LOS 15d Discuss the impact of subsidies quotas and markets for illegal goods on demand supply and market equilibrium

Subsidies arc payments made bv governments to producers, often farmers. The effects of a subsidy are illustrated in Figure 7, where we use the market for soybeans as an example. Note here that with no subsidies, equilibrium quantity in the market for soybeans is 60 tons annually at a price of $60 per ton. A subsidy of $30 per ton causes a downward shift in the supply curve from S to (S - subsidy), which results in an increase in the equilibrium quantity to 90 million tons per year and a decrease in the equilibrium price (paid by buyers) to $45 per ton. At the new equilibrium, farmers receive $75 per ton (the market price of $45, plus the $30 subsidy).

Recognizing that the (unsubsidized) supply curve represents the marginal cost and that the demand curve represents the marginal benefit, the marginal cost is greater than the marginal benefit at the new equilibrium with the subsidy. This leads to a deadweight loss from overproduction. The resources used to produce the additional 30 million tons of soybeans have a value in some other use that is greater than the value of these additional soybeans to consumers.

Figure 7: Soybean Price Subsidy

Price (dollars per ton)

Price (dollars per ton)

Production quotas are used to regulate markets by imposing an upper limit on the quantity of a good that may be produced over a specified time period. Quotas are often used by governments to regulate agricultural markets.

Continuing with our soybean example, let's suppose the government imposes a production quota on soybeans of 60 million tons per year. In Figure 8, we see that in the absence of a quota, soybean production is 90 million tons per year at a price of $45 per ton. With a 60 million ton quota, the equilibrium price rises to $75 per ton.

The reduction in the quantity of soybeans produced due to the quota leads to an inefficient allocation of resources and a deadweight loss to the economy. The quota not only increases the market price, it lowers the marginal cost of producing the quota quantity. At the quota amount, marginal benefit (price) exceeds marginal cost. This explains why producers often seek the imposition of quotas.

Note that if a quota is greater than the equilibrium quantity of 90 million tons, nothing will change because farmers are already producing less than the maximum production allowed under che quota.

Figure 8: Soybean Production Quota

Price (dollars per ton)

Price (dollars per ton)

Illegal Goods

When people get caught buying or selling illegal goods, such as drugs or guns, the}- must pay penalties, including fines, imprisonment, or both. As the severity of the penalty or the likelihood of getting caught increases, the total costs of illegal trade increase. To see how the penalties from breaking the law affect the equilibrium quantity of an illegal good, consider the U.S. market for Cuban cigars illustrated in Figure 9. Here, the supply curve, S, represents the minimum prices that sellers would accept if Cuban cigars were legal, and the demand curve, D, represents the maximum prices that buyers would pay for Cuban cigars without any laws restricting their purchase. The equilibrium price and quantity under legal trade are at point L, where the equilibrium quantity is Ql at a price of P^. Because selling Cuban cigars is illegal in the U.S., the compensation for the expected penalty for selling cigars, EPS, is added to the sellers' minimum prices, shifting the supply curve in Figure 9 up to S + EPg. If only sellers are penalized, the new equilibrium is represented by point M.

In the U.S. it is also illegal to purchase and possess Cuban cigars, so the cost of the expected penalties for buyers must be subtracted from the maximum price that buyers are willing to pay. This causes the demand curve to shift downward to D - EPD. If only buyers were subject to the penalty, the Cuban cigar market would move from point L to

When both buyers and sellers of illegal Cuban cigars must pay a penalty, the new equilibrium price and quantity are represented by point O in Figure 9. As we have drawn it, the expected penalties for sellers and buyers are equal (EPS = EPD), so the new market price remains at the original market price, PL, but the quantity purchased declines to Q*. Effectively, buyers pay PB, which is PL plus an added cost equal to the value of the expected penalty for buying and possessing Cuban cigars, and sellers effectively receive Ps, which is PL minus the amount to compensate for the expected penalty for selling Cuban cigars. Note that buyers pay, and sellers receive, a cash price equal to PL in this example.

The decrease in supply or demand for an illegal good increases as the value of the penalty increases. If the penalty is larger for the seller, the supply curve will shift by a greater amount than the demand curve and the cash market price will rise above what it would have been if the good were not illegal, perhaps very significantly so. The opposite is true when penalties are higher for buyers.

Figure 9: Market for Illegal Cigars

Price

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O/'

Quantity

Good is Legal (Point L) Cash price = P^ Full cost to buyer = Pt Net benefit to seller = PL

Illegal to Sell (Point M) Cash price = PM Full cost to buyer = PM Net benefit to seller = PN

Illegal to Buy (Point N) Cash price = PN Full cost to buyer = PjM Net benefit to seller = PN

Illegal to Buy or Sell (Point O) Cash price = Pj Full cost to buyer = PB Net benefit to seller = P,.

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