the government.Q2 denotes the quantity supplied, and Q1 denotes the quantity demanded. The difference between Q1 and Q2 represents excess supply, or rather, unsold supply.Therefore, Consumer Surplus (Pindyck and Rubinfeld, 2005310)Those consumers who still purchase the good must now pay a higher price (Rectangle D).Some consumers will also drop out of the market (Triangle B).Therefore, consumer surplus remains the kindred as before and indicates that consumers are actually worse off as a result of this policyCS = (-D) BProducer Surplus (Pindyck and Rubinfeld, 2005311)Producers, on the other hand, receive a higher price for the units they sell, which results in an increase of surplus (Rectangle D).Rectangle D can also be better described as the transfer of funds between consumers and producers.But, the drop in sales from Q0 to Q1 actually results in a loss of surplus which is represented by triangle C.Also remember that the supply curve is a internal representation of the additional cost of producing each incremental unit. Thus, the area under the supply curve from Q1 to Q2 is the cost of producing quantity Q2 less Q1. This area is represented by os trapezoideum E. Unless producers respond to unsold output by cutting production, the total change in producer surplus will bePS = D C EMinimum prices is merely one of the modalitys to raise prices above the prevailing market level through the direct intervention and regulation of the government simply make it illegal to charge a price lower than a specific minimum level. As a result, this form of government intervention can reduce producers profits because of the cost of excess production. Another example of this is a minimum wage law. In other words, a wage rate at a level higher than the market price will result in those workers who can find jobs and earn a higher payoff. However, some people who want to work will be unable to, which will result in a policy that brings about unemployment (Pindyck and Rubinfeld, 2005311).Price Supports and work Quotas anyhow rarefied a minimum price, the government can also increase the price of a good in other ways. In agricultural policy the system is mostly based on price supports, but prices can also be increased by restricting production, either directly or through incentives to producers (Pindyck and Rubinfeld, 2005314). In this section these policies will be examined in more detail as to show how consumers, produ cers and the government budget are affected.Price SupportsIn general, price supports aim to increase the prices of dairy products, tobacco, peanuts, etc. This is done with the intention that the producers of these types of products earn higher incomes. This basically entails that the government sets the supporting price and then buys up whatever output is needed to keep the market price at this level. The resulting gains/losses will be as followsFigure 3 Government Price SupportsConsumers Surplus (Pindyck and Rubinfeld, 2005315)At price P2, the quantity demanded falls to Q1, and the quantity supplied increases to Q2.To maintain this price and avoid inventories having to pile up, the government must buy the quantity Qg = Q2 Q1.Because the government adds its demand to the demand of the consumers, producers can sell all they want at price P2.Therefore, the consumer surplus will be calculated in the comparable way as with minimum pricesCS = (-D) BProducers Surplus (Pindyck and Rubin feld, 2005315)Price support policies are implemented with the intention to increase the gains that producers receive because producers are now selling a higher quantity (Q2) at a higher price (P2).Therefore producer surplus will be as followsPS = D + B + FGovernment Welfare (Pindyck and Rubinfeld, 2005315)However, there is also a cost to government, which in essence is paid for by imposees.Thus, ultimately this is actually a cost indirectly related to consumers.This amount is represented by the rectangle that makes up BCEFG.This cost may be reduced if the government can dump some of its purchases, for example, selling them abroad at a low price. However, doing so hurts the ability of the domestic market to sell in foreign markets.The total welfare cost of this policy could be defined asCS + PS Cost to Gov = D (Q2 Q1)P2If the objective is to give producers an additional income equal to D + B + F, it is far less costly to society if government were to give them this money directly rather than via price supports. This can be supported by the fact that price supports are costing consumers D + B anyway. If government pay producers directly, then society will save the large rectangular area BCEFG less triangle F (Pindyck and Rubinfeld, 2005316). However, price supports are in use most likely because they are a less obvious giveaway and, therefore, politically more correct.Production QuotasThe government can also cause the price of a good to rise by reducing supply. Government can do this by stage setting quotas on how much each firm can produce. With appropriate quotas, the price can then be forced up to any arbitrary level. An example of this could be the control of liquor licenses by the government. By requiring any bar or restaurant to have a liquor license and, at the same time limiting the number of licenses, will result in limited entrants into that market. This also allows those with licenses to earn higher prices and profit margins. The welfare effects of production quotas will be explained in the following section (Pindyck and Rubinfeld, 2005317)The government restricts the quantity supplied to Q1, rather than at the market level of Q0.Thus the supply curve becomes the vertical line of products S at Q1.As a result consumer surplus is reduced by rectangle D plus triangle B.On the other hand, producers gain rectangle D less triangle C.Thus, once again, there is a deadweight loss that occurs which is represented by B + CCS = (-D) BPS = D C + (Payments for not producing)However, the cost to the government is a payment sufficient enough to give producers an incentive to reduce output to Q1.That incentive must be at least as large as (B + C + F), because that area represents the additional profit that could have been made if the quota was not applicable.Also remember that the higher price (P2) give producers incentive to produce more even though the government is trying to get them to produce less.Thus, the cost to government is at least B + C + F and the total change in producer surplus isPS = D C + B + C + F = D + B + FWelfare = (-D) B + D + B + F B C F = (-B) CFigure 4 Supply Restrictions via Production QuotasThis is the same change in producer surplus as with price supports therefore, producers should in essence be indifferent between the two policies because they end up gaining the same amount of money from each. Likewise, consumers end up losing the same amount of money (Pindyck and Rubinfeld, 2005318). It can also be noted that, once again, the society will clearly be better off in efficiency terms if the government simply gave the producers (loosely in the agricultural sector) D + B + C, leaving price and output alone. Producers would then gain D + B + C and the government would lose this profit for a total welfare change of zero, instead of a loss of B + C. However, economic efficiency is not always the objective of government policy.Import Quotas and taxsMany countries use import quotas and obligations to keep the domestic price of a product above globe levels and thereby enable the domestic industry to enjoy higher profits than it would under free trade. However, the cost to taxpayers from this protection can be relatively high. Without a quota or tariff, a country will import a good when its price is below the price that would prevail domestically, were there no imports (Pindyck and Rubinfeld, 2005321, 322 and Perloff, 2005298, 299).Figure 5 The Affect of an Import Tariff/Quota on ImportsS and D represent the domestic supply and demand.Because the world price (P1) is below domestic demand and supply, it gives domestic consumers an incentive to purchase from abroad if imports are not restricted.If that is the case then domestic price will fall to the world price at P1.At a lower price, domestic production will fall to Q1 and consumption will rise to Q2.So imports will be the difference between domestic consumption and production (Q2 Q1).Now suppose the government, b owing to pressure from the domestic industry, eliminates imports by imposing a quota or a tariff at Q0.This will forbid any importation of the good in question.With no imports allowed the domestic price will rise to P0.Consumer SurplusAs a result, consumers who still purchase the good will now pay a higher price and will lose the surplus represented by trapezoid A and triangle B.In addition, some consumers will no longer buy the good which results in a further loss represented by triangle C. Therefore, the total change in consumer surplus will beCS = (-A) B CProducer SurplusIn byplay with producers, output is now higher (Q0 instead of Q1).Output is also sold at a higher price (P0 instead of P1).Producer surplus therefore increases by the amount of trapezoid APS = AWelfare = (-B) CCombining both CS and PS to obtain the total welfare effect merely indicates once again that there is a deadweight loss. This loss indicates that consumers lose more than what producers gain.Imports cou ld also be reduced to zero by imposing a sufficiently large tariff. The tariff would have to be equal to or greater than the difference between P0 and P1. With a tariff of this size there will be no imports and, therefore, no government revenue from tariff collections. Thus, the effect on consumers and producers would be the same as with a quota (Pindyck and Rubinfeld, 2005323).However, government policy is more often designed to reduce, but not eliminate, imports (as shown in Figure 6. Again, this can be done with either a tariff or a quota (Pindyck and Rubinfeld, 2005323 and Perloff, 2005300, 301)When imports are reduced, the domestic price is increased from P1 to P0.Trapezoid A is again the gain to domestic producers.The loss to consumers is A + B + C + D.Thus, if a tariff is used, the government will gain rectangle D, the revenue from the tariff.Therefore, the net domestic loss will be B + C.If a quota is used instead, then rectangle D becomes part of the profits of foreign pro ducers, and the net domestic loss will be B + C + D.Figure 6 The General Case with an Import Tariff or QuotaThe Impact of a Tax or SubsidyThe burden of a tax (or the benefit of a subsidy) falls partially on the consumer and partly on the producer. In this section it will become clear that the share of a tax accepted by consumers depends on the shapes of the demand and supply curves and, in particular, on the relative elasticities of demand and supply (Pindyck and Rubinfeld, 2005326).The Effects of a Specific TaxA specific tax can be better defined as a tax of a certain amount of money per unit sold. This is in contrast to an ad valorem tax which is a proportional tax. However, the analysis of an ad valorem tax is nearly the same and yields the same qualitative results (Pindyck and Rubinfeld, 2005326). Examples of specific taxes are sin taxes on cigarettes and liquor.Suppose the government imposes a tax of t cents per unit. This means that the price the buyer pays must exceed the pr ice the trafficker receives by t cents. Figure 7 illustrates this accounting relationship and its implications (Pindyck and Rubinfeld, 2005326)Figure 7 The Effects of a Specific TaxHere, P0 and Q0 represent the price and quantity before the tax is imposed.Pd is the price that buyers pay and Ps is the price that sellers receive after the tax is imposed.Therefore, Pd Ps = t.Here the burden of a tax is split evenly between buyers and sellers. Buyers lose A + B, while sellers lose D + C.On the other hand, the government earns A + D in revenue.Thus, the deadweight loss is once again B + C.The solution is therefore to find the quantity that corresponds to a price of Pd and Ps so that t = Pd Ps. This quantity is shown as Q1. As seen from Figure 8, the burden of the tax is shared about evenly between buyers and sellers. It can also be stated that the price that buyers pay rises by half of the tax, and the price that sellers receive falls by roughly half of the tax. As Figure 7 and 8 sho ws, market clearing requires tetrad conditions to be satisfied after the tax is in place (Pindyck and Rubinfeld, 2005327, 328). These cardinal conditions can also be written and distinguished as four different equations that must always be trueThe quantity sold and the buyers price must lie on the demand curve, because buyers are interested only in the price that they must pay. Qd = Qd(Pd)The quantity sold and the sellers price must both lie on the supply curve, because sellers are only concerned with the price they are to receive. Qs = Qs(Ps)The quantity demanded must equal the quantity supplied (Q1). Qd = QsThe difference between the prices of buyers and sellers must equal t. Pd Ps = tThere is a change in consumer and producer surplus, as well as in government revenue can be summarised as follows (Pindyck and Rubinfeld, 2005328 and Perloff, 2005289, 290)CS = (-A) BPS = (-C) DWelfare = (-A) B C D + A + D = (-B) CFrom the above information we have seen that the burden of a tax is shared almost evenly between buyers and sellers, however, this is not always the case. If demand is inelastic and supply is relatively, then the burden of the tax will fall mostly on the buyer. Demand will work in the opposite way. It can also be determined if the burden of a tax falls more on the buyer or the seller (Pindyck and Rubinfeld, 2005328)Pass-through fraction (Buyer) = Ed / (Es Ed)This equation thus stipulates what fraction of the tax is passed-through to consumers (buyers) and producers (sellers) in the form of higher prices. So, if the demand is solely inelastic (when Ed = 0) so that the pass-through fraction is 1, then all the tax is borne by the consumers (Pindyck and Rubinfeld, 2005328). Similarly, when demand is totally elastic, the pass-through fraction is zero and producers bear all the tax. Therefore, the equation basically indicates that a tax falls on the buyer if Ed / Es is small, and on the seller if Ed / Es is large.The Effects of a SubsidyA subsid y can be analysed in much the same way as a tax. In fact, a subsidy can be better defined as a negative tax. With a subsidy, the sellers price exceeds the buyers price and the difference between the two is the amount of the subsidy. Thus, the effect of a subsidy on the quantity produced and consumed is the opposite of the effect of a tax, which also means that the quantity will increase (Pindyck and Rubinfeld, 2005329).Figure 8 The Effects of a SubsidyIn general, the benefit of a subsidy accrues mostlyto buyers if Ed / Es is small, and to sellers if Ed / Es is large. Also, the same four conditions needed for the market to clear, apply for a subsidy as it did for a tax. The only difference is that now the difference between the sellers price and the buyers price is equal to the subsidy (Pindyck and Rubinfeld, 2005329)Qd = Qd(Pd)Qs = Qs(Ps)Qd = QsPs Pd = sConclusionFrom this paper the evidence shows that simple models of demand and supply can be used to analyse a wide variety of gove rnment policies. These include price controls, minimum prices, price supports, production quotas, import tariffs and quotas, and taxes and subsidies. In each case, consumer and producer surplus are used to evaluate the gains and losses to consumers and producers. These gains and losses can be quite large.Evidence have also indicated that when the government imposes a tax or subsidy, price normally does not rise or fall by the full amount of the tax or subsidy. Also, the incidence of a tax or subsidy is commonly split between consumers and producers. The fractions that each group ends up paying/receiving depend on the relative elasticities of demand and supply.It is important to remember that government intervention generally leads to a deadweight loss, even if consumer and producer surplus is weighted equally. In some cases this deadweight loss will be small, but in other cases (price supports and import quotas) it is large. This deadweight loss is a form of economic inefficiency t hat must be taken into account when policies are designed and implemented.In summation, government intervention in a competitive market is not always bad. Government, and the society it represents, might have objectives other than economic efficiency. There are also situations in which government intervention can improve economic efficiency. Examples are externalities and cases of market failure.