Economics Chapter 11 Market Intervention

Policies by the government (violate free market) Bounded by economic laws (effective in economics) Usually have good intentions: Protect working poor Avoid market overheat Increase the tax income Lower the disparity between the rich and the poor

1. Price ceiling (P c ) The maximum price permitted by law. It is illegal to trade above P c. Aim at keeping the price stable Avoid P  Encourage consumption

Effects on Price (P) and Quantity transacted (Q t ) In free market: Equil. Quantity at Q d =Q s, i.e. Q t =40 Equil. Price (P e ) = $4 If a price ceiling is set, where P c = $2 Market Price = P c = $2 (restricted by law) At this price level, Q d = 60, Q s = 20, ∴ Q t = 20 (amount available in the market) Conclusion: P , from P e to P c ($4) ($2) Q t , from Q e to Q s (40) (20) Shortage = Q d - Q s = 60 – 20 = 40 units P($)Q d (units)Q s (units) D P ($) Q0 P e =4 P c =2 20 S 4060

Does it work to promote sale by implementing P c ? E.g. Bus services Market equilibrium: P e = $15 Q e = 100 rides Environment protection  Gov’t promotes using public transport  fewer private cars  less air pollution Set P c = $10 Market price = P c = $10 Q d = 120, Q s = 50, ∴ Q t = 50 rides Although Q d , Q t  and cause a shortage Policy of P c = $10 can’t serve the initial purpose Bus service P($)Q d (rides)Q s (rides) D P ($) Q S

Effective P c ? Yr.1: Free market P e = $4 Q e = 70 rides D P ($) Q0 4 S 70 P($)Q d (units)Q s (units) Yr.2: Price ceiling P c = $3 Q t = Q s = 60 rides D P ($) Q0 S Yr.3: Price ceiling P c = $6 P e = $4 is available Q t = 70 rides (where Q d = Q s ) Same as no P c D P ($) Q0 6 S 70 ∴ To be effective, P c must be lower than P e,( i.e. P c < P e ) If P c > P e, ineffective price ceiling. 4

Removal of P c At first, with price ceiling: P c = $4 Q t = Q s = 50 Total revenue = $4 x 50 = $200 Shortage = 150 – 50 = 100 units After removal of P c P   P e = $10 Q t = Q d = Q s = 100 Total revenue = $10 x 100 = $1000 No shortage Result: TR  and shortage disappear Q0 D P ($) P e =10 P c =4 50 S

Other effects 1. Black market At first, with price ceiling: P c = $2 Q d = 60, Q s = 50 Shortage = 40 units For consumer: P c When Q = 20 units MB = $6  Black market price MB - P c = $6 - $2 = $4 i.e. consumers are willing to pay $4 more to obtain 20 units of good Gain from illegal trading = $4 x 20 = $80 The development if black market: Mr. A gets 20 units at P c ($2) from the market. Then, he sells at P b ($6) Cost bear by government: Cost of implementing law (price ceiling) Cost of crime-fighting Q0 D P ($) P e = 4 P c = 2 20 S 4060 P b = 6

Other effects 2. Non-price method Allocation of products by First-come-first-serve (e.g. EAG tickets) Rationing by Seniority Needs Sellers preferences Drawing lots (e.g. public housing) Cost of different method First-come-first-serve: Time to queue up Drawing lots: Submit application Opportunity cost   Full price  To consumer: Full price = MB MB > P c (profit not being maximized) Q0 D P ($) PcPc 20 S 4060 PfPf

Other effects 3. Quality Profit maximization: P e (where MB=MC) But product is sold at P c, which is lower than MB Producer can’t get the highest profit  then cut cost  quality  Q0 D P ($) PcPc 20 S 4060 PfPf

2. Price ceiling (P c ) The minimum price permitted by law. It is illegal to trade below P f. Aim at Protect the workers (e.g. min. wage) Enable stable income (e.g. taxi fare) Encourage supply

Effects on Price (P) and Quantity transacted (Q t ) In labour market: Equil. Quantity at Q d =Q s, i.e. Q t =100 workers Equil. Price (P e ) = $30 If a price floor is set, where P f = $30 Market Price = P c = $30 (restricted by law) At this price level, Q d = 80, Q s = 120, ∴ Q t = 80 ( Q d in the market) Conclusion: P , from P e to P f ($20) ($30) Q t , from Q e to Q s (120) (80) Surplus = Q s - Q d = 120 – 80 = 40 labours i.e. 40 labours will be unemployed. wage($)Q d (units)Q s (units) D Wage ($) Labour0 P e = 20 P f = S

Effective P f ? Yr.1: Free market P e = $20 Q e = 100 workers D Wage ($) Labour0 20 S 100 Yr.2: Price floor P f = $30 Q t = Q d = 80 workers D Wage ($) Labour0 S Yr.3: Price floor P f = $10 P e = $20 is available Q t = 100 rides (where Q d = Q s ) Same as no P f D Wage ($) Labour0 10 S 100 ∴ To be effective, P f must be higher than P e,( i.e. P f > P e ) If P f < P e, ineffective price floor. 20 Allow to 

Other effects 1. Black market At first, with price floor: P f = $6 Q d = 20, Q s = 60 Q t = 60 Unemployment = 40 workers For boss: At P f Q d = 20 workers MC = P b = $10  Black market price i.e. someone is willing to pay $10 to hire 20 workers Save from illegal employment = $20 x 20 = $400 Sources of black labour market People without working permit Domestic helpers for other jobs Cost bear by government: Social conflicts (business vs. workers) Legislation (price floor) Cost of crime-fighting Labour0 D Wage ($) P e = 20 P b = S 4060 P f = 30 Unemployment

Other effects 2. Non-price method Better services Better quality High entry requirements  skills  qualification Corruption

Minimum wage (P f ) Aim at: Protect the workers  Higher wages  Better living Possible outcome: High cost  Business close down  Unemployment  Poor living Supporters: Workers Poor families Labour unions LegCo member (aim at social welfare and helping the poor) Opponents Businessmen Elderly Handicapped Low skill workers LegCo member (aim at business sector)

Question Explain with the aid of a diagrame the following situations. Given that the demand of good X is elastic. If an effective price floor is set, a. What’s effective in price and quantity transacted? (6 marks) b. What is the change of the total revenue? a. Price floor is the minimum price permitted by law. An effective price floor must be set above the equilibrium price. Therefore, the price will be higher (from P 1 to P 2 ) and so the quantity transacted will decrease (from Q 1 to Q 2 ). b. Since demand of good X is elastic, percentage increase in price is less than percentage decrease in quantity demanded, the total revenue will fall. Q0 D P ($) P1P1 Q2Q2 S Q1Q1 P2P2 Price floor

3. Quota The maximum quantity supplied of goods/services imposed by the gov’t. license of unit supply. A kinked supply curve Assume: Quota = 20 units P($)QsQs Q s w/ quota P ($) Q S D P ($) Q S

HK: Taxi Urban (Red) : N.T. (Green) : 2838 Lantau (Blue) : 50

Effects on P and Q t Without quota P e = $5 Q e = 50 units TR = $250 With quota = 30units, P e = $7 Q t = 30units Conclusion P  Q t  P ($) Q0 5 S 50 P ($) S 30 Q0 7 D D

Effects on different E d Elastic demand (E d >1) P = $7 Q t = quota = 30 TR = $7 x 30 = $210 (  ) Inelastic demand (E d <1) P = $10 Q t = quota = 30units TR = $10 x 30 = $300 (  ) Conclusion With quota, Elastic demand  TR  Inelastic demand  TR  P ($) S 30 Q0 10 D P ($) S 30 Q0 7 D

Price of a quota Quota = 30 units Seller A Quota: 20 units Q s = 10 units Seller B Quota for: 10 units Q s = 20 units Quota selling = 10 unites (from A to B) A gains from selling of quota B gains from more Q s Trade of quota freely At Q = 30 units MB = $20, MC = $8 Price of quota = $20 - $8 = $12 P ($) S2S2 30 Q 0 20 D S1S1 8

Better quality (p.129) Assume the unit price of quota: $200,000 Before buying quota: Price of high-quality car = $400,000, Relative price = 4 LQ cars Price of low-quality car = $100,000, Relative price = 0.25 HQ car After buying quota: Price of high-quality car = $600,000, Relative price = 2 LQ cars Price of low-quality car = $300,000, Relative price = 0.5 HQ car i.e. after buying quota, Relative price of HQ car  Relative price of LQ car   Benefit to import HQ car

4. Sales tax Goods and services tax (GST) Tax imposed on goods or services No GST in HK 2 types Unit tax – fixed amount of money/tax imposed on each unit Ad valorem tax – a certain percentage of the price Aim at Discourage consumption (e.g. cigarette) Increase government revenue Support other policies (e.g. plastic bag)

Unit tax Supply schedule P($) QsQs before taxAfter tax QsQs P($)before taxAfter tax

Unit tax Tobacco, unit tax = $4 D P ($) 14 S1S P($) QsQs before taxAfter tax Q S2S2 22

Effects on Price and Q Unit tax = $4 D P ($) 0 S1S Q S2S2 20 QsQs P($)QdQd before taxAfter tax Before tax, P e = $18 Q e = 50 units After tax, P e = $20 Q e = 45 units P , Q 

Example Good A, unit tax = $2 D P ($) 0 S1S Q S2S2 12 QsQs P($)QdQd before taxAfter tax P , Q   TR  (elastic demand) Tax revenue = $2 x 300 = $600 Before tax, P e = $11 Q e = 350 units TR = $11x350=$3850 After tax, P e = $12 Q e = 300 units TR = $12x300=$3600

Tax burden Tax revenue = Unit tax x Q t = $4 x 45 = $180 Tax incidence Consumers’ tax burden Before tax, P = $18 After tax, P = $20 Tax burden = ($20 - $18) x 45 = $90 Producers’ tax burden Before tax, P = $18 After tax, P = $20, Unit tax = $4 Actually receive: $20 - $4 = $16 Tax burden = ($18 - $16) x 45 = $90 D P ($) 0 S1S Q S2S Consumers’ burden Producer’s burden

Example Unit tax = $6 Equil. price: $____  $____ Equil. Q: ____ units  ____ units Total tax burden = $6 x ____ = $____ Consumers’ tax burden = ($____ - $____) x ____ = $____ Producers’ tax burden = ($____ - $____) x ____ = $____ Price Q d (unit) Q s before tax (unit) Q s after tax (unit)

Example Unit tax = $6 Equil. price: $18  $22 Equil. Q: 36 units  32 units Total tax burden = $6 x 32 = $192 Consumers’ tax burden = ($22 - $18) x 32 = $128 Producers’ tax burden = ($18 - $16) x 32 = $64 Price Q d (unit) Q s before tax (unit) Q s after tax (unit)

Tax burden Before tax Producers’ TR = P 1 x Q 1 After tax Total tax revenue = ( P 2 – P 3 ) x Q 2 Producers’ TR (before paying tax) = P 2 x Q 2 Producers’ TR (after paying tax) = P 3 x Q 2 Producers’ TR  D P ($) 0 S1S1 Q2Q2 Q1Q1 P1P1 Q S2S2 P2P2 P3P3 Loss

Tax burden and elasticity Inelastic demand and elastic supply ( E d 1 ) Consumers’ tax burden = ( P 2 - P 1 ) x Q 2 = Producers’ tax burden = ( P 2 – P 3 ) x Q 2 = E d < E s, Consumers bear more burden (Lower E d, Tax burden  ) Producers bear less burden (Higher E s, Tax burden  ) D P ($) 0 S1S1 Q2Q2 Q1Q1 P1P1 Q S2S2 P2P2 P3P3 Consumers’ burden Producer’s burden Consumers’ burden Producer’s burden

Tax burden and elasticity Elastic demand and inelastic supply ( E d > 1 ) ( E s < 1 ) Consumers’ tax burden = ( P 2 - P 1 ) x Q 2 = Producers’ tax burden = ( P 2 – P 3 ) x Q 2 = E d > E s, Consumers bear less burden (Higher E d, Tax burden  ) Producers bear more burden (Lower E s, Tax burden  ) D P ($) 0 S1S1 Q2Q2 Q1Q1 P1P1 Q S2S2 P2P2 P3P3 Consumers’ burden Producer’s burden Consumers’ burden Producer’s burden

Tax burden and elasticity E d = E s Consumers’ tax burden = ( P 2 - P 1 ) x Q 2 = Producers’ tax burden = ( P 2 – P 3 ) x Q 2 = Same tax burden D P ($) 0 S1S1 Q2Q2 Q1Q1 P1P1 Q S2S2 P2P2 P3P3 Consumers’ burden Producer’s burden Consumers’ burden Producer’s burden

Tax burden and elasticity Perfectly elastic demand ( E d = ∞ ) Consumers pay the same price No tax burden Producers’ tax burden = ( P 1 – P 3 ) x Q 2 = ∴ E d = ∞, producers bear all the tax burden D P ($) 0 S1S1 Q2Q2 Q1Q1 P1P1 Q S2S2 Producer’s burden P3P3

Tax burden and elasticity Perfectly inelastic demand ( E d = 0 ) Consumers’ tax burden = ( P 2 – P 1 ) x Q 1 = Producers get the same price after tax No tax burden ∴ E d = 0, consumers bear all the tax burden D P ($) 0 S1S1 Q1Q1 P2P2 Q S2S2 P1P1 Consumers’ burden

Tax burden and elasticity Perfectly elastic supply ( E s = ∞ ) Consumers’ tax burden = ( P 2 – P 1 ) x Q 1 = Producers get the same price after tax No tax burden ∴ E s = ∞, consumers bear all the tax burden D P ($) 0 S1S1 Q1Q1 P2P2 Q S2S2 P1P1 Consumers’ burden Q2Q2

Tax burden and elasticity Perfectly inelastic supply ( E s = 0 ) Producers’ tax burden = ( P 2 – P 1 ) x Q 1 = Consumers pay the same price after tax No tax burden ∴ E s = 0, producers bear all the tax burden D P ($) 0 S1S1 Q1Q1 P2P2 Q P1P1 Producers’ burden Producers’’ burden

5. Subsidy The financial aid the government gives on each unit of goods or services E.g. Education (pri. and sec. education, university) Medical ($44 + subsidy)

Equil. Price and Q Unit subsidy = $4 D P ($) 0 S1S Q S2S2 18 QsQs P($)QdQd before subsidy After subsidy Before subsidy, P e = $18 Q e = 50 units After subsidy, P e = $16 Q e = 55 units P , Q 

Subsidy benefit Total subsidy = Unit subsidy x Q t = $4 x 55 = $180 Subsidy benefit Consumers’ subsidy benefit Before subsidy, P = $18 After subsidy, P = $16 subsidy benefit = ($18 - $16) x 55 = $110 Producers’ subsidy benefit Before subsidy, P = $18 After subsidy, P = $16, Unit tax = $4 Actually receive: $16 - $4 = $20 Tax burden = ($20 - $18) x 55 = $110 D P ($) 0 S2S Q S1S Consumers’ subsidy benefit Producer’s subsidy benefit $4

Example Unit subsidy = $6 Equil. price: $____  $____ Equil. Q: ____ units  ____ units Total subsidy benefit = $6 x ____ = $____ Consumers’ subsidy benefit = ($____ - $____) x ___ = $____ Producers’ subsidy benefit = ($____ - $____) x ___ = $____ Price Q d (unit) Q s before subsidy (unit) Q s after subsidy (unit)

Example Unit subsidy = $6 Equil. price: $18  $14 Equil. Q: 36 units  40 units Total subsidy = $6 x 40 = $240 Consumers’ subsidy benefit = ($18 - $14) x 40 = $160 Producers’ subsidy benefit = ($20 - $18) x 40 = $80 Price Q d (unit) Q s before subsidy (unit) Q s after subsidy (unit)

Subsidy and total revenue Before subsidy Producers’ TR = P 1 x Q 1 After subsidy Total subsidy = ( P 3 – P 2 ) x Q 2 Producers’ TR (before getting subsidy) = P 2 x Q 2 Producers’ TR (after getting subsidy) = P 3 x Q 2 Producers’ TR  D P ($) 0 S2S2 Q1Q1 Q2Q2 P2P2 Q S1S1 P1P1 P3P3 Gain

Subsidy benefit and elasticity Inelastic demand and elastic supply ( E d 1 ) Consumers’ subsidy benefit = ( P 1 – P 2 ) x Q 2 = Producers’ subsidy benefit = ( P 3 – P 1 ) x Q 2 = E d > E s, Consumers have more subsidy benefit (Lower E d, subsidy benefit  ) Producers have less subsidy benefit (Higher E s, subsidy benefit  ) D P ($) 0 S2S2 Q1Q1 Q2Q2 P1P1 Q S1S1 P2P2 P3P3 Producer’s benefit Consumers’ benefit Producer’s benefit

Subsidy benefit and elasticity Elastic demand and inelastic supply ( E d > 1 ) ( E s < 1 ) Consumers’ subsidy benefit = ( P 1 – P 2 ) x Q 2 = Producers’ subsidy benefit = ( P 3 – P 1 ) x Q 2 = E d > E s, Consumers have less subsidy benefit (Higher E d, subsidy benefit  ) Producers have more subsidy benefit (Lower E s, subsidy benefit  ) D P ($) 0 S2S2 Q1Q1 Q2Q2 P1P1 Q S1S1 P2P2 P3P3 Consumers’ benefit Producer’s benefit Consumers’ benefit Producer’s benefit

Subsidy benefit and elasticity E d = E s Consumers’ subsidy benefit = ( P 1 – P 2 ) x Q 2 = Producers’ subsidy benefit = ( P 3 – P 1 ) x Q 2 = D P ($) 0 S2S2 Q1Q1 Q2Q2 P1P1 Q S1S1 P2P2 P3P3 Consumers’ benefit Producer’s benefit Consumers’ benefit Producer’s benefit

Subsidy benefit and elasticity Perfectly elastic demand ( E d = ∞ ) Producers’ subsidy benefit = ( P 3 – P 1 ) x Q 2 = Consumers have no subsidy benefit D P ($) 0 S2S2 Q1Q1 Q2Q2 P1P1 Q S1S1 P3P3 Producer’s benefit

Subsidy benefit and elasticity Perfectly inelastic demand ( E d = 0 ) Consumers’ subsidy benefit = ( P 1 – P 2 ) x Q 2 = Producers have no subsidy benefit D P ($) 0 S2S2 Q1Q1 Q S1S1 P2P2 P1P1 Consumers’ benefit

Subsidy benefit and elasticity Perfectly elastic supply ( E s = ∞ ) Consumers’ subsidy benefit = ( P 1 – P 2 ) x Q 2 = Producers have no subsidy benefit D P ($) 0 S2S2 Q1Q1 Q2Q2 P1P1 Q S1S1 P2P2 P3P3 Consumers’ benefit

Subsidy benefit and elasticity Perfectly inelastic supply ( E d = 0 ) Producers’ subsidy benefit = ( P 1 – P 2 ) x Q 2 = Consumers have no subsidy benefit S P ($) 0Q1Q1 Q D P2P2 P1P1 Producer’s benefit

Explain why under rent control, there will be non-price competition, (5) and rental residential units tend to lack maintenance? (3) a.Rent control is a kind of price ceiling. It is the maximum price permitted by law. Trading above the price ceiling is illegal. (1) With rent control, the trading price cannot be higher than P c (fig.1) (1). At P c, quantity demanded is greater than quantity supplied. So shortage exists. (1) Since it is illegal to trade at a higher price, there will be non-price competition (1) such as first-come-first- serve, rationing by conditions or drawing lots. (1) b.With price ceiling, quantity transacted will be at Q s (fig.1). At Q s, marginal benefit is greater than the marginal cost. (1) Therefore, profit maximization cannot be achieved. (1) Suppliers will cut cost by lowering the quality. So, the rental residential units tend lack maintenance. (1)

(a)Given that the demand of Good X is elastic. If an effective price floor is set, what is the effect on (i) Price (ii) Quantity transacted (iii) Total revenue Answer the question with an aid of a diagram. (8) (b)What do you expect the quality of Good X? (2) a. Price floor is the minimum price permitted by law. It is illegal to trade below price floor, P 2 (fig.2). (1) An effective price floor must be set higher than the equilibrium price, P1. Therefore the price for transaction will be higher. (1) According to the law of demand, increase in price will lead to a decrease in quantity demanded. So, quantity transacted will decrease from Q 1 to Q 2. Since the demand of Good X is elastic, the percentage decrease in quantity demanded is greater than the percentage increase in price. The total revenue will decrease b. With an effect price floor, surplus will be found in Good X. So, the quality of Good X will become to ensure the sakes as soon as possible.