Chapter 2C

Question 1

Govt intervention

Answer 1

When markets fail to allocate resource efficiently and the govt believes price mechanism in a market is inefficient and not desirable for economy govt intervenes with

1. direct intervention policies- direct price controls
2. market based policies - indirect price controls

Question 2

The reason for govt intervention

Answer 2

1. encourage/discourage or prohibit production/consumption of a good
2. raise revenue
3. make certain goods more affordable
4. redistribute income

Question 3

Direct price controls

Answer 3

1. Price floor (P min)
2. Price ceiling (P max)

used when equilibrium price may not be deemed by the govt as most desirable. Hence price might be kept artificially lower or higher

Question 4

Price ceiling

Answer 4

The maximum legal price set and allowed by the government

legal market price is set below the equilibrium price to be effective

no good should be transacted at a price higher than the P max upper limit

Question 5

Reasons for price ceilings

Answer 5

1. affordability and fairness
   allow the poor to buy a good that might otherwise be otherwise be unaffordable
   prevent exploitation by supplier who may charge high charges during times of shortage
2. anti inflationary policy
   detrimental to economic growth and people’s SoL

Question 6

Effects of price ceilings

Answer 6

1. Shortage
2. Emergence of black markets
3. Allocation of the good or service to a first come first serve basis
4. Issue of fairness is a problem
5. Firms deciding which customers should be allowed to buy
6. Rationing through issue of coupons
7. Producers have less incentive to invest in quality control and innovation

FREAPSI

Question 7

1. Shortage

Answer 7

availability of goods and services may also decrease over time as new production is discouraged and resources are being allocated to production of substitutes since producers expect lower future profits

Question 8

2.Emergence of black markets

Answer 8

when goods are illegally sold at prices above a legal price ceiling. Allowing producers to earn more revenue

emerges with setting of price ceilings as long as there are potential consumers willing and able to pay more than legislated maximum market price to obtain goods and services

govt’s objective of achieving a fairer distribution of the goods and services by ensuring their affordability is not met

Question 9

3.Allocation of the good or service to a first come first serve basis

Answer 9

Adoption of queuing system/ waiting systems

consumers incur the additional opportunity cost of extra time spent searching/waiting for good

Question 10

4.Issue of fairness is a problem

Answer 10

People who need it most may not be the amongst the first in line to get the good

Question 11

5. Firms deciding which customers should be allowed to buy

Answer 11

for instance giving preference to regular customers

Question 12

6.Rationing through issue of coupons

Answer 12

Through the issue of coupons

Question 13

7. Producers have less incentive to invest in quality control and innovation

Answer 13

due to lower profitability of providing the goods and services the benefit of lower price thus offset in part by lower quality and variety

Question 14

Price floors

Answer 14

minimum legal market price set and allowed by the government

market price not allowed to fall below the legislated minimum market price and no good should be transacted at prices below the lower limit

legal market price has to be set above free market equilibrium price for effectiveness

Question 15

Reasons for price floors

Answer 15

1. Protect producers’ income (for example of farmers’)
2. Create a surplus
   3.Minimum wage
   prevent wage rates from falling below a certain level to ensure acceptable level of living standards

Question 16

Protection of producer income

Answer 16

if industry is subjected to fluctuations minimum prices would prevent producers’ incomes from falling dueing periods of low demand

in addition to price floor the govt has to buy up surpluses

Question 17

Create a surplus

Answer 17

In periods of glut which can be stored in preparation of future shortages

Question 18

Effects of a pricefloor

Answer 18

1. Producers selling their goods at prices lower than legislated prices so they can earn higher revenue (esp if price elastic)
2. Law abiding producers earn lesser revenue compared to pre intervention levels of revue due to more than proportionate fall in quantity if demand is price elastic

3.Artificially high prices cushion inefficiency
firms feel less need to find more efficient methods of production

4. Discourages firms from producing alternative goods which they could produce more efficiently or which are in higher in demand but nevertheless have lower market price

Question 19

How the govt deals with surpluses and limitations

Answer 19

1. Govt could buy surpluses and store it/destroy it/sell it abroad
   - Buying up surpluses is expensive
   -offloading surplus into global market may cause competition between foreign and local goods
   further depresses world price due to increase in world supply
   - if goods are perishable then storage is a poor choice
   - storing of goods can be costly
2. Supply can be artificially lowered by restricting producers to particular quotas
   - quotas inevitably lower quantity available for transaction and will cause market prices to increase hence rendering price controls unnecessary
   - loss of consumption due to disruption of market forces will lower economic welfare for all
3. Raising demand by advertising by finding alternative uses for good or reducing consumption of good
   - however if demand can be increased then there is no need for price floor.
   - costs are incurred in advertising

Question 20

Direct quantity controls

Answer 20

1.Quotas

Question 21

Quota

Answer 21

legal limit set by govt on quantity of a good that can be transacted in a market

set the legal maximum quantity of the good that can be purchased

equilibrium quantity not allowed to rise above the legislated legal maximum and no good should be transacted beyond this upper quantity limit

Question 22

Reasons for Quotas

Answer 22

1. to reduce consumption of certain goods that are overconsumed or harmful
2. To protect domestic industries from foreign competition by restricting quantity of foreign imports legally allowed to be supplied in the country

Question 23

Effects of a quota

Answer 23

1. societal welfare is reduced
2. setting a quota below the free market equilibrium quantity decrease consumption of good raising its prevailing market price ceteris paribus reducing consumption of certain goods by restricting qty available in market and increasing its price

Question 24

Indirect price controls/Market based policies

Answer 24

1. Taxes

2. Subsidies

Question 25

Taxes

Answer 25

involuntary payment of funds to the govt by a household or firm for which for which the household or firm receives no good or service in return

1. direct
2. indirect

Question 26

Direct taxes

Answer 26

Taxes on income/wealth paid directly to the tax authorities

e.g. income tax and capital gains tax

Question 27

Indirect taxes

Answer 27

Taxes on expenditure paid to tax authorities by the suppliers of the goods. consumers pay the tax indirectly in the form of higher prices

e.g. GST, VAT (values added), excise duties on cigarettes

Question 28

Direct and indirect taxes

Answer 28

can be imposed as a specific tax or ad valorem tax

Question 29

Specific tax

Answer 29

fixed amount of tax charged per unit sold therefore tax per unit of good is the same regardless of the price of the good

Question 30

Ad valorem tax

Answer 30

a percentage of the price or value added at each stage of production. good or service is taxed a certain percentage based on the value of the product (higher price, higher tax)

Question 31

Effects of specific indirect taxes

Answer 31

1. Producers’ per unit cost of production will increase leading to decrease in supply
2. The govt receives tax revenue
3. decreases demand

Question 32

How price elasticity affects impact of specific indirect taxes

Answer 32

impact on equilibrium price and quantity will depend on the relative price elasticities of demand and supply

draw the diagram out

Price inelastic demand
-Govt receives more tax
Price elastic demand
- Govt receives less tax

Question 33

Direct subsidies

Answer 33

Subsidies that increase households’ income and wealth paid directly to households e.g. cash benefits

Question 34

Indirect subsidies

Answer 34

Subsidies on expenditure paid directly to the suppliers of the goods and services and consumers benefit indirectly through reduced prices e.g. subsidised education

Question 35

Effect of specific indirect subsidies

Answer 35

1. Increases supply by lower unit cost of production for producers
2. increases demand
3. Govt pays subsidy expenditure

Question 36

How price elasticity affects impact of specific indirect subsidies

Answer 36

impact on equilibrium price and quantity will depend on the relative price elasticities of demand and supply

draw diagram

Price inelastic
Subsidy expenditure is lesser
Price elastic
subsidy expenditure is greater