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To begin with … 6.1 Price ceiling 6.2 Price floor 6.3 Quantity control: quota

Chapter 6. Market intervention (I) . To begin with … 6.1 Price ceiling 6.2 Price floor 6.3 Quantity control: quota. To begin with …. We have learned that: The equilibrium price and quantity of a good are determined by market demand and market supply in a free market. P. S. P 0. D. Q.

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To begin with … 6.1 Price ceiling 6.2 Price floor 6.3 Quantity control: quota

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  1. Chapter 6 Market intervention (I) To begin with … 6.1 Price ceiling 6.2 Price floor 6.3 Quantity control: quota

  2. To begin with … We have learned that: The equilibrium price and quantity of a good are determined by market demand and market supply in a free market. P S P0 D Q 0 Q0

  3. To begin with … In this chapter, we will study the situations under which the government intervenes in the market. Common types of government intervention Price control Quantity control Unit tax Unit subsidy Scope of this chapter Quota Price ceiling Price floor

  4. Task 6.1 • A nuclear leak has occurred at the nuclear plant of City J. • City H is close to City J. There is a rumour that salt can prevent radiation poisoning. City J The price of salt has soared to $1,000 per pack (100 g). Price = $1,000 per pack Price = $10 per pack The government passes an emergency act to ban sellers selling salt from charging more than $10 per pack. Salt Salt 100g 100g City H

  5. Task 6.1 Before the act, we could buy very little salt because the price was so high. Since the act has been passed, we can still only buy very little salt because now there’s a shortage. A poor housewife The government should not intervene in the market! Before the ban, I could buy salt easily. Now it is difficult to get it! A rich man who is a salt lover

  6. Task 6.1 1. How has the act affected the salt retailing market? Price? Quantity transacted? Total revenue? Price, quantity transacted and total revenue have all decreased.

  7. Task 6.1 2. Under such a circumstance, would you support the act? For whom to produce? Economic reasons versus political reasons

  8. Task 6.1 3. Suppose you were the rich man. Try to think of a method for getting the amount of salt you want. Free answer. For example: Buying salt in the black market at a higher price. Can you suggest more methods?

  9. 6.1 Price ceiling

  10. 6.1 Price ceiling • Maximum price allowed by the government Why imposes a price ceiling? Think about the case in ‘Task 6.1’.  To ensure the public can consume some necessities at affordable prices  Example: Rent control from 1947 to 1998 in HK

  11. 6.1 Price ceiling • Effective or not? Effective only if it is imposed below the equilibrium price Which one is effective? P P S S P1 P0 P0 P2 D D Q Q 0 0 Q0 Q0 Fig. B Fig. A

  12. A. Effects on price and quantity P S 5 4 3 3 12 12 3 2 1 D Q 0 12 16 20 12 4 8 Table 6.1 Fig. 6.1 What are the equilibrium price and quantity? The market equilibrium is achieved when the market quantity demanded is equal to market quantity supplied at the same price. The equilibrium quantity and price are 12 units and $3, respectively.

  13. A. Effects on price and quantity P S 5 4 3 Priceceiling 2 2 1 D Q 0 16 20 12 4 8 Table 6.1 Fig. 6.1 Suppose the government imposes a pricing ceiling of $2 on the good. What will the new price and the new quantity transacted be? As the maximum price ($2) is lower than the original equilibrium price ($3), the price ceiling is effective. Thus, the new price will be $2.

  14. A. Effects on price and quantity P S 5 4 3 Priceceiling 2 2 = Qt 1 D Q 0 16 20 12 4 8 8 Table 6.1 Fig. 6.1 At the controlled price of $2, Qd = 16 units and QS = 8 units. Whenever Qd is not equal to QS, only the smaller of the two quantities can be traded.

  15. A. Effects on price and quantity P S 5 4 3 Priceceiling 2 2 = Qt 1 D Q 0 16 20 12 4 8 8 Table 6.1 Fig. 6.1 At the controlled price ($2), Qd = 16 units and QS = 8 units. Whenever Qd is not equal to QS, only the smaller of the two quantities can be traded. When an effective price ceiling is imposed, the quantity transacted is equal to the quantity supplied.

  16. A. Effects on price and quantity P S 5 4 3 Priceceiling 2 Shortage 1 D Q 0 16 20 12 4 8 Table 6.1 Fig. 6.1 At the controlled price ($2): Shortage Qd > QS

  17. B. Effects on total expenditure and total revenue P S 5 4 A 3 B Priceceiling 2 1 D Q 0 16 20 12 4 8 Table 6.1 Fig. 6.1 The effective price ceiling leads to a movement along the supplycurvefrom Point A to Point B.

  18. B. Effects on total expenditure and total revenue P S 5 4 A 3 B Priceceiling 2 1 D Q 0 16 20 12 4 8 Table 6.1 Fig. 6.1 Consumers’ total expenditure and producers’ total revenue: Before the imposition of the price ceiling After the imposition of the price ceiling = $3 × 12 = $36 = $2 × 8 = $16 Decrease!

  19. Effects of an effective price ceiling To conclude, an effective price ceiling has the following effects: 1. The market price decreases. 2. A shortage or excess demand is created. 3. The quantity transacted decreases. 4. Producers’ total revenue (or consumers’ total expenditure)decreases. Why must producers’ total revenue decrease under an effective price ceiling? Answers will be provided in the final version.

  20. Test yourself 6.1 • Suppose the equilibrium price of a return air ticket between Hong Kong and London is $10,000. • If the government does not allow airline companies to sell the air ticket for more than $5,000, what effects will there be on the price and quantity transacted of air tickets? • What will happen to the total revenue of airline companies?

  21. Price ($ / unit) Quantity (units / period) 0 Test yourself 6.1 (con’t) The price of air tickets will decrease to $5,000. The quantity transacted of air tickets will. The total revenue of airline companies will increase / decrease / remain unchanged. • Answer: decrease S 10,000 Maximum price 5,000 D Q2 Q1

  22. C. How to deal with a shortage that results from a price ceiling Due to the excess demand under a effective price ceiling, buyers have to compete with each other by 1. non-price competition; or 2. price competition.

  23. C. How to deal with a shortage that results from a price ceiling 1. Non-price competitionamong buyers Buyers may need to meet certain criteria or use other means to get the good, including a. ‘first-come, first-served’ (queuing); b. by luck (e.g., drawing lots); c. by need; or d. other criteria, such as producers’ preference, friendship, age, height, etc.

  24. C. How to deal with a shortage that results from a price ceiling 2. Price competition among buyers a. Extra fees Buyers may be asked to pay extra fee (legally or illegally) before they buy the good. Examples:  Membership fee  Entrance fee  Key money

  25. C. How to deal with a shortage that results from a price ceiling 2. Price competition among buyers b. Black market In a black market, goods are sold at prices higher than the legal maximum. P In the previous example, buyers are willing to pay up to $4 per unit on the black market at the quantity transacted of 8 units. S 5 4 3 2 Priceceiling Shortage 1 D Q 0 16 20 12 4 8

  26. Learning tips 6.1 Ineffective price ceiling • A price ceiling is ineffective when it is imposed above the equilibrium price. P No effect on the price, quantity transacted and total revenue No excess demand S P1 Priceceiling Pe Total revenue D Q 0 Qe

  27. Learning tips 6.1 Ineffective price ceiling • A price ceiling is ineffective when it is imposed above the equilibrium price.  Suppose the price ceiling is now set at $4.  As the price ceiling is ineffective, the market price and the quantity transacted will stay at $3 and 12 units. Table 6.1

  28. Learning tips 6.1 Ineffective price ceiling • Real-life example: Tunnel tolls at the Western Harbor Tunnel Table 6.2 Gazetted and actual tolls at the Western Harbour Tunnel

  29. Discuss 6.1 • Why has the Hong Kong Government set an ineffective price ceiling on tolls for the Western Harbour Tunnel? Discuss in groups the possible reasons. Back in the early 1990s, the Government wanted to attract private companies to build and operate the Western Harbour Tunnel, so it allowed the successful company to raise tolls (i.e., the price ceiling) when the actual revenue was below the forecast level. However, the tunnel company noticed that its total revenue would be maximised when the tolls are set below the price ceiling (at the mid-point of the demand curve where the demand elasticity is equal to one), hence the price ceiling becomes ineffective.

  30. Test yourself 6.2 • Based on the following diagrams, indicate the price, quantity transacted and total revenue after the imposition of a price ceiling. b. a. P P S S P1 Price ceiling P0 P0 P1 Price ceiling D D Q Q 0 0 Q2 Q2 Q0 Q1 Q0 Q1

  31. Learning tips 6.2How does the change in demand or supply affect the effectiveness of price ceiling? • Suppose the government has imposed an effective price ceiling. The price ceiling will become ineffective if the equilibrium price drops below the maximum price allowed. P This can be caused by: (a) A decrease in demand S P1 Priceceiling Pe D1 D2 Q 0 Q1 Qe

  32. Learning tips 6.2 (con’t)How does the change in demand or supply affect the effectiveness of price ceiling? • Suppose the government has imposed an effective price ceiling. The price ceiling will become ineffective if the equilibrium price drops below the maximum price allowed. P This can be caused by: (b) An increase in supply S1 S2 P1 Priceceiling Pe D Q 0 Qe Q1

  33. Economics at work 6.1Effects of rent control on residential units • Hong Kong had a rent control before 1999. This resulted in excess demand of rental units. Non-price methods had to be used to allocate the limited number of rental units. For example, allocation may be based on tenants’ family status or jobs. Some landlords require key money before tenants get a rental contract. Fig. 6.7 Under rent control, conditions in residential units tend to deteriorate.

  34. Economics at work 6.1 (con’t)Effects of rent control on residential units • Other effects of rent control: • Tenants are reluctant to move out.  Landlords have little incentive to maintain their flats. Conditions in the flats deteriorate.

  35. Test yourself 6.3 • Does rent control imposed on old private residential flats benefit the tenants? Explain with the aid of a diagram. Answer: Tenants who have already rented their flats can / cannot benefit from rent control as they now pay a lower / higher rent. P S Pe P1 Price ceiling Excess demand D Q 0 Q2 Qe Q1

  36. Test yourself 6.3 (con’t) • Does rent control imposed on old private residential flats benefit the tenants? Explain with the aid of a diagram. Answer: However, since landlords are more / less willing to rent out their flats, potential tenants can rent flats more / less easily. non-price competition Potential tenants have to engage in __________________ and even pay a higher / lower black market rent to landlords. Therefore, potential tenants may not benefit from rent control.

  37. Test yourself 6.3 (con’t) • Does rent control imposed on old private residential flats benefit the tenants? Explain with the aid of a diagram. Answer: Since rent control limits the rental income received by landlords, they lack an incentive to maintain the quality of their flats. So, there will be deterioration in the quality of rental flats in the market. Therefore, tenants as a whole suffer from a decrease in the quality of rental flats.

  38. Test yourself 6.4 • a. Apart from family status and income status, suggest TWO other methods for allocating the limited number of rental units under rent control. Answer:  first-come, first-served  relationships or friendships with landlords  age  any other possible reasons

  39. Test yourself 6.4 (con’t) • b. If there is rent control, what effect would this have on the turnover rate of rental units? Explain your answer. Answer: Under rent control, _______ of private rental units exists. The tenants are paying a rent which is higher / lower than the equilibrium level. They are _______ to move out. Therefore, the turnover rate will increase / decrease. shortage reluctant

  40. Discuss 6.2 • In recent years, as the rent for private residential housing has risen rapidly, more and more people have urged the Hong Kong Government to impose rent controls again. Discuss in groups the pros and cons of imposing rent controls on private residential housing. Pros: Cons: The poor can pay a lower rent  To the tenants, landlords cannot charge excessive rents Fairer to the tenants A shortage of rental housing units  Landlords will lack incentives to maintain the buildings  Infringe private property rights

  41. Past exam Q • 1. Suppose the government imposed an effective price ceiling on good X. If the government raises the price ceiling, the total consumer expenditure on good X A. would increase. B. would decrease. C. would remain unchanged. D. may increase, decrease or remain unchanged depending on the elasticity of demand. (HKCEE 2009, Q8)

  42. Past exam Q • 2. Suppose the government introduces an effective rent control which sets a maximum rental per square feet the landlords can charge to any tenants. Which of the following statements is correct? (1) There will be a shortage of rental units. (2) The landlords will have less incentive to rent out their flats. (3) The landlords will spend less on maintenance of the rental flats. A. (1) and (2) only B. (1) and (3) only C. (2) and (3) only D. (1), (2) and (3) (HKDSE 2013, Q15)

  43. 6.2 Price floor

  44. Task 6.2 • There are many rice farmers in Country T. Due to the country’s abundant supply of rice, the market price is low. In order to protect the income of rice farmers, the government has set a minimum price which is above the market price for rice. Consumers must pay at or above the minimum price to buy rice. Country T

  45. Task 6.2 With the price limit, I can’t buy rice as cheaply as before. So, I’m consuming more of other types of staple food and less rice now. A consumer I’m not sure whether the limit can help me. I can’t sell as much as I produce. A rice farmer

  46. Task 6.2 1. Why can’t the farmer sell as much as he produces when there is a price limit? QS? Qd? When the price is set higher than the equilibrium, the quantity demanded of rice will be smaller than the quantity supplied.

  47. Task 6.2 2. As a consumer, would you support the price limit? Price? Free answer. Suggested answer: No, I need to pay higher price.

  48. Task 6.2 3. As a rice farmer, would you support the price limit? Total revenue? Free answer. Suggested answer: Yes, only if I can sell rice at the higher price. If there is a surplus, some farmers may not be able to sell their products and their total revenue may fall (which depends on price elasticity of demand)

  49. 6.2 Price floor • Minimum price allowed by the government Why imposes a price floor?  To protect the income of some parties or to encourage local production.  Example: Minimum wage in Hong Kong

  50. 6.2 Price floor • Effective or not? Effective only if it is imposed above the equilibrium price Which one is effective? P P S S P1 P0 P0 P2 D D Q Q 0 0 Q0 Q0 Fig. B Fig. A

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