1. Policy Implications

2. OIL AND PRICE CONTROL
• Estimated subsidy on LPG, 2011-12 : Rs 25,000
crores
• Government provides subsidy to
- Kerosene: Rs 31/ltr
- Diesel : Rs 13.64/ltr
- One LPG cylinder (14.6kg): Rs 479
• Reduction in subsidy : average Rs 7.5/ltr

3. OIL AND PRICE CONTROL
• How does price control effect the society?
• Who benefits from this?
• Who looses?
• When is price control effective?

4. Price Controls and
Natural Gas Shortages
• QS = 14 + 2PG + 0.25PO
– Quantity supplied in trillion cubic feet (Tcf)
• QD = -5PG + 3.75PO
– Quantity demanded (Tcf)
• PG = price of natural gas in $/mcf
• PO = price of oil in $/b
4

5. Price Controls and
Natural Gas Shortages
• Using PO = $8/b and Q DG G
QS gives equilibrium
values for natural gas
– PG = $2/mcf and QG = 20 Tcf
• Price ceiling was set at $1/mcf
5

6. Price Controls and
Natural Gas Shortages
Price
($/mcf) D S
2.40
B
2.00
C
A
(Pmax)1.00
0 5 10 15 18 20 25 30 Quantity (Tcf)
Chapter 9 6

7. No Regulation
• What is the consumer surplus?
• What is the producer surplus?
• What is the total surplus in the economy?

8. Price Control
• Price control will be effective only if the price
is no higher than the equilibrium price

9. Price Controls and
Natural Gas Shortages
Price
($/mcf) D S
The gain to consumers is
2.40 rectangle A minus triangle B,
and the loss to producers is
rectangle A plus triangle C.
B
2.00
C
A
(Pmax)1.00
0 5 10 15 18 20 25 30 Quantity (Tcf)
9

10. Price Controls and
Natural Gas Shortages
• What will be effect of price control of $1 on
the amount traded?
• Will there be shortage or surplus?
• How will the producers get effected?

11. Price Controls
Effect on Producer Surplus
- Decrease in Producer Surplus
- Value: A+C = (-)$18+1 billion
- Loss due to lower per unit price :- Area A
- Loss due to seller selling fewer units- Area C

12. Price Controls
Effect on Consumer Surplus
- Gain due to lower per unit price :- Area A
- Loss due to seller selling fewer units- Area B
- Net Change in consumer surplus:- A-B= $18-
0.4 = $17.6 bn

13. Price Control
• Net Effect = Change in Producer Surplus +
Change in Consumer Surplus
• = (-) [Area A+ B] + Area A – Area C
• Net Loss of Area B + C = $0.4+1 mn
• DEADWEIGHT LOSS

14. Price Control
• Can society ever benefit with a price control?
• When will the deadweight loss decrease?
• Lower subsidy
• Lower demand and supply elasticity

15. Price Control
• Measuring effects of government price
controls on the economy can be estimated by
measuring these two triangles
• To measure the effect of government price
control one needs information on elasticity of
demand and supply
15

16. MARKET FOR HUMAN KIDNEYS

17. The Market for Human Kidneys
• The 1984 National Organ Transplantation Act
prohibits the sale of organs for transplantation
• What has been the impact of the Act?
17

18. The Market for Human Kidneys
• We can measure this using the supply and
demand for kidneys from estimated data
– Supply: QS = 8,000 + 0.2P
– Demand: QD = 16,000 - 0.2P
• Since the sale of organs is not allowed, the
amount available depends on the amount
donated
– Supply of donated kidneys is limited to 8,000
18

19. The Market for Kidneys
Price S’
The loss to suppliers
is seen in areas A & C. S
$40,000
$30,000 D If kidneys are zero cost,
consumer gain would
B be A minus B.
$20,000 A and D measure the
total value of kidneys
C when supply is
constrained.
$10,000 A
D
0 4,000 8,000 12,000 Quantity
19

20. The Market for Human Kidneys
• Recipients:
– Since they do not have to pay for the kidney, they
gain rectangle A ($140 million) since price is $0
– Those who cannot obtain a kidney lose surplus
equal to triangle B ($40 million)
– Net increase in surplus of recipients of $160 - $40
= $120 million
20

21. The Market for Human Kidneys
• Suppliers:
– Those who supply them are not paid the market
price, estimated at $20,000
• Loss of surplus equal to area A = $160 million
– Some who would donate for the equilibrium price
do not donate in the current market
• Loss of surplus equal to area C = $40 million
– Total SUPPLIER loss of A + C = $200 million
21

22. The Market for Human Kidneys
• Net Effect = Change in Producer Surplus +
Change in Consumer Surplus
• = (-) [Area A+ C] + Area A – Area B
• Net Loss of Area B + C = $80 mn
• DEADWEIGHT LOSS

23. The Market for Human Kidneys
• Arguments in favor of prohibiting the sale of
organs:
1. Imperfect information about donor’s health and
screening
2. Unfair to allocate according to the ability to pay
23

24. MINIMUM PRICES

25. Support Price for Rice farmers
• Support price for common rice, 2012: Rs
1,250/kg
• Increase from 2011 : Rs 1,080/kg

26. Minimum Support Price

27. Minimum Support Price
• What is the effect of Minimum Support Price
on the economy?
• Who benefits from it and who looses?
• When is Minimum Support Price effective?

28. Minimum Prices
• When price is set above the market clearing
price.
• Effective minimum price only operates when
minimum price support is above the
equilibrium price.
28

29. Minimum Prices
Price
S If producers produce
Q2, the amount Q2 - Q3
will go unsold.
Pmin
A D measures total cost of
B increased production
P0 C not sold.
The change in producer
D surplus will be
A - C - D. Producers
may be worse off.
D
Q3 Q0 Q2 Quantity
29

30. Minimum Prices
• Losses in consumer surplus are
– Increased price leading to decreased quantity
equals area A
– Those priced out of the market lose area B
• Producer surplus
– Increases from increased price for units sold equal
to A
– Losses from drop in sales equal to C
30

31. Minimum Prices
• Net Effect of the price control on the society
• DEADWEIGHT LOSS OF B+C
• Deadweight loss decreases as
- Subsidy is smaller
- Elasticity of demand and supply is lower

32. Minimum Prices
• What if producers expand production to Q2
from the increased price?
32

33. Minimum Prices
Price
S If producers produce
Q2, the amount Q2 - Q3
will go unsold.
Pmin
A D measures total cost of
B increased production
P0 C not sold.
The change in producer
D surplus will be
A - C - D. Producers
may be worse off.
D
Q3 Q0 Q2 Quantity
33

34. Minimum Prices
• What if producers expand production to Q2
from the increased price?
– Since they only sell Q3, there is no revenue to
cover the additional production (Q2-Q3)
– Supply curve measures MC of production so total
cost of additional production is area under the
supply curve for the increased production (Q2-Q3)
= area D
– Total change in producer surplus = A – C – D
34

35. Supporting the Price of Wheat
• The supply and demand for wheat in 1981 was
– Supply: QS = 1,800 + 240P
– Demand: QD = 3,550 - 266P
– Equilibrium price and quantity was $3.46 and
2,630 million bushels
• Government raised the price to $3.70 through
government purchases
35

36. The Wheat Market in 1981
Price •AB consumer loss
•ABC producer gain S
Qg By buying 122
million bushels,
PS = $3.70 the government
A C increased the
B
P0 = $3.46 market-clearing
price.
D D + Qg
1,800 2,566 2,630 2,688 Quantity
36

37. Supporting the Price of Wheat
• How much would the government have had
to buy to keep price at $3.70?
– QDTotal = QD + Q g = 3,550 - 266P + Q g
– QS = QDT
• 1,800 + 240P = 3,550 - 266P + Qg
• Qg = 506P - 1,750
• At a price of $3.70, government would buy
• Qg = (506)(3.70) - 175 = 122 million bushels
37

38. Supporting the Price of Wheat
• We can quantify the effects on CS
– The change in consumer surplus = (-A -B)
• A = (3.70 - 3.46)(2,566) = $616 million
• B = (1/2)(3.70 - 3.46)(2,630 - 2,566) = $8 million
– CS = -$624 million
38

39. Supporting the Price of Wheat
• Cost to the government:
– $3.70 x 122 million bushels = $451.4 million
– Total cost of program = $624 + 451 = $1,075
million
• Gain to producers
– A + B + C = $638 million
– Government also paid 30 cents/bushel = $806
million
39

40. Supporting the Price of Wheat
• In 1996, Congress passed the Freedom to
Farm law
– Goal was to reduce the role of government and
make agriculture more market-oriented
– Eliminated production quotas, gradually reduced
government purchases and subsidies through
2003
44

41. Supporting the Price of Wheat
• In 2002, Congress and President Bush
reversed the effects of the 1996 bill by
reinstating subsidies for most crops
– Calls for “fixed direct payments”
– New bill would cost taxpayers almost $1.1 billion
in annual payments to wheat producers alone
– 2002 farm bill expected to cost taxpayers $190
billion over 10 years
• Estimated $83 billion over existing programs
45

42. MINIMUM WAGES

43. Minimum Wages
• Wage is set higher than market clearing wage
• Decreased quantity of workers demanded
• Those workers hired receive higher wages
• Unemployment results, since not everyone
who wants to work at the new wage can
47

44. The Minimum Wage
w Firms are not allowed to
pay less than wmin. This
results in unemployment.
S
wmin A is gain to workers
A who find jobs at
B higher wage.
w0
C
The deadweight loss
is given by
triangles B and C.
Unemployment
D
L1 L0 L2 L
48

45. EFFECT OF TAX AND SUBSIDY

46. The Impact of a Tax or Subsidy
• The government wants to impose a $1.00 tax
on movies. It can do it two ways:
– Make the producers pay $1.00 for each movie
ticket they sell
– Make consumers pay $1.00 when they buy each
movie
• In which option are consumers paying more?
50

47. The Impact of a Tax or Subsidy
• The burden of a tax (or the benefit of a
subsidy) falls partly on the consumer and
partly on the producer
• How the burden is split between the parties
depends on the relative elasticities of demand
and supply
51

48. The Effects of a Specific Tax
• For simplicity we will consider a specific tax
on a good
– Tax of a particular amount per unit sold
• For our example, consider a specific tax of $t
per cigarette sold
52

49. Incidence of a Specific Tax
• Four conditions that must be satisfied after
the tax is in place:
1. Quantity sold and buyer’s price, Pb, must be on
the demand curve
• Buyers only concerned with what they must pay
2. Quantity sold and seller’s price, PS, must be on
the supply curve
• Sellers only concerned with what they receive
53

50. Incidence of a Specific Tax
3. QD = QS
4. Difference between what consumers pay and
what buyers receive is the tax
54

51. Incidence of a Specific Tax
Price
S
Pb price •Buyers lose A + B
buyers pay
A •Sellers lose D + C
Tax = B
$1.00 P0 •Government gains A +
C
D D in tax revenue.
PS price
producers •The deadweight
get loss is B + C.
D
Q1 Q0 Quantity
55

52. Incidence of a Specific Tax
• In the previous example, the tax was shared
almost equally by consumers and producers
• If demand is relatively inelastic, however,
burden of tax will fall mostly on buyers
– Cigarettes
• If supply is relatively inelastic, the burden of
tax will fall mostly on sellers
56

53. Impact of Elasticities on Tax Burdens
Burden on Buyer Burden on Seller
Price D Price S
Pb
S
t Pb
P0 P0
PS
t
D
PS
Q1 Q0 Quantity Q1 Q0 Quantity

54. The Impact of a Tax or Subsidy
• We can calculate the percentage of a tax
borne by consumers using pass-through
fraction
– ES/(ES - Ed)
– Tells fraction of tax “passed through” to
consumers through higher prices
– For example, when demand is perfectly inelastic
(Ed = 0), the pass-through fraction is 1 –
consumers bear 100% of tax
58

55. A Tax on Gasoline
• The goal of a large gasoline tax is to:
– Raise government revenue
– Reduce oil consumption and reduce US
dependence on oil imports
• We will consider a gas tax in the market during
mid-1990’s
59

56. A Tax on Gasoline
• Measuring the Impact of a 50 Cent Gasoline
Tax
• QD = 150 - 50P
• QS = 60 + 40P
– QS = QD at $1 and 100 billion gallons per year
(bg/yr)
60

57. A Tax on Gasoline
• With a 50 cent tax:
QD = QS
150 - 50Pb = 60 + 40PS
150 - 50(PS+ 0.50) = 60 + 40PS
PS = .72
Pb = PS + 0.50 = $1.22
QD = QS = 89 bg/yr
Chapter 9 61

58. A Tax on Gasoline
• With a 50 cent tax:
– Q falls by 11%
– Price to consumers increases by 22 cents per
gallon
– Producers receive about 28 cents per gallon less
– Government revenue would be significant at $44.5
billion per year
62

59. The Impact of a 50 Cent Gasoline Tax
D S
Price
($ per
gallon)
Consumer Loss = A + B
B
Producer Loss = C + D
Pb = 1.22
A The buyer pays 22 cents of the
$0.50 P0 = 1.00 tax, and
Tax C the producer pays 28 cents.
D
PS = .72 Government revenue = A + D =
0.50(89) = $44.5 billion.
11
Quantity (billion
50 60 89 100 150 gallons per year)
Chapter 9 63

60. The Effects of Subsidy
• A subsidy can be analyzed in much the same
way as a tax
– Payment reducing the buyer’s price below the
seller’s price
• It can be treated as a negative tax
• The seller’s price exceeds the buyer’s price
• Quantity increases
64

61. Effects of a Subsidy
Price
S
Like a tax, the benefit
PS of a subsidy is split
between buyers and
Subsidy P0 sellers, depending
upon the elasticities of
Pb supply and demand.
D
Q0 Q1 Quantity
Chapter 9 65

62. Effects of a Subsidy
• The benefit of the subsidy accrues mostly to
buyers if ED /ES is small
• The benefit of the subsidy accrues mostly to
sellers if ED /ES is large
66