ECB1101 · Introductory Microeconomics
Government and Market Intervention
When government caps a price, sets a floor or taxes a good, it pushes a market off the efficient equilibrium that maximised total surplus — so almost any intervention destroys some surplus as deadweight loss. A binding price ceiling below P* creates a shortage; a binding price floor above P* creates a surplus (in a labour market, unemployment); a control on the 'right' side of equilibrium does nothing. A per-unit tax of $t leaves price free but drives a wedge so that the price buyers pay (Pb) is $t above the price sellers keep (Ps); it shrinks quantity, hands government revenue (the rectangle t×Q2), and burns a deadweight-loss triangle. The ECB1101 welfare-area decomposition labels six areas A–F: CS = A, PS = F, revenue = B + D, DWL = C + E. Incidence is set by relative elasticity — the less-elastic side bears more — and taxing the inelastic good minimises DWL. This is the most-drawn Section C chapter: label every area.
What this chapter covers
- 01Price ceilings (shortage) & price floors (surplus)
- 02When a control binds — the short side of the market
- 03The per-unit tax wedge: Pb − Ps = t
- 04Tax revenue (rectangle) vs deadweight loss (triangle)
- 05The welfare-area decomposition A–F (worked)
- 06Tax incidence — the less-elastic side bears more
- 07What to tax: the inelastic good minimises DWL
Worked example: a per-unit tax — wedge, revenue and the welfare areas
- +2(a) The wedge: the tax opens a $t gap at the new quantity Q2 — buyers pay Pb (on demand), sellers keep Ps (on supply), with Pb − Ps = t. Quantity falls from Q1 to Q2.
- +2(b) CS = A (it loses B + C from before) and PS = F (it loses D + E).
- +1(b) Government revenue = B + D — the rectangle t × Q2, taken from old CS (B) and old PS (D).
- +1(b) Deadweight loss = C + E, and (c) DWL = ½ × t × (Q1 − Q2) — the lost surplus on the trades that no longer happen.
Key terms
- Price ceiling
- A legal maximum price. It binds only when set below equilibrium, where it creates a shortage (quantity demanded exceeds quantity supplied); trade then happens at the short side, the quantity supplied. A ceiling above P* is non-binding.
- Price floor
- A legal minimum price. It binds only when set above equilibrium, where it creates a surplus (quantity supplied exceeds quantity demanded); in a labour market this surplus is unemployment. A floor below P* is non-binding.
- Tax wedge
- The $t gap a per-unit tax drives between the price buyers pay (Pb, on demand) and the price sellers keep (Ps, on supply) at the new lower quantity Q2: Pb − Ps = t. It does not matter who legally pays — the outcome is identical.
- Tax incidence
- Who actually bears the economic burden of a tax, decided by relative elasticity, not by who writes the cheque. The less-elastic (steeper) side — the one that can least escape — bears the larger share.
- Deadweight loss of a tax
- The triangle of surplus destroyed by a per-unit tax: DWL = ½ × t × (Q1 − Q2), the lost CS + PS on the trades between Q2 and Q1 that no longer happen, captured by no one. Revenue (the rectangle) is merely transferred, not lost.
Government and Market Intervention FAQ
When does a price control actually do anything?
Only when it binds — that is, when it sits on the 'wrong' side of equilibrium. A ceiling binds below P* (creating a shortage); a floor binds above P* (creating a surplus). A ceiling ABOVE equilibrium, or a floor BELOW it, is non-binding: the market just settles at P* as before. Examiners love a non-binding trap option, so always check which side of P* the control sits on before drawing a shortage or surplus.
Does it matter whether the tax is placed on buyers or sellers?
No — the economic outcome is identical whoever legally pays. The tax inserts a $t wedge between the two curves at the new lower quantity, so buyers end up paying Pb and sellers keep Ps regardless of who writes the cheque. The statutory payer tells you nothing about who really bears the tax; that is decided by relative elasticity (incidence).
Why is deadweight loss the triangle, not the revenue rectangle?
Government revenue (areas B + D, the rectangle t × Q2) is surplus merely TRANSFERRED from buyers and sellers to the government — it isn't destroyed, just moved. Deadweight loss (areas C + E, the triangle beyond Q2) is surplus that VANISHES: the value from the Q1 − Q2 trades that no longer happen, gained by no one. Shading the rectangle as the loss is a classic dropped mark; the loss is always the triangle, DWL = ½·t·(Q1 − Q2).
Who actually bears a tax, and what should the government tax?
The less-elastic (steeper) side bears more of the tax, because it can least escape: the price moves a long way against the side that keeps trading anyway. The same property sets the deadweight loss — an inelastic curve means a small quantity fall, so a small DWL. To minimise deadweight loss the government should tax goods with inelastic demand or supply (groceries, not restaurant meals). Name the efficiency-equity tradeoff, though: the efficient tax on a necessity is also the regressive one.
Exam move
This is the heaviest Section C drawing chapter, so practise the diagram until every area is automatic. The exam-move chain for any control or tax: (1) draw D and S, mark P*, Q1, and label every axis and curve; (2) apply the policy — for a control show the binding line and the short side, for a tax open the wedge Pb/Ps at Q2; (3) shade and letter the areas (CS = A, PS = F, revenue = B + D, DWL = C + E); (4) compute revenue = t·Q2 and DWL = ½·t·ΔQ; (5) for incidence or what-to-tax, invoke elasticity — less-elastic side bears more, tax the inelastic good for least DWL. Put arrows on every shift; markers deduct for unlabelled graphs more than for arithmetic slips.
