Effects of Government Regulation on Demand and Supply

A government can impose various restrictions that will lead to an imbalance in the quantity and price equilibrium resulting in a deadweight loss.

These interventions include:

• Price ceilings and price floors
• Taxes and trade restrictions
• Minimum wages
• Subsidies and Quotas

Price Ceilings

A price ceiling is the highest price at which it is legal to trade a particular good or service.

Assume that the demand and supply of housing determines the equilibrium rent of $550 a month and the equilibrium quantity of 4,000 units of housing.

The following graph shows the efficient housing market with maximum consumer and producer surplus.

Suppose the government imposes a rent ceiling of $400 per month which is below the equilibrium price. As a result the following changes happen.

1. Rent ceiling restricts quantity supplied. Supplied quantity is 3000 and quantity demanded is 6000. Shortage of 3000 units.
2. Rent ceiling creates a black market. Some people will be willing to pay $625 per month for a house.
3. Resources get used in costly search activity including both time and cost.
4. A dead weight loss arises.

Price Floor

A price floor makes it illegal to pay a price lower than a specified level. An example of price floor is minimum wage.

Let’s say the equilibrium wage rate per hour is $5 at the equilibrium quantity of 5000 workers.

Minimum wage is imposed at $7 per hour. The graph will change as follows:

1. The minimum wage restricts the quantity demanded by the firms. At $7 per hour, only 3000 jobs are available.
2. People will find it hard to find jobs, and some people will be willing to take a job at lower rate. Someone will be ready to take a job at $3 per hour also. Illegal wage rates will range from $3 to below $7.
3. The firms’ surplus and the workers’ surplus shrinks.
4. A deadweight loss arises.
5. Other resources are used up in job search activity.

Taxes

Taxes will increase the equilibrium price and decrease the equilibrium quantity, creating a deadweight loss.

Production Quotas

A production quota is an upper limit to the quantity of a good that may be produced in a specified time period.

With a production quota, the quantity decreases, the consumer surplus shrinks, the producer surplus expands, and a dead weight loss arises.

Subsidies

Subsidies are payments made by governments to producers such as farmers. Subsidies lower the prices paid by buyers and increase the prices received by sellers. With a subsidy, the quantity increases, and a dead weight loss arises due to overproduction.