Effects of government price controls and taxes on economic Efficiency

Introduction

Consumers and producers sometimes lobby the government to  set a market price different from the equilibrium. This lobbying is facilitated by consumer watch groups and manufacturer associations in the country. Though society benefits more in a competitive market environment, customers love to pay a price lower than the equilibrium, and producers would love to sell their products at a price higher than the equilibrium price.  For instance, during the Great Depression in the 1930’s government of the United States introduced price floors in response to farmers’ plea to sell their products only at low prices. That move by farmers’ is one of the many reasons why authorities intervene through price control and market regulation mechanisms. Price floors entice producers to produce more output than the market demands. The surplus created by the price floor is stored by the government to help in national planning.

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The most notable intervention of government is through tax collection from both consumers and producers. Most governments in the world have introduced what is often refered to as sin tax. This is tax levied cigarettes and alcoholic beverages so as to control public consuption of harmful substances on one hand while they over-tax it on the other hand to meet revenue targets.

Consumer surplus, producer surplus and economic surplus

For us to appreciate the effect of government price controls and taxes on economic efficiency, it is important to understand consumer surplus, producer surplus and economic surplus.Consumer surplus refers to the difference between the maximum  price a consumer is ready and able to pay and the one he actually pays. It is a measure of the dollar benefit consumers get from buying goods and services from a certain market. Producer surplus refers to the difference between the lowest price a firm is willing to accept and the one it actually accepts. A firm will produce an extra unit only and only if  they get a price equal to the extra cost of producing that unit. Economic surplus is best described as the sum of consumer surplus and producer surplus. This offers the best way of measuring how society benefits from best practises of production of a product. A dead weight loss is the reduction in economic surplus when a market is out of competitive equilibrium.

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Economic efficiency: when the marginal benefit to consumers of the last unit produced is same as  its marginal cost of production in a market, and where the sum of consumer and producer surplus is at a maximum, then economic efficiency is said to have been achieved.

Government policy: Price ceilings and Price floors

Governments influence market outcome by imposing price ceiling or floors. A price ceiling implies the maximum price that businesses may be charged for a product as a result of external influences. As such a price ceiling limits the price that a good reaches its market equilibrium price.  When the ceiling price is below the equilibrium its effect self- evident in the form of :

1. Low quantity supplied

2. High demand in the market

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This will create a shortage since the quantity demanded is less than the quantity supplied. Such a product should be rationed by price otherwise it will end up in the black market. A black market refers to buying and selling of goods and services at prices that violate government price regulations. Examples can found in gas prices and caps on consultancy fees.

In over 200 cities in the United States, government has placed ceilings on the maximum rent the landlords can charge for their apartments. Price ceilings are found mostly in markets of apartments of various cities. It is estimated that in New York City, over one million apartments are subject to rental control. The impact of a price ceiling on rent is that the quantity asked at the ceiling price, for istance $800 per month, is greater than the quantity supplied. Contrary when an equilibrium price of about $1600 were allowed, the quantity supplied would be higher than the quantity supplied.

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