5. Market Intervention

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5. Market Intervention

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Chapter 5 : main menu5.1 Price ceiling Theory in Life 5.1

5.2 Price floorTheory in Life 5.2

Concept Explorer 5.1

Progress Checkpoint 1

5.3 QuotaTheory in Life 5.3



5.4 Per-unit taxTheory in Life 5.4


5.5 Per-unit subsidyTheory in Life 5.5



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Theory in Life 5.1

Price ceiling and traffic congestion During rush hours, the Cross Harbour

Tunnel is highly congested. After its toll has been raised, congestion is

only slightly reduced. How will the total expenditure spent on

crossing the tunnel change?

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Theory in Life 5.1 As there is a maximum

capacity for tunnel, the supply of tunnel service is perfectly inelastic, i.e. the supply curve is vertical .

Before the increase in toll, it was set at P1 (below the equilibrium level).

As the quantity demanded (Qd1) was greater than the quantity supplied (Qs), traffic congestion (ED1) occurred.

gain

D

Quantity

P1

P2

P ($)S

ED1

ED2

Qs Qd2 Qd1

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Theory in Life 5.1 When the toll is raised to P2,

the quantity demanded drops to Qd2.

The smaller shortage (ED2) indicates that congestion is slightly reduced.

However, as P2 is still below the equilibrium level, there is still congestion.

The increase in toll causes an increase in total expenditure. The quantity transacted remains at Qs, and the increase in total expenditure is shown by the shaded area.

gain

D

Quantity

P1

P2

P ($)S

ED1

ED2

Qs Qd2 Qd1

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Theory in Life 5.2

Price Floor and Filipino Maids Filipino maids often have to wait for

employment in Hong Kong. Why did they have to wait longer but earn

less immediately after the Asian financial turmoil in 1998?

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Theory in Life 5.2 The Filipino maids are

protected by a minimum wage law.

With the demand curve D1 and the supply curve S, a surplus (ES1) of the maids’ service occurs at the minimum wage (W).

Hence they often have to wait for employment in Hong Kong.

Their total income is shown by the area W x Qd1.

loss

D1

Filipino maids’service

S

D2

W

ES1

ES2

Qd2 Qd1 Qs0

Wage rate ($)

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Theory in Life 5.2 After the Asian financial

turmoil occurred in 1998, the income of Hong Kong people dropped.

As the maids’ service is a normal good, the demand for their service decreased from D1 to D2.

A larger surplus (ES2) means they had to wait longer for employment in Hong Kong.

Their total income is shown by area W x Qd2, which decreased by the shaded area.

loss

D1

Filipino maids’service

S

D2

W

ES1

ES2

Qd2 Qd1 Qs0

Wage rate ($)

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Price ceiling (floor) set above (below) equilibrium level Is it effective if a price ceiling (floor) is set

above (below) equilibrium level?

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If a price ceiling is set at Pc, the market price will be Pe and the quantity transacted will be Qe.

The price ceiling set above the equilibrium level is ineffective. 0 Q/t

S

D

Pe

QeQ1 Q2

Pc

P ($)

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If a price floor is set at Pf, the market price will be Pe and the quantity transacted will be Qe.

The price floor set below the equilibrium level is ineffective. 0 Q/t

S

D

Pe

QeQ1 Q2

Pf

P ($)

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Suppose the government sets a price ceiling on gasoline. With the aid of well-labelled supply-demand diagram(s), explain the effect on the market price, quantity transacted and total revenue of (a) gasoline sellers; and (b) private car sellers.

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When the government sets a price ceiling on gasoline, the market price will fall from P1 to P2, quantity transacted will fall from Q1 to Q2, and total revenue of gasoline sellers will fall by the shaded area.

Q / t0 Q1

S

P1

P2

Gasoline

D

P ($)

price-ceiling

Q2

LOSS

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Progress Checkpoint 1 When a price ceiling is set on

gasoline, gasoline becomes cheaper.

As gasoline and private cars are complementary goods, the demand for private cars will rise. The demand curve will shift from D1 to D2.

Equilibrium price will rise from P1 to P2, and equilibrium quantity will rise from Q1 to Q2. Total revenue of the private car sellers will rise by the shaded area.

Q / t0

P ($)

S

D1Q1

P1

Q2

P2

D2

Private cars

GAIN

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With the aid of a well-labelled supply-demand diagram, explain(a) why the total income of workers may decrease, and (b) why even more people may become jobless once the minimum wage law is passed.

Nowadays, many people are jobless. The recent unemployment rate reached a climax,and analysts said that the average income of households could not afford a respectable life. In response to this, many legislators propose to introduce a minimum wage law, hoping that the work force is guaranteed a minimum amount of income. They even urged the government to …

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Progress Checkpoint 1 When market wage

rate was at W1, quantity transacted of labour was at L1.

There was already unemployed, represented by U1 (surplus of labour).

loss

Labour

Wage rate S

D

U2

U1W2

W1

L2 L10

gain

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Progress Checkpoint 1(a) When a minimum

wage is set at W2, there will be a rise in market wage rate. But the quantity transacted of labour will fall from L1 to L2.If demand for labour is elastic (Ed > 1), i.e. the percentage change in quantity demanded is greater than the percentage change in wage rate, the gain in total income will be less than the loss, resulting in a net decrease in total income.

loss

Labour

Wage rate S

D

U2

U1W2

W1

L2 L10

gain

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Progress Checkpoint 1(b) When the

quantity transacted of labour decreases from L1 to L2, there will be a larger pool of surplus labour, represented by U2 in the diagram.

loss

Labour

Wage rate S

D

U2

U1W2

W1

L2 L10

gain

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Theory in Life 5.3

Quota and the quality of garment products The U.S. government has long been

imposing quota on garment products from Hong Kong.

It is observed that the quality of garment products is raised, and the garment exporters received higher total revenue after such quality improvement. Why is this so?

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Theory in Life 5.3 Before a quota is set, the

price of garment products is at P1, which is determined by D1 and S1.

When a quota is set, supply decreases from S1 to S2. Price increases from P1 to P2, and quantity transacted decreases from Q1 to Q2.

If demand is elastic, garment exporters may experience a decrease in total revenue.

gain

Quantity

D1

D2

P2

P3

Q2

S2P ($)

S1

P1

Q1

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Theory in Life 5.3 In order to earn more

total revenue, the garment producers may improve the quality of garment products.

With a higher quality, the demand for garment products will increase from D1 to D2.

Price will increase from P2 to P3, and total revenue will increase by the shaded area.

gain

Quantity

D1

D2

P2

P3

Q2

S2P ($)

S1

P1

Q1

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Quota set above equilibrium level Is it effective if a quota is set above the

equilibrium level?

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If a quota is set at Q1, the market price will be Pq and the quantity transacted will be Q1.

The quota set below the equilibrium level is effective.

S

D

Pe

Qe

P ($)

quota

Pq

Q1

S2

Q

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If a quota is set at Q2, the market price will be Pe and the quantity transacted will be Qe.

The quota set above the equilibrium level is ineffective.

Q

S

D

Pe

Qe

P ($)

quota

Q2

S2

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Suppose in the cigarettes market, there is an effective quota.

If the government raises this quota volume, but the new quota volume is no longer effect, how will the market price and quantity transacted of cigarettes change?

Explain with the aid of a well-labelled supply-demand diagram.

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The market price will decrease from P1 to P2, which is the equilibrium level.

The quantity transacted will increase from Q1 to Q2, which is the equilibrium level.

S

D

Quantity

P ($)S1 S2

P1

P2

Q1 Q2 Q3

old quota

new quota

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Theory in Life 5.4

Tax and gasoline smuggling Many drivers complain that the gasoline

sold in Hong Kong is very expensive. More and more of them respond to this by

buying illegal gasoline from smugglers. These smugglers earn higher total income

than before. Why is this so?

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Theory in Life 5.4 The HKSAR government

imposes a per-unit tax on gasoline. As a result, the supply curve of gasoline sold in legal gasoline stations shifts from S1 to S2. Price increases from P1 to P2, and quantity transacted decreases from Q1 to Q2.

Both buyers and sellers have to pay for the gasoline tax. Their burdens are shown by the respective areas in the diagram.

Producers’ tax burden

Consumers’ tax burden

D

S1

S2

per-unit tax

P1

P2

Q2 Q1

P ($)

Quantity

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Theory in Life 5.4P ($)

D1 D2

S

Q1 Q2

gainP1

P2

Quantity

As gasoline sold in legal gasoline stations becomes more expensive after tax, some drivers will turn to buy gasoline from illegal smugglers.

The demand for gasoline from illegal smugglers increases from D1 to D2.

Price increases from P1 to P2, and quantity transacted rises from Q1 to Q2.

The increase in total revenue received by the smugglers is shown by the shaded area.

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When tax is imposed under perfect elasticity Normally, the tax burden is shared between

consumers and producers. However, under the following conditions, it will

be borne by one party only:

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Demand is perfectlyelastic

0 Q/t

P($)

P

S2S1

Q1Q2

D

Per-unittax

Producers’tax burden

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Demand is perfectly inelastic

0 Q/t

P($) S2S1

P1

Q

D

Per-unittax

Consumers’tax burden

P2

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Supply is perfectlyelastic

0 Q/t

P($)

S1

D

Q1

Per-unittax

P1

S2

Q2

P2

Consumers’tax burden

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Supply is perfectly inelastic

0 Q/t

P($)

D

Q

S

Per-unittax

Producers’tax burden

P

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Theory in Life 5.5

Subsidy and environmental protection A number of firms engage in recycling

usable resources in Hong Kong. However, several are nearly closing down. Some environmental protection

organizations urge the government to help them by providing subsidies. How does this help?

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Theory in Life 5.5 These firms are nearly

closing down because their cost of production is too high. Hence, the price of their output may also be quite high (at P1).

If the government provides a per-unit subsidy to the firms, their cost of production can be reduced and their supply curve will shift down from S1 to S2.

Price will decrease from P1 to P2, and quantity transacted will increase from Q1 to Q2.

Consumers’subsidy benefit

Producers’subsidy benefit

D

0 Q / t

S2

S1

P1

P2

Q1 Q2

per-unit subsidy

Price ($)

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Theory in Life 5.5 The respective

consumers’ and producers’ subsidy benefits are shown by the shaded areas.

As the firms receive subsidy benefit from the government, they may not need to close down.

Consumers’subsidy benefit

Producers’subsidy benefit

D

0 Q / t

S2

S1

P1

P2

Q1 Q2

per-unit subsidy

Price ($)

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When subsidy is provided under perfect elasticity Normally, the subsidy benefit is shared

between consumers and producers. However, under the following conditions, it

will be received by one party only:

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Demand is perfectlyelastic

00 Q/tQ/t

P($)P($)

PP

S1S1S2S2

Q2Q2Q1Q1

DD

Per-unitsubsidy

Producers’subsidybenefit

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Demand is perfectly inelastic

00 Q/tQ/t

P($)P($) S1S1S2S2

P2P2

QQ

DD

Per-unitsubsidyConsumers’

subsidybenefit

P1P1

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Supply is perfectlyelastic

00 Q/tQ/t

P($)P($)

S2S2

DD

Q2Q2

Per-unitsubsidy

P2P2

S1S1

Q1Q1

P1P1

Consumers’subsidybenefit

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Supply is perfectly inelastic

00 Q/tQ/t

P($)P($)

DD

QQ

SS

Per-unitsubsidy

Producers’subsidybenefit

PP

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Suppose the government wants to reduce cigarette consumption. Which policy, imposing quota or sales tax, will yield a more certain result?

Quota. It is because quota directly puts a maximum limit on the quantity of cigarette consumption, while tax just raises the price. If the demand for cigarette is very inelastic, the sales volume of cigarette may not decrease significantly.

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How will the total subsidy benefit provided by the government change if the government reduces a currently provided subsidy by 50% when demand is perfectly inelastic?

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Area B

Area A

Quantity0

D S1

S3

S2P1

P2

P3

Q

P ($) Without subsidy, the

supply curve is S1. Price is P1.

With subsidy, the supply curve is S2. Price will fall from P1 to P2. Total subsidy benefit is area A + area B.

When the subsidy is cut by 50%, price changes from P2 to P3. Total subsidy benefit is only area B. It also falls by 50%.

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End of Chapter 5

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5. Market Intervention