Chapter 12
Government Intervention
in the Product Market
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Contents:
• Market Price as a Social Coordinator
• Government Intervention – Price Ceiling
• Price Floor
• Quota
• Output Tax
• Subsidy
• Quality Control
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Market Price as a
Social Coordinator
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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.
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Relation among price, revenue and value
Relation between price and revenue
TR = P  Q
AR =
TR
P xQ

P
Q
Q
MR: In a price-taking market
 P
In a price-searching market  P
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Relation between price and exchange value
Exchange value (or market value) of a good
= revenue from selling the good or
= expenditure on buying the good.
T EV  T R  P  Q
AEV  AR  P
MEV: In a price-taking market:
= MR = P
In a price-searching market: = MR
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<P
Relation between price and use 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.
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Determination of market price (traditional analysis)
Qd>Qs P ; Qd<Qs P ; Qd=Qs P unchanged
$
S
Equilibrium price
Pe
D
Qd=Qs
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Q
Determination of market price (modern analysis)
* 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.
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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.
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Government Intervention --Price Ceiling
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What is a price ceiling?
Price ceiling
 is the maximum price allowed by law; or
 is the price fixed below the equilibrium level.
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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.
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Graphical illustration
$
S=MC
(Equilibrium price)P0
(Price ceiling)P1
D=MUV
Qd1
Qs1
Shortage
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Q
Effects of price ceiling on a price-taking market
falls from P0 to P1.
1. The price _______
2. Quantity demanded ___________
increases to Qd1.
decreases to Qs1.
Quantity supplied ___________
A shortage arises = Qd1 – Qs1.
falls to Qs1. Why?
3. Quantity transacted _______
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4. Non-price competition exists among buyers
Qs is inadequate and the price is fixed
 non-price competition exists among buyers
Examples:
 First-come, first-served
 Ballot
 Allocation on the basis of ability
 Sellers’ preferences
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 Buyers are willing
to pay a maximum
non-monetary cost
(= MUV - P1).
The maxi. cost one is willing to
pay in the non-price competition.
$
S=MC
 Full cost
= P1 + non-monetary cost.
D=MUV
P1
Qd1 Q
Qs1
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Shortage
5. Final allocation
 No resale + people have the same ability
 individuals with higher MUV will get the good.
Why?
 No resale + people have different ability
 individuals who can accomplish higher achievement
will get the good
(≠highest MUV nor best ability).
Why?
 Resale
 individuals with higher MUV will get the good.
Why?
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6. Income redistribution (or wealth transfer)
Who gains?
 Gov’t officials who execute the price control
 Winners whose full cost < equilibrium price
Who loses?
 Producers
Why?
 Winners whose full cost > equilibrium price
 Former winners but present losers
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Why?
7. Efficiency loss
 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 )
$
S=MC
Deadweight loss brought
by under-production
D=MUV
(Price ceiling) P1
Qs1
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Qd1
Q
8. Black market
in which the good is sold illegally at a price above P1
S=MC
$
D=MUV
(Price
ceiling) P1
Qs1
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Qd1
Q
9. Reduction in product quality
As Qd > Qs ,
many consumers are willing to accept lower quality gds
this induces producers to lower quality, to cut cost and to
gain more
10. Drop in the turnover rate of tenants
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
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Remark: Differences between scarcity and shortage
Differences
Definition
Cause
Result
Nature
Scarcity
Shortage
Q available <
Q desired
(at zero price)
Qs < Qd
(at a certain price).
Unlimited wants
vs. limited resources
All kinds of
competition may arise
Fixed P < equil. P
Basic problem of all
economic systems
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Under price control,
only non-P competition
may arise
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
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Q12.3
Evaluate if the imposition of price ceiling benefits society.
Does it lower the price, benefit the poor and
achieve efficiency?
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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*.
$
MC
P*
MR
Qm Qpt
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D
Q
Price Floor
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What is a price floor?
Price floor
 is the minimum price allowed by law; or
 is the price fixed above the equilibrium level.
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What is a price floor?
To be effective, a price floor must be set above
the equilibrium price.
Why?
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Graphical illustration
$
S=MC
(Price floor) P2
(Equilibrium price) P0
D=MUV
0
Qd2
Qs2
Surplus
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Q
Effects of a price floor on a price-taking market
rises from P0 to P2.
1. The price _______
decreases to Qd2.
2. Quantity demanded __________
increases to Qs2.
Quantity supplied __________
A surplus arises = Qs2 – Qd2.
falls to Qd2. Why?
3. Quantity transacted _______
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4. Non-price competition exists among sellers
 Inadequate buyers + fixed price
 non-P competition exists among sellers
$
 Sellers are willing
(Price
to pay a max. cost
floor) P2
(= P2 - MC) to
compete for buyers.
0
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S=MC
D=MUV
Q
Qs2
Qd2
Surplus
5. Efficiency loss
If Qs2 is produced
If Qd2 is produced
( the case of quota)
Production
efficiency
Consumption
efficiency
Allocative
efficiency
Waste in non-P
comp?

X
(Qs2 are produced by
producers of the lowest cost)
(Qd2 may not be produced by
producers of the lowest cost)
X

(Q consumed < Q produced
 under-consumption)
(Q produced are consumed
by individuals with
the highest MUV)
X
X
(At Qs2, MUV < MC
 over-production)
(At Qd2, MUV > MC
 under-production)
Yes, among sellers
Yes, among sellers
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Quota
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6. Black market
 some units of the
good may be sold at
a P below P2 illegally.
7. Product quality
 Product quality is
improved.
Why?
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$
S=MC
(Price
floor) P2
0
D=MUV
Q
Qs2
Qd2
Surplus
What is a quota?
Quota
 is the maximum quantity supplied allowed by law.
$
S’
S=MC
 To be effective,
P3
quota (Q3) must be
set below the
equilibrium quantity MC
3
(Q0).
D=MUV
Q
Q3
Q0
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Effects of quota on a price-taking market
1. The supply curve turns ___________
vertical
at Q3.
2. Price ________
rises to P3, where D meets S.
3. Quantity transacted ___________
falls
to Q3.
( Options: horizontal / vertical / rises / falls )
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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.
$
Max. unit
price of
quota
S’
S=MC
P3
MC3
Q3
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Q0
D=MUV
Q
5. Efficiency Loss
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.)
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Graphical illustration:
$
S’
Deadweight loss brought by
under-production
S=MC
P3
MC3
D=MUV
Q3
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Q0
Q
Output Tax
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What is a tax?
Tax: is a compulsory payment levied on
individuals, firms or commodities by the gov’t.
TAX
TAX
Government
Firms
TAX
Commodities
Individuals
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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
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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 
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Effects of output tax on a price-taking market
(imposed on sellers)
$
S1
tax
Pb=P1
S0
P0
Ps=P2
D0
Q1
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Q0
Q
Effects of output tax (con’t)
upward by t.
1. The supply curve shifts ________
rises from P0 to P1.
2. The market price ______
rises from P0 to P1.
The price paid by buyers (Pb) ______
The actual price received by sellers (Ps) ______
drops from
P0 to P2 (= Pb - t).
drops
3. Quantity transacted ______from
Q0 to Q1.
( Options: downward / upward / drops / rises )
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4. Income distribution
$
S1
Tax revenue
tax
Drop in buyer’s
Pb=P1
surplus
P0
Drop in
seller’s surplus P =P
s
2
D0
Q1
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S0
Q0
Q
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.)
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Net social gain = Rise in tax revenue
+ drop in buyer’s surplus
+ drop in seller’s surplus
$
S1
Tax revenue
tax
Drop in buyer’s
Pb=P1
surplus
Net social gain < 0
(deadweight loss)
P0
Drop in
seller’s surplus P =P
s
2
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S0
D0
Q1
Q0
Q
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.
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Tax and Quality
Average product quality
Under a unit tax or a specific tax
 Improved
Under a percentage tax or an ad valorem tax
 No change
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Why?
Distribution of tax burden
Buyers’ share of tax burden
Sellers’ share of tax burden
$
Price elasticity of supply
= Price elasticity of demand
tax
Buyers’ share ofPb=P1
tax burden
P0
Sellers’ share of
tax burden
Ps=P2
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S1
S0
D0
Q1
Q0
Q
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.
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Subsidy
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What is a subsidy?
Subsidy
 is a payment made by the government
to cover part of the cost of a good.
Subsidy
Government
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Industry
Effects of subsidy on a price-taking market
(granted to sellers)
$
Ps=P2
S0
subsidy
P0
Pb=P1
S1
D0
Q0
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Q1
Q
Effects of subsidy (con’t)
downward by s.
1. The supply curve shifts ___________
2. The market price _______
falls to P1.
falls from P0 to P1.
The price paid by buyers (Pb) ________
rises from
The actual price received by sellers (Ps) _______
P0 to P2 (= Pb + s).
3. Quantity transacted _________
rises from Q0 to Q1.
( Options: downward / upward / falls / rises )
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4. Income distribution
Government subsidy
$
Seller’s share P =P
s
2
S0
subsidy
of subsidy
P0
Buyer’s share
Pb=P1
of subsidy
S1
D0
Q0
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Q1
Q
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)
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Graphical illustration:
$
Ps=P2
S0
S1
Deadweight loss
brought by
over-production
P0
Pb=P1
subsidy
D0
Q0
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Q1
Q
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
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Quality Control
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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 gov’t has quality control on
the cleanliness of restaurants, licensing of professionals,
safety of products, etc.
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Effects of quality control
 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
 With quality control
 only good quality can be supplied
 only high MUV buyers can afford them
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Correcting Misconceptions:
1. Price does not exist without money.
2. Scarcity can be eliminated by price mechanism.
3. Shortage is the same as scarcity.
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Correcting Misconceptions:
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.
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Correcting Misconceptions:
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.
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Correcting Misconceptions:
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.
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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.
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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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