Question

The scenario:

Suppose that the market for good X is free and competitive, where the equilibrium price and quantity are $30 per ton 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 the elasticities of demand and supply for good X are unknown and therefore, this price support policy could be too costly for the government.

The 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 million per year,

( Hint : make some reference to elasticity .)

Explain your reasoning carefully, and illustrate with an appropriate diagram using demand and supply curves,

Answer 1

Elasticity of demand = %change in quantity demanded / %change in price

More flatter the demand / supply curve, more elastic it is

Less flatter the demand / supply curve, more inelastic it is.

Now come to actual problem, price floor of 40 is imposed and government buy the extra surplus. Government will spent money equal to shaded portion in diagram below.

a) If government spent more than 200 million, A - B must be greater than 5 because government will buy at a price of 40. For A - B to be more than 5, either demand or supply or both is elastic.

b) If government spent less than 200 million, A - B less than 5. For A - B to be less than 5, either supply or demand or both must be inelastic.

c) If government spent exactly 200 million, A - B must be 5. Demand and supply could be equally elastic in this case.