Question

2. Your uncle from back east visits for Thanksgiving. He tells you about his proposal to prevent high prices for plowing snow from driveways after snowstorms. Private companies charge $300 for this service, a price he considers too high. He wants the city council to pass a law capping the price at $100.

Using your recent learning in economics, draw the supply/demand diagram showing the situation before the law is passed. What does it look like?

Then, how would your uncle's proposal affect the market? Show this in your diagram?

What would be a better proposal? Show why this proposal is better using a supply/demand diagram.

Answer 1

• Refer to Figure 1, which shows the market of plowing snow services. The X –axis shows the quantity demanded/supplied of the services, whereas the Y-axis shows the price of the service. The demand (D) and supply (S) curves intersect at point E1, where equilibrium prices are $300 and equilibrium quantity is QE. This summarizes the situation, before the law is passed. Here ,

Consumer Surplus = Area of Triangle KLE1

{Area above the price line and below demand curve}

Producer Surplus = Area of Triangle MLE1

{Area below the price line and above supply curve}

Total surplus = Sum of the above two triangles (Area of Triangle KME1)

• If the city council passes a law to cap the price at $100, this means it uses the tool of price ceiling. Here the capped price is below the initial equilibrium price, i.e. $100<$300. At the new lower prices the quantity demanded for snow plowing services exceeds the quantity supplied, which creates a shortage in the market.

               Excess Demand = Qd – Qs

With such a tool, there is a set of consumers who’s willingness to pay is more than the capped price are left un-serviced by the market due to the shortage. There is a reduction the consumer surplus as well as producer surplus, because now selling at any price higher than the capped price is illegal which reduces their willingness to produce more.

This leads a reduction on total surplus leading to deadweight/welfare loss in the market. So graphically we can see the total surplus with price celling is given by the area KMFD.

Dead Weight Loss = KME1 – KMFD = Shaded region A+B

• As seen a policy of price ceiling leads to a situation of shortages as well reduces the total surplus that generates welfare losses. So instead of using this tool, the government can us the policy of per unit subsidy. It’s a mechanism, where government provided financial support to producers for each unit produced.

o Refer to figure 2: Without any government intervention, the market equilibrium is at E1 with equilibrium price $300 and equilibrium quantity Q1. The Demand curve (D) intersects the supply Curve (S1) at E1.

Consumer Surplus = Area of Triangle NGE1

{Area above the price line and below demand curve}

Producer Surplus = Area of Triangle MGE1

{Area below the price line and above supply curve}

Total surplus = Sum of the above two triangles (Area of Triangle NME1)

o Suppose the city council instead of capping the prices, decides to subsidize the snow plowing services by $100. This decrease the marginal cost of producers at each unit of output an shifts the supply curve downwards by $100 from S1 to S2. This means for every additional unit of services provided, the private companies /producer gets $100 as subsides from the city council.

o The new equilibrium moves to Point B. Quantity demand and supplied increases from Q1 to Q2. Thus, for a higher quantity, the consumers pay a lower amount i.e $250 as compared to earlier prices, whereas the private companies receives higher amount of $350. So producers earn some additional revenue with the application of subsidy.

Increase in Producer Surplus = Area KGAF

Increase in consumer Surplus = Area GLFB

Total Cost of the Subsidy on City Council: $ 100 x Q2 = Area KLAB

Total cost of Subsidy exceeds the benefit enjoyed by both producers and consumers which creates a welfare loss by are of triangle ABE1

Subsidy = A – B

Despite both the tools discussed above creates a welfare loss, a subsidy is better proposal than the price ceiling because in case of a price ceiling, the market operates faces disequilibrium due to shortages. Because of this the economy would face an increased demand of imports and the domestic private companies have to suffer by selling lower units at lower prices.