4. ECO162- Market Equilibrium and Government Intervention

MICROECONOMICSMICROECONOMICS(ECO 162)(ECO 162)

MARKET EQUILIBRIUM & GOVERNMENT INTERVENTIONMs. Tai Nyuk Chin

LEARNING OUTCOMESLEARNING OUTCOMES

• At the end of this lesson, the students should be able to:

i. Define and determine the market equilibrium.

ii. Explain the changes in equilibrium affects price and quantity.

iii. Differentiate between price ceiling and price floor and its advantages and disadvantages.

iv. Explain graphically the impact of tax and subsidy on the market equilibrium.

MARKET EQUILIBRIUMMARKET EQUILIBRIUM

Market equilibrium can be define as a situation where the quantity demanded for a good is equal to its quantity supplied. (Qdd = Qss)

In economics, an equilibrium is a situation in which:

i. There is no tendency for price or quantity to change

ii. Quantity demanded equals quantity supplied

iii. The market just clears without surplus/shortage

Market equilibriumMarket equilibrium

Price (RM)

Quantity (Units)

DD

SS

8

4000

9

2000 6000

Figure 3.10 : Market equilibrium

7

E

Surplus: 4000 units

Shortage: 4000 units

A shortage (excess demand) occurs when quantity demanded exceeds quantity supplied.A shortage implies the market price is too low.

A surplus (excess supply) occurs when quantity supplied exceeds quantity demanded.A surplus implies the market price is too high.

Equilibrium price and quantity refers to the price and quantity that consumers are willing to buy as they needed and suppliers are willing to sell as they wanted.

CHANGES IN EQUILIBRIUM CHANGES IN EQUILIBRIUM PRICE & QUANTITYPRICE & QUANTITY

i. Market experienced surplus (Excess Supply)

Equilibrium point

Excess SS condition: At any price above the equilibrium price, $95, producers are

willing to supply goods at 110 units. But at that price level, consumers are only willing to buy goods

at 75 units . Therefore, when Qss > Qdd, there will be an excess supply, 35

units (110units -75 units). The producers will compete among themselves for sales by

cutting down the price and the price will decline. As price falls, quantity supplied by producer decrease until it

reaches equilibrium where surplus will be eliminated (market forces).



ii. Market experienced shortage (Excess demand)

Equilibrium point


Excess dd condition: At any price below the equilibrium price, $20, consumers are willing

to purchase at higher quantity than the equilibrium point, Qdd=105 However, at lower price of $20, producer supply less, Qss=80 and

consumers want to buy more than that. Therefore, when Qdd>Qss, there will be an excess demand at 25 units

(105units-80units) . When market is experiencing shortage, the producers sees it as an

opportunity to create more profit. Therefore, they increase the price. As prices increase, quantity demanded by consumers will drop (law

of dd) and quantity supplied by producer increase (law of supply) until market reaches equilibrium where shortage will disappear.

THE CONTROL OF PRICESTHE CONTROL OF PRICES

Price control refers to the process of fixing the price regardless of the market demand and supply.

Intervention from government occurs when government is not satisfied with the market price and therefore, it interfere in the market to influence the price.

There are two types of government intervention in free market;

i. Price ceiling (maximum price)

ii. Price Floor (minimum price)

PRICE CEILING PRICE CEILING (MAXIMUM PRICE)(MAXIMUM PRICE)

i. Price Ceiling (Maximum price) Refers to the highest price that a seller can charge. Also known as a legally established price that is not

allowed to increase above a maximum level set by government.

When government feels that high price of essential goods such as rice, oil, sugar and others is likely to affect the lower income group, price ceiling will be imposed.

E.g.: Price of sugar is fixed at RM 1.65 per kg, therefore sellers can sell the product below RM 1.65 per kg but not more than that.


Besides essential goods, government also imposed price ceiling on rent houses or apartments as consumers allocate a large portion of their income in paying for houses/apartments.

E.g: In Malaysia, government control the price of low-cost houses at RM42,000, which is below the market price. This is to ensure that lower income group afford to own a house.


Price Controls: Maximum prices below normal equilibriumThe government imposes a maximum price of RM6 (P Max)

Price (RM)

Quantity (Units)

D

S

10

100

6 Price Ceiling

At the lower price, supply would fall whereas demand would rise – a shortage would exist.

60 140

18

Figure 3.11 : Government intervention (price ceiling)

E

Shortage (excess demand)


One of the main reasons for government to sets a maximum price is to prevent the market price of a good from increasing above certain level.

Besides, government also sets maximum price for the the reason of fairness.

E.g: During wartime or inflation, government may impose maximum price for basic goods so that the poor people can afford to purchase the items.

DISADVANTAGES OF PRICE DISADVANTAGES OF PRICE CEILINGCEILING

i. Unfair to producers Producers have to sell less quantity than what they have sold

before. Besides, producers are also forced to sell at lower prices.

ii. Lead to shortage problem Once government imposes a maximum price, consumers can

afford to buy more goods than before. Thus, this will lead to excess demand or shortage problem.

DISADVANTAGES OF DISADVANTAGES OF PRICE CEILINGPRICE CEILING

iii. Wastage of resources and money The imposition of maximum price also gives rise to a system of

‘first come, first serve’ basis. This situation forced the government to impose a fair distribution

system through giving out coupon or rationing. This would cost a lot of money and cause a waste of resources as a

lot of valuable time and resources are wasted in the process of distribution.

iv. Emergence of black market Imposition of price ceiling also lead to the emergence of black

market as some producer tend to seek higher profit as excess demand exist in the market.

PRICE FLOOR PRICE FLOOR (MINIMUM PRICE)(MINIMUM PRICE)

ii. Price Floor (Minimum price) Refers to the lowest price permitted by law or authority. Price floor also referred as legally established price set by

the government at a level above the equilibrium price in free market.

This price is not allowed to decrease below a minimum level set by government but sellers are allowed to sell at higher price than the minimum level.

E.g.: Minimum wage rate for labor is fixed at RM600-RM700 per month. Thus, employers cannot decrease the wage rate below the fixed rate but are allowed to pay higher.

PRICE FLOOR (MINIMUM PRICE FLOOR (MINIMUM PRICE)PRICE)

Price Controls:Minimum prices set above normal equilibrium

Price (RM)

Quantity (Units)

D

S

5

200

9 Price Floor

170 240

At the higher price, demand would fall whereas supply would rise – a surplus would exist.

Example – Minimum Wage Legislation in the UK

Figure 3.12 : Government intervention (price floor)

Surplus (excess supply)

PRICE FLOOR PRICE FLOOR (MINIMUM PRICE)(MINIMUM PRICE)

Government sets price floor for several reasons;

i. Protect the income of farmers/producers Excess supply (surplus) which occurs in the market will threatens to force

down the prices. When this happens, government will sets minimum prices to prevent the fall

of sellers’ or producers’ income during the periods of low prices.

ii. Create a surplus Government also impose price floor to create surplus for future use. E.g.: government impose price floor on paddy which can be stored in

preparation for future shortage.

iii. Preventing workers’ income from falling With the imposition of minimum wage rate, this can prevent workers’

income from decreasing below a certain level.

DISADVANTAGES OF PRICE DISADVANTAGES OF PRICE FLOORFLOOR

i. Unfair to consumer Consumer have to pay more than what they have paid before. After the imposition of price floor, consumers are force to pay

more for lesser amount of goods.

ii. Unfair to taxpayer When the government imposes a minimum price, there would

be a surplus in the market. Once surplus (excess supply) exist in the market, government

will have purchase the surplus and the purchase is financed by the tax revenue collected from taxpayers.

iii.

DISADVANTAGES OF PRICE DISADVANTAGES OF PRICE FLOORFLOOR

iii. Wastage of money and resources The surpluses bought by the government are kept as stock but are

easily perishable. To overcome this situation, government will either destroy the

goods or export to overseas and sell with cheaper price (dumping). Both the solutions clearly results in wastage of money and

resources.

iv. Leads to unemployment problem Minimum wage rate imposed by government will increase the cost

of production. Thus, a lot of companies will have to retrench workers as a solution

to decrease the cost of production.

THE CONTROL OF PRICESTHE CONTROL OF PRICES

Price Ceiling (Max price) Price Floor (Min price)

PricePrice is set below the equilibrium price and is not allowed to rise.

Price is set above the equilibrium price and is not allowed to drop.

Market Condition

Shortage Surplus

Advantages

Consumer could purchase goods and services at lower prices

• Higher wage rate help low-skilled labor to earn higher and stable income• Protects producers’ income especially

farmers.

Disadvantages• Emergence of black market• Producers supplied at lower

quantity• Producers tend to receive illegal

payment from consumers

• Consumers pay more than the equilibrium price

•Surplus of production lead to waste of resources for government.

• Minimum wage rate leads to unemployment

CONTROL OF PRICES FROM CONTROL OF PRICES FROM ISLAMIC VIEWPOINTISLAMIC VIEWPOINT

Through Islamic point of view, price controls are only allowed under certain circumstances.

Islam forbids price controls because they are unfair to both producers and consumers.

Maximum price is unfair to the consumers whereas minimum price is unfair to the producers.

However, Islam allows the government to control prices if it is proven that the increase and the decrease in prices are due to injustice or manipulation of the market.

E.g.: If the steep high prices is due to a planned decrease in the supply by the monopolist, then the responsibility is on the government to interfere in order to protect the welfare of society.

INDIRECT TAX AND INDIRECT TAX AND SUBSIDYSUBSIDY

Tax is the main sources of revenue for government. Government levy taxes on wide variety of goods, such

as cigarettes and alcohol, on payroll and profits. Taxes basically aim to restrict consumption by

reducing demand and supply or both. There are two types of taxes:

i. Indirect taxes

ii. Direct taxes (Income tax)

INDIRECT TAXESINDIRECT TAXES

Indirect tax is tax imposed by government on producers or sellers but paid by or passed to end-users (consumers).

Indirect taxes consist of import duties, excise duties, sales taxes, service taxes and export duties.

Two types of indirect tax:

i) Ad Valorem (Based on percentage) Based on the value of the dutiable item and expressed in percentage

terms E.g.: Taxes on imported cars

ii)Specific tax (Based on quantity sold) A tax levied at a fixed rate per physical unit of the good taxed,

regardless of its price. E.g: Taxes on liquor, services tax on pizza, kfc

IMPACT OF TAXES ON IMPACT OF TAXES ON GOODS GOODS

Indirect taxes will increase the price of the good sold. This is because the impositions of indirect taxes on

good will increase the production cost of the good. Thus, to avoid earning lower profit, producer would

reduce the supply of the good in the market. Once the quantity supplied decrease, the price of

goods will increase as there is an excess demand in the market.


Figure 3.13 : Effect of tax on DD and SS of cigarettes

Price of cigarettes ($)

Quantity (Packs)

E0

E1 8.50

7.50

200 300

S1

S0

S0

S1

6.50DD

E1

E0

S1

S0


Figure 3.13 shows the equilibrium in a market with DD curve and S0 as the initial supply curve.

Before tax, the equilibrium price and the equilibrium quantity is RM 7.50 per pack and 300 packs, respectively.

When government impose excise tax on cigarettes, there is no change in DD, but movement along the demand curve takes place.

The SS curve shift leftward to S1 as tax imposition will lead the cost of production to rise and force producers to decrease the supply.

The new equilibrium occurs when new SS curve, S1 intersect with DD curve at price of RM 8.50 per pack and quantity of 200 packs.

When tax is imposed, who ultimately pay the tax? What is the incidence??

ELASTICITY AND INCIDENCE ELASTICITY AND INCIDENCE OF TAXATIONOF TAXATION

The portion of tax shared between buyer and seller depends on the elasticity of demand and supply.

The burden of tax will differ depending on the elasticity of demand and supply.

i. When demand is inelastic than supply, buyer will shares more of the burden of tax.

ii. When demand is more elastic than supply, seller shares more of the burden of tax.

ELASTICITY AND ELASTICITY AND INCIDENCE OF TAXATIONINCIDENCE OF TAXATION

Figure 3.14 Incidence of taxation: Demand is inelastic compared to supply

Price of cigarettes (RM)

Quantity (Packs)

E0

E1

200 300

S1

S0

S0

S1 DD

Buyer bears more tax compared to seller/producer when demand is inelastic compared to supply

E1

E0

S1

S0

Seller’s portion

Buyer’s portion

7.00

7.50

9.00RM1.50 bear by the buyer

RM0.50 bear by the seller

Demand is inelastic compared to supply: %∆Q<%∆P


Figure 3.14 shows the equilibrium in a market with DD curve and So as the initial supply curve.

Before tax, the equilibrium price and quantity is RM 7.50 per pack and 300 packs, respectively.

After tax, the equilibrium price and quantity is RM9 per pack and 200 packs. The price the buyer pays is RM9 per pack, while the price the seller receives

is RM7 per pack. The buyer had to bear the tax burden of RM1.50, while the seller only shares

RM0.50 The difference between the buyers’ price and sellers’ price is the amount of

tax (RM 9.00-RM7 = RM 2)

:. When demand > inelastic than supply, buyers pay more tax than seller.


Figure 3.15 Incidence of taxation: Demand is more elastic compared to supply

Price of Handphone (RM)

Quantity (Unit)

E0

E1

200 300

S1

S0

S0

S1

DD

Seller bears more tax compared to buyer/consumer when demand is more elastic than supply.

E1

E0

S1

S0

Buyer’s portion

Seller’s portion

600

750

800

RM150 bears by the seller

RM50 bears by the buyer

Demand is more elastic compared to supply: %∆Q>%∆P



Before tax, the equilibrium price and quantity is RM 7.50 per pack and 300 packs, respectively.

After tax, the equilibrium price and quantity is RM8 per pack and 200 packs. The price the buyer pays is RM8 per pack, while the price the seller receives

is RM6 per pack. The seller had to bear the tax burden of RM1.50, while the buyer only shares

RM0.50 The difference between the buyers’ price and sellers’ price is the amount of

tax (RM 8.00-RM6 = RM 2)

:. When demand > elastic than supply, sellers pay more tax than buyer.

SUBSIDIESSUBSIDIES

Subsidies can be define as an incentive from government to encourage producers or sellers to produce more goods.

Subsidy works in exactly the opposite way as taxes as subsidies would help producers to cut down the cost of production.

When cost of production is lower, producer’s profit will increase and they are wiling to produce more as profit is high.

Malaysian Government provides subsidies for fertilizers, petrol, diesel and others.

IMPACT OF SUBSIDIES ON IMPACT OF SUBSIDIES ON GOODS GOODS

Figure 3.16 : Effect of subsidies on DD and SS of petrol

Price of Petrol (RM per gallon)

Quantity (gallons)

E0

E1 1.50

1.00

200 300

S1

S0

S0

S1

0.50DD

E1

E0 S1

S0

IMPACT OF SUBSIDY ON IMPACT OF SUBSIDY ON GOODS GOODS

Figure 3.13 shows the equilibrium in a market with DD curve and S0 as the initial supply curve.

Before subsidy, the equilibrium price and the equilibrium quantity is RM 1.50 per gallon and 200 gallons, respectively.

The SS curve shift leftward to S1 as subsidy provision will lowers down the cost of production and encourage producers to increase the supply.

The new equilibrium occurs when new SS curve, S1 intersect with DD curve at price of RM1 per gallon and quantity of 300 gallons.

Between sellers and buyers, who will gain more benefits when the government provides subsidies??

ELASTICITY AND SUBSIDYELASTICITY AND SUBSIDY

Subsidy works in exactly the opposite way as taxes as it will reduce the production cost of the good.

The benefit of subsidy will differ depending on the elasticity of demand and supply.

i. When demand is inelastic than supply, buyer will enjoys more of the benefit of subsidy provision.

ii. When demand is more elastic than supply, seller enjoys more of the benefit of subsidy provision.


Figure 3.17 Effect of subsidies: Demand is Inelastic than supply

Price of fuel (RM per gallon)

Quantity ( million gallons)

E0

E1

1 1.2

S1

S0

S0

S1 DD

Buyer enjoy more benefit of the subsidy compared to seller/producer when demand is inelastic to supply

E0

E1

S1

S0

Seller’s portion

Buyer’s portion

0.50

0.80

1.50RM0.70 enjoy by the buyer

RM0.30 enjoy by the seller

Demand is inelastic compared to supply: %∆Q<%∆P



Before subsidy, the equilibrium price and quantity is RM 1.50 per gallon and 1m gallons, respectively.

After subsidy the equilibrium price and quantity is RM0.80 per gallon and 1.2m gallons.

The price the buyer pays is RM0.80 per gallon, while the price the seller receives is RM0.50 per gallon.

The buyer enjoys RM0.70 of the benefit of subsidy, while the seller only enjoys RM0.30.

The total between the buyers’ and sellers’ shares of subsidy is the amount of total subsidy given by the government (RM 0.70 + RM0.30 = RM 1)

:. When demand > inelastic than supply, buyers enjoy more subsidy than seller.


Figure 3.18 Effect of subsidies: Demand is more elastic compared to supply

Price of Fuel (RM)

Quantity (Million gallons)

E0

E1

1 1.2

S1

S0

S0

S1

DD

Seller enjoys more subsidy compared to buyer/consumer when demand is more elastic than supply.

E0

E1

S0

S1

Buyer’s portion

Seller’s portion

0.50

1.20

1.50

RM0.70 enjoys by the seller

RM0.30 enjoys by the buyer

Demand is more elastic compared to supply: %∆Q>%∆P



Before subsidy, the equilibrium price and quantity is RM 1.50 per gallon and 1m gallons, respectively.

After subsidy, the equilibrium price and quantity is RM1.20 per gallon and 1.2m gallons.

The price the buyer pays is RM1.20 per gallon, while the price the seller receives is RM0.50 per gallons.

The seller enjoys subsidy of RM0.70, while the buyer only enjoys RM0.30 The total between the buyers’ and sellers’ shares of subsidy is the amount of

total subsidy given by the government (RM 0.70 + RM0.30 = RM 1)

:. When demand > elastic than supply, sellers enjoy more subsidy than buyer.

That’s all for Chapter 4!That’s all for Chapter 4!Mahalo!

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4. ECO162- Market Equilibrium and Government Intervention