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The key to seeing why the subsidy does not increase value is to
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The key to seeing why the subsidy does not increase value is to realize what scarcity implies.
The production of more bread requires more resources, and these resources must be drawn from
other uses. To get the extra bread, consumers must do with less of other goods.
In the simple model illustrated above, the value and cost of the extra bread can be measured. The
value of the extra bread is the amount that people are willing to pay for it. Consumers were not
willing to buy the extra bread at the old price, so it must be less valuable to them than the old
price. It will, in fact, be equal to the extra area under the demand curve, or area b+c+d in graph
Production of this extra bread requires resources that have more value than the value of the extra
bread. Marginal cost is the value that must be paid to resources in order to produce one more loaf
of bread, and this value exceeds the value of the loaf with the subsidy. The extra cost will be the
area under the old supply curve, or area a+b+c+d. The subsidy causes businesses to take
valuable resources and to transform them into less valuable output. There is a waste in this
process, and the triangular area a measures this waste. Economists call this area welfare loss.
Although bread subsidies are wasteful, they can be politically popular. People see the good side
of the subsidy--the cheap bread. What they usually do not understand is the bad side of the
subsidy. They do not realize that the higher prices of other goods can be related to the low price
of bread. An economic system is a complicated system, and many of the cause-effect
relationships take a good deal of abstract thinking to comprehend.
If a government subsidy increasing the amount of bread does not help consumers, perhaps a
contraction of the amount of bread will. The discussion of consumers' and producers' surpluses
suggested that producers or consumers could gang up on the other and transfer surplus. Suppose
that bread buyers unite and restrict purchases of bread. This union, which changes our
assumption of price taking, will force down the price of bread.
The graph below illustrates the story of the consumers' union. For the union to be successful,
each buyer must restrict purchases as Jane does in the graph. Consumers as a whole will be better
off as a result of this action because consumers' surplus will rise. Prior to the union, consumers'
surplus will be a+e on the graph, but after the price reduction, it will be a+c. As long as area c is
greater than area e, the consumers' union benefits consumers.
However, the union does not benefit society as a whole because the Martha Smiths are as much
members of society as are the Jane Does. The consumers are better off only because they have
seized value that was already there, captured by the producers. But in the process of making this
transfer, value equal to areas e+f was lost.
Furthermore, there are changes that could improve consumer well-being. If consumers could
continue to buy Q1 at price P1, they would be willing to buy additional loaves at a higher price.
Another loaf has greater value to them than the resources needed to make it. If they could keep
the low price of P1 for quantity Q1 and then pay extra for additional loaves, they could capture
some of the wasted value. By restricting bread production, resources have shifted from bread
production to other uses that are less valuable to society than the value of foregone bread.
QD = 3750 - 725P
P = 5.17 - 0.0014Q
QS = 920 + 690P
P = -1.33 + 0.00145Q
QD @ P = 2.50
QD = 3750 - 725(2.50)
QD = 1937.50
C.S. under free market: = [(5.17 + 2.00) ? 2] x 2300 (2.00 x 2300) = 8245.5 - 4600
C.S. under free market = 3645.5
C.S. under support price: = [(5.17 + 2.50) ? 2] x 1937.50 (2.50 x 1937.50) = 7430.31 - 483.75
C.S. under price support = 2586.56
Price support results in a loss of $1058.94 in consumer surplus.
Price floors create surpluses by fixing the price above the equilibrium price. At the price
set by the floor, the quantity supplied exceeds the quantity demanded.
In agriculture, price floors have created persistent surpluses of a wide range of
agricultural commodities. Governments typically purchase the amount of the surplus or
impose production restrictions in an attempt to reduce the surplus.
Price ceilings create shortages by setting the price below the equilibrium. At the ceiling
price, the quantity demanded exceeds the quantity supplied.
Rent controls are an example of a price ceiling, and thus they create shortages of rental
It is sometimes the case that rent controls create ?backdoor? arrangements, ranging
from requirements that tenants rent items that they do not want to outright bribes, that
result in rents higher than would exist in the absence of the ceiling.
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This question was answered on: Feb 21, 2020
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