What this lesson teaches
I can explain, draw and evaluate the ways a government corrects market failure, from price controls and taxes to regulation and direct provision.
Syllabus K343, 2.10.3. Government intervention to address market failure: definitions, drawing and interpretation of diagrams, advantages and disadvantages of: maximum and minimum prices in product markets, indirect taxation, subsidies; definitions, advantages and disadvantages of: regulation, privatisation, nationalisation, direct provision of goods and services, quotas, e.g. for the extraction of natural resources
Make a guess
A minimum price for milk is set above the market price. What appears in the market?
- A surplus: farmers offer more milk than people buy.
- No change, because farmers still sell at the market price.
- A shortage: people cannot find enough milk at the higher price.
Show the answer
A surplus: farmers offer more milk than people buy.
At the higher price, quantity supplied extends and quantity demanded contracts. The gap is unsold milk.
A minimum price set above equilibrium makes quantity supplied exceed quantity demanded, so there is a surplus that someone must buy, store or waste.
A minimum price, or price floor, is the lowest price the law allows. To change anything it must be set above the equilibrium price. A floor below equilibrium has no effect, because the market price is already higher.
Draw it as a horizontal line above equilibrium. At this higher price firms are willing to supply more, so quantity supplied extends along the supply curve to Qs. Buyers find the good dearer, so quantity demanded contracts along the demand curve to Qd. Because Qs is greater than Qd, there is a surplus (excess supply). The price cannot fall to clear it, because the law stops it.
Producers who still sell gain a higher price per unit. Consumers lose: they pay more and buy less. The surplus must go somewhere. A government that wants to protect farmers may buy it at the minimum price and store it, which uses taxpayers' money. In the 1980s the European Community bought so much unsold butter this way that newspapers called the stockpiles "butter mountains".
A minimum price can also discourage a harmful good. Since 2018 Scotland has set a minimum price per unit of alcohol, so the cheapest strong drinks cannot be sold below it. Singapore seldom sets price floors on goods; it taxes harmful goods such as tobacco instead. Its Progressive Wage Model sets minimum pay for some jobs, such as cleaners and security officers, which is a floor in the labour market.
- Minimum price
- A legal floor set above equilibrium; Qs exceeds Qd, giving a surplus.
- Cost of a guarantee
- If the government buys the surplus: (Qs - Qd) x minimum price, plus storage.
- Uses
- Raise farmers' incomes, discourage harmful goods (alcohol), raise low pay (wage floors).
Worked example: Measuring the surplus and its cost
Suppose the market for rice clears at $2 a kilogram, with 500 tonnes sold a month. The government sets a minimum price of $3 a kilogram and promises to buy any rice farmers cannot sell.
- Suppose at $3, farmers supply 700 tonnes (Qs) and households buy 400 tonnes (Qd).
- Surplus = Qs - Qd = 700 - 400 = 300 tonnes a month.
- Cost to the government = 300,000 kg x $3 = $900,000 a month, before storage costs.
- Judgement: farmers gain, but households pay $1 more per kilogram and taxpayers fund the surplus.
Watch out for this
A minimum price is set below the equilibrium price so that goods stay cheap.
That is a maximum price. A minimum price is a floor; it only has an effect when it is set above equilibrium, and it makes goods dearer, not cheaper.
Check your understanding
On a minimum price diagram, which gap shows the surplus?
- Quantity supplied minus quantity demanded at the minimum price
- The change in equilibrium quantity after the floor is set
- Quantity demanded minus quantity supplied at the minimum price
Show the answer
Quantity supplied minus quantity demanded at the minimum price
Right. At the floor, sellers offer Qs but buyers want only Qd, so Qs - Qd is left unsold.
Check your understanding
A legal floor keeps dairy prices above their equilibrium level. Who is most likely to be worse off?
- Nobody, because the market returns to equilibrium
- Dairy farmers who still sell all their milk
- Consumers, who pay more and buy less milk
Show the answer
Consumers, who pay more and buy less milk
Right. The floor raises the price buyers pay, so quantity demanded contracts.
Check your understanding
A government sets a minimum price of $2 per kg for a crop and buys any surplus. At $2, farmers supply 1,200 tonnes and households buy 900 tonnes. How much does the government spend?
- $2,400,000
- $600,000
- $600
- $1,800,000
Show the answer
$600,000
Right. The surplus is 300 tonnes, which is 300,000 kg, and 300,000 x $2 = $600,000.