6 Price controls, quotas, taxes and subsidies

Chapter Six Price controls, quotas, taxes and subsidies

Self-assessment Questions

6.1 The market price, quantity transacted and total revenue will all remain unchanged.

6.2 No! Both price ceiling and price floor will result in a drop in quantity transacted.

6.3 Yes! If the quota limit is set above the equilibrium quantity, producers will not use up the quota.
They will produce up to the equilibrium level only and charge the market equilibrium price.

In other words, the quota will produce no effects on price and quantity.

6.4(a) After a sales tax is imposed, it is possible for gross revenue to increase if demand is inelastic.
In our example, gross revenue increases from $28,000 to $32,400.

6.4(b) However, it is not possible for net revenue to increase, since both the net price and quantity
transacted drop. In the example, net revenue is just $21,600.

6.5 The tax burden would be distributed equally between producers and consumers.

6.6(a) The tax burden is borne entirely by consumers when demand is perfectly inelastic or supply
is perfectly elastic.

6.6(b) The tax burden is borne entirely by producers when demand is perfectly elastic or supply is
perfectly inelastic.

6.7(a) The whole benefit of a subsidy will be captured by the producers if demand is perfectly
elastic or supply is perfectly inelastic.

P P
S1 S1
E
P1 S2 P1 E
subsidy subsidy
P2 D1 P2 F
F G

D1
Q Q
Q1 Q2 Q1

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Suggested Solutions (2004 reprint with minor amendments)
 6 Price controls, quotas, taxes and subsidies

6.7(b) The whole benefit of a subsidy will be captured by the consumers if demand is perfectly
inelastic or supply is perfectly elastic.

P P
D1 S1
S2 E
P1 E P1 S1
subsidy subsidy
P2 F P2 S2

F
D1

Q Q
Q1 Q1 Q2

Multiple Choice Questions

1 C 2 B 3 A 4 B 5 B
6 D 7 C 8 C

1 The long queue is the result of the price being controlled below the equilibrium level, which
creates a shortage.

2 If the price ceiling is set above the equilibrium level, the price will fall back to the equilibrium
level. Hence, there will be no effect on the price and quantity transacted.

Short Questions

9(a)(i) Public education will lead to a fall in the demand for cigarettes. With a fall in demand, the
equilibrium quantity will fall.

S1

E
P1
F
P2

D1

D2
Q
Q2 Q1

New Introductory Economics 3rd Edition 16 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)
 6 Price controls, quotas, taxes and subsidies

9(a)(ii) By imposing taxes, the supply of cigarettes will decrease. With a decrease in supply, the
equilibrium quantity will fall.

P S2

S1
F
P2

E
P1

D1

Q
Q2 Q1

9(a)(iii) A quota sets the maximum quantity that can be traded, thereby restricting the quantity of
cigarettes consumed.

P
SQ

F S1
P2

E
P1

D1

Q
Q2 Q1

9(b)(i) Imposing a tax to discourage smoking will be ineffective. The tax will result in higher
prices. If demand is inelastic, the higher price will lead to a relatively small drop in quantity
demanded.

9(b)(ii) Imposing a tax to raise revenue will be effective. Tax revenue is equal to the product of the
tax rate and quantity transacted. If demand is inelastic, the quantity transacted will drop
proportionately less. As quantity transacted drops by only a small percentage, the
government can raise a substantial amount of revenue by imposing taxes.

New Introductory Economics 3rd Edition 17 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)
 6 Price controls, quotas, taxes and subsidies

Structured Essay Question

10(a)(i) The demand and supply curves are plotted below.

Price per trip ($)

S
18
16
14
12

10
8 D

No. of trips
0 10,000 12,000 14,000 16,000 18,000 20,000

10(a)(ii) Equilibrium price = $12 per trip

Number of trips provided = 16,000 trips/week

10(b)(i) 15,000 trips per week

10(b)(ii) Income of taxi drivers = $150,000

10(b)(iii) The average waiting time will be longer. This is because at the regulated price, there is a
shortage.

10(c)(i) Equilibrium price/trip = $14

Number of trips = 17,000 trips per week

10(c)(ii) Equilibrium price/trip = $8

Number of trips = 20,000 trips per week

10(c)(iii) Equilibrium price/trip = $10

Number of trips = 20,000 trips per week

New Introductory Economics 3rd Edition 18 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)