Topic 2.8 The Effects of Government Intervention in Markets: analyze binding price ceilings and floors, per-unit taxes and subsidies, and quantity controls, showing the resulting shortages, surpluses, tax incidence, and deadweight loss.

What this topic is asking

Topic 2.8 examines what happens when the government interferes with a competitive market. The College Board wants you to analyze price ceilings and price floors, per-unit (excise) taxes and subsidies, and quantity controls (quotas), showing the resulting shortages and surpluses, who bears a tax (incidence), and the deadweight loss that intervention creates by moving output away from the efficient quantity.

Price controls: ceilings and floors

A ceiling set above equilibrium, or a floor set below it, is non-binding and has no effect, because the market clears at the free equilibrium anyway. Classic examples: rent control (a binding ceiling) creates a housing shortage; a minimum wage (a binding floor) can create a surplus of labor (unemployment). Both block the price mechanism's self-correction from Topic 2.7, so the shortage or surplus persists, and both reduce total surplus, creating a deadweight loss because mutually beneficial trades go unmade.

Per-unit taxes and tax incidence

A per-unit (excise) tax on producers raises their cost of supplying each unit, shifting the supply curve up (left) by the amount of the tax.

The split of the tax between buyers and sellers is tax incidence, and it depends on elasticity:

Subsidies and quantity controls

A per-unit subsidy is the mirror image of a tax: it lowers producers' effective cost, shifting supply down (right) by the subsidy. The price buyers pay falls, the price sellers receive (including the subsidy) rises, and quantity rises above the efficient level. Because output now exceeds the point where marginal benefit equals marginal cost, a subsidy also creates a deadweight loss in an otherwise efficient market (though it can be justified where a positive externality exists, a Unit 6 idea).

A quota (quantity control) caps the amount that can be sold. A quota set below the equilibrium quantity raises the price buyers pay, lowers the price sellers receive at that restricted quantity (creating a wedge), and reduces total surplus, again a deadweight loss.

Try this

Q1. A price floor is set below the equilibrium price. State its effect on the market. [1 point]

• Cue. None: the floor is non-binding because the market clears at the higher equilibrium price anyway.

Q2. A per-unit tax is placed on a good whose supply is perfectly inelastic. State who bears the entire tax. [1 point]

• Cue. Sellers bear the whole tax, because perfectly inelastic supply cannot change quantity, so producers absorb all of it.