5. Market Intervention

1. 5. Market Intervention

2. Chapter 5 : main menu

3. 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?

4. P ($) S P2 gain ED2 P1 D ED1 Quantity Qs Qd2 Qd1 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.

5. 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. P ($) S P2 gain ED2 P1 D ED1 Quantity Qs Qd2 Qd1

6. 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?

7. Wage rate ($) ES2 S ES1 W loss D1 D2 Filipino maids’ service Qd2 Qd1 Qs 0 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.

8. Theory in Life 5.2 Wage rate ($) • 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. ES2 S ES1 W loss D1 D2 Filipino maids’ service Qd2 Qd1 Qs 0

9. Concept Explorer 5.1 • Price ceiling (floor) set above (below) equilibrium level • Is it effective if a price ceiling (floor) is set above (below) equilibrium level?

10. P ($) S Pc Pe D Q/t 0 Q1 Qe Q2 Concept Explorer 5.1 • 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.

11. P ($) S Pe Pf D Q/t 0 Q1 Qe Q2 Concept Explorer 5.1 • 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.

12. Progress Checkpoint 1 • 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.

13. P ($) Gasoline S P1 LOSS price- ceiling P2 D Q2 Q1 0 Q / t Progress Checkpoint 1 • 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.

14. P ($) Private cars S P2 GAIN P1 D2 D1 Q1 Q2 0 Q / t 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.

15. 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 … Progress Checkpoint 1 • 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.

16. Wage rate S U2 W2 U1 gain W1 loss D 0 L2 L1 Labour 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).

17. Progress Checkpoint 1 Wage rate S (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. U2 W2 U1 gain W1 loss D 0 L2 L1 Labour

18. Progress Checkpoint 1 Wage rate S (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. U2 W2 U1 gain W1 loss D 0 L2 L1 Labour

19. 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?

20. P ($) S2 S1 P3 gain P2 P1 D2 D1 Q2 Q1 Quantity 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.

21. 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. P ($) S2 S1 P3 gain P2 P1 D2 D1 Q2 Q1 Quantity

22. Concept Explorer 5.2 • Quota set above equilibrium level • Is it effective if a quota is set above the equilibrium level?

23. P ($) S2 S Pq Pe D Q Q1 Qe quota Concept Explorer 5.2 • 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.

24. P ($) S2 S Pe D Q Qe Q2 quota Concept Explorer 5.2 • 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.

25. Progress Checkpoint 2 • 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.

26. P ($) S1 S2 S P1 P2 D Q1 Q2 Q3 Quantity old quota new quota Progress Checkpoint 2 • 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.

27. 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?

28. P ($) S2 S1 per-unit tax P2 Consumers’ tax burden P1 Producers’ tax burden D Quantity Q2 Q1 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.

29. P ($) S P1 gain P2 D2 D1 Q1 Q2 Quantity Theory in Life 5.4 • 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.

30. Concept Explorer 5.3 • 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:

31. S2 P($) S1 Per-unit tax D Q/t 0 Q2 Q1 Concept Explorer 5.3 • Demand is perfectlyelastic Producers’ tax burden P

32. D S2 P($) S1 Per-unit tax P2 P1 Q/t 0 Concept Explorer 5.3 • Demand is perfectly inelastic Consumers’ tax burden Q

33. P($) Consumers’ tax burden Per-unit tax S1 S2 D Q/t 0 Q2 Q1 Concept Explorer 5.3 • Supply is perfectlyelastic P2 P1

34. S P($) Per-unit tax P D Q/t 0 Concept Explorer 5.3 • Supply is perfectly inelastic Producers’ tax burden Q

35. 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?

36. Price ($) S1 S2 Producers’ subsidy benefit per-unit subsidy P1 Consumers’ subsidy benefit P2 D 0 Q1 Q2 Q / t 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.

37. Theory in Life 5.5 Price ($) • 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. S1 S2 Producers’ subsidy benefit per-unit subsidy P1 Consumers’ subsidy benefit P2 D 0 Q1 Q2 Q / t

38. Concept Explorer 5.4 • 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:

39. S1 P($) S2 Per-unit subsidy D Q/t 0 Q1 Q2 Concept Explorer 5.4 • Demand is perfectlyelastic Producers’ subsidy benefit P

40. D S1 P($) S2 Per-unit subsidy P1 P2 Q/t 0 Concept Explorer 5.4 • Demand is perfectly inelastic Consumers’ subsidy benefit Q

41. P($) Consumers’ subsidy benefit Per-unit subsidy S1 S2 D Q/t 0 Q1 Q2 Concept Explorer 5.4 • Supply is perfectlyelastic P1 P2

42. S P($) Per-unit subsidy P D Q/t 0 Concept Explorer 5.4 • Supply is perfectly inelastic Producers’ subsidy benefit Q

43. Progress Checkpoint 3 • 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.

44. Progress Checkpoint 3 • 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?

45. P ($) S1 D S3 P1 S2 Area B P3 Area A P2 0 Q Quantity Progress Checkpoint 3 • 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%.

46. End of Chapter 5