1. © Pilot Publishing Company Ltd. 2005 Chapter 12 Government Intervention in the Product Market

2. © Pilot Publishing Company Ltd. 2005 Market Price as a Social Coordinator Government Intervention – Price Ceiling Price Floor Quota Output Tax Subsidy Quality Control Contents:

3. © Pilot Publishing Company Ltd. 2005 Market Price as a Social Coordinator

4. © Pilot Publishing Company Ltd. 2005 What is price? Price is an exchange ratio showing the actual amount of a commodity (money or another good) that one has to pay in order to obtain a unit of the good. Nominal (or money or absolute) price is the exchange ratio expressed in terms of money. Relative price is the exchange ratio expressed in terms of another good.

5. © Pilot Publishing Company Ltd. 2005 Relation among price, revenue and value Relation between price and revenue TR = AR = MR: In a price-taking market In a price-searching market

6. © Pilot Publishing Company Ltd. 2005 Exchange value (or market value) of a good = revenue from selling the good or = expenditure on buying the good. MEV: In a price-taking market: = MR = P In a price-searching market: = MR < P Relation between price and exchange value

7. © Pilot Publishing Company Ltd. 2005 Price Use value However, to maximize utility, buyers will consume the quantity at which MUV=P. Price = the maximum amount one is willing to pay for the good at the margin, i.e., MUV. Relation between price and use value

8. © Pilot Publishing Company Ltd. 2005 Determination of market price (traditional analysis) $ Q S D Equilibrium price P e Q d =Q s Q d >Q s P ; Q d <Q s P ; Q d =Q s P unchanged

9. © Pilot Publishing Company Ltd. 2005 * Market D curve = MUV. Market S curve = MC. * If TC = 0, whenever MUV MC, mutually beneficial trade is possible at a price between MUV & MC, until MUVs = MCs = P and Q d = Q s. * As MCs are equal, MUVs are equated and MUVs = MCs, the market equilibrium is efficient in resource allocation. Determination of market price (modern analysis)

10. © Pilot Publishing Company Ltd. 2005 Functions of market price 1. Determine who wins and who loses in a market economy. Only the highest bidder can get the good. 2. Rewards (maximizers) or penalizes (non-maximizers) decisions or performance 3. A signal which transmits information and directs resource allocation. Price is the invisible hand.

11. © Pilot Publishing Company Ltd. 2005 Government Intervention --- Price Ceiling

12. © Pilot Publishing Company Ltd. 2005 Price ceiling What is a price ceiling? is the maximum price allowed by law; or is the price fixed below the equilibrium level.

13. © Pilot Publishing Company Ltd. 2005 Q12.2 Analyse the effect on the price and the quantity transacted of a good if the maximum price allowed by law (the price ceiling) is set (a) below the equilibrium price; (b) above the equilibrium price.

14. © Pilot Publishing Company Ltd. 2005 (Price ceiling)P 1 Q s1 Q d1 Shortage $ Q S=MC D=MUV (Equilibrium price)P 0 Graphical illustration

15. © Pilot Publishing Company Ltd. 2005 2. Quantity demanded ___________ to Q d1. Quantity supplied ___________ to Q s1. A shortage arises = Q d1 – Q s1. Effects of price ceiling on a price-taking market 1. The price _______ from P 0 to P 1. falls decreases increases falls 3. Quantity transacted _______ to Q s1. Why?

16. © Pilot Publishing Company Ltd. 2005 Examples: 4. Non-price competition exists among buyers Q s is inadequate and the price is fixed non-price competition exists among buyers First-come, first-served Ballot Allocation on the basis of ability Sellers preferences

17. © Pilot Publishing Company Ltd. 2005 $ Q S=MC D=MUV Q s1 Q d1 P 1 Shortage The maxi. cost one is willing to pay in the non-price competition. Buyers are willing to pay a maximum non-monetary cost (= MUV - P 1 ). Full cost = P 1 + non-monetary cost.

18. © Pilot Publishing Company Ltd. 2005 No resale + people have different ability individuals who can accomplish higher achievement will get the good (highest MUV nor best ability). Why? 5. Final allocation No resale + people have the same ability individuals with higher MUV will get the good. Why? Resale individuals with higher MUV will get the good. Why?

19. © Pilot Publishing Company Ltd. 2005 6. Income redistribution (or wealth transfer) Who gains? Who loses? Govt officials who execute the price control Why? Winners whose full cost < equilibrium price Producers Why? Winners whose full cost > equilibrium price Former winners but present losers

20. © Pilot Publishing Company Ltd. 2005 Production efficiency (to maximize wealth, producers will produce the goods at the minimum cost) x Consumption efficiency (winners of non-P competition may not be individuals with the highest value) x Allocative efficiency (MUV > MC under-production ) 7. Efficiency loss Deadweight loss brought by under-production D=MUV $ Q S=MC Q s1 Q d1 (Price ceiling) P 1

21. © Pilot Publishing Company Ltd. 2005 in which the good is sold illegally at a price above P 1 (Price ceiling) P 1 $ Q S=MC D=MUV Q s1 Q d1 8. Black market

22. © Pilot Publishing Company Ltd. 2005 9. Reduction in product quality As Q d > Q s, many consumers are willing to accept lower quality gds this induces producers to lower quality, to cut cost and to gain more Rent control shortage of flats whenever a tenant change his residence, he has to bear a high full cost in order to win the non-P competition turnover rate of tenants drops 10. Drop in the turnover rate of tenants

23. © Pilot Publishing Company Ltd. 2005 Remark: Differences between scarcity and shortage DifferencesScarcityShortage Definition Q available < Q desired (at zero price) Qs < Qd (at a certain price). Cause Unlimited wants vs. limited resources Fixed P < equil. P Result All kinds of competition may arise Under price control, only non-P competition may arise Nature Basic problem of all economic systems Specific problem of the market system

24. © Pilot Publishing Company Ltd. 2005 Remark: Price ceiling results in shortage & disequilibrium? If we consider the price competition only at the price ceiling (P 1 ), Q d1 > Q s1 shortage & disequilibrium appear To compete for the inadequate Q, a non-P comp. must emerge. If we consider the full cost (P 1 + non-monetary cost) full cost & Q d until Q d = Q s (at Q s1 ) shortage vanishes & equilibrium is achieved

25. © Pilot Publishing Company Ltd. 2005 Q12.3 Evaluate if the imposition of price ceiling benefits society. Does it lower the price, benefit the poor and achieve efficiency?

26. © Pilot Publishing Company Ltd. 2005 Q12.4 (a) If a price ceiling (P*) is imposed on a price-searching market, what will be the shape of the new marginal revenue curve? (b) Find out the equilibrium price and the equilibrium quantity if a price ceiling is set at P*. $ P* QmQm Q MR D MC Q pt

27. © Pilot Publishing Company Ltd. 2005 Price Floor

28. © Pilot Publishing Company Ltd. 2005 Price floor is the minimum price allowed by law; or is the price fixed above the equilibrium level. What is a price floor?

29. © Pilot Publishing Company Ltd. 2005 What is a price floor? To be effective, a price floor must be set above the equilibrium price. Why?

30. © Pilot Publishing Company Ltd. 2005 (Price floor) P 2 $ Q S=MC D=MUV 0 (Equilibrium price) P 0 Q d2 Q s2 Surplus Graphical illustration

31. © Pilot Publishing Company Ltd. 2005 2. Quantity demanded __________ to Q d2. Quantity supplied __________ to Q s2. A surplus arises = Q s2 – Q d2. Effects of a price floor on a price-taking market 1. The price _______ from P 0 to P 2. rises increases decreases falls 3. Quantity transacted _______ to Q d2. Why?

32. © Pilot Publishing Company Ltd. 2005 4. Non-price competition exists among sellers Inadequate buyers + fixed price non-P competition exists among sellers $ Q S=MC D=MUV 0 (Price floor) P 2 Q d2 Q s2 Surplus Sellers are willing to pay a max. cost (= P 2 - MC) to compete for buyers.

33. © Pilot Publishing Company Ltd. 2005 5. Efficiency loss If Q s2 is produced If Q d2 is produced ( the case of quota) Production efficiency (Q s2 are produced by producers of the lowest cost) X (Q d2 may not be produced by producers of the lowest cost) Consumption efficiency X (Q consumed < Q produced under-consumption) (Q produced are consumed by individuals with the highest MUV) Allocative efficiency X (At Q s2, MUV < MC over-production) X (At Q d2, MUV > MC under-production) Waste in non-P comp? Yes, among sellers

34. © Pilot Publishing Company Ltd. 2005 Quota

35. © Pilot Publishing Company Ltd. 2005 6. Black market $ Q S=MC D=MUV 0 (Price floor) P 2 Q d2 Q s2 Surplus some units of the good may be sold at a P below P 2 illegally. 7. Product quality Product quality is improved. Why?

36. © Pilot Publishing Company Ltd. 2005 What is a quota? Quota is the maximum quantity supplied allowed by law. To be effective, quota (Q 3 ) must be set below the equilibrium quantity (Q 0 ). Q3Q3 MC 3 $ Q S=MC D=MUV Q0Q0 S P3P3

37. © Pilot Publishing Company Ltd. 2005 2. Price ________ to P 3, where D meets S. Effects of quota on a price-taking market 1. The supply curve turns ___________ at Q 3. 3. Quantity transacted ___________ to Q 3. ( Options: horizontal / vertical / rises / falls ) vertical rises falls

38. © Pilot Publishing Company Ltd. 2005 $ Q S=MC D=MUV Q3Q3 Q0Q0 P3P3 S MC 3 Max. unit price of quota 4. Allocation of quota To compete for the quota, sellers are willing to pay a maximum cost of (P 3 –MC 3 ) to compete for each unit of quota. In auction, the quota goes to the highest bidder.

39. © Pilot Publishing Company Ltd. 2005 X Production efficiency (The goods may not be produced by producers of the lowest cost.) Consumption efficiency (The goods are consumed by individuals with the highest value.) X Allocative efficiency (MUV > MC Under-production.) 5. Efficiency Loss

40. © Pilot Publishing Company Ltd. 2005 $ Q S=MC D=MUV Q3Q3 Q0Q0 P3P3 S MC 3 Deadweight loss brought by under-production Graphical illustration:

41. © Pilot Publishing Company Ltd. 2005 Output Tax

42. © Pilot Publishing Company Ltd. 2005 Tax: is a compulsory payment levied on individuals, firms or commodities by the govt. What is a tax? Government Commodities Individuals Firms TAX

43. © Pilot Publishing Company Ltd. 2005 Classification according to the tax burden Direct tax taxpayers cannot shift the tax burden to others a tax levied on individuals, income or wealth Indirect tax taxpayers can shift the tax burden to others a tax levied on goods and services

44. © Pilot Publishing Company Ltd. 2005 Classification according to the tax rate Progressive tax as taxpayers income, tax rate Proportional tax as taxpayers income, tax rate unchanged Regressive tax as taxpayers income, tax rate

45. © Pilot Publishing Company Ltd. 2005 S1S1 Q1Q1 P b =P 1 $ Q S0S0 D0D0 Q0Q0 P0P0 P s =P 2 tax Effects of output tax on a price-taking market (imposed on sellers)

46. © Pilot Publishing Company Ltd. 2005 2. The market price ______ from P 0 to P 1. The price paid by buyers (P b ) ______ from P 0 to P 1. The actual price received by sellers (P s ) ______ from P 0 to P 2 (= P b - t). Effects of output tax (cont) 1. The supply curve shifts ________ by t. 3. Quantity transacted ______from Q 0 to Q 1. ( Options: downward / upward / drops / rises ) upward rises drops

47. © Pilot Publishing Company Ltd. 2005 4. Income distribution Drop in sellers surplus Drop in buyers surplus Tax revenue $ Q S0S0 D0D0 Q1Q1 Q0Q0 P b =P 1 S1S1 P0P0 P s =P 2 taxtax

48. © Pilot Publishing Company Ltd. 2005 5. Efficiency Loss Production efficiency (Goods are produced by producers with the min. cost.) Consumption efficiency (Goods are consumed by consumers with the highest value.) X Allocative efficiency (MUV > MC Under-production.)

49. © Pilot Publishing Company Ltd. 2005 Drop in sellers surplus Drop in buyers surplus Tax revenue Net social gain < 0 (deadweight loss) Net social gain = $ Q S0S0 D0D0 Q1Q1 Q0Q0 P b =P 1 S1S1 P0P0 P s =P 2 taxtax Rise in tax revenue + drop in buyers surplus + drop in sellers surplus

50. © Pilot Publishing Company Ltd. 2005 Q12.6 Find out the quantity transacted, the market price, the actual price paid by buyers and the actual price received by sellers (a) if the output tax is imposed on buyers. (b) if the output tax is shared equally between buyers and sellers. Compare the above results with those if the output tax is imposed on sellers.

51. © Pilot Publishing Company Ltd. 2005 Average product quality Under a unit tax or a specific tax Improved Tax and Quality Under a percentage tax or an ad valorem tax No change Why?

52. © Pilot Publishing Company Ltd. 2005 Distribution of tax burden Buyers share of tax burden Price elasticity of supply Sellers share of tax burden Price elasticity of demand = $ Q S0S0 D0D0 Q1Q1 Q0Q0 P b =P 1 S1S1 P0P0 P s =P 2 taxtax Buyers share of tax burden Sellers share of tax burden

53. © Pilot Publishing Company Ltd. 2005 Q12.7 (a)Draw a diagram to show the distribution of tax burden in each of the following special cases. (i)pEs = 0; (ii)pEs = infinity; (iii)pEd = 0; (iv)pEd = infinity. (b)Refer to the above results. Under what situations will the following happen? (i)Buyers bear the whole tax burden. (ii)Sellers bear the whole tax burden. (iii)The government gets the largest amount of tax revenue. (iv)The government gets the smallest amount of tax revenue.

54. © Pilot Publishing Company Ltd. 2005 Subsidy

55. © Pilot Publishing Company Ltd. 2005 What is a subsidy? Subsidy is a payment made by the government to cover part of the cost of a good. Subsidy Government Industry

56. © Pilot Publishing Company Ltd. 2005 S1S1 P b =P 1 subsidy P s =P 2 Effects of subsidy on a price-taking market (granted to sellers) $ Q S0S0 D0D0 Q0Q0 P0P0 Q1Q1

57. © Pilot Publishing Company Ltd. 2005 2. The market price _______ to P 1. The price paid by buyers (P b ) ________ from P 0 to P 1. The actual price received by sellers (P s ) _______ from P 0 to P 2 (= P b + s). Effects of subsidy (cont) 1. The supply curve shifts ___________ by s. 3. Quantity transacted _________ from Q 0 to Q 1. ( Options: downward / upward / falls / rises ) downward falls rises

58. © Pilot Publishing Company Ltd. 2005 Sellers share of subsidy Buyers share of subsidy $ Q S0S0 D0D0 Q0Q0 Q1Q1 P s =P 2 S1S1 P0P0 P b =P 1 subsidysubsidy 4. Income distribution Government subsidy

59. © Pilot Publishing Company Ltd. 2005 5. Efficiency Loss Production efficiency (Goods are produced by producers of the lowest cost) Consumption efficiency (Goods are consumed by consumers with the highest value) X Allocative efficiency (MUV < MC over-production)

60. © Pilot Publishing Company Ltd. 2005 Deadweight loss brought by over-production $ Q S0S0 D0D0 Q0Q0 Q1Q1 P s =P 2 S1S1 P0P0 P b =P 1 subsidysubsidy Graphical illustration:

61. © Pilot Publishing Company Ltd. 2005 Distribution of subsidy Distribution of subsidy between buyers and sellers: Buyers share of subsidy Price elasticity of supply Sellers' share of subsidy Price elasticity of demand =

62. © Pilot Publishing Company Ltd. 2005 Quality Control

63. © Pilot Publishing Company Ltd. 2005 What is quality control? Quality control is the stipulation of a minimum standard set by the government on the quality of a good. Examples: The HK govt has quality control on the cleanliness of restaurants, licensing of professionals, safety of products, etc.

64. © Pilot Publishing Company Ltd. 2005 Without quality control both good-quality & poor-quality goods co-exist in the market by the law of demand, P of poor-quality goods will be lowered & consumed by low-MUV buyers Effects of quality control With quality control only good quality can be supplied only high MUV buyers can afford them

65. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. Price does not exist without money. 2. Scarcity can be eliminated by price mechanism. 3. Shortage is the same as scarcity.

66. © Pilot Publishing Company Ltd. 2005 4. Shortage is caused by either an increase in demand or a decrease in supply. 5. Shortage exists whenever there is a queue. 6. The use of non-price competition implies that price competition (market solution) cannot solve the problem of shortage. Correcting Misconceptions:

67. © Pilot Publishing Company Ltd. 2005 7. Price is the fairest allocative device. 8. If resale is allowed, a good under price control must finally be allocated to those with higher income (or more wealth). 9. Price control results in disequilibrium. Correcting Misconceptions:

68. © Pilot Publishing Company Ltd. 2005 10. Price ceiling lowers the cost, helps the poor and benefits society. 11. Provision of subsidy shifts the supply curve downward and lowers the market price. Correcting Misconceptions: 12. Quality control improves the welfare of everyone as it guarantees the quality of goods sold in the market.

69. © Pilot Publishing Company Ltd. 2005 Survival Kit in Exam: Question 12.1: Suppose that the supply of a crop is perfectly inelastic and a storm has destroyed half of the crop. If the government fixes the price of the crop at its pre-disaster level and allocates the crop by rationing, explain the effects on the final allocation, wealth transfer and efficiency.

70. © Pilot Publishing Company Ltd. 2005 Survival Kit in Exam: Question 12.2: After the imposition of a per unit output tax of t, (a) under what conditions will consumers bear a smaller share of tax burden? (b) under what conditions will producers bear the whole tax burden?