Question

Suppose that market for good X is free and competitive, where the equilibrium price and quantity are $30 per tops 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 elasticities of demand and supply for good X are unknown and therefore, this price support policy could be too costly for the government. Question: Under what conditions could this price regulation cost the government 1, more than $100 million per year 2, less than $100 million per year 3, equal to $100 million per year (Hint: Make some reference to elasticity.) Explain your reasoning carefully, and illustrate with appropriate diagram using demand and supply curves. ( write words more than 300 words.)

Answer 1

With the imposition of price floor by the government, the government has to purchase the surplus amount of the product X at the price floor of $40. However, the exact amount of magnitude of the government expenditure is determined by the price elasticity of demand and price elasticity of supply. In the short run, when the elasticity is relatively inelastic, then amount of expenditure spent by the government is less and in the long run, when the value of elasticity increases, then surplus amount purchased by the government also increases and this increases expenditure of the government. This is explained by using the diagrams below: