San José State University
Department of Economics

Thayer Watkins
Silicon Valley
& Tornado Alley

Economic Welfare Analysis

Taxes and
Marginal Cost



Price Ceilings

Competitive Markets

A competitive market is one in which the buyers and sellers have no control over prices; they are price takers rather than price makers. Such markets are described by supply and demand curves and the market equilibrium is established at a price at which the quantity demanded is equal to the quantity supplied.

When the government sets a price ceiling for a competitive market there are several inevitable immediate consequences. The situation is shown in the graph below. Since the price ceiling Pc is below the equilibrium price P the quantity demanded is greater than the quantity supplied. This means there is a shortage. Buyers cannot buy as much as they would like to at the controlled price. This leads to other consequences. A black market may develop for those who do not get the product at the controlled price.

The black market price Pbm would be the price at which the quantity demanded is equal to the quantity Qc which is supplied at the controlled price. This black market price Pbm is not only higher than the controlled price Pc, it is higher than what the market price would be in the absence of the government price ceiling, P.

Some feel they are benefited by the price ceiling; they are the lucky ones who are able to get what they want at the controlled price. The producers are disadvantaged by the price ceiling. The black market price is the price at which people can get the product. Those who are able to buy at the controlled price might be able to resell at the black market price and thus make a profit. Even those who buy at the controlled price are making their decisions based upon the black market price because when they decide to consume they are taking into account the loss of profit they could make by selling on the black market. Soon the black marketeers, strictly interested only in black market profits, will be competing with consumers in trying to get hold of the available supply. How much is the black market profit to be made in the market. It is the product of the amount supplied at the controlled price times the difference between the black market price and the price ceiling imposed by the government. In the graph below it is shown as the area shaded in lines over the pink and blue areas. This ignores any transaction cost involved in reselling in the black market. Government attempts to suppress the black market by imposing such transaction costs.

The loss of profit to the producers is measured by the loss of producers' surplus, as shown in the graph below in blue. The effect of the price ceiling to consumers is composed of two parts. First there is the loss of consumers' surplus because the effective price is raised from the equilibrium price P to the black market price Pbm. This loss of consumers' surplus is shown in pink in the graph below. Second there is the gain of black market profits, (Pbm-Pc)Qc. The graph below shows that the loss in terms of consumers' and producers' surplus is less than the amount of the black market profits. This means that there is a deadweight loss to society from the price controls. This deadweight loss is shown in the graph below in unshaded pink and blue. It could be in some cases, although not in the one shown below, that the net gain to consumers, ignoring the loss to producers, is positive rather than negative.

Price Floors

The most important case of government establishing a price floor is the case of a minimum wage rate in the labor market. Consider first the case of a competitive labor market, as shown in the graph below. Without governmental intervention the wage rate would be established at the equilibrium level of W. At that wage the quantity of labor demanded (jobs) is equal to the quantity of labor supplied (labor force) and there is no unemployment. If the government establishes a wage rate above the equilibrium level then the quantity of labor demanded will be less and the quantity of labor supplied will be more than at the equilibrium and thus there will be unemployment, as is shown in the graph.

For those who have a job at the controlled wage the government intervention seems a good thing. For those who lose their job as a result of the government intervention the controlled wage is a bad thing, but even these people may publicly favor the government intervention because they expect that they will eventually find a job at the controlled wage. The gain for those who are employed is the difference between what they are getting paid and what they would have been willing to work at if need be. In order to quantify the gains and losses from the government intervention it is convenient to consider a kind of black market for jobs.

Suppose job holders could subcontract the performance of their jobs. Suppose the job is driving a truck and the truck driver employee recognized that he could get someone else to actually drive the truck for less than he was getting paid. If a market for driver surrogates developed then the wage established would be at the intersection of the vertical line representing the jobs available at the controlled wage and the supply curve for labor. In the graph below this is shown as Wbm.

The profit the job holders could make by subcontracting their jobs at the black market wage is (Wmin-Wbm)Lmin. This shown as the area shaded by lines in the graph below. The area shown in pink is the loss of profits to the employers of labor. The area shown in blue is the loss to the workers who work in the subcontracted jobs at Wbm instead of the free market equilibrium of wage of W.

Monopolistic Markets

The economic welfare loss due to monopoly is really due to a firm have a protected monopoly that enables it to restrict production in order to raise price without fear of other firms entering the industry. The diagrams below show the welfare loss to the consumers in comparison to the profits gained by the firm from its protected monopoly position. As can be seen from the diagrams the gain to the monopolist is less than the loss to consumers. For more on this topic go to Economic Analysis of Monopoly

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