Question

Suppose that market for good X is free and competitive, where the equilibrium price and quantity are $30 per tops and 10 million tons per year respectively. The producers of good X complain to the government that the current market price is too low to provide them with sufficient income, and they want the government to set a price floor of $40 per ton and to purchase all resulting surplus in order to guarantee that the price support is maintained. Some government advisors are concerned by the fact that elasticities of demand and supply for good X are unknown and therefore, this price support policy could be too costly for the government.

Question:

Under what conditions could this price regulation cost the government

1, more than $200 million per year

2, less than $200 million per year

3, equal to $200 per year

(Hint: Make some reference to elasticity.)

Explain your reasoning carefully, and illustrate with appropriate diagram using demand and supply curves. ( write words more than 300 words.)

Answer 1

1. More than $200 million per year:

When both demand and supply price elasticity are high, then the amount of surplus caused by the price floor is more and as the amount of surplus increases, the government will have to spend more than $200 million per year.

2. Less than $200 million per year:

As price elasticity of demand and supply decreases or it becomes relatively inelastic, then the amount of surplus will decrease in the market and as the amount of surplus decreases, government will have to spend less amount on the purchase of surplus.

3. Equal to $200 million per year

When both the demand and supply curves are unitary price elastic, then government will have to spend exactly 4200 billion.

The diagrams can be represented as: