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

© Pilot Publishing Company Ltd. 2005

Chapter 12Government Intervention

in the Product Market


• Market Price as a Social Coordinator• Government Intervention – Price Ceiling• Price Floor• Quota• Output Tax• Subsidy • Quality Control

Contents:


Market Price as a Social Coordinator


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.


Relation among price, revenue and value

QPQP

PQ

Q x P

Q

TR P

Q

Q x P

Q

TR

Relation between price and revenue

TR =

AR =

MR: In a price-taking market PP

PP In a price-searching market


Exchange value (or market value) of a good

= revenue from selling the good or

= expenditure on buying the good.

QPTRTEV QPTRTEV

PARAEV PARAEV

MEV: In a price-taking market: = MR = P

In a price-searching market: = MR < P

Relation between price and exchange value


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


Determination of market price (traditional analysis)

$

Q

S

D

Equilibrium price Pe

Qd=Qs

Qd>Qs P ; Qd<Qs P ; Qd=Qs P unchanged


* 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 Qd = Qs.

* As MCs are equal, MUVs are equated and MUVs = MCs, the market equilibrium is efficient in resource allocation.

Determination of market price (modern analysis)


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.


Government Intervention ---Price Ceiling


Price ceiling

What is a price ceiling?

is the maximum price allowed by law; or

is the price fixed below the equilibrium level.


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.


(Price ceiling)P1

Qs1 Qd1

Shortage

$

Q

S=MC

D=MUV

(Equilibrium price)P0

Graphical illustration


2. Quantity demanded ___________ to Qd1.

Quantity supplied ___________ to Qs1.

A shortage arises = Qd1 – Qs1.

Effects of price ceiling on a price-taking market

1. The price _______ from P0 to P1.falls

decreasesincreases

falls3. Quantity transacted _______ to Qs1. Why?


Examples:

4. Non-price competition exists among buyers

Qs 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


$

Q

S=MC

D=MUV

Qs1 Qd1

P1

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 - P1).

Full cost = P1 + non-monetary cost.


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?


6. Income redistribution (or wealth transfer)

Who gains?

Who loses?

Gov’t 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


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

Deadweight loss brought by under-production

D=MUV

$

Q

S=MC

Qs1 Qd1

(Price ceiling) P1


in which the good is sold illegally at a price above P1

(Price ceiling) P1

$

Q

S=MC

D=MUV

Qs1 Qd1

8. Black market


9. Reduction in product quality

As Qd > Qs , many consumers are willing to accept lower quality gdsthis 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


Remark: Differences between scarcity and shortage

Differences Scarcity Shortage

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


Remark: Price ceiling results in shortage & disequilibrium?

If we consider the price competition only at the price ceiling (P1), Qd1 > Qs1

shortage & disequilibrium appear

To compete for the inadequate Q, a non-P comp. must emerge. If we consider the full cost (P1 + non-monetary cost) full cost & Qd until Qd = Qs (at Qs1)

“shortage” vanishes & equilibrium is achieved


Q12.3Evaluate if the imposition of price ceiling benefits society. Does it lower the price, benefit the poor and achieve efficiency?


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*

Qm

Q

MR D

MC

Qpt


Price Floor


Price floor is the minimum price allowed by law; or

is the price fixed above the equilibrium level.

What is a price floor?


What is a price floor?

To be effective, a price floor must be set above the equilibrium price. Why?


(Price floor) P2

$

Q

S=MC

D=MUV

0

(Equilibrium price) P0

Qd2 Qs2

Surplus

Graphical illustration


2. Quantity demanded __________ to Qd2.

Quantity supplied __________ to Qs2.

A surplus arises = Qs2 – Qd2.

Effects of a price floor on a price-taking market

1. The price _______ from P0 to P2.rises

increasesdecreases

falls3. Quantity transacted _______ to Qd2. Why?


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) P2

Qd2 Qs2

Surplus

Sellers are willing to pay a max. cost (= P2 - MC) to

compete for buyers.


5. Efficiency lossIf Qs2 is produced

If Qd2 is produced ( the case of quota)

Production efficiency

(Qs2 are produced by produce

rs of the lowest cost)

X (Qd2 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 Qs2, MUV < MC over-production)

X (At Qd2, MUV > MC

under-production)

Waste in non-P comp?

Yes, among sellers Yes, among sellers


Quota


6. Black market $

Q

S=MC

D=MUV

0

(Price floor) P2

Qd2 Qs2

Surplus

some units of thegood may be sold ata P below P2 illegally.

7. Product quality Product quality is improved. Why?


What is a quota?

Quota is the maximum quantity supplied allowed by law.

To be effective, quota (Q3) must be set below the equilibrium quantity (Q0).

Q3

MC3

$

Q

S=MC

D=MUV

Q0

S’

P3


2. Price ________ to P3, where D meets S.

Effects of quota on a price-taking market

1. The supply curve turns ___________ at Q3.

3. Quantity transacted ___________ to Q3.

( Options: horizontal / vertical / rises / falls )

vertical

rises

falls


$

Q

S=MC

D=MUV

Q3 Q0

P3

S’

MC3

Max. unit price of quota

4. Allocation of quota

To compete for the quota, sellers are willing to pay a maximum cost of (P3–MC3) to compete for each unit of quota.

In auction, the quota goes to the highest bidder.


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


$

Q

S=MC

D=MUV

Q3 Q0

P3

S’

MC3

Deadweight loss brought by Deadweight loss brought by under-productionunder-production

Deadweight loss brought by Deadweight loss brought by under-productionunder-production

Graphical illustration:


Output Tax


Tax: is a compulsory payment levied on individuals, firms or commodities by the gov’t.

What is a tax?

Government

Commodities

Individuals

Firms

TAX

TAX

TAX


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


Classification according to the tax rate

Progressive tax as taxpayer’s income , tax rate

Proportional tax

as taxpayer’s income , tax rate unchanged

Regressive tax

as taxpayer’s income , tax rate


S1

Q1

Pb=P1

$

Q

S0

D0

Q0

P0

Ps=P2

taxtax

Effects of output tax on a price-taking market (imposed on sellers)


2. The market price ______ from P0 to P1.

The price paid by buyers (Pb) ______ from P0 to P1.

The actual price received by sellers (Ps) ______ from

P0 to P2 (= Pb - t).

Effects of output tax (con’t)

1. The supply curve shifts ________ by t.

3. Quantity transacted ______from Q0 to Q1.

( Options: downward / upward / drops / rises )

upward

rises

rises

drops

drops


4. Income distribution

Drop in seller’s surplus

Drop in buyer’s surplus

Tax revenue$

Q

S0

D0

Q1 Q0

Pb=P1

S1

P0

Ps=P2

taxtaxtaxtax


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.)


Drop in seller’s surplus

Drop in buyer’s surplus

Tax revenue

Net social gain < 0 (deadweight loss)

Net social gain =

$

Q

S0

D0

Q1 Q0

Pb=P1

S1

P0

Ps=P2

taxtaxtaxtax

Rise in tax revenue+ drop in buyer’s surplus+ drop in seller’s surplus


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.


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?


Distribution of tax burden Buyers’ share of tax burden Price elasticity of supply Sellers’ share of tax burden Price elasticity of demand =

$

Q

S0

D0

Q1 Q0

Pb=P1

S1

P0

Ps=P2

taxtaxtaxtaxBuyers’ share of tax burdenSellers’ share of tax burden


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.


Subsidy


What is a subsidy?Subsidy is a payment made by the government to cover part of the cost of a good.

Subsidy

Government

Industry


S1Pb=P1

subsidysubsidyPs=P2

Effects of subsidy on a price-taking market (granted to sellers)

$

Q

S0

D0

Q0

P0

Q1


2. The market price _______ to P1.

The price paid by buyers (Pb) ________ from P0 to P1.

The actual price received by sellers (Ps) _______ from

P0 to P2 (= Pb + s).

Effects of subsidy (con’t)

1. The supply curve shifts ___________ by s.

3. Quantity transacted _________ from Q0 to Q1.

( Options: downward / upward / falls / rises )

downward

fallsfalls

rises

rises


Seller’s share of subsidy

Buyer’s share of subsidy

$

Q

S0

D0

Q0 Q1

Ps=P2

S1P0

Pb=P1

subsidysubsidysubsidysubsidy

4. Income distribution

Government subsidy


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)


Deadweight loss brought by

over-production

Deadweight loss brought by

over-production

$

Q

S0

D0

Q0 Q1

Ps=P2 S1

P0

Pb=P1

subsidysubsidysubsidysubsidy

Graphical illustration:


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 =


Quality Control


What is quality control?

Quality controlis the stipulation of a minimum standard set bythe government on the quality of a good.

Examples: The HK gov’t has quality control onthe cleanliness of restaurants, licensing of professionals,safety of products, etc.


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


Correcting Misconceptions:

1. Price does not exist without money.

2. Scarcity can be eliminated by price mechanism.

3. Shortage is the same as scarcity.


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.



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.



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.


12. Quality control improves the welfare of everyone as it guarantees the quality of goods sold in the market.


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.


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?

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

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