Question

The government is considering imposing a new law to improve health that French fries have to

be sold for at least $4. (this question is unrelated to part A)

-In order to be binding would this be a ceiling or floor?

-Use a supply and demand graph to explain the impact of this policy. Use both positive and

normative analysis and describe the pros and cons of the policy.

Answer 1

Since the government intends to improve health, it would try and reduce the consumption of french prices. If the price is below market equilibrium (price ceiling), it would trigger higher demand for french fried. However, if the price is above the equilibrium price (price floor), it would reduce demand for french fries. Therefore, in order to be binding, this would be a price floor.

The chart below gives the supply and demand for french fries followed by the explanation.

In the chart above, the initial supply and demand for french fries is given by S and D respectively. The initial equilibrium price and quantity demanded are given by P and Q respectively.

With the government intending to reduce consumption of french fries, the price floor of $4 is placed as indicated by the horizontal line. It is clear that the price floor is above the equilibrium price of P. The result is that the quantity demand falls to Q1 and the quantity supplied increases to Q2. Overall, this reduces consumption of french fries and creates a surplus of french fries that is represented by the gap = Q2 - Q1.

The positive aspect is that the government achieves the objective of reducing consumption of french fries and that serves the objective from a health perspective.

However, it is worth noting that as the quantity demanded declines, it creates a dead weight loss in the economy. This dead weight loss is represented by the area "ABC." A dead weight loss implies that there is an overall decline in economic surplus. In other words, the sum of consumer surplus and producer surplus declines. T

Therefore, while the government achieves the objective, it creates a decline in total economic welfare or total economic surplus. From an economic perspective, this is the reason why government intervention can be counter-productive (dead-weight loss).