This Document Contains Chapters 4 to 6 CHAPTER 4 ELASTICITY Chapter Overview Supply and demand may be the most common words in economics, but applying these concepts to the real world requires a bit of elaboration. Elasticity is the first of several concepts we will study that will help you to apply the concepts of supply and demand to business and policy questions. In this chapter we saw how elasticity can be used to predict how price changes will influence revenue. In the coming chapters we will use elasticity to predict the effects of government intervention in the market, and we will dig deeper into the consumer and producer choices that drive elasticity. Learning Objectives LO 4.1: Calculate price elasticity of demand using the mid-point method. LO 4.2: Explain how the determinants of price elasticity of demand affect the degree of elasticity. LO 4.3: Calculate price elasticity of supply using the mid-point method. LO 4.4: Explain how the determinants of price elasticity of supply affect the degree of elasticity. LO 4.5: Calculate cross-price elasticity of demand, and interpret the sign of the elasticity. LO 4.6: Calculate income elasticity of demand, and interpret the sign of the elasticity. Chapter Outline OPENING STORY: COFFEE BECOMES CHIC What Is Elasticity? Price Elasticity of Demand Calculating Price Elasticity of Demand (LO 4.1) Determinants of Price Elasticity of Demand (LO 4.2) Using Price Elasticity of Demand BOX FEATURE: REAL LIFE – DOES CHARGING FOR BEDNETS DECREASE MALARIA? BOX FEATURE: WHAT DO YOU THINK? – SHOULD ENTRANCE FEES AT NATIONAL PARKS BE RAISED? Price Elasticity of Supply Calculating Price Elasticity of Supply (LO 4.3) Determinants of Price Elasticity of Supply (LO 4.4) Other Elasticities Cross-Price Elasticity of Demand (LO 4.5) Income Elasticity of Demand (LO 4.6) BOX FEATURE: WHERE CAN IT TAKE YOU? – PRICING ANALYST Beyond the Lecture Class Activity: Calculating Price Elasticity of Demand (LO 4.1) Netflix enacted a large percentage price increase in 2016 (read an article about this price increase here). Using the original estimates in the article, have students consider the price elasticity of demand for Netflix. This works well with small groups. If the price increases from $8 to $10 and subscriptions fall by 480,000, what economic phenomena are we seeing? (the answer is the first law of demand) Given that analysts expected higher revenues as a result of the higher prices, what can we say about the elasticity of demand for Netflix? Class Discussion: Determinants of Price Elasticity of Demand (LO 4.2) Ask students to consider the price elasticity of demand for cigarettes. The article here discusses a recent proposal to increase the federal cigarette tax. This is also a nice topic for a small group discussion or in an online environment. How do smokers respond to a change in the price of cigarettes? Are they relatively elastic or relatively inelastic? What are the factors that drive the price elasticity of demand for cigarettes? Are there any substitutes for cigarettes? It is interesting to consider a federal tax, state tax, or local tax here as the answers are slightly different. Does the other things constant assumption hold when taxes on cigarettes rise? Writing Assignment: Determinants of Price Elasticity of Demand (LO 4.2) Have students listen to this EconTalk podcast by Russell Roberts featuring Richard McKenzie on prices. Why do prices fall after a major gift-giving season? Why does popcorn at the movie theatre generally seem to be so expensive? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Which of the following will likely have the most elastic demand? [LO 4.2] a specific brand of cereal gasoline drugs needed to cure a serious illness electricity Feedback: A specific brand of cereal will likely have many substitutes. The closeness and availability of substitutes plays a large role in the determination of elasticity. More substitutes will mean that a good is more elastic. 2. Which is the most likely to have a perfectly inelastic demand? [LO 4.2] Your favorite fast food burrito that you like to eat once a week Gasoline College tuition Life-saving surgery Feedback: Gas may not have a lot of substitutes in the short run, but if prices get very high, we will still choose to drive less when we can. If we need a life-saving surgery, we’ll get it no matter the price. 3. Why do we use the midpoint method in calculating demand elasticity instead of just a simple percent change formula? [LO 4.1] Complicated math equations are generally more accurate To avoid elasticity estimate changes due to a change in which direction we move along the demand curve To make sure our elasticity answer is always a larger value To make our demand elasticity value turn into a positive number Feedback: Using a percent change can cause a “directionality” issue in which switching your new and old measurement point can change your answer, even though you’re using the same two points. The midpoint method eliminates this problem. 4. The sign (positive or negative) of a cross-price elasticity value can tell us [LO 4.5] if a good is normal or inferior if two goods are complements or substitutes if a good is seasonal or purchased year-round if a good has a downward sloping demand 5. Suppose milk has an income elasticity that is positive, but less than 1. What does this mean? [LO 4.6] Milk is an inferior good Milk is a necessity Milk is a luxury Milk is a scarce good Feedback: Remind your students that in this case, “necessity” doesn’t mean something we “need”. It’s just a category label based on numerical results of income elasticity. You can tell them to think about their income tripling. They may buy a little more milk each week, but certainly not 3 times as much. Solutions to End-of-Chapter Questions and Problems Review Questions You are advising a coffee shop manager who wants to estimate how much sales will change if the price of a latte rises. You tell him that he should measure the change in sales using the percentage change in quantity of coffee sold rather than the number of cups of coffee or the total ounces of coffee sold. Similarly, you tell him that he should measure the price increase in percentage terms rather than in terms of absolute dollars. Explain why he should measure elasticity in percentage terms rather than in terms of dollars and cups. [LO 4.1] Answer: If the coffee shop manager measures elasticity in percentage changes, he will have an understanding of the price sensitivity of demand for lattes that will be consistent regardless of the units of measure. By using percentage changes to calculate elasticity, he will have the same sense of price sensitivity regardless of whether lattes are measured in cups, gallons, or ounces and whether price is measured in dollars or cents. Explain why the coffee shop manager should calculate elasticity using the mid-point method. [LO 4.1] Answer: Using the mid-point method to calculate elasticity is useful because the coffee shop manager will have a single measure of the price sensitivity of demand over a particular range of prices regardless of the direction price is moving. For example, he would know how sensitive demand is to a price change between $3 and $5 regardless of whether price increases from $3 to $5 or decreases from $5 to $3. Because the mid-point method considers the average of these prices ($4) as the base, he will have the same elasticity measure over that price range, whichever direction price moves. You are working as a private math tutor to raise money for a trip during spring break. First explain why the price elasticity of demand for math tutoring might be elastic. Then explain why the price elasticity of demand for math tutoring might be inelastic. [LO 4.2] Answer: This would depend on the availability of other tutors who might charge prices lower than you and how desperate your students are for tutoring. If your students can easily switch to another tutor and/or think of tutoring as a luxury they can do without if prices rise, the price elasticity of demand would be elastic. If there are no other tutors your students can turn to or if they feel they cannot possibly pass their course without tutoring, the price elasticity of demand could be inelastic. You are working as a private math tutor to raise money for a trip during spring break. You want to raise as much money as possible. Should you should increase or decrease the price you charge? Explain. [LO 4.2] Answer: Whether you should raise or lower your prices depends on the price elasticity of demand. If demand is elastic, you will increase your revenue by lowering prices. With elastic demand, lower prices mean that people will hire enough additional tutoring hours from you to offset the lower price. If demand is inelastic, you will raise prices by increasing prices. With inelastic demand, people will reduce tutoring hours a bit when you raise prices, but not enough to offset your gain from charging more. You have been hired by the government of Kenya, which produces a lot of coffee, to examine the supply of gourmet coffee beans. Suppose you discover that the price elasticity of supply is 0.85. Explain this figure to the Kenyan government. [LO 4.3] Answer: A price elasticity of supply of .85 would mean that supply of gourmet coffee beans is inelastic, or not very responsive to prices. For example, if the price of gourmet coffee beans rose by 5%, the supply of gourmet coffee beans would increase by less than 5% in the short run. This could be because it takes a long time to increase supply and/or there may be other constraints like limitations on land. You could advise the Kenyan government to explore the factors that make supply less responsive to price changes. You have noticed that the price of tickets to your university’s basketball games keeps increasing but the supply of tickets remains the same. Why might supply be unresponsive to changes in price? [LO 4.3] Answer: It may not be possible to increase the supply of tickets. The number of tickets is likely fixed in the short run. There are usually a specific number of seats in a sports arena that won’t change as prices fluctuate. In this case, supply is perfectly inelastic and the same number of seats will be supplied, even as prices rise. In a longer term, your university could build a bigger arena. Which will have a more price-elastic supply over six months: real estate in downtown Manhattan or real estate in rural Oklahoma? Explain your reasoning. [LO 4.4] Answer: Real estate in rural Oklahoma will be more price-elastic in the short run than real estate in Manhattan. Land is scarce in Manhattan, making it difficult to increase real estate. Higher buildings can often replace smaller ones, but this takes more time. Land is more easily available for development in rural Oklahoma, making this area better able to respond quickly to changes in the price of real estate. Certain skilled labor, such as hair cutting, requires licensing or certification, which is costly and takes a long time to acquire. Explain what would happen to the price elasticity of supply for haircuts if this licensing requirement were removed. [LO 4.4] Answer: The price elasticity of supply would increase (become more elastic). If the requirement for licensing were removed, a hair salon could expand its staff more easily in response to increasing prices because they would not be limited to only hiring licensed haircutters. Although we could describe both the cross-price elasticity of demand between paper coffee cups and plastic coffee lids and the cross-price elasticity of demand between sugar and artificial sweeteners as highly elastic, the first cross-price elasticity is negative and the second is positive. What is the reason for this? [LO 4.5] Answer: Goods that are strong complements like coffee cups and coffee lids will have a more elastic cross-price elasticity. Likewise, goods that are strong substitutes like sugar and artificial sweeteners will also have a more elastic cross-price elasticity. In both cases the goods are closely related so quantity demanded of one good (such as coffee cups) will be more responsive to changes in the price of the other good (coffee lids) than if the two goods were less related. However, complements and substitutes will have different signs. For complements, like coffee cups and coffee lids, the sign will be negative. When the price of coffee lids increases, we buy fewer coffee cups. With substitutes, the sign is positive. As the price of artificial sweeteners increases, quantity demanded of sugar will also increase. Name two related goods you consume that would have a positive cross-price elasticity. What happens to your consumption of the second good if the price of the first good increases? [LO 4.5] Answer: When I am craving something sweet, I like cookies and donuts. These treats are substitutes for me. If the price of cookies at my local bakery increases, I will choose donuts. Name two related goods you consume which would have a negative cross-price elasticity. What happens to your consumption of the second good if the price of the first good increases? [LO 4.5] Answer: One of my favorite snacks is chips and guacamole. These goods are complements for me because I consume them together. They have a negative cross-price elasticity for me. If the price of chips increases, I purchase less guacamole. In France, where cheese is an important and traditional part of people’s meals, people eat about six times as much cheese per person as in the United States. In which country do you think the demand for cheese will be more income-elastic? Why? [LO 4.6] Answer: Demand for cheese will be more income-elastic in the United States. While people in the United States also enjoy cheese, it is not as culturally important as it is in France. People in France already prioritize cheese and eat a lot of cheese. If incomes rise, they are unlikely to significantly increase how much cheese they consume. Conversely, if incomes fall, they will try to avoid significantly deceasing consumption of cheese. They may choose to make other sacrifices before they reduce cheese consumption. Name a good you consume for which your income elasticity of demand is positive. What happens when your income increases? [LO 4.6] Answer: Most goods are normal and behave this way. I love dining out at nice restaurants with my friends and family, but eating out at nice restaurants is expensive. When my income increases, I tend to increase the number of meals I eat at nice restaurants. For me, a meal at nice restaurants is a normal good and my income elasticity of demand is positive. Name a good you consume for which your income elasticity of demand is negative. What happens when your income increases? [LO 4.6] Answer: I have always loved to travel. When I was a student, I would stay at youth hostels because they are much less expensive than hotels. I worked part-time as a student and couldn’t afford the luxury of hotels. These days, I earn more than I did as a student, so I tend to stay in hotels. For me, hostels are an inferior good and my income elasticity of demand is negative. When my income increased, my demand for hostel stays decreased. Problems and Applications 1. When the price of a bar of chocolate is $1.00, the quantity demanded is 100,000 bars. When the price rises to $1.50, the quantity demanded falls to 60,000 bars. Calculate the price elasticity of demand using the mid-point method. [LO 4.1] Suppose price increases from $1 to $1.50. Calculate the price elasticity of demand. Suppose price decreases from $1.50 to $1. Calculate the price elasticity of demand. Answer: [(60,000 − 100,000)/80,000]/[(1.50 − 1.00)/1.25] = -1.25. [(100,000 − 60,000)/80,000]/[(1.00 − 1.50)/1.25] = -1.25. Using this method, the price elasticity of demand calculation is the same whether price increases or decreases. If the price elasticity of demand for used cars priced between $3,000 and $5,000 is –1.2 (using the mid-point method), what will be the percent change in quantity demanded when the price of a used car falls from $5,000 to $3,000? [LO 4.1] Answer: −1.2 = % change in Qd/[(3,000 − 5,000)/4,000] −1.2 = % change in Qd/−0.5 (−0.5) × (−1.2) = % change in Qd −0.6 × 100 = % change in Qd 60 percent = % change in Qd Three points are identified on the graph in Figure 4P-1. [LO 4.2] At point A, demand is ____. At point B, demand is ____. At point C, demand is ____. Answer: For any linear demand curve, the mid-point represents demand being unit-elastic. At any point on the upper-portion of the curve, demand is price elastic. At any point on the lower-portion of the curve, demand is price inelastic. a. Elastic. Unit-elastic. Inelastic. 4. Which of the following has a more elastic demand in the short run? [LO 4.2] Pomegranate juice or drinking water? Cereal or Rice Krispies®? Speedboats or gourmet chocolate? Answer: Pomegranate juice. Demand for pomegranate juice would be much more elastic than demand for drinking water (a necessity). Rice Krispies. There are more substitutes for a particular type of cereal like Rice Krispies than there are for cereal itself. Speedboats. Even though both goods could be considered luxuries, a speedboat is a much higher portion of a household budget than chocolate. Therefore, demand for speedboats will be more sensitive to price changes. 5. In each of the following instances, determine whether demand is elastic, inelastic, or unitelastic. [LO 4.2] If price increases by 10 percent and quantity demanded decreases by 15 percent, demand is _______. If price decreases by 10 percent and quantity demanded increases by 5 percent, demand is _______. Answer: Elastic. Inelastic. 6. In each of the following instances, determine whether quantity demanded will increase or decrease, and by how much. [LO 4.2] If price elasticity of demand is -1.3 and price increases by 2 percent, quantity demanded will ______ by ______ percent. If price elasticity of demand is -0.3 and price decreases by 2 percent, quantity demanded will ______ by ______ percent. Answer: Quantity demanded will decrease by > 2 percent. Quantity demanded will increase by 2%. Quantity supplied will decrease by < 2%. 18. Suppose that the price of peanut butter rises from $2 to $3 per jar. [LO 4.5] The quantity of jelly purchased falls from 20 million jars to 15 million jars. What is the cross-price elasticity of demand between peanut butter and jelly? Are they complements or substitutes? The quantity of jelly purchased increases from 15 million jars to 20 million jars. What is the cross-price elasticity of demand between peanut butter and jelly? Are they complements or substitutes? Answer: The cross-price elasticity of demand between peanut butter and jelly using the mid-point method is [(15 million – 20 million)/17.5 million]/[(3 − 2)/2.5] = −0.71. Peanut butter and jelly are complements. The cross-price elasticity of demand between peanut butter and jelly using the mid-point method is [(20 million – 15 million)/17.5 million]/[(3 − 2)/2.5] = 0.71. Peanut butter and jelly are substitutes. 19. For each of the following pairs, predict whether the cross-price elasticity of demand will be positive or negative: [LO 4.5] a. Soap and hand sanitizer. CDs and MP3s. Sheets and pillowcases. Answer: Positive. Soap and hand sanitizer are substitutes. If the price of soap increases, the demand for hand sanitizer will increase. If the price of soap decreases, the demand for hand sanitizer will decrease. Positive. CDs and MP3s are substitutes. If the price of CDs increases, the demand for MP3s will increase. If the price of CDs decreases, the demand for MP3s will decrease. Negative. Sheets and pillowcases are complements. If the price of sheets increases, the demand for pillowcases will decrease. If the price of sheets decreases, the demand for pillowcases will increase. 20. Suppose that when the average family income rises from $30,000 per year to $40,000 per year, the average family’s purchases of toilet paper rise from 100 rolls to 105 rolls per year. [LO 4.6] Calculate the income-elasticity of demand for toilet paper. Is toilet paper a normal or an inferior good? Is the demand for toilet paper income-elastic or income-inelastic? Answer: The income-elasticity of demand is [(105 − 100)/102.5]/[(40,000 − 30,000)/35,000] = 0.17. Toilet paper is a normal good because the income elasticity is positive. Toilet paper is an income-inelastic good because the income elasticity is greater than zero but less than one. 21. In each of the following instances, determine whether the good is normal or inferior, and whether it is income‐elastic or income‐inelastic. [LO 4.6] If income increases by 10 percent and the quantity demanded of a good increases by 5 percent, the good is ______ and ______. If income increases by 10 percent and the quantity demanded of a good decreases by 20 percent, the good is ______ and ______. Answer: If income increases by 10% and the quantity demanded of a good increases by 5%, the good is normal (income elasticity is positive) and income-inelastic (income elasticity of 5/10 is less than one). If income increases by 10% and the quantity demanded of a good decreases by 20%, the good is inferior (income elasticity is negative) and income-elastic (income elasticity of 20/10 is greater than one). CHAPTER 5 EFFICIENCY Chapter Overview In this chapter we’ve introduced the concepts of willingness to pay and willingness to sell, which help explain when individual buyers and sellers will choose to make a trade. We’ve also discussed what it means to measure consumer and producer surplus and shown that the market equilibrium is efficient because it maximizes total surplus. As we’ll see in the next chapter, surplus and deadweight loss are powerful tools for understanding the implications of business ideas and public policies. Who will benefit from the policy? Who will be harmed by it? What effect will it have on the economy overall? The language of surplus, efficiency, and distribution of benefits is particularly helpful for getting to the bottom of controversial decisions. Later in the book, we will describe important cases in which the efficiency rule about market equilibrium does not always hold true, and we’ll see how surplus can also help us understand these cases. Learning Objectives LO 5.1: Use willingness to pay and willingness to sell to determine supply and demand at a given price. LO 5.2: Calculate consumer surplus based on a graph or table. LO 5.3: Calculate producer surplus based on a graph or table. LO 5.4: Calculate total surplus based on a graph or table. LO 5.5: Define efficiency in terms of surplus, and identify efficient and inefficient situations. LO 5.6: Describe the distribution of surplus, or benefits to society, that results from a policy decision. LO 5.7: Calculate deadweight loss. LO 5.8: Explain why correcting a missing market can make everyone better off. Chapter Outline OPENING STORY: A BROKEN LASER POINTER STARTS AN INTERNET REVOLUTION Willingness to Pay and Sell (LO 5.1) Willingness to Pay and the Demand Curve Willingness to Sell and the Supply Curve BOX FEATURE: REAL LIFE – HAGGLING AND BLUFFING Measuring Surplus BOX FEATURE: FROM ANOTHER ANGLE – HOW MUCH WOULD YOU PAY TO KEEP THE INTERNET FROM DISAPPEARING? Consumer Surplus (LO 5.2) Producer Surplus (LO 5.3) Total Surplus (LO 5.4) BOX FEATURE: REAL LIFE – AIRWAVES THAT COST $20 MILLION Using Surplus to Compare Alternatives Market Equilibrium and Efficiency (LO 5.5) Changing the Distribution of Total Surplus (LO 5.6) Deadweight Loss (LO 5.7) Missing Markets (LO 5.8) BOX FEATURE: WHAT DO YOU THINK – KIDNEYS FOR SALE Beyond the Lecture Class Activity: Consumer Surplus and Producer Surplus (LO 5.2, LO 5.3) Class activities that highlight definitions and intuition in consumer surplus and producer surplus can help students to understand the concepts. It is important to try to get students to consider the maximum that they would pay for something and the minimum that they would accept. There is often a difference between the market price and the price they would pay or accept. 1. Consumer surplus: Have a Dutch auction for something in class, perhaps a college or University t-shirt or hoodie. Once the winner is determined, ask if he/she would have been willing to pay more than the price they actually did pay. Here is information on a Dutch auction (only one bid and the auction is over)! 2. Producer surplus: Ask for a student “helper” for 10 minutes of your lecture. The student can erase the board, click through slides, get papers, or even hang up your coat or shine your shoes. Be creative. Offer to pay $1, $2, etc. for the helper until you find a volunteer. After the helper does the tasks, pay them a few dollars extra beyond the price they accepted. Illustrate that producer surplus was received then the student received more money than their minimum willingness to accept. Writing Assignment/Class Discussion: Market Equilibrium and Efficiency (LO 5.5) Have students read Joel Waldfogel’s The Deadweight Loss of Christmas (1993 American Economic Review 83:5, pp. 1328-1336). This may be a slightly difficult read for some students, but most can understand the concept. Have students write a brief essay regarding the potential for deadweight loss with gift-giving, and consider the following questions for class: Why might there be a deadweight loss associated with gift-giving? Who is most likely to give you a gift with a large deadweight loss? Who is most likely to give you a gift that has little or no deadweight loss? Why doesn’t everyone simply give cash as a gift? Also, you may want to consider a brief clip from the movie Old School. In the movie, Will Ferrell tries to give a bread maker that he received as a gift to others. Class Discussion: Missing Markets (LO 5.8) In order to highlight how change and technology can impact missing markets, have students consider the impact of the internet on consumer and producer surplus. Many students likely do not remember the pre-internet age, so this can be a nice small group discussion in class or in an online environment. You can use this article from The Economist to start a discussion. Have students consider the following: What is the impact of the internet on producer and consumer surplus? What is the impact of overall surplus? What was the impact of the internet on transactions costs associated with trades? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Where does consumer surplus come from? [LO 5.1] Consumers paying a price for a good that is less than their willingness to pay Consumers buying goods at low prices A consumer sees a high price, so he doesn’t buy the good and keep his money A consumer buying high-quality good Feedback: Low prices don’t necessarily mean consumer surplus. Maybe the willingness to pay is also low! 2. Suppose Dave sells hot dogs from a food truck. Why doesn’t he just sell hot dogs at $500 each to generate a lot of producer surplus? [LO 5.1, LO 5.3] It is against the law to sell hot dogs at that price There are no willing buyers at that price Other food trucks would also raise their prices to $500, and Dave wouldn’t get any additional producer surplus The law of supply doesn’t include such high prices Feedback: To get producer surplus, you actually have to sell something! Each transaction requires a willing buyer and willing seller. No one is willing to buy a hot dog for $500. 3. A binding price ceiling will cause deadweight loss because [LO 5.7] Some producer surplus is transferred to consumers Consumers gain surplus on trades with lower prices The supply curve shifts and decreases the potential surplus available Fewer trades occur compared to equilibrium Feedback: High or low prices themselves don’t reduce surplus. The deadweight loss comes from the fact that we stop short of the equilibrium quantity. We could have had more trades at a different price. Those trades would have generated surplus. But those trades don’t happen, so we can’t get the surplus. 4. Imagine a small market where there are just a few buyers and sellers. In order for a firm to maximize its producer surplus, the firm would have to know _________ at various prices [LO 5.6] All consumers’ willingness to pay and its own willingness to sell The richest consumer’s willingness to pay and its own production costs The poorest consumer’s willingness to pay Possible deadweight loss areas for non-equilibrium prices Feedback: This one is a little tough. Keep in mind that at higher prices, the firm is willing to sell more, but consumers are willing to buy less. This may just have to be done with a table showing everyone’s willingness to pay. Then, the firm can measure its own surplus at various prices, being sure to remember that they can only get surplus if a consumer buys the good at that price! 5. Which of the following will help correct a missing market? [LO 5.8] Reducing government regulations or restrictions on certain goods Improvement in technology and production capabilities Increase in information and communication between buyers and sellers All of the above Feedback: Keep in mind that we may not want to correct all missing markets. For example, we may want to keep certain drugs illegal or highly regulated. Solutions to End-of-Chapter Questions and Problems Review Questions Bill is a professional photographer. His camera is broken, and he needs a new one within the next hour, or he will miss an important deadline. Lisa is a high-school student who doesn’t have a camera but wants to get one to take pictures at her prom next month. Who do you think would have a higher willingness to pay for a particular camera today? Why? [LO 5.1] Answer: Bill will have the higher willingness to pay. He needs a camera for his job and he has no time to spare looking. Meeting his important deadline depends on him finding a camera within the next hour. Bill’s options are limited and his willingness to pay will reflect that. While Lisa would like to have a camera for her prom night, Lisa has time to look for the best deal. And if she never found a camera priced at or below her reservation price, Lisa could rely on friends and Facebook for prom photos. The fact that Lisa has more time and other options for photos will make her willingness to pay less than Bill’s. You are in the market for a new couch and have found two advertisements for the kind of couch you want to buy. One seller notes in her ad that she is selling because she is moving to a smaller apartment, and the couch won’t fit in the new space. The other seller says he is selling because the couch doesn’t match his other furniture. Which seller do you expect to buy from? Why? (Hint: Think who would be the more motivated seller.) [LO 5.1] Answer: You would expect to buy from the seller whose couch won’t fit in the new space. This seller will probably be willing to sell at a lower price because she does not have the option of keeping the couch if she can’t get a higher price. She needs to sell the couch and has revealed as much to you in her advertisement. The other seller may not like the fact that his couch doesn’t match his other furniture, but he does have the option of keeping the couch if he can’t find a buyer to pay what he thinks it’s worth. You will probably get a better deal from the first seller. Suppose you are at a flea market and are considering buying a box of vintage records. You are trying to bargain down the price, but the seller overhears you telling a friend that you are willing to pay up to $50. Why is your consumer surplus now likely to be lower than it would have been if the seller hadn’t overheard you? [LO 5.2] Answer: Now that the seller knows your highest willingness to pay (how much the records are worth to you), she knows she doesn’t have to accept your lower offers. She will charge you $50, knowing that you are going to purchase at that price. If you pay exactly what something is worth to you, you will have no consumer surplus. Your surplus would be greater if you were able to buy the box for less than $50, but you have unknowingly revealed your willingness to pay more. Consider a market in equilibrium. Suppose supply in this market increases. How will this affect consumer surplus? Explain. [LO 5.2] Answer: If supply increases, equilibrium price will decrease. This is a movement along the demand curve. The lower equilibrium price will mean more consumer surplus. You currently have a television that you want to sell. You can either pick a price and try to sell it at a yard sale or auction it off on eBay. Which method do you think will yield a higher producer surplus? Why? [LO 5.3] Answer: Auctioning the television on eBay should yield a higher price. eBay will give you access to many more consumers than those who might stop by your yard sale. And auctioning the television will force consumers to compete with each other for your television and reveal their willingness to pay. Consider a market in equilibrium. Suppose demand in this market decreases. How will this affect producer surplus? Explain. [LO 5.3] Answer: If demand decreases, equilibrium price will decrease. This is a movement along the supply curve. The lower equilibrium price will mean less producer surplus. Consider the market for plane tickets to Hawaii. A bad winter in the mainland United States increases demand for tropical vacations, shifting the demand curve to the right. The supply curve stays constant. Does total surplus increase or decrease? (Hint: Sketch out a generic supply and demand curve and look at what happens to the size of the triangle that represents total surplus when the demand curve shifts right.) [LO 5.4] Answer: Willingness to buy is represented by the demand curve. When demand increases and supply (willingness to sell) stays the same, total surplus increases. You can see this by sketching a graph like the one below and looking at what happens to total surplus when the market demand shifts. When demand = D1, total surplus = Area A. When demand = D2, total surplus = Area A + Area B. You need to paint your fence but you really hate this task. You decide to hire the kid next door to do it for you. You would be willing to pay him up to $100, but you start by offering $50, expecting to negotiate. To your great surprise, he accepts your $50 offer. When you tell your friend about the great deal you got, she is shocked that you would take advantage of someone. What can you tell your friend to assure her that you did not cheat the kid next door? [LO 5.4] Answer: You can tell your friend that as long as the kid next door was not afraid of you and didn’t feel that he had no choice but to accept your offer, the trade was voluntary. You certainly received surplus from the exchange since you would have been willing to pay more. But just because you hate painting and were willing to pay more does not mean that it was a zero-sum game. The kid next door might like to paint and be outdoors and may have been willing to do the job for even less than $50. By accepting your offer, the kid signaled that $50 was at least equal to his reservation price. If he would have accepted less than $50 to do the job, then he had surplus from the exchange as well. New York City has a long-standing policy of con-trolling rents in certain parts of the city—in essence, a price ceiling on rent. Is the market for apartments likely to be efficient or inefficient? What does this imply for the size of total surplus? [LO 5.5] Answer: The market for apartments under the maximum price policy is inefficient. Efficiency means maximizing total surplus. If the maximum price policy moves the price away from its equilibrium price (which it does), surplus will not be maximized. Any price other than the equilibrium price will not maximize surplus. It should be noted that the goal of placing a maximum price on apartments is not to make the market efficient. It is an attempt to make the market more equitable. We will address the tradeoff between efficiency and equity more as we move forward. Total surplus is maximized at the equilibrium price and quantity. When demand increases, price increases. Explain how total surplus is still maximized if price increases due to an increase in demand. [LO 5.5] Answer: When demand increases, the market moves to a new equilibrium. The price will be higher but surplus will still be maximized because the market is still functioning at its (new) equilibrium price. When the price of gasoline was very high in the summer of 2008, several U.S. presidential candidates proposed implementing a national price ceiling to keep fuel affordable. How would this policy have affected producer and consumer surplus? How would it have affected total surplus? [LO 5.6] Answer: A price ceiling (maximum price) below the equilibrium price would reduce producer surplus. There would be fewer trades and the trades that did occur would happen at a lower price. For consumers, the story is a bit more complicated. Some consumers would gain and some would lose surplus. Consumers who were able to trade would do so at a lower price. They would gain surplus. However, because there would be fewer trades, some consumers would no longer be able to trade and would lose surplus. In the end, the losers (producers and some consumers) would lose more than the winners (consumers able to find trades) would gain, and total surplus would decrease. Consider a policy to help struggling farmers by setting a minimum trade price for wheat. Will this be an effective way to increase their surplus? Explain. [LO 5.6] Answer: Minimum prices are also inefficient and cause fewer trades to occur than would occur at the equilibrium price. In the case of a minimum price for wheat, some farmers would gain because they will receive a higher price than the equilibrium price. However, fewer trades will occur and some farmers will be unable to trade. Remember that at a price above equilibrium, quantity supplied exceeds quantity demanded and there is excess supply. If rent control creates deadweight loss for both consumers and suppliers of housing, why are consumers often in favor of this policy? [LO 5.7] Answer: Even though rent control causes fewer trades and deadweight loss, some consumers will benefit by the lower prices. Consumers support the policy if they believe they will be among those who are able to find housing at lower prices. Suppose price is 5 percent above equilibrium in two markets: a market for a necessity and a market for a luxury good. All else equal (including supply conditions), in which market do you expect deadweight loss to be greater? Explain. [LO 5.7] Answer: Deadweight loss would be greater in the market for the luxury good. This is because demand will be more elastic. Consumers will react more (in terms of buying less of a good) to a higher price when demand is elastic. Your grandmother likes old-fashioned yard sales and doesn’t understand why everyone is so excited about eBay. Explain to her why the creation of a market that enables people who don’t live in the same town to buy and sell used goods increases total surplus over the yard-sale market. [LO 5.8] Answer: Yard sales are nice because you get to meet people and chat with them face to face, but eBay helps people connect across great distances. If you are looking to buy something in particular and are limited to looking at yard sales in your town, you may not find what you’re looking for. If you do a search on eBay, though, your chances are much greater that you will find somebody selling that item. And if you want to sell something, you will have access to many more buyers on eBay than those that might wander by your yard sale. It’s also possible that more than one person will be interested in what you are selling and their competition for your item will get you a much better price. At Zooey’s elementary school, children are not allowed to trade lunches or components of their lunches with other students. Lunchroom monitors watch closely and strictly enforce this policy. Help Zooey make an argument about the inefficiency of this policy to her principal. [LO 5.8] Answer: The school policy is preventing a market that would generate mutually beneficial trades. A student who likes bologna sandwiches better than tuna sandwiches might trade her tuna sandwich to another student who thinks the bologna sandwich in her lunch pail is gross. Both students are happier after this trade. The ban on lunch trading prevents the surplus that would be generated by allowing lunch items to be allocated according to voluntary trades from being realized. (Of course, the principal might care less about the preferences of the students than those of their parents!) Problems and Applications Use the information in Table 5P-1 to construct a step graph of the six consumers’ willingness to pay. [LO 5.1] Answer: At a price of $16, one consumer is willing to buy the good (Morgan). At a price of $12, two consumers are willing to buy the good (Morgan and Andre). At a price of $8, three consumers are willing to buy the good (Morgan, Andre, and Fred). At a price of $4, four consumers are willing to buy the good (Morgan, Andre, Fred, and Hanson). At a price of $2, all six consumers are willing to buy the good. Use the information in Table 5P-2 to construct a step graph of the six sellers’ willingness to sell. [LO 5.1] Answer: At a price of $10, one producer is willing to sell the good (Peter). At a price of $20, two producers are willing to sell the good (Peter and Juan). At a price of $25, four producers are willing to sell the good (Peter, Juan, Joseph, and Candice). At a price of $50, five producers are willing to sell the good (Peter, Juan, Joseph, Candice, and Solomon). At a price of $60, all six producers are willing to sell the good. Answer the following questions based on Tables 5P-3 and 5P-4. [LO 5.1] What is the quantity demanded at $10? What is the quantity supplied at $10? What is the quantity demanded at $25? What is the quantity supplied at $25? Answer: Quantity demanded is 8 units. All consumers except for consumer I are willing to pay at least $10. Quantity supplied is 2 units. Only suppliers A and B are willing to sell at a price of $10. Quantity demanded is 3 units. Only consumers A, B, and C are willing to pay $25. Quantity supplied is 7 units. Suppliers A, B, D, E, F, H, and I (all but C and G) are willing to sell at a price of $25. Based on Table 5P-1, calculate consumer surplus for each consumer when the price is $17. What is the total consumer surplus at this price? [LO 5.2] Answer: Consumer A: $0 (WTP < $17). Consumer B: $10 ($27 - $17 = $10). Consumer C: $0 (WTP $20). Seller H: $11 ($20 – $9 = $11). Seller I: $0 (WTS > $20). Total producer surplus = 0 + 16 + 0 + 6 + 8 + 5 + 0 + 11 + 0 = $46. Use the supply curve represented in Figure 5P-3 to draw the producer surplus when the market price is $5. What is the value of producer surplus at this price? [LO 5.3] Answer: The producer surplus is the area above the supply curve and below $5. The value of producer surplus at this price is 0.5 base × height = 0.5(20)(2) = $20. Based on Figure 5P-2, producer surplus is $0 when price is less than or equal to what price? [LO 5.3] Answer: Producer surplus is $0 when price is ≤ $3. Use the market represented in Figure 5P-2 to plot the equilibrium price and quantity and to draw the producer surplus when the market is in equilibrium. What is the value of producer surplus at the equilibrium price? [LO 5.3] Answer: The equilibrium price is $7. The producer surplus is the area above the supply curve and below $7. The value of producer surplus at this price is 0.5 base × height = 0.5(40)(4) = $80. Use the market represented in Figure 5P-2 to draw the producer surplus if the price is $9. What is the value of producer surplus at this price? [LO 5.3] Answer: At a price of $9, consumers are only willing to purchase 20 units of the good. The producer surplus is measured as the area above the supply curve and below the price. To calculate this area, we can divide the shape into a triangle and a rectangle. The area of the rectangle is (9 - 5)(20) = $80 The area of the triangle is 0.5(base)(height) = 0.5(20)(5 - 3) = $20. The value of producer surplus at this price is 80 + 20 = $100. Use the market represented in Figure 5P-4 to draw the consumer and producer surplus when the market is in equilibrium. What is the value of total surplus at equilibrium? [LO 5.4] Answer: The total surplus is equal to the sum of consumer and producer surplus. We can calculate total surplus as one large triangle or as two smaller triangles. As two triangles, calculate consumer surplus and producer surplus first, and then sum them to get total surplus: Consumer surplus = 0.50(60)(40 - 20) = 0.50(60)(20) = 600. Producer surplus = 0.50(60)(20 - 10) = 300. Total surplus = Consumer surplus + Producer Surplus = 900. A faster way to calculate total surplus is to calculate the area of the entire triangle at once. In this case, the "base" of the triangle is measured on the y-axis: 40 - 10 = 30. The "height" is measured along the x-axis: 60 - 0 = 60. Total surplus = 0.50(base)(height) = 0.50(30)(60) = 900. Consider the market represented in Figure 5P-5. [LO 5.4] Calculate total surplus when demand is D1. Calculate total surplus when demand decreases to D2. Answer: Total surplus when demand is D1: 0.5(100)(22 — 6) = $800. Total surplus when demand decreases to D2: 0.5(50)(16 — 6) = $250. 16. Consider the market represented in Figure 5P-6. [LO 5.4] Calculate total surplus when supply is S1. Calculate total surplus when supply increases to S2. Answer: Total surplus when supply is S1: 0.5(50)(50 — 20) = $750. Total surplus when supply increases to S2: 0.5(75)(50 — 10) = $1,500. 17. Consider the market represented in Figure 5P-7. [LO 5.5] Draw the consumer surplus and the producer surplus at the equilibrium price and quantity. What is the value of total surplus at equilibrium? Draw the consumer surplus and the producer surplus if the price is $30. What are the values of consumer surplus, producer surplus, and total surplus at this price? Draw the consumer surplus and the producer surplus if the price is $10. What are the values of consumer surplus, producer surplus, and total surplus at this price? Answer: Total surplus = 0.50(40)(4) = $80. Consumer surplus = 0.50(40 - 30)(2) = $10. Producer surplus = (30 - 10)(2) + 0.50(10)(2) = $50. Total surplus = $60. Consumer surplus = 0.50(40 - 30)(2) + (30 - 10)(2) = $50. Producer surplus = 0.50(10)(2) = $10. Total surplus = $60. 18. Assume the market for wine is functioning at its equilibrium. For each of the following situations, say whether the new market outcome will be efficient or inefficient. [LO 5.5] a. A new report shows that wine is good for heart health. The government sets a minimum price for wine, which increases the current price. An unexpected late frost ruins large crops of grapes. Grape pickers demand higher wages, increasing the price of wine. Answer: Efficient. Demand increases and the market functions at its new equilibrium. Inefficient. Setting a minimum price will move the market away from its equilibrium. Efficient. Supply decreases and the market functions at its new equilibrium. Efficient. Supply decreases and the market functions at its new equilibrium. 19. Based on Figure 5P-8, choose all of the following options that are true. [LO 5.5, 5.6] a. The market is efficient. Total surplus is higher than it would be at market equilibrium. Total surplus is lower than it would be at market equilibrium. Producer surplus is lower than it would be at market equilibrium. Consumer surplus is lower than it would be at market equilibrium. Answer: C and E. Total surplus is lower than it would be at market equilibrium. Consumer surplus is lower than it would be at market equilibrium. 20. In which of the following situations can you say, without further information, that consumer surplus decreases relative to the market equilibrium level? [LO 5.6] Your state passes a law that pushes the interest rate (i.e., the price) for payday loans below the equilibrium rate. The federal government enforces a law that raises the price of dairy goods above the equilibrium. Your city passes a local property tax, under which buyers of new houses have to pay an additional 5 percent on top of the purchase price. The government lowers the effective price of food purchases through a food-stamp program. Answer: B and C. The federal government enforces a law that raises the price of dairy goods above the equilibrium. Your city passes a local property tax, under which buyers of new houses have to pay an additional 5 percent on top of the purchase price. 21. Use the areas labeled in the market represented in Figure 5P-9 to answer the following questions. [LO 5.6] What area(s) are consumer surplus at the market equilibrium price? What area(s) are producer surplus at the market equilibrium price? Compared to the equilibrium, what area(s) do consumers lose if price is P2? Compared to the equilibrium, what area(s) do producers lose if the price is P2? Compared to the equilibrium, what area(s) do producers gain if the price is P2? Compared to the equilibrium, total surplus decreases by what area(s) if the price is P2? Answer: A, B, C. D, E. B, C. E. B. C, E. Figure 5P-10 shows a market for cotton, with the price held at $0.80 per pound. Calculate the dead-weight loss caused by this policy. [LO 5.7] Answer: Deadweight loss = 0.5(30/100)(20m) = $3 million Consider the market represented in Figure 5P-11. [LO 5.7] Suppose the government sets a minimum price of $25 in the market. Calculate the deadweight loss. Suppose the government sets a maximum price of $25 in the market. Calculate the deadweight loss. Answer: The equilibrium price would be $20, but the price cannot be lower than $25. Deadweight loss = 0.5(10)(12) = $60. Deadweight loss = $0. If the maximum price is $25, the market will function at its equilibrium price, which is $20. What is the value of the existence of the market represented in Figure 5P-12. [LO 5.8] Answer: The total surplus is 0.50(70)(44 – 2) = $1,470. We can consider the market for traveling to Mars to be missing, because no technology exists that allows this service to be bought and sold. Suppose that someone has invented spacetravel technology that will enable this service to be provided. Figure 5P-13 shows the estimated market for trips to Mars. Calculate the surplus that could be generated by filling in this missing market. [LO 5.8] Answer: Since the market does not currently exist, the surplus gained would be the area of total surplus: 0.5(40)(310,000 – 150,000) = $3,200 thousand. CHAPTER 6 GOVERNMENT INTERVENTION Chapter Overview If you listen to the news, it might seem as if economics is all about business and the stock market. Business matters, but many of the most important, challenging, and useful applications of economic principles involve public policy. This chapter gives you the basic tools you need to understand government interventions and some of the ways they can affect your everyday life. Of course, the real world is complicated, so this isn’t our last word on the topic. Later, we discuss how to evaluate the benefits of both markets and government policies. We’ll also discuss market failures and whether and when governments can fix them. Learning Objectives LO 6.1: Calculate the effect of a price ceiling on the equilibrium price and quantity. LO 6.2: Calculate the effect of a price floor on the equilibrium price and quantity. LO 6.3: Calculate the effect of a tax on the equilibrium price and quantity. LO 6.4: Calculate the effect of a subsidy on the equilibrium price and quantity. LO 6.5: Explain how elasticity and time period influence the impact of a market intervention. Chapter Outline OPENING STORY: FEEDING THE WORLD, ONE PRICE CONTROL AT A TIME Why Intervene? Three Reasons to Intervene Four Real-World Interventions Price Controls Price Ceilings (LO 6.1) BOX FEATURE: WHAT DO YOU THINK? – PUT A CAP ON PAYDAY LENDING? Price Floors (LO 6.2) Taxes and Subsidies Taxes (LO 6.3) Subsidies (LO 6.4) BOX FEATURE: REAL LIFE – THE UNINTENDED CONSEQUENCES OF BIOFUEL SUBSIDIES Evaluating Government Interventions (LO 6.5) How Big Is the Effect of a Tax or Subsidy? BOX FEATURE: WHERE CAN IT TAKE YOU? – PUBLIC ECONOMICS Long-Run versus Short-Run Impact BOX FEATURE: WHAT DO YOU THINK? – FARM SUBSIDIES Beyond the Lecture Class Discussion: Price Ceilings (LO 6.1) Have students read Rent-Stabilized Apartments, Ever More Elusive by Mark Santora. The NY Times article highlights the shortage of rent-stabilized apartments in New York City and discusses some of the other issues associated with rent controls. Additionally, consider showing this clip from the TV show Seinfeld (Season 2: The Apartment), where Jerry discusses rent control apartments in New York City. What are the proposed benefits of rent controls? What are the costs? How do rent controls impact price and quantity? How do rent controls impact the market for housing? You can also use this opportunity to talk about “unintended consequences”, where the policy may hurt those it intended to help. This is sort of an economic irony. Rent control is meant to help low-income people, but the resulting shortage often causes the existing units to be allocated to the highest bidder by bribery, under-the-table money, or even by nepotism or other networking. This certainly hurts low-income people, as they most likely won’t have upfront money to pay to get the cheap unit. Class Discussion: Price Floors (LO 6.2) Discuss the minimum wage with students as an example of a price floor. Students really enjoy this topic. Consider asking students to read The Business of the Minimum Wage by Christina D. Romer. This is a nice topic for a small group in the classroom or for students in an online format. The following are great questions to consider with students: What are the proposed benefits and potential problems associated with an increase in the minimum wage? What is the likely impact on price (wage in this case) and quantity? Although economists care deeply about improving the situation of individuals earning low salaries, why might many economists be less likely to support higher minimum wages relative to other policies to help lower-income individuals? Class Discussion: Taxes (LO 6.3) In order to highlight the potential impact of a tax, show students this map of the United States, which displays the total gasoline tax per gallon that drivers face in each state. Have students consider the impact of an increase in the gasoline tax on price and quantity. How does the price elasticity of demand play a role in the impact of a tax? Ask students how they would respond to increased gas taxes. Class Discussion: Subsidies (LO 6.4) Have students view this short video report by Angel Gonzalez from the Wall Street Journal. It discusses the impact of subsidized gasoline in Venezuela. The report shows the opportunity for arbitrage in neighboring Colombia, where gasoline prices are much higher. Additionally, the attempt of the government to combat gasoline smuggling is discussed. How do gasoline subsidies impact gasoline prices in Venezuela? How does the subsidy impact the quantity demanded? How does the gasoline subsidy in Venezuela create an arbitrage opportunity? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Why is a reason the government would intervene in the market? [LO 6.1, 6.2] To reduce overall surplus To purposefully hurt wealthy firms or consumers To reduce competition To change the distribution of surplus Feedback: While “fairness” is often a reason given for intervention, remember that this is a normative argument. In addition, intervention often reduces efficiency by creating deadweight loss. 2. While a price ceiling may increase consumer surplus, what is a negative market consequence? [LO 6.1] Producers will produce too much of the good A shortage may occur The market will become too efficient Sales tax revenues will go down from people buying fewer goods Feedback: The price ceiling (and low price) may not do all consumers well if there isn’t enough of the good available to buy at the low price! Producers don’t want to produce as much at low prices. 3. How can government eliminate excess supply with binding price floors? [LO 6.2] Government forces consumers to buy the supply at reduced prices Government buys up the excess supply, no matter the price Government shifts the market supply to the left, putting some producers out of business to keep the price high for remaining firms Government gives money to buyers so they are able to buy more at the high price Feedback: This may keep prices high. It’s effectively the government artificially increasing demand to keep the price high. But that government spending is paid for by tax dollars! 4. The tax wedge model shows that if a tax is levied on consumers, then [LO 6.3] The consumers will pay all of the tax The government receives less revenue compared to levying a tax on producers Taxes improve market efficiency The tax burden will be split between consumers and firms Feedback: Note that the split may not be 50/50 in terms of who pays. In addition, the only time the tax burden is paid entirely by firms or consumers is if there is a perfectly inelastic or perfectly elastic demand or supply function. 5. If subsidies increase the amount of market activity, how do they create deadweight loss? [LO 6.4] When the government pays for the subsidy, it spends tax dollars that could have been spent elsewhere. Government spending always creates deadweight loss The market produces a quantity at a cost which is higher than the benefit to consumers. D. Because the government is helping firms instead of consumers Feedback: It’s a tough question! But remember that any deviation away from equilibrium results in deadweight loss. This can include doing too much of the activity as well as doing too little. Solutions to End-of-Chapter Questions and Problems Review Questions You are an advisor to the Egyptian government, which has placed a price ceiling on bread. Unfortunately, many families still cannot buy the bread they need. Explain to government officials why the price ceiling has not increased consumption of bread. [LO 6.1] Answer: The price ceiling has not increased the consumption of bread because it reduces the quantity supplied. A price ceiling below the equilibrium price will mean that some families will be able to purchase bread at a lower price, but on the whole fewer families will be able to purchase bread at all because there will be a shortage. Suppose there has been a long-standing price ceiling on housing in your city. Recently, population has declined, and demand for housing has decreased. What will the decrease in demand do to the efficiency of the price ceiling? [LO 6.1] Answer: A binding price ceiling keeps the price below the equilibrium quantity and creates both a shortage and a deadweight loss. If demand decreases, the equilibrium price would fall. This will make the shortage and deadweight loss smaller. If demand decreases enough, the price ceiling could become non-binding and there would be no shortage or deadweight loss. Suppose the United States maintains a price floor for spinach. Why might this policy decrease revenues for spinach farmers? [LO 6.2] Answer: A binding price floor will guarantee a minimum price for spinach above the equilibrium price. Farmers will receive a higher price for the spinach that they are able to sell. However, the price floor will create excess supply, as quantity demanded will decrease due to the higher price. If demand for spinach is elastic, revenues would decrease. Suppose Colombia maintains a price floor for coffee beans. What will happen to the size of the deadweight loss if the price floor encourages new growers to enter the market and produce coffee? [LO 6.2] Answer: If additional producers enter the market, the supply curve would shift right and the equilibrium price would fall. That is, the price that would prevail in the absence of the floor would be even lower than the original equilibrium. This means the price floor is even more distortionary than it was before. The size of the deadweight loss would increase. Many states tax cigarette purchases. Suppose that smokers are unhappy about paying the extra charge for their cigarettes. Will it help smokers if the state imposes the tax on the stores that sell the cigarettes rather than on smokers? Why or why not? [LO 6.3] Answer: No. The statutory incidence does not matter. If sellers were taxed instead of buyers of cigarettes, the price that consumers pay would remain exactly the same. The tax incidence or burden of the tax is a function of the relative elasticities of supply and demand and is not determined by which side of the market is officially taxed. Consider a tax on cigarettes. Do you expect the tax incidence to fall more heavily on buyers or sellers of cigarettes? Why? [LO 6.3] Answer: The tax incidence will fall more heavily on the side of the market that is less elastic. In the case of cigarettes, demand could be less elastic than supply because smoking is addictive and consumers may have a harder time reducing consumption than producers would have reducing supply. In the United States, many agricultural products (such as corn, wheat, and rice) are subsidized. What are the potential benefits of subsidizing these products? What are the costs? [LO 6.4] Answer: Subsidizing agricultural production will increase both consumer and producer surplus. Consumers will be able to buy at a lower price and producers will receive a higher price. Therefore, the domestic equilibrium quantity will increase. Government will have to pay for the subsidy, however. And this will come at the expense of taxpayers. A subsidy will increase consumer and producer surplus in a market and will increase the quantity of trades. Why, then, might a subsidy (such as a subsidy for producing corn in the United States) be considered inefficient? [LO 6.4] Answer: A subsidy might be considered inefficient because the prices that consumers pay are artificially low and the prices sellers receive are artificially high. These prices would not occur without the subsidy, which comes at a cost to taxpayers. Looking at the market equilibrium, a subsidy will encourage trades to occur past this point. But for each unit to the right of the market equilibrium quantity, the cost of supplying that unit or exceeds the willingness to pay. This is why these trades don’t occur in the absence of the subsidy. The subsidy encourages the market to move beyond the point where willingness to pay is greater than or equal to willingness to sell. It is always a good idea to ask why we want a market to function beyond its equilibrium. If we think the market equilibrium quantity is too low and we want more trades to occur, the cost of the subsidy might be worth it. If not, the subsidy is inefficient. Suppose the government imposes a price ceiling on gasoline. One month after the price ceiling, there is a shortage of gasoline, but it is much smaller than critics of the policy had warned. Explain why the critics’ estimates might still be correct. [LO 6.5] Answer: Elasticity is greater over a longer time horizon. In the first month, supply and demand are less responsive to a price control than they will be over a longer time horizon. Over time the shortage of gasoline is likely to grow as elasticity in the market increases. The critics’ estimate of a larger shortage than was seen after one month might turn out to be on target if measured over a longer time frame. A state facing a budget shortfall decides to tax soft drinks. You are a budget analyst for the state. Do you expect to collect more revenue in the first year of the tax or in the second year? Why? [LO 6.5] Answer: You would expect to collect more tax revenue in the first year. You collect taxes only on trades that occur. Taxes will reduce the number of trades. In the first year, the number of trades reduced due to the tax will be smaller than in the second year because elasticity is larger over a longer time frame. Problems and Applications 1. Many people are concerned about the rising price of gasoline. Suppose that government officials are thinking of capping the price of gasoline below its current price. Which of the following outcomes do you predict will result from this policy? Check all that apply. [LO 6.1] a. Drivers will purchase more gasoline. Quantity demanded for gasoline will increase. Long lines will develop at gas stations. Oil companies will work to increase their pumping capacity. Answer: B and C. Quantity demanded for gasoline will increase at a price below the equilibrium price. Drivers will not purchase more gasoline, however, because quantity supplied will be below the equilibrium quantity. As a result, there will be a shortage of gasoline and long lines will develop at gas stations. With a ceiling on price, oil companies will not have an incentive to increase supply. 2. Consider the market shown in Figure 6P-1. The government has imposed a price ceiling at $18. [LO 6.1] At a price ceiling of $18, what is quantity demanded? Quantity supplied? At this price ceiling, is there a shortage or a surplus? By how many units? Answer: If there is a price ceiling of $18, the quantity demanded is 140, and the quantity supplied is 40. There is a shortage of 100 units. 3. Figure 6P-2 shows a market in equilibrium. [LO 6.1] Draw a price ceiling at $12. What is the amount of shortage at this price? Draw and calculate the deadweight loss. Draw a price ceiling at $4. What is the amount of shortage at this price? Draw and calculate the deadweight loss. Answer: The price ceiling is non-binding because it is above the equilibrium quantity. There is no shortage, and there is no deadweight loss. The market will function at its equilibrium. Shortage = 0 and DWL = $0. The shortage due to the price ceiling is Qd – Qs = 8 – 2 = 6. The deadweight loss is 0.5(6 – 2)(16 – 4) = $24. 4. Decades of overfishing have dramatically reduced the world supply of cod (a type of whitefish). Farm-raised halibut is considered a close substitute for ocean-fished cod. Figure 6P- 3 shows the market for farm-raised halibut. [LO 6.1] What effect will overfishing cod have on the price of cod? On the graph, show the effect of overfishing cod on the market for farmed halibut. A fast-food chain purchases both cod and halibut for use in its Fish ’n’ Chips meals. Already hurt by the reduced supply of cod, the fast-food chain has lobbied aggressively for price controls on farmed halibut. As a result, Congress has considered imposing a price ceiling on halibut at the former equilibrium price—the price that prevailed before overfishing reduced the supply of cod. What will happen in the market for farmed halibut if Congress adopts the price control policy? Draw and label the price ceiling, quantity demanded, quantity supplied, and deadweight loss. Answer: Due to the reduced supply of cod, the price of cod will rise. Because they are substitutes, if the price of cod goes up, demand for farmed halibut will increase. This will cause the price and quantity of farmed halibut to increase. Demand for halibut has increased due to the reduced supply of cod. If the price of halibut is not allowed to increase accordingly, demand for halibut will exceed supply and there will be a shortage of QD – QS. The deadweight loss is the surplus that is lost when the quantity is less than the equilibrium (efficient) quantity. 5. Consider the market shown in Figure 6P-4. The government has imposed a price floor at $36. [LO 6.2] At a price floor of $36, what is quantity demanded? Quantity supplied? At this price floor, is there a shortage or a surplus? By how many units? Answer: If there is a price floor of $36, the quantity demanded is 90 and the quantity supplied is 225. There is a surplus of 135 units. Because quantity supplied exceeds quantity demanded, there is a shortage. The shortage is equal to QS - QD = 225 - 90 = 135. 6. The Organization for the Promotion of Brussels Sprouts has convinced the government of Ironia to institute a price floor on the sale of brussels sprouts, at $8 per bushel. Demand is given by P = 9 − Q and supply by P = 2Q, where Q is measured in thousands of bushels. [LO 6.2] a. What will be the price and quantity of brussels sprouts sold at market equilibrium? What will be the price and quantity sold with the price floor? How big will be the excess supply of brussels sprouts produced with the price floor? Answer: Solve for equilibrium. P = 9 - Q = 2Q; 9 = 3Q; Q = 3 thousand bushels. P = $6. The price floor is above the equilibrium price, so it is binding. The price will be P = $8 = 9 - Qd; so Qd = 1 thousand bushels. At this price of $8, quantity supplied is $8 = 2Qs, Qs = 4 thousand bushels, but quantity demanded is only 1 thousand. Therefore, the quantity sold is 1 thousand bushels. The amount of excess is supply is Qs - Qd = 4 - 1 = 3 thousand bushels. 7. The traditional diet of the citizens of the nation of Ironia includes a lot of red meat, and ranchers make up a vital part of Ironia’s economy. The government of Ironia decides to support its ranchers through a price floor, which it will maintain by buying up excess meat supplies. Table 6P-1 shows the supply and demand schedule for red meat; quantities are given in thousands of pounds. [LO 6.2] How many thousands of pounds of meat would you recommend that the government purchase to keep the price at $4/pound? How much money should the government budget for this program? Answer: At a price of $4, quantity supplied = 60,000 but quantity demanded equals 35,000. So excess supply is 25,000. This is what the government will need to purchase. If the government buys 25,000 of excess supply at $4 per unit, it will need to budget $100,000. 8. The market shown in Figure 6P-5 is in equilibrium. Suppose there is a $15 per unit tax levied on sellers. [LO 6.3] Draw the after-tax supply curve. Plot the after-tax price paid by consumers and the after-tax price paid by sellers. Answer: Each unit of the good is now $15 more costly to produce and sell. Thus, the supply curve increases (up along the y-axis) by $15. Buyers now pay the market price ($40). Sellers must then give the government $15, so the after-tax price received by sellers = 40 - 15 = $25. 9. The market shown in Figure 6P-6 is in equilibrium. Suppose there is a $1.50 per unit tax levied on sellers. [LO 6.3] Draw the after-tax supply curve. Plot the after-tax price paid by consumers and the after-tax price paid by sellers. Draw consumer surplus, producer surplus, tax revenue, and deadweight loss after the tax. d. Calculate deadweight loss. e. Calculate total surplus. Answer: Each unit of the good is now $1.50 more costly to produce and sell. Thus, the supply curve increases (up along the y-axis) by $1.50. The new market price is $3.50. This is the price paid by buyers. Sellers then receive $3.50 - tax = $3.50 - $1.50 = $2.00. CS = 0.5($5.50 - $3.50)(40 - 0) = $40. PS = 0.5($2.00 - $1.00)(40 - 0) = $20. Tax Revenue = (tax)(quantity) = $1.50 x40 = $60. DWL = 0.5(base)(height) = 0.5(3.50 - 2.00)(60 - 40) = 0.5(1.50)(20) = $15. Total surplus is the sum of CS, PS, and Tax Revenue. CS = 0.5(40)(5.50 - 3.50) = 40. PS = 0.5(40)(2.00 - 1.00) = 20. Tax Revenue = (Tax)(Q) = (1.50)(40) = 60. Total surplus = 40 + 20 + 60 = 120. 10. Suppose the government is considering taxing cigarettes. Because it is often politically more popular to tax the producers of cigarettes than the consumers of cigarettes, the government first considers the impact on the market as a result of taxing the producers of cigarettes. Figure 6P-7 shows the market in equilibrium. [LO 6.3] Answer: The supply curve shifts up (vertically) by the amount of the tax, $2.50. Because sellers are paying this tax, they will charge the new equilibrium price to consumers ($8.00), but they then have to give the $2.50 tax per unit to the government. Thus, the seller only receives $8.00 - $2.50 = $5.50. Compared to the market equilibrium price with no tax ($6.00), consumers are paying $2.00 more while sellers are only receiving $0.50 less. Consumers bear the burden of this tax. d. The demand curve shifts down (vertically) by the amount of the tax, $2.50. Because consumers are paying this tax, they are not willing to pay as high of a price to sellers as before. The consumers give the sellers the new equilibrium price ($5.50), but they then have to give the government the $2.50 tax per unit. Thus, the after-tax price paid by consumers is $5.50 + $2.50 = $8.00. Compared to the market equilibrium price with no tax ($6.00), consumers are paying $2.00 more while sellers are only receiving $0.50 less. Consumers bear the burden of this tax. The statutory (legal) incidence of a tax does not determine who bears the economic burden of the tax. In each case, buyers pay $8.00 and sellers receive $5.50. 11. Suppose you have the information shown in Table 6P-2 about the quantity of a good that is supplied and demanded at various prices. [LO 6.3], [LO 6.5] Plot the demand and supply curves on a graph, with price on the y-axis and quantity on the x -axis. What are the equilibrium price and quantity? Suppose the government imposes a $15 per unit tax on sellers of this good. Draw the new supply curve on your graph. What is the new equilibrium quantity? How much will consumers pay? How much will sellers receive after the tax? Calculate the price elasticity of demand over this price change. If demand were less elastic (holding supply constant), would the deadweight loss be smaller or larger? Answer: See graph below, curve S1. The equilibrium price is $20 and the equilibrium quantity is 60. Check this against the table provided. See the graph in part a, curve S2. The new equilibrium quantity is 40. Consumers will pay $30 and suppliers will receive $15. Price elasticity of demand = (% change in Qd)/(% change in Pc). Pc is the price consumers pay. % change in Qd = (60 - 40)/[60 + 40)/2] = -0.4. % change in Pc = (30 - 20)/[(30 + 20)/2] = 0.4. Price elasticity of demand = -0.4/0.4 = -1. The DWL would be smaller if demand were less elastic. 12. The weekly supply and demand for fast-food cheeseburgers in your city is shown in Figure 6P-8. In an effort to curb a looming budget deficit, the mayor recently proposed a tax that would be levied on sales at fast-food restaurants. [LO 6.3] The mayor’s proposal includes a sales tax of 60 cents on cheeseburgers, to be paid by consumers. What is the new outcome in this market (how many cheeseburgers are sold and at what price)? Illustrate this outcome on your graph. How much of the tax burden is borne by consumers? How much by suppliers? What is the deadweight loss associated with the proposed tax? How much revenue will the government collect? What is the loss of consumer surplus from this tax? Answer: Quantity supplied and demanded with the tax = 30 thousand. Price paid by consumers = $1.40. Price received by sellers =$0.80. The pre-tax price is $1.10. Consumers pay $0.30 of the tax ($1.40 - $1.10). Suppliers pay $0.30 of the tax ($1.10 - $0.80). The tax burden is therefore shared equally by consumers and producers. The efficiency costs of the tax are the mutually beneficial trades between 30,000 and 45,000 cheeseburgers that do not occur. DWL = ½ (45,000 - 30,000) × ($0.60) = $4,500. The government will collect $0.60 on each cheeseburger sold. Therefore, tax revenue will be 0.60(30,000) = $18,000. The loss of consumer surplus is the portion of tax revenue that is borne by consumers as well as the portion of deadweight loss that comes from consumers. The consumer potion of the tax burden is $0.30, so 0.30(30,000) = $9,000. This is the consumer surplus that is lost to tax revenue. The consumer portion of the deadweight loss is 0.5(15,000)(0.30) = $2,250. The total amount of surplus consumers lose is $9,000 + $2,250 = $11,250. 13. The market shown in Figure 6P-9 is in equilibrium. Suppose there is a $15 per unit subsidy given to buyers. [LO 6.4] Draw the after-subsidy demand curve. Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers. Answer: Each unit of the good is now $15 less expensive to buy. Thus, the demand curve increases (up along the y-axis) by $15. Sellers receive the market price ($35). Buyers then receive $15 from the government, making the after-subsidy price paid by consumers = 35 - 15 = $20. The market shown in Figure 6P-10 is in equilibrium. Suppose there is a $15 per unit subsidy given to sellers. [LO 6.4] Answer: Each unit of the good is now $15 cheaper to produce and sell. Thus, the supply curve decreases (down along the y-axis) by $15. Buyers pay the sellers $35 per unit. The sellers then receive an additional $15 from the government, such that the price the sellers receive is 35 + 15 = $50. Demand and supply of laptop computers are given in Figure 6P-11. The quantity of laptops is given in thousands. Suppose the government provides a $300 subsidy for every laptop computer that consumers purchase. [LO 6.4] What will be the quantity of laptops bought and sold at the new equilibrium? What will be the price consumers pay for laptops under the subsidy? What will be the price that sellers receive for laptops under the subsidy? How much money should the government budget for the subsidy? Answer: The quantity of laptops bought and sold at the new equilibrium is 14,000. Consumers will pay $500. Sellers will receive $800. Government should budget $300 for each computer sold: $300(14,000) = $4,200,000. 16. The market shown in Figure 6P-12 is in equilibrium. Suppose there is a $1.50 per unit subsidy given to buyers. [LO 6.4] Draw the after-subsidy demand curve. Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers. Draw government expenditures for the subsidy. Calculate government expenditures. Answer: Each unit of the good is now $1.50 less expensive to buy. Thus, the demand curve increases (up along the y-axis) by $1.50. Sellers now receive the market price ($4.00). The government gives each buyer a $1.50 subsidy, making the after-subsidy price paid by consumers = $4.00 - $1.50 = $2.50. The amount of the subsidy can be seen between the price paid by consumers and the price received by sellers. The quantity is 60. The area of the resulting rectangle is government expenditures. Government Expenditures = (Subsidy)(Quantity) = (1.50)(60) = $90. 17. The market shown in Figure 6P-13 is in equilibrium. Suppose there is a $3 per unit subsidy given to buyers. [LO 6.4] Draw the after-subsidy demand curve. Plot the after-subsidy price paid by consumers and the after-subsidy price paid by sellers. Draw the deadweight loss after the subsidy. Calculate deadweight loss. Answer: Each unit of the good is now $3.00 less expensive to buy. Thus, the demand curve increases (up along the y-axis) by $3.00. The new market price is the after-subsidy price received by the sellers: $10.00. Consumers then receive $2.50 from the government. Thus, the after-subsidy price paid by consumers is $10.00 - $2.50 = $7.50. The units from 80 to 100 are consumed unnecessarily. The additional government expenditure that does not become either consumer or producer surplus is the deadweight loss. DWL = 0.5(base)(height) = 0.5(10.00 - 6.00)(100 - 80) = 0.5(3.00)(20) = $30. 18. Suppose government offers a subsidy to laptop sellers. Say whether each group of people gains or loses from this policy. [LO 6.4] a. Laptop buyers. Laptop sellers. Desktop computer sellers (assuming that they are different from laptop manufacturers). d. Desktop computer buyers. Answer: Gain: The subsidy will lower the price consumers pay. Gain: The subsidy will increase the price sellers receive. Lose: If laptops are a substitute for desktops, the subsidy for laptops will reduce demand for desktops and drive the price down. Gain: If laptops are a substitute for desktops, the subsidy for laptops will reduce demand for desktops and drive the price down. Those who still wish to purchase a laptop can do so at a lower price. 19. Suppose that for health reasons, the government of the nation of Ironia wants to increase the amount of broccoli citizens consume. Which of the following policies could be used to achieve the goal? [LO 6.1], [LO 6.4] A price floor to support broccoli growers. A price ceiling to ensure that broccoli remains affordable to consumers. A subsidy paid to shoppers who buy broccoli. A subsidy paid to farmers who grow broccoli. Answer: C and D. Price controls will reduce the quantity traded in a market. A price ceiling will mean that quantity demanded is greater than quantity supplied but the number of trades will be lower than the equilibrium quantity. A subsidy, however, will increase consumer purchases by the same amount whether the subsidy is given to consumers or to producers. 20. The following scenarios describe the price elasticity of supply and demand for a particular good. In which scenario will a subsidy increase consumption the most? Choose only one. [LO 6.5] Elastic demand, inelastic supply. Inelastic demand, inelastic supply. Elastic demand, elastic supply. Inelastic demand, elastic supply. Answer: C. Quantity will change the most when both supply and demand are elastic. With elastic demand, consumers will respond more to price falling. With elastic demand, suppliers will respond more to price rising. Both sides of the market will respond strongly to the favorable price conditions they receive with the subsidy. 21. The market shown in Figure 6P-14 is in equilibrium. [LO 6.5] a. If a tax was imposed on this market, would buyers or sellers bear more of the burden of the tax? Why? Answer: If a tax was imposed on this market, buyers would bear more of the tax burden because the demand curve is more elastic than the supply curve. If a tax is imposed, consumers' quantity demanded will not be as responsive to the price change as the supplier. Thus, the price consumers pay will be pushed up by more than the price sellers receive is reduced. 22. The following scenarios describe the price elasticity of supply and demand for a particular good. All else equal (equilibrium price, equilibrium quantity, and size of the tax), in which scenario will government revenues be the highest? Choose only one. [LO 6.5] a. Elastic demand, inelastic supply. Inelastic demand, inelastic supply. Elastic demand, elastic supply. Inelastic demand, elastic supply. Answer: B. All else equal, the government will raise more revenue taxing goods that are inelastically supplied and demanded. Inelastic supply and demand mean that neither side of the market is very responsive to price changes. Consumers pay a higher price after the tax, but inelastic demand means that quantity demanded does not decline much. Producers receive less after a tax, but inelastic supply means that quantity supplied does not decline much. Consumers and producers are stuck paying the tax when supply and demand are inelastic. Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436
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