Once we have established the idea of surplus, we can now begin looking at how governments might intervene in a market, and what effect that would have.
In each case, we want to define winners and losers. In short – if the surplus increases for a group, they are winners. If surplus decreases for a group, they are losers.
When a government intervenes in a market, they change either the way that surplus is distributed, or the total amount of surplus in the market. There are four basic ways that a government can intervene in a market.
- Price Ceiling
- Price Floor
A price ceiling sets the maximum price that a good or service can have in the market. Consequently, it will always be below the equilibrium price (otherwise there would be no need for it.)
The effect of a price ceiling will be trapping the market price below the equilibrium price. Obviously, this means that producers earn less profit, and consumers get more surplus due to paying less for the goods. So in this case, we can say that the consumers are the winners and the producers are the losers.
However, the surplus doesn’t just get redistributed. Due to some producers having reservation prices above the price ceiling, some producers will be forced out of the market. This creates a region in which surplus is lost due to efficient trades not taking place. This region is called deadweight loss.
When there is deadweight loss present, the economy is worse off than it was before the intervention.
A price floor operates in a similar way to a price ceiling, except that it is a minimum price imposed by the government. A price floor will always occur above the equilibrium price.
This time, instead of producers exiting the market, consumers with lower reservation prices will exit the market. Producers are winners, and consumers are losers. Like a price ceiling, there is a deadweight loss due to the efficient trades that are not happening.
The simple way to remember the effect of taxation is that the price gets forced up. Therefore, it operates the same as a price floor, but for one important difference.
When the price increases, the production cost for the producers goes up by the amount of the tax. Therefore, they do not experience the benefit that a price ceiling would.
By examining the price movement, we can see that the consumers will bear a fraction of the burden, while the producers also bear a fraction. The surplus lost by the producers and consumers is recognised by the government as tax revenue.
There is also the deadweight loss present as in the price floor.
Put simply, a subsidy is the opposite of a tax. However, the effects it has are not the same as a price ceiling.
The reason for this is that when a subsidy is offered, more producers will enter the market and supply will increase. This pushes the supply curve to the right. The subsidy effectively means that a producer can sell a product for price A, but enjoy the profits as if it sold the product for price B where B>A.
This decreases the price, but more trades will now be taking place. Therefore, both the consumers will benefit (from the lower price) and the producers will benefit (from the higher profits) and their surplus will increase. However, there is still a deadweight loss.
The deadweight loss this time occurs due to the fact that inefficient trades are happening. This is a burden on the economy.
A better alternative?
In all of these cases, there is a deadweight loss. Also, in each of these cases, there is a point to the government intervention.
- Price Ceiling: To lower the price and make goods more affordable.
- Price Floor: To benefit consumers and give inventive to enter a certain market.
- Taxation: To raise government revenue, and increase the price of a good to discourage market participants (for example, alcohol and tobacco taxes).
- Subsidy: To lower the prices for consumers and encourage producers to enter the market.
So, there must be a better alternative. In economics, at least, there is. To achieve the effects of the surplus changes, the party that ‘wins’ could do a ‘lump sum transfer’ to the party that ‘loses’ in the amount that the surplus changed the balance.
Economists even argue that as long as the lump sum transfer is less than the deadweight loss, it will occur because a burden on the economy is a burden on everyone.
There are, however the major flaw in this assumption is that markets are always perfectly competitive. The reality is that they are not. The costs for getting into the mining business are extreme, so businesses are not free to enter or exit the market whenever they please.
Human also don’t make decision based on purely economic reasons. An energy company may opt into a less profitable renewable sector because they are conscious about the environment, or a food producer may produce food in a more expensive way due the culture or religious values that they hold.
So, a lump sum transfer may never work. The competitive market is as much of a fiction as finance’s idea of an efficient market.