Question

1. Many governments control the price of tobacco by creating a price floor. If a government decides to create a price floor for a product, the economy will have a deadweight loss. Draw a supply and demand curve and show how the price floor will create deadweight loss. In your diagram show the areas for Consumer Surplus, Producer Surplus, and Deadweight Loss.

2. Government regulations in some countries do not allow Milk price to be more than a certain price. Should we expect product shortage or product surplus in the market? Why? Draw the supply and demand graph and show this on the graph

Answer 1

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The initial equilibrium is given by the intersection of demand curve and supply curve, i.e initial equilibrium price of tobacco is P* and initial equilibrium quantity of tobacco is Q*. Now before the price floor, consumer surplus is the area below the demand curve and above the equilibrium price I.e area of triangle ABC. Producer surplus is the area above the supply curve and below the equilibrium price I.e area of triangle BCO. Now price floor is the legal minimum price that consumers are bound to pay. In case of a binding price floor, price is set above the equilibrium price level. Here the binding price floor is set at price level P1 with respect to which the quantity demanded is Q1 and the quantity supplied of tobacco is Q2. Here as quantity supplied exceeds the quantity demanded, hence the binding price floor results in excess supply or surplus of tobacco given by ( Q2- Q1). Now after the imposition of price floor, consumer surplus falls from the area of the triangle ABC to the area of the triangle ADE and producer surplus increases from the area of the triangle BCO to the area of the rectangle DEFG+ area of the triangle GFO. Also as the price floor results in inefficiency as it leads to excess supply, hence the inefficiency is given by the area of the triangle ECF which is known as the deadweight loss.

Supply > Shortage Price ceiling \ Demaid Qz . Qo Qi Scanned with CamScanner

As Government regulations in some countries do not allow Milk price to be more than a certain price, this legal maximum price that producers can charge is known as the price ceiling. In order for the price ceiling to be effective, the price is set below the equilibrium price P0, this price ceiling is known as the binding price ceiling. At binding price ceiling P1, quantity demanded of milk is Q1 and quantity supplied of milk is Q2. Now at price P1 , as quantity demanded of milk is greater than the quantity supplied of milk, hence this price ceiling results in excess demand for milk or shortage of milk given by ( Q1-Q2).