Market intervention (I)

Market intervention (I)
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. Q P S D P0 Q0

Common types of government intervention
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 ceiling Price floor Price control Quantity control Quota Unit tax Unit subsidy Scope of this chapter

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). City H Salt 100g Price = $1,000 per pack The government passes an emergency act to ban sellers selling salt from charging more than $10 per pack. Price = $10 per pack

A rich man who is a salt lover
Task 6.1 A poor housewife 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 rich man who is a salt lover The government should not intervene in the market! Before the ban, I could buy salt easily. Now it is difficult to get it!

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.

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

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?

6.1 Price ceiling

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

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

A. Effects on price and quantity
Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 3 3 12 12 2 1 D Q 4 8 12 12 16 20 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.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 2 2 Price ceiling 1 D Q 4 8 12 16 20 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.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 2 2 Price ceiling = Qt 1 D Q 4 8 8 12 16 20 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.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 2 2 Price ceiling = Qt 1 D Q 4 8 8 12 16 20 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.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 2 Price ceiling Shortage 1 D Q 4 8 12 16 20 Table 6.1 Fig. 6.1 At the controlled price ($2): Qd > QS  Shortage

B. Effects on total expenditure and total revenue
Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 A 3 B 2 Price ceiling 1 D Q 4 8 12 16 20 Table 6.1 Fig. 6.1 The effective price ceiling leads to a movement along the supply curve from Point A to Point B.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 A 3 B 2 Price ceiling 1 D Q 4 8 12 16 20 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!

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.

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?

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

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.

1. Non-price competition among 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.

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

2. Price competition among buyers b. Black market In a black market, goods are sold at prices higher than the legal maximum. Q P S D 1 2 3 4 5 8 12 16 20 Shortage Price ceiling 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.

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 Price ceiling Pe Total revenue D Q Qe

A price ceiling is ineffective when it is imposed above the equilibrium price.  Suppose the price ceiling is now set at $4. Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1  As the price ceiling is ineffective, the market price and the quantity transacted will stay at $3 and 12 units. Table 6.1

Real-life example: Tunnel tolls at the Western Harbor Tunnel Vehicle Effective from 31 July 2013 Gazetted toll (HK$) Actual toll (HK$) Motorcycles 90 25 Private cars 165 55 Taxis 50 Public and private light buses 190 65 Table Gazetted and actual tolls at the Western Harbour Tunnel

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.

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

Learning tips 6.2 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. This can be caused by: (a) A decrease in demand P S P1 Price ceiling Pe D1 D2 Q Qe Q1

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. This can be caused by: (b) An increase in supply P S1 S2 P1 Price ceiling Pe D Q Q1 Qe

Economics at work 6.1 Effects of rent control on residential units
Hong Kong had a rent control before 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 Under rent control, conditions in residential units tend to deteriorate.

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.

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 Q1 Qe Q2

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. 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. non-price competition

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.

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

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

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

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)

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)

6.2 Price floor

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

Task 6.2 A consumer 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 rice farmer I’m not sure whether the limit can help me. I can’t sell as much as I produce.

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.

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.

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)

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

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

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 3 2 1 D Q 4 8 12 12 16 20 Table 6.3 Fig. 6.10 Again, the original quantity and price are 12 units and $3, respectively.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 Price floor 3 2 1 D Q 4 8 12 16 20 Table 6.3 Fig. 6.10 Suppose the government imposes a pricing floor of $4 on the good. What will the new price and the new quantity transacted be? As the minimum price ($4) is higher than the original equilibrium price ($3), the price floor is effective. The new price will be $4.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 Price floor = Qt 3 2 1 D Q 4 8 8 12 16 20 Table 6.3 Fig. 6.10 At the controlled price ($4), Qd = 8 units and QS = 16 units. Whenever Qd is not equal to QS, only the smaller of the two quantities can be traded. When an effective price floor is imposed, the quantity transacted is equal to the quantity demanded.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 Surplus 4 Price floor 3 2 1 D Q 4 8 12 16 20 Table 6.3 Fig. 6.10 At the controlled price of $4: Qd < QS  Surplus

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 C 4 Price floor 3 A 2 1 D Q 4 8 12 16 20 Table 6.3 Fig. 6.10 The effective price ceiling leads to a movement along the demand curve from Point A to Point C.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 C 4 Price floor 3 A 2 1 D Q 4 8 12 16 20 Table 6.3 Fig. 6.10 Consumers’ total expenditure and producers’ total revenue: Before the imposition of the price floor After the imposition of the price floor = $3 × 12 = 36 = $4 × 8 = 32 In this case, both TE and TR decrease.

The effect of a price floor on total revenue depends on the elasticity between the original price and the minimum price: Gain > If demand is inelastic (i.e., Ed < 1), P Loss S then total revenue will increase. P2 Price floor P1 D Q Q2 Q1

The effect of a price floor on total revenue depends on the elasticity between the original price and the minimum price: Gain < If demand is elastic (i.e., Ed > 1), P Loss S P2 Price floor then total revenue will decrease. P1 D Q Q2 Q1

The effect of a price floor on total revenue depends on the elasticity between the original price and the minimum price: Gain = If demand is unitarily elastic (i.e., Ed = 1), P Loss S P2 then total revenue will remain unchanged. Price floor P1 D Q Q2 Q1

Effects of an effective price floor
To conclude, an effective price floor has the following effects: 1. The market price increases. 2. A surplus or excess supply is created. 3. The quantity transacted decreases. 4. Producers’ total revenue (or consumers’ total expenditure) may increase, decrease or remain unchanged. This depends on the elasticity of demand between the original equilibrium price and the minimum price.

Test yourself 6.5 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 less than $15,000, what effects will this have on the price and quantity transacted of air tickets? What will happen to the total revenue of airline companies?

The price of air tickets will increase to $15,000. The quantity transacted of air tickets will The total revenue of airline companies may increase, decrease or remain unchanged, depending on the decrease price elasticity of demand S D 10,000 15,000 Q1 Q2 Minimum price Price ($ / unit) Quantity (units / period)

C. How to deal with the surplus that results from a price floor
Due to the excess supply under a effective price floor, sellers have to compete with each other by 1. non-price competition; or/and 2. price competition.

1. Non-price competition among sellers Sellers may need to meet certain criteria or use other means to sell their good, including a. Improving the quality of goods; b. Providing extra gifts or services; c. other criteria, such as buyers’ preference, friendship, seniority, height, strength, etc. For example, when a minimum wage is imposed, workers (especially the low-skilled) have to invest more resources to acquire more skills, e.g., attending training courses.

2. Price competition among sellers a. Extra fees Sellers may be asked to pay buyers (or middlemen) legally or illegally an extra fee in order to have priority over others in selling their goods.

2. Price competition among sellers b. Illegal price cutting (or illegal price concession) Suppliers may sell their goods at prices lower than the legal minimum. In the previous example, suppliers are willing to sell illegally at $2 per unit when the quantity transacted is 8 units. P S 5 Surplus 4 Price floor 3 2 1 D Q 4 8 12 16 20

Learning tips 6.3 Ineffective price floor
A price floor is ineffective when it is imposed below the equilibrium price. Pe Q P S D P1 Price floor Qe  No effect on the price, quantity transacted and total revenue  No excess supply Total revenue

Test yourself 6.6 Based on the following diagrams, indicate the price, quantity transacted and total revenue after the imposition of a price floor. a. b. P P S S P0 Price floor P1 P1 P0 Price floor D D Q Q Q0 Q1 Q2 Q0 Q1 Q2

Test yourself 6.7 With reference to ‘Learning tips 6.2’, explain how the change in demand or supply affects the effectiveness of price floor.

When there is an increase in demand or a decrease in supply, the price floor will become ineffective if the new equilibrium price is higher than the minimum price imposed. This can be caused by: (a) A increase in demand (b) A decrease in supply P P S2 S S1 Pe Pe Price floor Price floor P1 P1 D2 D1 D Q Q Q1 Qe Qe Q1

Economics at work 6.2 Exploitation of workers under the minimum wage
The minimum wage law was implemented in Hong Kong on 1 May After the implementation, cases of worker exploitation, especially of older workers, were occasionally discovered. Excess supply of labour exists in some industries. Employers tend to hire younger workers with more skills and higher productivity. To avoid losing their jobs to younger workers, some older and low-skilled workers are forced to accept wages that are lower than the statutory minimum level.

Economics at work 6.2 (con’t) Exploitation of workers under the minimum wage

Test yourself 6.8 Can a minimum wage law help low-wage, unskilled workers in Hong Kong to earn a larger total income? Explain with the aid of a diagram. Answer: A minimum wage will raise / reduce employment of workers. Workers who can still secure employment after the introduction of the minimum wage would benefit / suffer from the higher / lower wage rate. P1 Q P S D1 Pe Minimum wage Qe Q1 Q2 Surplus

Test yourself 6.8 (con’t) Can a minimum wage law help low-wage, unskilled workers in Hong Kong to earn a larger total income? Explain with the aid of a diagram. Answer: However, since the minimum wage creates an excess demand / supply of labour (Q2 – Q1), employers can be more selective in choosing employees. They tend to employ workers with more skills and higher productivity. Some workers, mainly those who are unskilled or with lower productivity, are unemployed. P1 Q P S D1 Pe Minimum wage Qe Q1 Q2 Surplus

Moreover, workers must compete among themselves to be employed. They have to engage in non-price competition (e.g., attending self-financed training courses). Some workers may need to agree to an illegal wage cut proposed by employers to become employed. Therefore, potential employees may not benefit from the minimum wage.

Test yourself 6.9 Why are old watchmen and exploited domestic helpers willing to receive wages lower than the statutory minimum? Answer: They are afraid of losing their jobs to young workers. Old workers can easily / hardly get recruited when they are unemployed.

Discuss 6.3 Some employers offer to pay their watchmen or foreign domestic helpers wages that are higher than the statutory minimum. Why would this happen? Is it just because those employers are kind to their employees? Free answer. Perhaps these employers find that the workers are more productive and deserve a wage higher than the statutory minimum. Any other reasons?

Discuss 6.4 There is only one minimum wage for all sectors in Hong Kong. Discuss in which sectors the minimum wage is most likely to be effective and how it affects those sectors. Free answer. It is most likely that the minimum wage is effective for cleaning and security industries. Since cleaners and watchmen are unskilled, employers will pay lower wages to them if there is no minimum wage law.

Past exam Q 3. Refer to the above diagram. Which of the following statements is correct? A. If a price ceiling is set at P1, the quantity transacted is Q3. B. If a price floor is set at P1, the quantity transacted is Q2. C. If a price floor is set at P3, the quantity transacted is Q2. D. If a price ceiling is set at P3, non-price competition will occur. (HKCEE 2004, Q12)

Past exam Q 4. Suppose in Hong Kong there is an excess supply of Filipina domestic helpers at the minimum wage (w) set by the government. Also suppose that recently Hong Kong employers have to purchase an additional insurance policy for newly hired Filipina domestic helpers. Which of the diagrams on the right correctly reflects the above situation in the Filipina domestic helpers market in Hong Kong? (HKCEE 2011, Q7)

6.3 Quantity control: quota

Task 6.3 Traffic congestion is serious in Beijing.
Starting from 2011, the Beijing government has set a limit on the number of new vehicle licences issued each month in an effort to solve the problem. 京 A • 20000

Task 6.3 Mr Chen I want to buy a new car. The number of new vehicle licences issued per month is 20,000 but there are more than 50,000 applications. We need to wait for the result from the drawing of lots. Miss Li (Car agent) The number of new vehicles transacted has decreased greatly. What should I do?

Task 6.3 1. Since the new policy, in which form of competition has Mr Chen engaged? Waiting? He has engaged in non-price competition.

Task 6.3 2. What should Miss Li do to raise her revenue from selling cars? Change the prices? Improve quality? Any other ways?

Task 6.3 3. Suggest other methods that can reduce the number of new private cars on the roads.  Raising the first registration fee  Increasing annual licence fee  Raising fuel tax  Introducing electronic-road pricing Many other ways!

6.3 Quota  Maximum amount of output that the government allows
Why imposes a quota?  Many reasons. For example: ‘Two-can limit’ on baby formula to deal with milk shortage fear. Restricted number of taxis and minibuses to reduce traffic congestion.

6.3 Quota Fig. A Fig. B Effective or not?
 Effective only if it is imposed below the equilibrium quantity Which one is effective? Q P S D Fig. A Fig. B P0 Q0

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 P S 5 4 3 2 1 D Q 4 8 12 16 20 Fig. 6.16 Table 6.4 Again, the original quantity and price are 12 units and $3, respectively.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 Market QS under quota (units / week) 8 4 P S’ S 5 4 3 2 1 D Q 4 8 12 16 20 Fig. 6.16 Table 6.4 Suppose the government imposes a quota of 8 units on the good. What will the new price and the new quantity transacted be? The maximum amount the producers can sell is only 8 units. The supply curve becomes kinked. The new price and the new quantity transacted will be $4 and 8 units, respectively.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 Market QS under quota (units / week) 8 4 P S’ S 5 H 4 3 A 2 1 D Q 4 8 12 16 20 Fig. 6.16 Table 6.4 The effective quota leads to a movement along the demand curve from Point A to Point H.

Price ($ / unit) Market Qd (units / week) Market QS 5 4 20 8 16 3 12 2 1 Market QS under quota (units / week) 8 4 P S’ S 5 H 4 3 A 2 1 D Q 4 8 12 16 20 Fig. 6.16 Table 6.4 Consumers’ total expenditure and producers’ total revenue: Before the imposition of the quota After the imposition of the quota = $3 × 12 = 36 = $4 × 8 = 32 In this case, TE and TR decrease.

The effect of a quota on total revenue depends on the elasticity of demand between the original equilibrium price and the new market price:  If demand is inelastic (i.e., Ed < 1), then total revenue will increase.  If demand is elastic (i.e., Ed > 1), then total revenue will decrease.  If demand is unitarily elastic (i.e., Ed = 1), then total revenue will remain unchanged.

C. Effect on quality A producer may need to pay a price to obtain a quota right. Both the prices of higher quality goods and lower quality goods increase by the same amount. How does the price of a higher quality good relative to the price of a lower quality good change? Before the imposition of quota: Relative price of a higher quality good = Price of a higher quality good Price of a lower quality good After the imposition of quota: Relative price of a higher quality good = Price of a higher quality good Price of a lower quality good + Price of quota right The price of a higher quality good relative to the price of a lower quality good will decrease.

C. Effect on quality As the relative price of a higher quality good decreases, relatively more higher quality goods will be consumed. Thus, when an effective quota is imposed, the average quality of the good will improve.

Effects of an effective quota
To conclude, an effective quota has the following effects: 1. The quantity transacted decreases. 2. The market price increases. 3. Producers’ total revenue (or consumers’ total expenditure) may increase, decrease or remain unchanged. This depends on the elasticity of demand between the original equilibrium price and the new selling price. 4. It leads to an improvement in product quality.

Test yourself 6.10 What effects will there be on the price and quantity transacted of private cars if the Hong Kong Government imposes an effective quota on imported cars? What about its effects on the quality of imported cars in Hong Kong? Answer: The price will increase / decrease. The quantity transacted will increase / decrease. The quality will improve

Test yourself 6.11 With reference to ‘Learning tips 6.2’, explain how the change in demand or supply affects the effectiveness of quota.

When there is a decrease in demand or a decrease in supply, the quota will become ineffective if the new equilibrium quantity is lower than the quota imposed. This can be caused by: (a) A decrease in demand (b) A decrease in supply P Sq P Sq P1 P2 Pe P1 D1 S2 D2 S1 D Q Q Qe Q1 Q2 Q1

Learning tips 6.4 Ineffective quota
A quota is ineffective when it is imposed above the equilibrium quantity. S2  No effect on the price, quantity transacted and total revenue P S1 Pe Price ($ / unit) Market Qd (units / week) Market QS Under quota 5 4 16 8 3 12 2 1 20 Total revenue D Q Qe Fig An ineffective quota Table A quota of 16 units per week on Good X

Past exam Q 5. Refer to the following demand and supply schedules of Good X. Unit price ($) 100 90 80 70 60 50 Quantity demanded (Units) 120 140 160 180 Quantity supplied (Units) 200 40 If the government fixes the production quota of Good X at 80 units, the total expenditure of consumers on the good will be ________. A. $5,600 B. $6,400 C. $8,000 D. $9,600 (HKCEE 2011, Q13)

Past exam Q 6. In Country A, there is a quota restriction on an imported good. When the import quota quantity is Q1, the market price of the good is P1. Now suppose Country A increases the quota quantity from Q1 to Q3 as shown in the diagram below. As a result, the new total sales revenue would be A. P1 × Q1 B. P2 × Q2 C. P1 × Q3 D. P3 × Q3 (HKCEE 2006, Q10)

Past exam Q 7. Last year, the government reduced the import quota of fresh chicken into Hong Kong. On the other hand, many Hong Kong citizens have changed their habit of consuming fresh chicken to consuming chilled chicken. Which of the following diagrams illustrates this phenomenon? (HKCEE 2009, Q12)

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