Micro CHAPTER 2.8:

Market Disequilibrium and The Effects of Government Intervention in Markets

CHAPTER SUMMARY

Markets are not always in equilibrium. When they are not, this is called disequilibrium. There are many reasons that the price level might not result in the quantity supplied equaling the quantity demanded.

This can happen in two ways (see graphs below).

If the price level is below the equilibrium price, then the quantity demanded will be higher than the quantity supplied. This situation is called excess (too much) demand or a shortage. In this situation, people want to buy something, but there is no more of it available.

If the price level is above the equilibrium price, then the quantity supplied will be higher than the quantity demanded. This situation is called excess supply or a surplus. In this situation, producers want to sell something, but there is a lot of extra that no one wants to buy.

How can this happen? Sometimes, markets just don't work perfectly. One cause of this is sticky prices - this is the idea that companies don't change their prices every single time the market changes slightly. As a result, sometimes prices don't keep up with changes in the market. Other times, there is imperfect information in the market - not everyone knows what they need to know to set the market-clearing price.

Other times, disequilibrium can be caused by actions of the government. Governments understand this, but may choose to intervene (step in and take action) in markets anyway for various reasons. Here are a few government interventions and how they might affect a market:

Price ceiling: The government sets a maximum legal price for a good or service. No one is allowed to sell the product for more than this price. If this ceiling is below the equilibrium price, it can cause a shortage. Because governments know this, they might also set rules about how much of the product each person can buy to make sure there is enough available for everyone.
Price floor: The government sets a minimum legal price for a good or service. No one is allowed to sell the product for less than this price. If this floor is above the equilibrium price, it can cause a surplus. Because governments know this, they might also agree to buy the extra, leftover products from producers.
Subsidy: The government pays producers a specific amount of money for each unit of something they produce. This effectively reduces the cost to produce something, increasing supply. Governments often do this for products they believe are extremely important to the economy or the country, such as fuel.
Excise Tax: The government puts a per-unit tax on something. If they tax the production, it increases the costs of production, decreasing supply. Governments often do this when a product is bad for the economy or individuals, such as alcohol.

When the price level is not equal to the equilibrium price, we do not achieve the optimally (most/best) efficient outcome. In the charts below, you can see that when there is a shortage or a surplus, there is still some consumer surplus (CS) and producer surplus (PS), but we don't get as much as we could have. The CS and PS that we did not receive because of the disequilibrium is called deadweight loss, and can be seen in the yellow triangles.

Deadweight loss due to a shortage

Deadweight loss due to a surplus

When the government implements an excise tax, the result is a decrease in supply that causes a deadweight loss, but also gives the government tax revenue.

You can see in the chart below, that the box bounded by the original equilibrium price line ($10), the equilibrium price line after the change in supply ($12), the quantity demanded after the tax (600), and the y-axis represent the portion of the tax that is effectively paid by consumers.

The box bounded by the original equilibrium price line ($10), the quantity demanded after the tax (600), the price at the intersection of that line and the original supply curve ($5), and the y-axis represent the portion of the tax effectively paid by producers.

The elasticity of both the supply and demand curves can influence what proportion (ratio/percentage) of the tax is paid by consumers vs. producers.

The space between the demand curve, the original supply curve, and the vertical line at the new quantity (600) represents the deadweight loss resulting from the tax.