Price floor on the cheese market
Tax on the cheese market

Price floor on the cheese market

Suppose that the government imposes a price floor on the market for cheese. Using a supply and demand graph, illustrate the effects this will have on the market.

A price floor is when the government mandates the minimum price that a firm is allowed to charge for a product. Often it is applied farm products to ensure farmers receive a higher price for their produce.

The effects of the price floor are depicted in the graph below.

Before the introduction of the price floor the output is produced at the point $Q_1$ which corresponds to the point where the supply and the demand curve intersect. The price of output is $P_1$. When the government sets a binding price floor, they force producers to sell the good for the price $P_{floor}$. This increase in the price causes some consumers who currently demand the good to no longer wish to purchase the good as it is too expensive. Moreover, the increase in price causes more suppliers to enter the market as they will be now receiving a higher price. The level of demand drops from $Q_1$ to $Q_d$ and the quantity supplied increases from $Q_1$ to $Q_S$. As supply is now larger than the quantity demanded, this creates a surplus of $Q_S - Q_D$.

What happens to cheese farmers revenue?

Could the price floor have unintended negative consequences for the suppliers of the good?

It is possible. The increase in the price floor will cause the total revenue of all suppliers to increase by $(P_{floor}-P_1)*Q_1$ and decrease by $(Q_1 - Q_D)*P_1$. Therefore, if $(P_{floor}-P_1)*Q_1 < (Q_1 - Q_D)*P_1$ the suppliers of cheese will be worse off.

Tax on the cheese market

Suppose that the government imposes a tax on the market for cheese. Using supply and demand analysis, explain what happens to the quantity and price for cheese.

A tax on the price of cheese drives a wedge between the price that consumers pay and the price that suppliers receive. The effects are depicted in the graph below.

Initially, the equilibrium quantity produced occurs at $Q_1$ where the supply and the demand curves intersect and the price is $P_1$. When the government imposes the tax, it causes the supply curve to shift to the left. This increases the price that is paid by consumers from $P_1$ to $P_c$. At this price, only $Q_T$ Consumers desire to consume the good. As the suppliers have to give the tax to the government, they only receive $P_S$ for each unit they produce, so they decrease their supply down to $Q_T$. Ultimately, the tax on cheese causes the quantity of output to decrease by $Q_1 - Q_T$ and causes the price to increase by $P_C- P_1$ for consumers and decreases by $P_1 - P_s$ for suppliers.

Does the price increase by the size of the tax?

Often you might hear that 'firms will just pass the entire tax onto consumers' in response to a tax increase. However, as we can see from our supply and demand analysis, the increase in the price for consumers is less than the size of the tax. This is because the tax causes suppliers to move leftwards down the supply curve, decreasing the cost of supply. Thus, not all the costs are passed onto consumers.