Market Intervention

Control on prices

• When policymakers believe the market price is “unfair” to buyers or sellers, they implement legal restrictions
• Price Ceiling is a legal maximum on the price at which a good can be sold.
• Price Floor is a legal minimum on the price at which a good can be sold.

Tax

• Who actually bears the burden of a tax?
• When a good is taxed, the quantity sold is smaller in the new equilibrium.
• burden of a tax falls more heavily on the side of the market that is less elastic (more “stiff” or less able to leave the market).
• If Demand is Inelastic (e.g., Cigarettes): Buyers have few alternatives and will pay most of the tax.
• If Supply is Inelastic (e.g., Luxury Yachts in the short run): Sellers cannot easily change their production, so they bear more of the burden.

The Cost of Taxation

The Deadweight Loss of Taxation

When the government imposes a tax, it places a “wedge” between the price buyers pay and the price sellers receive. This wedge causes the quantity of the good sold to fall below the level that would maximize the total surplus.

The size of the deadweight loss is determined by the price elasticities of supply and demand.

Determinants of Trade

• If Domestic Price < World Price: The country has a comparative advantage in producing that good. Once trade is allowed, the country will become an exporter.
• If Domestic Price > World Price: Foreign countries have the comparative advantage. Once trade is allowed, the country will become an importer.

When a government restricts trade, it usually uses a Tariff.

• Effect of a Tariff: It raises the price of imported goods, reducing the quantity of imports and moving the market closer to the domestic equilibrium.
• The Result: It increases producer surplus and government revenue but decreases consumer surplus by a larger amount, creating deadweight loss.