CU Ecoh Demand and Supply Part B

SM/ECOH/MICRO/DEMAND & SUPPLY/PART-B/OCTOBER 2007 E-mail: smith2mankiw@gmail.
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E l a s t i c i t i e s o f D e m a n d a n d S u p p l y, C o n s u m e r ’s a n d P r o d u c e r ’s S u r p l u s ,
Burden of indirect taxes and subsidies, Price and Quantity controls,
M i n i m u m w a g e , I m p o r t t a r i ff a n d Q u o t a . C U , D S E , J N U Q / A i n c l u d e d .
The elasticity of demand is a measure of the responsiveness of quantity demanded of a

commodity to changes in either of the following: price of the commodity, the prices of related
commodities, consumer’s income etc. Depending on the factor which causes the quantity demanded to
change, we have three different elasticities of demand: own price elasticity, cross price elasticity and
income elasticity.
Price elasticity of demand is defined as the responsiveness of quantity demanded to changes in

commodity’s own price. It is expressed as the proportionate change in quantity demanded of a
commodity divided by the proportionate change in price. Thus,
Price Elasticity of Demand = proportionate change in quantity demanded
proportionate change in price
In terms of symbols, we can write:
ep = (∆Q/Q)/( ∆P /P)= (∆Q/∆P) . (P /Q)

where eP stands for price elasticity of demand, q stands for quantity of demand, P stands for price of
the commodity ∆Q and ∆P stand for small change in quantity demanded and price of the commodity
respectively.
Different Values of eP
The price elasticity of demand as measured by eP is a pure number, independent of the units or
scale of measurement of price and quantity. Its value is normally negative because of the inverse
relationship between quantity demanded and price implied by the ‘law of demand’. In exceptional
cases (for Giffen goods), price elasticity of demand could be positive.
The range of values of price elasticity of demand are:
- ∞ ≤ ep ≤ + ∞
CASE I : If eP = - ∞, the demand is INFINITELY ELASTIC:
It refers to a situation where the slightest rise in price causes the quantity demanded to fall to
zero and an infinite increase in the quantity demanded is possible at the prevailing price. The demand
SM/ECOH/MICRO/DEMAND & SUPPLY/PART-B/OCTOBER 2007 E-mail: smith2mankiw@gmail.com 2
in such a case is HYPER SENSITIVE and e P = -∞ (infinity). The demand curve is horizontal in
this case (Fig.1).
CASE II: If --∞ < eP < --1, the demand is ELASTIC / RELATIVELY ELASTIC:
It refers to that situation where a small proportionate reduction in price results in a larger
proportionate expansion in demand. Here a very small reduction in the price leads to a very large
increase in demand. Similarly, a small percentage rise in price results in a larger contraction in
demand. Here price elasticity is greater than one in absolute value. The demand curve is flatter in this
case (Fig.2).
CASE III: If –1<eP <0, the demand is INELASTIC / RELATIVELY INELASTIC:
In this case, a big reduction in the price causes only a very small expansion in the demand for
the commodity. The quantity demanded is relatively insensitive to change in price. Here price
elasticity is less than one in absolute value. The demand curve is steeper in this case (Fig.3)
CASE IV: If eP=0,the demand is PERFECTLY INELASTIC.
It refers to that situation where even substantial changes in price leave demand unaffected. In
other words, changes in price exert no influence on demand. It means that demand in such a case is
INSENSITIVE to change in price. The demand curve is vertical in this case.(Fig: 4)
CASE V: If ep = - 1, the demand is UNITARY ELASTIC.
In this case, the change in the quantity demanded is exactly proportional to the change in
price. For instance, a 10 per cent fall in price will bring about a 10 percent expansion in demand and
vice versa. The demand curve in this case neither flatter or steeper. (Fig: 5)
CASE VI: SPECIAL CASE: eP > 0, if the commodity is GIFFEN GOOD.
The Giffen Good is that commodity for which price and quantity demanded is directly related
i.e. an increase in price leads to an increase in quantity demanded and vice versa. Thus, the demand
curve for Giffen Good is positively sloped (or upwardly rising). In this case, the elasticity of demand is
positive i.e. eP> 0 (Fig.6 )
The price elasticity of demand measures the responsiveness of quantity demanded of a

commodity to a change in its price. When the change in price is large, we use the concept of arc
elasticity of demand. On the other hand, when the change in price is very small(infinitesimally
small),point elasticity of demand is used.
Arc elasticity is a measure of the average elasticity, that is, the elasticity at the mid-point of the
chord that connects two points or two price-quantity combinations on the demand curve. It is an
approximation of true elasticity of demand. Arc elasticity of demand has been measured in Fig:7.
In Fig:8 initial price-quantity combination is (P 1,Q1) shown by the point A and new price-
quantity combination is (P2,Q2) shown by point B. We connect two points A and B by a straight line
and measure arc elasticity by the following formula:
eP = ∆Q /(Q1 + Q2)/2 = ∆Q . (P1 + P2)

∆P /(P1 + P2)/2 ∆P (Q1 + Q2)
where ∆Q and ∆P stand for change in quantity demanded and price of the commodity respectively
and (P1 + P2)/2 and (Q1 + Q2)/2 stand for averages of initial and new prices and quantities respectively.
{(p1 + P2)/2 ,(Q1 + Q2)/2} combination basically denotes the coordinate of the mid-point of chord AB.
Thus arc elasticity is measured with reference to the average price and quantity.
The elasticity of demand measured at any point on the demand curve is known as point
Elasticity of demand. The point elasticity of demand is defined as the proportionate change in the
quantity demanded resulting from a very small proportionate change in price. Symbolically we may
write:
ep = dQ/Q /dP/P = dQ/dP . P/Q
Graphically the point elasticity of a linear demand curve is measured by the ratio of the segments of
the line to the right and to the left of the particular point. In Fig.8, the elasticity of the linear-demand
curve at point Z is the ratio ZD’/ZD.
In Fig: 8, DD′ is the demand curve which is a straight line and Z is the point where price
elasticity is to be measured. When price is OP1, quantity demanded is OQ1. Thus
P = OP1 and Q = OQ1.
Now the slope of the demand curve = dP/dQ = OD/OD′ = ZQ1/Q1D′.
Therefore, the reciprocal of the slope of demand curve = dQ/dP = Q1D′/ZQ1.
Substituting these values in the expression of elasticity, we can write:
eP = dQ/dP . P/Q = Q1D′/ZQ1 . OP1/ OQ1
Since, OP1 = ZQ1
eP = Q1D′/ZQ1 . ZQ1/ OQ1 = Q1D′/OQ1
Now, consider the triangles ΔZQ1D′ and ΔDP1Z.They are similar triangles because corresponding
angles of two triangles are equal.
Hence,
DZ / P1Z = ZD′ / Q1D′
Therefore,
Q1D′/ P1Z = ZD′/ DZ
Income elasticity of demand is defined as the responsiveness of quantity demanded to changes

in individual′s money income. It is expressed as the proportionate change in quantity demanded of a
commodity divided by the proportionate change in money income. Thus,
Income Elasticity of Demand = proportionate change in quantity demanded
proportionate change in money income
eM = ΔQ/Q / ΔM /M = ΔQ/ΔM . M /Q
where eM stands for income elasticity of demand, Q stands for quantity of demand, M stands for
money income of the individual, ΔQ and ΔM stand for small change in quantity demanded and
money income respectively. When the change in M is very small (almost equal to zero), we write the
above expression as:
eM = dQ/dM . M /Q
Income Elasticity and Nature of the commodity:
Like price elasticity of demand, income elasticity of demand measured by eM is a pure number,
independent of the units or scale of measurement of income and quantity. For normal or superior
commodities, its value is positive, but for inferior goods, income elasticity of demand is negative.
Different values of eM and the nature of the commodity are explained in terms of the following table:
Table: Income elasticity of Demand and Nature of the commodity
Nature of the commodity
Value of eM
SUPERIOR NECESSITY
eM > 0 0 < eM <1
SUPERIOR LUXURY
eM > 1
INFERIOR
eM < 0
It is obvious from the table, if income elasticity is positive, it may be less than one or greater
than one. If for some commodity, income elasticity is positive but less than one, the commodity is
called SUPERIOR NECESSITY. Again if some commodity income elasticity is positive and greater
than one, the commodity is called SUPERIOR LUXURY. On both the occasion, the commodity is
treated as NORMAL commodity. But if for some commodity, income elasticity is negative, the
commodity is called an INFERIOR commodity. A Giffen commodity, a commodity for which law of
demand is not effective, is necessarily an INFERIOR one, signifying the fact that for GIFFEN good eM
< 0.
Cross price elasticity of demand is defined as the responsiveness of quantity demanded of a

commodity (say, X) to changes in the price of its related commodity(say, Y). It is expressed as the
proportionate change in quantity demanded of a commodity(X) divided by the proportionate change in
price of its related commodity(Y). Thus,
Cross Price Elasticity of Demand = proportionate change in quantity demanded of X
proportionate change in price of Y
exy = ∆x/x / ∆py /py = ∆x/∆py . py /x

where exy stands for cross price elasticity of demand, x stands for quantity of demand of X, py stands
for price of the commodity Y, ∆x and ∆ py stand for small change in quantity demanded of X and
price of the commodity Y respectively. When the change in M is very small(almost equal to zero), we
write the above expression as:
exy = dx/dpy . py /x
Cross Price Elasticity and Relation between the commodities:
Cross price elasticity of demand measured by exy is also a pure number, independent of the units or
scale of measurement of income and quantity. The value of exy could be positive or negative. Different
values of exy and the relation between two commodities are explained in terms of the following table:
Table: Cross Price Elasticity of Demand and Relation between
the commodities.
Value of exy Relation between two commodities
SUBSTITUTES
exy > 0
COMPLEMENTS
exy < 0
From the table we can conclude that if cross price elasticity is positive, two commodities in question
are substitute to each other. Examples of such commodities are tea and coffee. If, however, cross price
elasticity is negative, two commodities are complements to each other. Examples of complements are
coffee and sugar, bread and butter etc. In exceptional cases when the commodities are not related in
any way, exy could be equal to zero.
In a market economy, if the price a consumer is willing to pay is higher than the price which he
actually pays, then the consumer is said to have a surplus. This surplus is known as ‘consumer surplus.
′
Marshall defined consumer surplus as ‘the excess of the price which the consumer would be
willing to pay rather than go without the thing over what the consumer does actually pay.’ Thus,
Consumer’s Surplus = Price consumer is willing to pay – Price consumer actually pays
= Consumer’s reservation price – Market Price
Consumer’s surplus is shown in Fig: 9. DD′ is the demand curve. Suppose the individual buys Q1 units
at price P1 per unit. Now,
The amount consumer is willing to pay for Q1 units = Area ODAQ1 under the demand curve.
The amount consumer actually pays for Q1 units = P1.Q1 = Area OP1AQ1 under the demand curve.
Therefore, Consumer’s Surplus = Area P1DA
Mathematical Note:
Suppose the (inverse) demand function is given as:
Pd = Pd(Q) , Pd ′ < 0
Let quantity demanded be Q1 at P = P1. Then consumer’s surplus is derived as:
CS = ∫0 Pd(Q) dQ – P1Q1
Example: Let the demand function be Q = 1 / (16 P)2. If the quantity demanded is 25 when price is
0.05, estimate consumer surplus.
From the demand function given, we find inverse demand function as: P = 1 / (4√Q). When
p1= 0.05, Q1= 25. Thus the consumer surplus is
CS = ∫0 1 / (4√Q) dQ – 0.05 . 25
= [(1/4).(Q1/2 ) / (½)]0 -- 1.25
= ½ √25 – 1.25
= 5/2 -- 1.25
= 1.25
The producer’s surplus is the amount that the producer receives over and above what he is
willing to sell for rather than forego a sell. It is defined as the excess of the commodity price over
marginal cost, and it is measured by the area between the commodity price and the marginal cost
curve. This is shown as in Fig: . SS′ is the supply curve. Suppose the producer sells Q 1 units at price
P1 per unit. Now,
The minimum amount at which producer is willing to sell Q 1 units = Area OSAQ1 under the SS′ curve.
The amount producer actually gets by selling Q1 units = P1.Q1 = Area OP1AQ1 under the SS′ curve.
Therefore, Producer’s Surplus = Area P1AS
Mathematical Note:
Suppose the supply function is given as:
Ps = Ps(Q) , Ps ′ > 0
Let quantity supplied be Q1 at P = P1. Then producer’s surplus is derived as:
PS = P1Q1 -- ∫0 Ps(Q) dQ
Example: Let the supply function be P = 10 + ½ Q. If the quantity supplied is 30 when price is 25,
estimate producer’s surplus.
When P1= 25, Q1= 30. Thus the producer surplus is
PS = 25 x 30 -- ∫0 [10 + ½ Q] dQ
= 750 -- [10Q + ½ Q2] 0
= 750 – [300 + 900/4]
= 750 – [300 + 225]
= 750 – 525
= 225
Although government intervention in a market model is not desirable, but sometimes it becomes
necessary for the government to intervene.
Different forms of government intervention are:
(i) imposition of taxes and subsidies;
(ii) price controls – price ceiling (price control of essential commodities) and
price floor (minimum wage legislation);
(iii) quantity controls (production quota),
(iv) import tariff and quota.
In the presence of taxes and subsidies,

the price buyers pay (Pd) ≠ the price suppliers(Ps) keep.
Quantity demanded depends on Pd whereas the quantity supplied depends on Ps. Thus, when a tax
is present, PD – Ps = t where t is the per unit tax.
PD = Ps + t (1) Of the
different kinds of taxes that are imposed, two examples are quantity tax and ad valorem tax. To
illustrate quantity tax and value tax symbolically, let PD be the price paid by demanders and PS, be the
price received by suppliers. If ‘t’ is the amount of quantity tax per unit sold, then
PD = PS + t (1)
On the other hand, a value tax is expressed in percentage terms. If the tax rate is given by  then
PD = (1+) PS (2)
The quantity tax is per unit tax. Equation (1) represents per unit tax. Advalorem tax or value tax is
shown by Equation (2).
If the tax rate is given by  then PD = (1+) PS (2)
When taxes are levied on sellers:
Before tax equilibrium D( PD ) = S( PS)
Since PS = P D – t (3)
After tax equilibrium:
D( PD ) = S(PD - t) (4)
 a parallel upward or leftward shift of the supply function which is now effectively a
function of Pd.
 demand function remaining unaffected, equilibrium market price (the price paid by
the buyer) increases to P2. The price received by the seller is P3.
 The difference between P2 and P3 is the tax per unit, which is paid to the
government by the seller.
When taxes are levied on buyers:
If demanders pay the tax, then PD = PS + t (6)
After tax equilibrium: D( PS + t ) = S(PS)
(7)
 a parallel downward or leftward shift of the demand function, which is now
effectively a function of Ps.
 supply function remaining unaffected, equilibrium market price (seller’s price)
decreases to P5 . The effective price paid by the buyer is P4.
 The difference between P4 and P5 is the tax per unit, which is paid to the
government by the buyer.
A Related Proposition:
As far as the equilibrium price is concerned, it does not matter who pays the tax-- what
matters is that the tax must be paid by someone.
After the tax is imposed, how much of the tax is borne by consumers and how much by
producers; that is, how do buyers and sellers share tax burden ?
Let the market demand function be
D = D(PD) (9)
and the market supply function
S = S(PS) (10)
At equilibrium D(PD) = S(PS) (11)
Before tax is imposed PD = PS = P (12)
After tax is imposed PD -- PS = t (13)
If suppliers pay the tax: P S = PD – t (14)
Letting PD = P we can write:
D( P ) = S(P - t)
Or, D( P ) -- S(P - t)= 0 (15)
Total differentiation: D′ ( P ) dP – S΄(P - t)dP + S′ (P – t)dt= 0
We can write in concise form
S′dt + [ D′ – S′ ]dP = 0
 (dS/dP )dt + [ dD/dP – dS/dP ]dP = 0

 (dS/dP )dt = [ dS/dP – dD/dP ]dP
 dP/dt = (dS/dP )/ [ dS/dP – dD/dP ]
Since at equilibrium D = S, multiplying both the numerator and denominator by p/S, we obtain:
dP/dt = e S / (eS – eD)
(16)
(i) If eD = 0 i.e. demand is perfectly inelastic, dP/dt = 1, thus the tax burden is entirely borne by the
buyers; (Fig: )
(ii) If eD =  i.e. demand is infinitely elastic, dP/dt = 0, thus the suppliers bear the full tax. (Fig: )
(iii) If eS = 0 i.e. supply is perfectly inelastic, dP/dt = 0, thus the tax burden is entirely borne by the
sellers; (Fig: )
(iv) If eS =  i.e. supply is infinitely elastic, dP/dt = 1, thus the tax burden is entirely borne by the
buyers; (Fig: )
In the intermediate cases the tax burden is shared by both demanders and suppliers.
More generally we may conclude:
(A) Given the supply curve, the greater (lesser) the elasticity of demand, the lesser
(greater) the burden of tax shifted on to the buyers and the greater (lesser) the burden of
tax borne by the sellers.
(B) Given the demand curve, the greater (lesser) the elasticity of supply, the greater
(lesser) the burden of tax sifted on to the buyers and the lesser (greater) the burden of tax
borne by the sellers.
Taxing a good by the government typically increases the price paid by the demanders(P D) and
decrease the price received by the suppliers(PS). This certainly represents a cost to the demanders and
suppliers, but from the economist's viewpoint, the real cost of the tax is that the output has been
reduced.
The lost output is the social cost of the tax. The social cost of a tax can be discussed using the
concepts of consumer and producer surplus. We start with the diagram given in Figure: which
depicts the equilibrium demand price and supply price after a tax, t , has been imposed. Output has
been decreased by this tax, from Q1 to Q2 . Now,
Consumer Surplus before tax = CS1 = A + B + E
Consumer Surplus after tax = CS2 = E
∆ CS = CS2 – CS1 = E – A – B – E = -- (A + B)
Similarly, Producer Surplus before tax = PS1 = C + D + F
Producer Surplus after tax = PS2 = F
∆ PS = PS2 – PS1 = F – C – D – F = -- (C + D)
Apart from consumers and producers, there is also a third party who stands to gain
from a tax. This is the government who imposes the tax. We may call this government surplus
(GS).
∆ GS = tax revenue = (A + C).
Therefore, change in society’s surplus is
∆ SS = ∆ CS + ∆ PS + ∆ GS = -- A – B – C – D + A + C = --(B + D)
Since, ∆ SS < 0, we call it the ‘deadweight loss’ or ‘social cost’ or the ‘excess burden’ of the tax.
Source of Deadweight Loss:

Basically it is the lost value to the consumers and producers due to the reduction in
the sales of the good. Surely, the government can't tax what isn't there. So the government
doesn't get any revenue on the reduction in sales of the good. From the viewpoint of
society, it is a pure loss -- a deadweight loss.
We could also derive the deadweight loss directly from its definition, by just
measuring the social value of the lost output. Suppose that we start at the old equilibrium
and start moving to the left. 'I'he first unit lost was one the price that someone was willing
to pay for it was just equal to the price that someone was willing to sell it for. Here there is
hardly any social loss since this unit was the marginal unit that was sold.
Now we move a little farther to the left. The demand price measures how much
someone was willing to pay to receive the good, and the supply price measures the price at
which someone was willing to supply the good. The difference is the lost value on that unit
of the good. If we add this up over the units of the good that are not produced and
consumed because of the presence of the tax, we get the deadweight loss.(F/V/16/7).
Subsidies:
A subsidy is financial grant to the producers or the consumers of

subsidized commodities, as the case may be. Accordingly, a subsidy may be in
the form of (a) production subsidy, and/or (b) user subsidy. For example, central
and state governments in India provide fertilizer and electricity subsidy to the
farmers (production subsidy); food subsidy to the consumers, and education
subsidy to the students (user subsidy). The question that we are concerned here
are: (i) how does a subsidy affect the equilibrium price and output of the
subsidized commodity? and (ii) who benefits from the subsidy?
In the presence of subsidies, as in case of taxes, the price buyers pay and the price
suppliers get are different, and the quantity demanded depends on the former price whereas the
quantity supplied depends on the latter price. Thus, when a subsidy is present in a market, the demand
price and the supply price differ by the amount of the subsidy. Of the different kinds of subsidies that
can be imposed, two examples are quantity subsidy and ad valorem subsidy (also called value
subsidy).
To illustrate quantity subsidy and value subsidy symbolically, let p D be the

price paid by demanders and pS, be the price received by suppliers. If ‘s’ is the
amount of quantity subsidy per unit sold, then
pD = p S - s (1)
On the other hand, a value subsidy is expressed in percentage terms. If the subsidy rate is given by
 then
pD = (1-) pS (2)
We wish to examine here the impact of a quantity subsidy.
When subsidies are paid to sellers (Production Subsidy):
Suppose that the suppliers are paid the subsidy. Then the amount that the
suppliers get will be the amount the demanders pay plus the amount of the
subsidy. Also the amount supplied will depend on the supply price and the
amount demanded will depend on the demand price. We thus have following
equations:
D( pD ) = S( pS)
pS = p D + s (3)
Substituting the second equation into the first we get
D( pD ) = S(pD + s) (4)
This amounts to a parallel downward or rightward shift of the supply function, demand function
remaining unaffected. Equilibrium market price will decrease, as we shall see later.
When subsidies are paid to buyers (User Subsidy):

If instead of suppliers being paid the subsidy, the demanders are paid the
subsidy, then we have
pD = p S - s (6)
This equation implies that the amount that buyers pay to the sellers is more than the amount they are
willing to pay, the difference being the amount that they get as subsidy from the government.
Substituting this into the demand-equals-supply condition we get
D( pS - s ) = S(pS) (7)
In this case there is a parallel upward or rightward shift of the demand function, supply function
remaining unaffected. Equilibrium market price will increase, as we shall see later.
A per unit subsidy
A per unit subsidy is a subsidy of a fixed amount s on each unit of

commodity. The effect of a per unit subsidy of s is illustrated in Figure: . The,
per-unit subsidy implies that:
the price buyers pay = the price sellers keep - the subsidy s.
(8)
In Figure: DD is the demand curve and SS the supply curve. Without the
subsidy the equilibrium price is P 0. This is the price buyers pay and the price
sellers keep. With the per unit subsidy, there is a wedge of height s between the
price buyers pay and the price sellers keep. Buyers move down the demand
curve, and sellers move up the supply curve until the vertical distance between
the two is equal to s. This is shown by the points B and C in Figure: . P 1 is the
price buyers pay, and P2 is the price sellers keep. The difference P 2 – P1 = s is the
subsidy the government pays. At the price P 1 the quantity demanded is Q 1, and
at the price P2, the quantity supplied is again Q 1, and, thus, there is equilibrium.
Since there is equilibrium, there are no forces producing any change. But from
the buyers' point of view the price has fallen from P 0 to P1, but from the sellers'
point of view the price has risen from P0 to P2. (F/M/2/9)
There are alternative ways of showing the new equilibrium. In Figure: we

labelled the vertical axis as "price" and said P1, is the price paid by buyers and P2,
the price kept by sellers. Instead, we can label the vertical axis as "consumers'
price." This is shown in Figure: . In this case, since the vertical axis measures
the price buyers pay, the demand curve stays the same but the supply curve
shifts down by a vertical distance equal to s, the per-unit subsidy. The
equilibrium market price (price paid by consumers) is P 1, and the quantity
demanded and supplied is Q1. (F/M/2/10)
When subsidies are paid to buyers (User Subsidy):
Alternatively, we can label the vertical axis as "sellers' price." In this case,
since this is the price suppliers keep, the supply curve stays the same but the
demand curve shifts up by a vertical distance equal to s. This is shown in Figure:
. The equilibrium market price (sellers' price) is P 2, and the quantity demanded
and supplied is Q1. (F/M/2/11)
A percentage subsidy:
We can now analyze a sales subsidy, which is a percentage subsidy.

Suppose the subsidy rate is  percent.
When the sellers are paid a per centage subsidy, supply curve shifts, but
the shift in the supply curve will not be a parallel shift (we may better call it as
rotation) as in the case of the per unit subsidy. At lower prices, the distance
between SS and S1S1, which measures the per unit amount of the subsidy, is
smaller than at higher prices. In fact, if  10 percent, the slope of S1S1 will be
0.9 times the slope of SS. This is shown in Figure: . (F/M/2/12).
When subsidies are levied on buyers (User Subsidy):
If subsidies are paid to buyers, there will be a shift in the demand curve,
but once again this shift will not be a parallel shift as in the earlier case. Again at
lower prices, the distance between DD and D 1D1, which measures the per-unit
amount of the subsidy, is smaller than at higher prices. With linear demand
curves and a 10 percent subsidy, the slope of D 1D1, will be 1.10 times the slope of
DD. This is also shown in Figure: . (F/M/2/12)
Incidence of a Subsidy:
Now we shall discuss after the subsidy is imposed, how much of the
subsidy is enjoyed by consumers and how much by producers. That is, how do
buyers and sellers share subsidy amount paid by the government? What
determines the shares of subsidy amount on buyer and sellers?
As we are aware that a subsidy creates a ‘wedge’ between the price paid
by demanders and the price received by suppliers. Let ‘s’ be the per unit subsidy,
pD be the price paid by demanders, and pS be the price received by suppliers.
Let the market demand function be
D = D(pD) (9)
and the market supply function
S = S(pS)
(10)
At equilibrium D(pD) = S(pS) (11)
Before subsidy is paid
pD = p S = p (12)
After subsidy is paid
pS – p D = s (13)
Suppose that the suppliers are required to pay the subsidy. Then the amount
that the suppliers get will be the amount the demanders pay minus the amount
of the subsidy:
pS = p D + s
(14)
Substituting the Eq. (14) into the Eq. (11) and letting pD = p we can write:
D( p ) = S(p + s)
Or, D( p ) -- S(p + s)= 0
(15)
Total differentiation of Eq. (15) yields
D’( p ) dp – S’(p + s)dp - S’(p + s)ds= 0
We can write in concise form
– S’ds + [D’ – S’]dp = 0
– (dS/dp )ds + [ dD/dp – dS/dp ]dp = 0

 – (dS/dp )ds = [ dS/dp – dD/dp ]dp
 dp/ ds=(dS/dp )/ [dD/dp – dS/dp ]
Since at equilibrium D = S, multiplying both the numerator and denominator by p/S, we obtain:
dp/ ds=e S/ (eD – eS) (16)
Equation implies that change in price due to an imposition of per unit subsidy on price depends on the
relative elasticities of demand and supply curves. The extent to which the sellers will extend the
benefits of subsidy to the buyers by lowering prices may be analysed using Equation (16).
(i) If eD = 0 i.e. demand is perfectly inelastic, dp/ ds=– 1, thus the benefits of subsidy is entirely
enjoyed by the buyers; (Fig: )
(ii) If eD =  i.e. demand is infinitely elastic, dp/ ds=0, thus the suppliers enjoy the full subsidy.
(Fig: )
(iii) If eS = 0 i.e. supply is perfectly inelastic, dp/ ds=0, thus the subsidy is entirely enjoyed by
the sellers; (Fig: )
(iv) If eS =  i.e. supply is infinitely elastic, dp/ ds=– 1, thus the benefits of subsidy is entirely
passed on to the buyers; (Fig: )
In the intermediate cases the subsidy amount is shared by both demanders and suppliers.
More generally we may conclude:

(A) Given the supply curve, the greater (lesser) the elasticity of demand, the
lesser (greater) the benefits of subsidy passed on to the buyers and the greater
(lesser) the benefits of subsidy enjoyed by the sellers. (Fig: )
(B) Given the demand curve, the greater (lesser) the elasticity of supply, the
greater (lesser) the benefits of subsidy passed on to the buyers and the lesser
(greater) the benefits of subsidy enjoyed by the sellers. (Fig: )
Import tariffs:
An import tariff is a tax levied when a good is imported. Specific tarrifs

are levied as a fixed charge for each unit of goods imported (for example, Rs.200
per barrel of oil). Ad valorem tariffs are taxes that are levied as a fraction of the
value of the imported goods, (for example, a 25 percent tariff on imported
trucks). In either case the effect of the tariff is to raise the cost of shipping goods
to a country.
Tariffs are the oldest form of trade policy and have traditionally been used
as a source of government income. Until the introduction of the income tax, for
instance, the U.S. government raised most of its revenue from tariffs. Their true
purpose, however, has usually been not only to provide revenue but to protect
particular domestic sectors. In the early century the United Kingdom used tariffs
(the famous Corn Laws) to protect its agriculture from import competition. In the
late nineteenth century both Germany and the United States protected their new
industrial sectors by imposing tariffs on imports of manufactured goods.
We shall now look at specific import tariff (or per unit import tariff).
Consider a commodity that is both domestically produced and consumed and
also traded in the world market. Let Pf be the foreign price or world price of the
commodity and let us assume that domestic buyers can buy any amount they
want at this price and domestic sellers can sell any amount they want at this
price in the world market (assuming no transportation costs as such). Then
without the tariff, the domestic price is also Pf .
The situation is shown in Figure: . DdDd is the domestic demand curve, SdSd
the domestic supply curve. Without any tariffs the domestic price is the foreign
price Pf . At this price DE is the quantity supplied domestically, and DF is the
domestic quantity demanded. The difference is made up by imports which are
given by EF.
With the imposition of a tariff ‘T’, the domestic price Pd is equal to Pf + T,
domestic quantity supplied rises to AB, and domestic quantity demanded falls to
AC. The difference is made up by imports which now fall to BC. The government
collects a revenue of T per unit of imports. Thus, the government's revenues are
given by the shaded area BCHG. (F/M/2/14)
The Deadweight Loss or Social Cost of a Tariff:
We've seen that imposition of a tariff on an imported good typically increases the
domestic price of the good. This certainly represents a cost to the demanders
and but a gain for the domestic suppliers, but from the society’s viewpoint, there
is loss of welfare or deadweight loss.
The social cost of a tariff can be discussed using the consumers’ and producers' surplus tools. We start
with the diagram given in Figure: which depicts the equilibrium demand price and supply price after
a tariff, T, has been imposed. Output has been increased by this tariff, from q1 to q2. Now,
 Loss in consumers' surplus = Areas of (W + X + Y + Z),

 Gain in producers' surplus = Area of W
   Total net loss to the consumers and producers=Loss in
consumers' surplus + Gain in producers' surplus
= Areas of ( X + Y + Z)
Apart from consumers and producers, there is also a third party who stands to gain from a
tariff. This is the government who imposes the tariff.
Then the net benefit to the government is the total revenue from the tax represented by the
area Y. The total net cost of the tariff is the algebraic sum of these areas: the loss in
Consumers' Surplus, - (W + X +Y +Z), the gain in Producers' Surplus, + W, and the gain
in government revenue, + Y. The net result is the area –(X+Z). This area is the deadweight
loss of the tariff or the excess burden of the tariff. Therefore,
Deadweight Loss = Total Net Loss to the society
= Loss of consumers’ surplus + Gain of producers’
surplus + Gain accrued to the government
= Areas of ( - W – X – Y – Z + W + Y )
= Areas of {- ( X + Z )}
Proposition #1: A tariff of T per unit has exactly the same effects as a
production subsidy of T per unit plus a consumption tax of T per unit.
The argument for the import tariff is to protect domestic production and
employment. We have already discussed about the effect of a tariff of T per unit
above (Fig: ) However, instead of a tariff on imports, suppose the government
gives a subsidy equal to T to domestic producers. The effect is that producers
get a price Pd and, hence, the quantity supplied rises to AB. But consumers still
pay Pf, and, thus, domestic quantity demanded does not change. It is still DF.
The difference GF is made up by imports.
However, along with a production subsidy of T, if the government imposes a
consumption tax of T per unit, the consumers also pay the price Pd, and thus
demand is curtailed to AC as before. The government now collects revenues of T
per unit on the total consumption, which is AC. This revenue is shown by the
area ACHD. But it pays out ABGD to producers as a subsidy. Thus, its net
revenue is as before BCHG (which is the revenue from the import tariff).
(F/M/2/14)
Export subsidies:
The case of export subsidies is exactly analogous to production subsidy. The

objective of export subsidy is to increase exports with a view to increasing
employment and export earning. This is shown in Figure: . DdDd is the domestic
demand curve, and SdSd is the domestic supply curve. Without any subsidies,
the domestic price is the foreign price Pf. At this price DG is the domestic
quantity demanded, and DH is the domestic quantity supplied. The difference
GH is exported.
Now, the government wants to stimulate exports and introduces an export
subsidy of S per unit. The domestic price rises to Pf = Pf + S. Domestic quantity
demanded falls to AB, and domestic quantity supplied increases to AC. The
difference is the exports BC, which are higher than GH. The cost to the
government is the subsidy of S per unit for the exports BC. It is thus the area of
the shaded rectangle BCFE.(F/M/2/15)
Proposition #2: An export subsidy of S per unit is exactly equivalent
to a production subsidy of S per unit plus a consumption tax of S per
unit.
We have already discussed about the effect of an export subsidy of S per
unit(Fig: ). Now exactly the same result is achieved by a production subsidy of
S per unit and a consumption tax of S per unit. The cost to the government for
the production subsidy is ACFD. The revenues from the consumption tax are
ABED. The difference is the net cost to the government, which is BCFE.
From Proposition #1 and 2 we can conclude:
Proposition #3: Both import tariffs and export subsidies are equivalent to a production
subsidy plus a consumption tax.
Price Controls:
There are several governmental policies that are designed to: (1) prevent prices from rising to
their market equilibrium level (Price Ceiling) or (2) prevent prices from falling to their market
equilibrating level(Price Floor). Examples of case (1) are interest rate controls, rent controls, controls
on natural gas prices, and controls on several consumer prices. Examples of case (2) are the price
support programs for different agricultural commodities and minimum wage laws.
In the case of controls on maximum prices, what the Government has in

mind is the idea that low-income consumers are likely to suffer a great hardship if
prices are “too high”. In the case of agriculture, the argument for the price
support programs is that farm incomes suffer if prices are “too low”. In the case
of minimum wage laws, again the stated purpose is to protect workers from
employers’ exploitation. In all these cases, one can argue that one should attack
the income problem by changing incomes directly (income subsidies) rather than
by tinkering with prices.
As can be seen from a simple demand and supply diagram like the one in
Fig: , fixing the prices below the market equilibrating level creates an excess
demand or shortage, and supporting the price above the market equilibrating
level creates an excess supply or a glut. What happens to this excess supply or
excess demand depends on the specific case we are considering. For instance, in
the case of agricultural price support programs the government purchases part of
the excess supply and subsidizes the farmers in storing the remainder. In the
minimum wage laws, the excess supply of labor goes in to the poll of
unemployed. Among this pool, those who qualify get unemployment insurance,
some of the workers get discouraged and drop out of the labor force, and some
others find jobs at lower wages among occupations not covered by the minimum
wage laws or in an illegal way even among those occupations covered by
minimum wage laws.
In the case of consumer goods subject to price controls, a black market will
develop as a consequence of excess demand. We will discuss this issue later. In
the case of price controls on natural gas, the excess demand (those customers
that cannot get natural gas) split over into the demand for alternative fuels (for
example, heating oil, electricity, and, in the case of industrial consumers into
coal).
In the case of rent controls, the excess demand will go into alternative housing arrangements.
Furthermore, the actual market price can really be higher than the controlled price, because landlords
can make tenants buy furniture from them at exorbitant prices and in some case demand “key money”
(down payment for the privilege of renting the apartments).
Maximum Price or Price Ceiling:
By depressing production and increasing demand, price controls create

excess demand. Fig: shows the changes in consumer and producer surplus
that result from government price control policy. Here, price of the good has been
regulated to be no higher than P max, which is below the market-clearing price Po.
The gain to consumers is the difference between rectangle A and triangle B. The
loss to producers is the sum of rectangle A and triangle C. Triangles B and C
together measure the deadweight loss from price controls. Some consumers will
have to be rationed out of the market because of price controls, and production
and sales fall from Q0 to Q1. Those consumers who can still purchase the good
can now do so at a lower price, so they enjoy an increase in consumer surplus,
which is given by rectangle A. However, some consumers can no longer buy the
good. Their loss of consumer surplus is given by shaded triangle B. The net
change in consumer surplus is therefore A - B. In Figure , rectangle A is
larger than triangle B, so the net change in consumer surplus is positive.(F/P/9/2)
What about the change in producer surplus? Those producers who are still
in the market and producing quantity Q, are now receiving a lower price. They
have lost the producer surplus given by rectangle A. However, total production
has also dropped. This represents an additional loss of producer surplus and is
given by triangle C. Therefore, the total change in producer surplus is -A - C.
Producers clearly lose as a result of price controls.
Is this loss to producers from price controls offset by the gain to

consumers? No-as Figure 9.2 shows, price controls result in a net loss of total
surplus, which we call a deadweight loss. Recall that the change in consumer
surplus is A - B and that the change in producer surplus is -A - C, so the total
change in surplus is (A - B) + (-A - C) = -(B +C). We thus have a deadweight
loss, which is given by the two triangles B and C in Figure . This deadweight
loss is an inefficiency caused by price controls; the loss of producer surplus
exceeds the gain in consumer surplus.
However, if the demand curve is very inelastic, price controls can result in a net loss of
consumer surplus, as Figure shows. In that figure, triangle B, which measures the loss to
consumers who have been rationed out of the market, is larger than rectangle A, which measures the
gain to consumers able to buy the good. Here, consumers value the good highly, so those who are
rationed out suffer a large loss. In this case, consumers suffer a net loss from price controls. (F/P/9/3).
Since one of the major objectives of the price controls (controls on natural gas prices, rent
controls, and so on) is to prevent large income transfers to the owners of these resources, it might be
interesting to see under what conditions this is possible. Consider the case where the quantity supplied
is fixed and equal to Q0. The effects of price controls in this situation are illustrated in Figure .
(F/M/2/16)
In Fig: , the supply curve SS is vertical at the quantity Q 0. DD is the demand curve. The
equilibrium price is P0 and, of course, the quantity supplied and demanded is Q0.
Suppose the price is controlled at P 0, which is less than P0. Then the quantity supplied is still P 0 as
before. There is, of course, an excess demand equal to BC, but this will remain unsatisfied. One thing
that has happened is that there is an income transfer equal to the shaded area shown in Figure:
from the producers of resource owners to consumers. Earlier consumers spent P 0 .Q0 for the amount Q0.
Now they spend only P0 .Q0 for the same amount Q0.
In the case of rent controls, assuming the quantity of housing to be fixed, there is an income
transfer from landlords to the tenants that are currently occupying the apartments or house. Of course,
the rent control draws new consumers into the market, and this is what causes the excess demand. But
since quantity supply is fixed, they cannot get any rental housing in this market.
The same thing will happen for price controls on natural gas. The price control result in an
income transfer from natural gas producers or pipeline companies to the consumers. Of course, the
low controlled price draws new customers into the market, and this is what produces the excess
demand. But since the quantity supply is fixed, these new customers cannot get natural gas and must
find alternative energy sources.
Of course, quantity supplied is not fixed except in the very short run and thus, the above
arguments may not hold good in the long run. But the argument about income transfers is based on an
implicit assumption of fixed supply.
Minimum Price or Price Floor:
Government policy sometimes seeks to raise prices above market-clearing

levels, rather than lower them. In the case of agriculture, the argument for the
price support programs is that farm incomes suffer if prices are “too low”. In the
case of minimum wage laws, again the stated purpose is to protect workers from
employers’ exploitation. One way to raise price above the market-clearing level is
by direct regulation-simply make it illegal to charge a price lower than a specific
minimum level.
We look at the Figure , where market equilibrium is attained at price P 0 .
Now, suppose the government set a minimum price Pmin . If producers correctly
anticipate that they can sell only the lower quantity Q 3 at price Pmin , the net
welfare loss will be given by triangles B and C. But producers might not limit their
output to Q3 and might produce Q2. Since at price Pmin, the quantity demanded is
Q3, the difference (Q2—Q3) represents an excess, unsold supply. Now let us follow
the resulting changes in consumer and producer surplus. (F/P/9/8)
Those consumers who still purchase the good must now pay a higher price and so suffer a
loss of surplus, which is given by rectangle A in Figure . Some consumers have also dropped out of
the market because of the higher price, with a corresponding loss of surplus given by triangle B. The
total change in consumer surplus is therefore
CS = –A – B = – (A + B)
Consumers clearly are worse off as a result of this Policy.
Producers receive a higher price for the units they sell, which results in an
increase of surplus, given by rectangle A. (Rectangle A represents a transfer of
money from consumers to producers.) But the drop in sales from Q 2 to Q3 results
in a loss of surplus, which is given by triangle C. Finally, consider the cost to
producers of expanding production from Q3 to Q2. Because they sell only Q3,
there is no revenue to cover the cost of producing Q 2 - Q3. This cost is the area
under the supply curve from Q3 to Q2, and is represented by the shaded trapezoid
D. So unless producers respond to unsold output by cutting production, the total
change in producer surplus is
PS = A - C - D
Given that trapezoid D can be large, a minimum price can even result in a
net loss of surplus to producers alone! As a result, this form of government
intervention can reduce producers' profits because of the cost of excess
production.
An example of a government-imposed price minimum is the minimum wage

law. This is illustrated in Figure , which shows the supply of labor and the
demand for labor. The wage is set at wmin, a level higher than the market-clearing
wage wo. As a result, those -workers who can find jobs obtain a higher wage.
However, some people who want to work will be unable to. The policy results in
unemployment, which in the figure is L2 – L1. (F/P/9/9)
Price Supports:
Besides imposing a minimum price, the government can increase the price of a
good in other ways. Much of the agricultural policies pursued in various
countries, including India, is based on a system of price supports, often
combined with incentives to reduce or restrict production (production quota). In
this section we examine how these policies work and their impact on consumers,
producers, and the government.
In India, price supports aim to increase the prices of agricultural crops

such as paddy, wheat, potatoes etc. so that the producers of those goods
can receive higher incomes. One way to do this is for the government to set
a support price Ps, and then buy up whatever output is needed to keep market
price at this level. Figure illustrates this. (F/P/9/11)
At price Ps, consumer demand falls to Q1, but supply increases to Q2 . To

maintain this price and avoid having inventories pile up in producer ware
houses, the government must buy the quantity Qg = Q2 - Ql. In effect
government adds its demand Qg to the demand of consumers, and producers
can sell all they want at price Ps.
Those consumers who purchase the good must pay the higher price Ps
instead of Po, and so they suffer a loss of consumer surplus given by rectangular
A. Other consumers no longer buy the good or buy less of it, and their loss of
surplus is given triangle B. So as with the minimum price, consumers lose, in this
case by an amount
CS = -A - B
On the other hand, producers gain (which is why such a policy is
implemented).Producers are now selling alarger quantity Q 2 instead of Q0, and at
a higher price Ps.From Figure , it is clear that producer surplus increases by the
amount
PS = A+B+D
But there is also a cost to the government (which must be paid for by taxes, and
so is ultimately a cost to consumers). That cost is (Q2- Q1)Ps, which is what the
government must pay for the output it purchases. In Figure this is the large
rectangle EFQ2Q1.
To find out the total welfare cost of this policy, we add the change in consumer surplus to the change
in producer surplus and then subtract the cost to the government. Hence the total change in welfare is
CS + PS - Cost to Govt. = D -- (Q2 – Q1)Ps
In terms of Figure , society as a whole is worse off by an amount given by the

large rectangle EFQ2Q1, less triangle D.
This welfare loss can be very large. But the most unfortunate part of this policy
is that there is a much more efficient way to make farmers better off. If the
objective is to give farmers an additional income equal to A + B + D, it is far less
costly to society to give them this money directly, rather than via price supports.
Since consumers are losing A + B anyway with price supports, by paying farmers
directly, society saves the large rectangle EFQ2Q1, less triangle D.
Quantity Controls:
There are also some governmental policies that are designed to prevent quantities from
reaching their market equilibrating level. Examples of this case are
(i) Import Quota and (ii) Production Quota.
Import quota:
An import quota is a direct restriction on the quantity of some good that may be imported.
Import quotas may be used to protect a domestic industry, to protect domestic agriculture and/or
balance of payments. It is an example of quantity control.
The effect of an import quota is the same as that of an import tariff.

Consider a commodity that is both domestically produced and consumed and
also traded in the world market. Let Pf be the foreign price or world price of the
commodity and let us assume that domestic buyers can buy any amount they
want at this price and domestic sellers can sell any amount they want at this
price in the world market (assuming no transportation costs as such). Then
without the tariff, the domestic price is also Pf .
The situation is shown in Figure: . DdDd is the domestic demand curve,

SdSd the domestic supply curve. Without any quantitative restrictions on imports
the domestic price is the foreign price Pf . At this price DE is the quantity
supplied domestically, and DF is the domestic quantity demanded. The
difference is made up by imports which are given by EF.
If the Government restricts imports to the level BC, the domestic price will rise to P d. The
Government can restrict imports by issuing import licenses equal to the amount BC. If these are issued
at random (by say a lottery), then the lucky importers who obtain the licenses will reap the benefit
which is BCxT or the shaded area BCHG in Fig: . However, if the Government auctions the import
licenses, then it will get revenues equal to the shaded area BCHG, which is what the Government gets
from an import tariff. Under such a situation the effect of an import quota is same as that of an import
tariff. However, if the government wants to control imports, import quota is more reliable and less
uncertain than an import tariff.
The social cost of an import quota tariff can also be discussed using the consumers’ and
producers' surplus tools. We start with the diagram given in Figure: which depicts the equilibrium
demand price and supply price after a quantitative restriction of BC units has been imposed on
imports. The domestic price rises to Pd and domestic output is increased from Q1 to Q2. Now,
 Loss in consumers' surplus = Areas of (W + X + Y + Z),

 Gain in producers' surplus = Area of W
   Total net loss to the consumers and producers=Loss in
consumers' surplus + Gain in producers' surplus
= Areas of ( X + Y + Z)
Apart from consumers and producers, the foreign producers also stand to gain from a quota.
This gain is in the form of higher profits as represented by the area Y. If Government auctions the
import licenses and gets a revenue equal to the area Y, the total net cost of the quota is the
algebraic sum of these areas: the loss in Consumers' Surplus, -- (W + X +Y +Z), the gain in
Producers' Surplus, + W, and the gain in government revenue, + Y. The net result is the
area –(X+Z). This area is the deadweight loss of the quota or the excess burden of the
quota. Therefore,
Deadweight Loss = Total Net Loss to the society
= Loss of consumers’ surplus + Gain of producers’
surplus + Gain accrued to the government
= Areas of ( - W – X – Y – Z + W + Y )
= Areas of {- ( X + Z )}
Import Restriction: A Ban on Imports (Example: A

ban in rice imports in Japan)
THE total supply curve shows the total quantity made available by all suppliers at
each possible price. For example, the total supply of rice in Japan is the sum of
the domestic and foreign supply curves of rice.
Suppose that the domestic supply curve (panel a) and foreign supply curve (panel b ) of rice in Japan
are as Figure (F/PF/2/5) shows. The total supply curve S in panel commodity, is the horizontal sum
of the Japanese domestic supply curve Sd, and the foreign supply curve S f in the figure the Japanese
and foreign supplies are zero at any price equal to or less than p, so the total supply is zero. At prices
above p, the Japanese and foreign supplies are positive, so the total supply is positive. For example,
when price is P*, te quantity supplied by Japanese firms is Qd* (panel a), the quantity supplied by
foreign firms is Qf* (panel b), and the total quantity supplied is Q* = Qd* + Qf* (panel c) . Because
the total supply curve is the horizontal sum of the domestic and foreign supply curves, the total supply
curve is flatter than either of the other two supply curves.
We can use this approach for deriving the total supply curve to analyze the effect
of government policies on the total supply curve. Traditionally, the Japanese
government banned the importion of foreign rice. We want to determine how
much less is supplied at any given price to the Japanese market because of this
ban.
Without a ban, the foreign supply curve is Sf in panel b of Figure .(F/PF/2/5) A

ban on imports eliminates the foreign supply, so the foreign supply curve after
the ban is imposed Sf is a vertical line at Qf = 0. The import ban has no effect on
the domestic supply curve, Sd so the supply curve is the same as in panel a.
Because the foreign supply with a ban Sf is zero at every price the total supply
with a ban, S in panel commodity is the same as the Japanese domestic supply,
Sd at any given price. The total supply curve under the ban lies to the left of the
total supply curve without a ban, S. Thus the effect of the import ban is to rotate
the total supply curve toward the vertical axis.
The limit that a government sets on the quantity of a foreign produced good that
may be imported is called a quota. By absolutely banning the importation of rice,
the Japanese government sets a quota of zero on rice imports. Sometimes
governments set positive quotas Q > 0.The foreign firms may supply as much as
they want, Qf as long as they supply no more than the quota : Qf < Q.
A government can affect a market equilibrium by imposing import ban. The

Japanese government’s ban on rice imports raises the price of rice in Japan
substantially. Figure
(F/PF/2/8) shows the Japanese demand curve for rice, D, and the total supply
curve without a ban, S. The intersection of S and D determines the equilibrium e 1,
if rice imports are allowed.
What is the effect of a ban on foreign rice on Japanese demand and supply? The ban has no effect on
demand if Japanese consumers do not care whether they eat domestic or foreign rice. The ban causes
the total supply curve to rotate toward the origin from S(no ban) (Total upply is the horizontal
sum of domestic and foreign supply) to S(ban) (total supply equals the domestic supply).
The intersection of S and D determines the new equilibrium e 2, which lies above
and to the left of e1. The ban causes a shift of the supply curve and a movement
along the demand curve. It leads to fall in the equilibrium quantity from Q 1 to Q2
and a rise in the equilibrium price from p 1 to p2 because of the Japanese ban on
imported rice, the price of rice in Japan has at times been over seven times
higher than the price in the rest of the world.
A quota of Q may have a similar effect to an outright ban; however, a quota may
have no effect on equilibrium if the quota is set so high that it does not limit
imports.
Production Quota:
Besides entering the market and buying up output, thereby increasing total
demand, the government can also cause the price of a good to rise by reducing
supply. It can do this by decree--the government simply sets quotas on how
much each firm can produce. By setting the appropriate quotas, the price can
then be forced up to any arbitrary level.
Another example of such a policy is the control of liquor licenses by state

governments. By requiring any bar or restaurant that serves alcohol to have a
liquor license and then by limiting the number of licenses, entry by new
restaurateurs is limited, which allows those who have the licenses to earn higher
prices and profit margins.
Figure shows how prices can be increased by reducing supply in this way. Due to this quantitative
restriction on production, the supply curve becomes completely inelastic at the quantity Q1, and the
market price is increased from P0 to Ps. Figure also shows the changes in consumer and producer
surplus resulting from this policy. Again, the change in consumer surplus is
CS = -A - B
Producers now receive a higher price for the production Q1, which corresponds to
a gain in surplus of rectangle A. But because production is reduced from Q0 to
Q1, there is a loss of producer surplus corresponding to triangle C. Finally,
producers receive money from the government as an incentive to reduce
production. Thus, the total change in producer surplus is now
PS = A - C + Payments for not producing
The cost to the government is a payment sufficient to give producers an
incentive to reduce output to Q1. That incentive must be at least as large as B +
C + D because that is the additional profit that could be made from production,
given the higher price Ps. So the cost to the government is at least B + C + D
and the total change in producer surplus is therefore
PS = A - C + B + C + D = A + B + D
This is the same change in producer surplus as with price supports maintained by
government purchases of output. (Refer to Figure ) Producers, then, should be
indifferent between the two policies because they end up, gaining the same
amount of money from each. Likewise, consumers lose the same amount of
money.
But which policy costs the government more? The answer depends on whether
the sum of triangles B + C + D in Figure is larger or smaller than (Q2 – Q1)Ps,
(the large rectangle EFQ2Q1) in Figure . Usually it will be smaller, so that a
production quota costs the government (and society) less than price supports
maintained by government purchases.
Still, quantitative restriction programme is more costly to society than simply

handing the producers money. The total change in welfare (CS + PS -- Cost to
Govt.) under the production quota is
Welfare = -- A -- B + A + B + D - B - C - D = - B – C
Society would clearly be better off in efficiency terms if the government simply
gave the producers A + B + D, leaving price and output alone. Producers would
then gain A + B + D, the government would lose A + B + D, for a total welfare
change of zero, instead of a loss of B + C.
Illegal activities and black markets:
In the previous section, when we discussed price controls, we argued that some of the excess demand
generates a “black market.” In other words, some transactions will take place at the controlled price
and some other transactions will take place above the controlled price in an illegal market often called
the “black market”. In the case of minimum wage laws, these transactions are below the price supports
(employment at wages below the minimum wage). To study the black market let us first consider
demand and supply in a completely illegal market.
Suppose buying and selling a good X is illegal. This could be babies, some drugs, human organs, or
U.S. jeans in Russia. The demand and supply curve supply are shown in Figure . DD and SS
show the demand and supply curves if the buying and selling were legal. The equilibrium would be at
A. (F/M/2/17)
Now suppose there is a penalty for those caught buying or selling the product. The consequence of this
is a decrease in demand and a decrease in supply. The equilibrium quantity falls but we can’t say
anything about the equilibrium price .
In actual practice, frequently only the sellers are penalized. In this case, only the supply curve shifts,
and equilibrium price clearly rises. However, the reduction in equilibrium quantity will not be as
dramatic. This demonstrates that if the objective of outlawing certain goods is to curtail their use, then
penalties should be imposed on both buyers and sellers.
Black markets develop when the government attempts to control the price of a product and that price
is below the equilibrium price. All trade in this product is not illegal, rather only trade at a price in
excess of the controlled price. The black market situations is shown in Figure : DD is the demand
curve and SS is the supply curve. The market equilibrium occurs at A. Suppose the price is controlled
at Level PC. This generates an excess demand equal to BC. These unsatisfied buyers enter the black
market. If there are no penalties on the buyer then their demand curve is EC. Suppose there is a
penalty on the seller. Then the supply curve shifts leftward to S1S1. The equilibrium is now at the point
F. The black market price is higher than the market equilibrating price. Actually, the average market
price (the weighted average of the legal price and black market price) could also be higher than the
market-equilibrating price.
Now suppose the buyers also pay a penalty. In the case the black market demand curve shifts leftward
to D1D1. The black market equilibrium is at the point G. In this case the black market price is below
the market equilibrium price but one can get another by changing the magnitudes of the shifts. If no
penalties are imposed on sellers and penalties are imposed on buyers only, the black market
equilibrium is at H (since the supply curve does not shift). Thus, if our concern is with the price in the
black market, it is better to penalize the buyers rather than the sellers.
Also, note that the penalties are sufficiently high, then the black market demand curve D 1D1 and the
black market supply curve may not intersect and, thus, no transactions can take place.
Finally, some supplies currently available in “free” market might disappear into the black market. Of
course, in the extreme case where all supplies disappear we can apply the analysis of the illegal
markets discussed earlier. The case where some of the supplies from the free market disappear into the
black market is illustrated in Figure . (F/M/2/19) All the curves and equilibrium points are defined
as in Figure . (F/M/2/18) The only change is than the black market supply point to the left of B.
S1B is the supply disappearing into the black market. The excess demand is now S1C instead of BC.
One can draw conclusions similar to those drawn with Figure . (F/M/2/18)
Actually, the case of a per unit tax considered earlier in Section 2.7.1 can also be viewed as one of
quantity control. Instead of letting the amount produced be Q0,the Government restricts output to Q1
by issuing production licenses for that amount. This amount will fetch the price P 1 in the market, but
the supplies are willing to supply this quantity at a price P 2. Thus (P2 - P1) Q1 represent the profits that
the lucky producers who get the licenses make, if the Government gives away licenses in a lottery.
However, if the production licenses are auctioned off, the Government will get revenues of (P 2 - P1)
Q1which is exactly the revenue it gets from a per unit tax, the situation is similar to an import quota.
There are several other examples of quantity controls. The Government policy of “pollution standards”
is a policy of pollution quotas where each firm is given a quota on the amount of pollution it can
generate.
We investigate the effect of such a quota in solved problem 2.1. In most of the
solved problems in this book, you are asked to determine how a change in a
variable or policy affects one or more variables. In this problem, the policy
changes from no quota to quota, which affects the total supply curve.
Answer
1. determine the American supply curve without the quota. The no-quota total
supply curve, S in panel commodity, in the horizontal sum of the U.S. Domestic
supply curve, Sd and the no quota foreign supply curve.
2. Show the effect of the quota on foreign supply: At prices less than p foreign
suppliers want to supply quantities less than the quota, Q. As a result, the foreign
supply curve under the quota, Sf is the same as the no quota foreign supply
curve, Sf for prices less than p. At prices above p, foreign suppliers want to
supply more but are limited to Q. Thus the foreign supply curve wit hectare a
quota Sf, is vertical at Q for prices above p.
3. Determine the American total supply curve with the quota: The total supply
curve with the quota, S, is the horizontal sum of Sd and Sf. At any price above p,
the total supply equals the quota plus the domestic supply. For example, at p*,
the domestic supply is Q*d and the foreign supply is Qf, so transformations he
total supply is Q*d + Qf Above p, S the domestic supply curve shifted Q units to
the right. As a result the portion of S above p has the same slope as Sd.
4. Compare the American total supply curves with and without the quota: At
prices less than or equal to p, the same quantity is supplied with and without the
quota, so S is the same as S. At prices above p, less is supplied with the quota
than without one, so S at steeper than S, indicating that a given increase in price
raises the quantity supplied by less with a quota than without one.
Solved problem 2.3

What is the effect of an united states quota on steel of Q on the equilibrium in the U>S. Steel market?
Hint; the answer depends on whether the quota binds (is low enough to affect the equilibrium)
Answer
1. show how a quota Q, affects the total supply of steel in the United States. The graph reproduces the
no-quota total American supply curve of steel S, and the total supply curve under the quota, S (which
we derived in solved problem 2.1) At a price below p, the two supply curves are identical because the
quota is not binding. It is greater than the quantity foreign firms want to supply. Above p, S lies to the
left of S.
2. show the effect of the quota if the original equilibrium quantity is less than the quota so that
transformations he quota does not bind : Suppose that the American demand is relateively how at any
given price so transformations hat the demand curve D` intersects both the supply curves at a price
below p. the equilibria both before and after the quota is imposed are at e1, where the equilibrium
price, p is les than p. thus if the demand curve lies near enough to the origin that the quota is not
binding, the quota has no effect on the equilibrium.
3. show the effect of the quota if the quota binds: with a relatively hgh demand curve, Dh, the quota
affects the equilibrium. The no quota equilibrium is e2, where Dh intersects the no quota total supply
curve, S. after the quota is imposed, the equilibrium is e3, where Dh intersects the total supply curve
with the quota, S. The quota raises the price of steel in transformations he United States from p2 to p3
and reduces the quantity from Q2 to Q3.
Page : 44 to 45
1. in 1998, a virus killed more than half the oysters used to produce pearls in the world’s busiest
undersea factory. Use a diagram to indicate why the price of pearls rose 18%. How did the equilibrium
quantity change?
2, Increasingly, instead of advertising in newspapers, individuals and firms use Web sites that offer
free classified ads, such as Realtor.com, Jobs.com Monster.com, and portals like Yahoo and America
online. Using a supply and demand model, explain what will happen to the equilibrium levels of
newspaadvertising as the use of the internet grows. Will the growth of the internet affect the supply
curve, the demand curve or both? Why?
3. what was the effect on the worldwide market for alcoholic beverages of the eighteenth amendment
to the U.S,. Constitution, which banned the sale or production of alcohol in the United states? Explain
what happened to the supply curve, demand curve and the equilibrium prices and the quantities.
4. the U.S,. supply of frozen orange juice comes from Florida and Brazsil. What is the effect of a
freeze that damages oranges in Florida on the price of frozen orgnage juice in the United States and on
the quantities of orange juice sold by Floridian and Brazilian firms?
5. what is the effect of a quota Q > 0 on equilibrium price and quaitity? (Hint carefully show how the
total supply curve changes.)
6. usury laws place a ceiling on interest rates that lenders such as banks can charge borrowers. Low
income households in states with usury laws have significantly lower levels of consumer credit loans
than comparable households in states without usury laws (villegas, 1989) why? (hint : The interest rate
is the price of a loan and the amount of the loan is the quantity measure.)
7. in 1999, after nearly 20 years of rent control in Berkeley, California, the elimination of the law led
to an estimated rise in rents of nearly 40%. Using supply and demand models, illustrate how the law
and then its elimination affected the rental housing market. Discuss the effects on the equilibrium
rental price and the quantity of housing rented.
8. After a major erthquake struck Los Angeles in January 1994, several stores raised the price of milk
to over $6 a gallon. The local authorities announced that they would investigate and that they would
enforce a law prohibiting price increases of more than 10% during an emergency period. What is the
likely effect of such a law?
9. Is it possible that an outright ban on foreign imports will have no effect on the equilibrium price?
(Hint : suppose that imports occur only at relatively high prices.)
10.If certain jurisdictions ban the use of skateboards on city streets, what is the likely effect on the
market for skateboards? How do such laws affect the supply curve the demand curve, and the
equilibrium price and quantity?
11. the New ay York Times reported in 1997 that a crack down on a cocaine smuggling ring caused
cocaine price s in Manhattan to rise from $20000 to $30000 a kilogram. Illustrate in a supply and
demand diagram why this happened, and explain in words.
12. in 1996, a group of American doctors called for a limit on the number of foreign trained physicians
permitted to practice in the United States? How are American trained doctors and consumers affected?
13. Suppose that cotton is produced only in the United /States and China. The U.S. government says
that if an American farmer sells a bale of cotton at the world price, p, the government will give the
farmer (p* - p) per bale, where p* > p. what happens to the quantities sold by American and Chinese
Growers and the world price of cotton?
14. Use a supply and demand diagram to explain the statement Talk is cheap because supply exceeds
demand At what price is this comparison being
made?
15. Using the estimated demand function for processed pork in Canada (Etq,. 2.2) determine how
price changes as the quantity demanded increases by one unit (that is, the quantity demanded increase
by 1 million Kg per year). (Hint: Rewrite the demand function so that price is a function of quantity.)
16. Using the estimated demand function for processed pork in Canada (eq. 2.2) show how the
quantity demanded at a given price changes as per capita income Y, increases by $100 a year.
17. Suppose that the price of beef, pb, in
Canada increased by 30% from $4 to $5.20. How does the demand curve for processed pork shift?
18. the supply of corn by the United States is Qa = a + bp, and the supply by the rest of the world is Qr
= c + ep. What is the world supply?
19. The demand function for a good is Q = a – bp, and the supply functions is Q = c + ep, where a, b,
c, and e are positive constants. Solve for the equilibrium price and quantity in terms of these four
constants.
20. show how the equilibrium quantity of pork varies with income.
21. Using the equations for processed pork demand (eq. 2.2) and supply (eq, 2.6) solve for the
equilibrium price and quantity in terms of price of hogs, ph; the price of chicken pc; and income y. If
ph = 1.5 dollars per kg. pb = 4 (dollars per kg) pc = 3 1/3 (dollars per kg) and y = 12.5 (thousands
dollars) what are the equilibrium price and quantity?
JNU Qs
26. Petrol is sold in a competitive market. The market demand for petrol is given by QD = 100 – 2Pc
where Pc is the price paid by consumers. The market supply cure is given by QS = 3PS where Ps is the
price received by suppliers.
a) If there are no taxes on petrol, what will be the equilibrium price and quantity?
b) Suppose the government imposes a unit tax of 1 per unit of petrol. In the new post-tax equilibrium
what price do the consumers pay, and what price do the suppliers receive? How many units of petrol
are sold? JNUAT--2003
19. If the demand curve is given by Q = 100 – P where Q is measured in metric tons and P in Rs. per
metric ton, the price elasticity of demand when P = Rs. 10 per ton is
a) Rs. 9 per metric ton, b) Rs. (1/9) per metric ton, c) 1/9 metric ton d) 1/9 JNU AT 2002
17. The demand curve facing a firm is as follows: q(p) = A p --ε
The demand curve is elastic if and only if
a) A > 1; b) A < 1 and ε > 0 ; c) ε > 1; d) ε < 1 JNU AT 2001
8. A demand curve is given. The price elasticity of demand is known to be constant and less than unit
(in absolute value). For this demand curve, an increase in price will be accompanied by
a) an increase in revenue; b) a decrease in revenue; c) no change in revenue; d) some change in
revenue which can not be specified. JNU AT 2000
3. If the absolute value of price elasticity of demand for a particular good is greater than one, then a
rise in the price of the good implies that the total expenditure on the good would
a) increase; b) decrease; c) remains the same; d) nothing can be inferred as more information is
required. JNU AT 1999
24. Suppose the price elasticity of demand for good X is 0.2 If the price of X rises by 2.8% What
effect on quantity demanded will this have? What effect does it have on the total expenditure on good
X?
25. A consumer’s demand function for a good is given by
Demand = 100 – 10p , where p denotes the market price of the good, what is the price elasticity of
demand when market price is 3 and the consumer is buying 70 units of the commodity. JNU AT 1999
5. For a commodity the price increases and the quantity purchased falls. The total revenue will remain
the same if
a) the change in price is greater than the change in quantity
b) the percentage change in price is less than the percentage change in quantity
c) the percentage change in price is greater than the percentage change in quantity
d) the percentage in price is three times the percentage change in quantity
e) the percentage change in price is equal to the percentage in quantity

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SM/ECOH/MICRO/DEMAND & SUPPLY/PART-B/OCTOBER 2007 E-mail: smith2mankiw@gmail.

The elasticity of demand is a measure of the responsiveness of quantity demanded of a

Price elasticity of demand is defined as the responsiveness of quantity demanded to changes in

ep = (∆Q/Q)/( ∆P /P)= (∆Q/∆P) . (P /Q)

The price elasticity of demand measures the responsiveness of quantity demanded of a

eP = ∆Q /(Q1 + Q2)/2 = ∆Q . (P1 + P2)

Income elasticity of demand is defined as the responsiveness of quantity demanded to changes

Cross price elasticity of demand is defined as the responsiveness of quantity demanded of a

exy = ∆x/x / ∆py /py = ∆x/∆py . py /x

Value of exy Relation between two commodities

In the presence of taxes and subsidies,

 (dS/dP )dt + [ dD/dP – dS/dP ]dP = 0

Source of Deadweight Loss:

A subsidy is financial grant to the producers or the consumers of

To illustrate quantity subsidy and value subsidy symbolically, let p D be the

We wish to examine here the impact of a quantity subsidy.

When subsidies are paid to sellers (Production Subsidy):

When subsidies are paid to buyers (User Subsidy):

A per unit subsidy

A per unit subsidy is a subsidy of a fixed amount s on each unit of

When subsidies are paid to sellers (Production Subsidy):

There are alternative ways of showing the new equilibrium. In Figure: we

When subsidies are paid to buyers (User Subsidy):

We can now analyze a sales subsidy, which is a percentage subsidy.

When subsidies are paid to sellers (Production Subsidy):

When subsidies are levied on buyers (User Subsidy):

– (dS/dp )ds + [ dD/dp – dS/dp ]dp = 0

 dp/ ds=(dS/dp )/ [dD/dp – dS/dp ]

dp/ ds=e S/ (eD – eS) (16)

More generally we may conclude:

An import tariff is a tax levied when a good is imported. Specific tarrifs

The Deadweight Loss or Social Cost of a Tariff:

 Loss in consumers' surplus = Areas of (W + X + Y + Z),

The case of export subsidies is exactly analogous to production subsidy. The

From Proposition #1 and 2 we can conclude:

In the case of controls on maximum prices, what the Government has in

Maximum Price or Price Ceiling:

By depressing production and increasing demand, price controls create

Is this loss to producers from price controls offset by the gain to

Minimum Price or Price Floor:

Government policy sometimes seeks to raise prices above market-clearing

An example of a government-imposed price minimum is the minimum wage

In India, price supports aim to increase the prices of agricultural crops

At price Ps, consumer demand falls to Q1, but supply increases to Q2 . To

CS + PS - Cost to Govt. = D -- (Q2 – Q1)Ps

In terms of Figure , society as a whole is worse off by an amount given by the

(i) Import Quota and (ii) Production Quota.

The effect of an import quota is the same as that of an import tariff.

The situation is shown in Figure: . DdDd is the domestic demand curve,

 Loss in consumers' surplus = Areas of (W + X + Y + Z),

Import Restriction: A Ban on Imports (Example: A

Without a ban, the foreign supply curve is Sf in panel b of Figure .(F/PF/2/5) A

A government can affect a market equilibrium by imposing import ban. The

Another example of such a policy is the control of liquor licenses by state

Still, quantitative restriction programme is more costly to society than simply

Illegal activities and black markets:

Solved problem 2.3

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