Hkcee: 2010 Econ Paper 2 Q2

A second part of Q2 often introduced a change in the market for a substitute. For example: “Suppose the government reduces the fare of the MTR. At the same time, a new bus route with lower fares is introduced. Explain the combined effect on the total revenue of the MTR company.”

Step 1 – Own-price effect (MTR fare reduction):
As per part (a), if MTR demand is inelastic, reducing its fare alone would lower MTR’s total revenue.

Step 2 – Cross-price effect (substitute bus route):
The introduction of a lower-fare bus route is a substitute for MTR travel. For substitutes, a decrease in the price of the substitute (bus) reduces demand for the original good (MTR), shifting the MTR demand curve to the left.

Step 3 – Combined effect on MTR’s total revenue:
Two forces act simultaneously:

The net effect on MTR’s total revenue is ambiguous without elasticity magnitudes, but the examiner’s expected answer was that total revenue would likely fall further because: hkcee 2010 econ paper 2 q2

Definition:
A price ceiling is a maximum legal price set by government.

Effect when set below P₁:

Diagram:

Answer:
Shortage occurs; some consumers unable to buy; possible illegal trading at higher prices.

Examiner’s note:
Students often draw ceiling above equilibrium (ineffective) or confuse with price floor. Must label shortage clearly.

This question beautifully illustrates three core principles: A second part of Q2 often introduced a

For HKCEE candidates, mastering question 2 meant mastering diagram analysis – always:

Negative externalities of production occur when a firm’s output imposes uncompensated costs on third parties. In the case given, the factory’s pollution harms local residents, so private marginal cost (MPC) underestimates marginal social cost (MSC = MPC + marginal external cost). The unregulated market equilibrium is where MPC equals marginal private benefit (MPB), producing Q_market which exceeds the socially optimal Q_social determined by MSC = MSB. This overproduction causes a deadweight loss equal to the triangular area between MSC and MPC from Q_social to Q_market.

To correct the market failure, the government could impose a Pigovian tax equal to the marginal external cost per unit. This raises the firm’s marginal private cost to MSC, internalizing the externality and restoring the social optimum. The tax is economically efficient and raises public revenue but requires accurate estimation of the external cost and effective enforcement; misestimation leads to inefficiency. Alternatively, the government can set emission standards or limits (regulation). Standards guarantee pollution reduction but can be less cost-effective because firms face different marginal abatement costs. Tradable permits (cap-and-trade) combine certainty about total emissions with cost-effectiveness: firms with low abatement costs sell permits to high-cost firms. Downsides include administrative complexity, initial permit allocation issues, and the need for robust monitoring.

Distributional concerns matter: pollution often disproportionately affects vulnerable communities, so policies may need compensation measures or targeted investment in local mitigation. Politically, firms may resist taxes or caps; phased implementation and stakeholder engagement reduce opposition. Where measurement of the marginal external cost is feasible, a properly set Pigovian tax is recommended; where uncertainty or heterogeneity is large, tradable permits with strong monitoring are preferable. In practice, combining market-based instruments with regulation and support for cleaner technology provides a balanced, implementable approach. The net effect on MTR’s total revenue is

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