CH-4-6 Equilibrium: How Supply and Demand Determine Prices – Modern Principles: Microeconomics : Book Guide

This Document Contains Chapters 4 to 6 CHAPTER 4 Modern Principles of Economics: Equilibrium: How Supply and Demand Determine Prices Facts and Tools 1. If the price in a market is above the equilibrium price, does this create a surplus or a shortage? Solution 1. A surplus: a lot of unsold goods. 2. When the price is above the equilibrium price, does greed (in other words, self-interest) tend to push the price down or up? Solution 2. Self-interest tends to push the price down: Business owners don’t like having unsold goods, so they cut the price. Note: Greed and self-interest have the same denotation but different connotations. 3. Jon is on eBay, bidding for a first edition of the influential Frank Miller graphic novel Batman: The Dark Knight Returns. In this market, who is Jon competing with: the seller of the graphic novel or the other bidders? Solution 3. He is competing with other bidders. 4. Now, Jon is in Japan, trying to get a job as a full-time translator; he wants to trans¬late English TV shows into Japanese and vice versa. He notices that the wage for translators is very low. Who is the “competition” pushing the wage down: Does the competition come from businesses who hire the translators or from the other translators? Solution 4. Jon is competing with other translators. 5. Jules wants to purchase a Royale with cheese from Vincent. Vincent is willing to offer this tasty burger for $3. The most Jules is willing to pay for the tasty burger is $8 (after all, his girlfriend is a vegetarian, so he doesn’t get many opportunities for tasty burgers). a. How large are the potential gains from trade if Jules and Vincent agree to make this trade? In other words, what is the sum of producer and consumer surplus if the trade happens? b. If the trade takes place at $4, how much producer surplus goes to Vincent? How much consumer surplus goes to Jules? c. If the trade takes place at $7, how much producer surplus goes to Vincent? How much consumer surplus goes to Jules? Solution 5. a and b and c. The potential gains from trade are $5 of value ($8 − $3 = $5 surplus): It might all be consumer surplus, it might be producer surplus, or it might be some mix of the two. If they trade at $4, $1 of producer surplus goes to Vincent, and $4 of consumer surplus to Jules. If the trade happens at $7, Vincent gets $4 of producer surplus, while Jules gets $1 of consumer surplus. 6. What happened in Vernon Smith’s lab? Choose the right answer: a. The price and quantity were close to equilibrium but gains from trade were far from the maximum. b. The price and quantity were far from equilibrium and gains from trade were far from the maximum. c. The price and quantity were far from equilibrium but gains from trade were close to the maximum. d. The price and quantity were close to equilibrium and gains from trade were close to the maximum. Solution 6. Option d was true: Price and quantity were close to equilibrium, and gains from trade (the sum of the consumer and producer surplus) were close to the maximum. 7. When supply falls, what happens to quantity demanded in equilibrium? (This should get you to notice that both suppliers and demanders change their behavior when one curve shifts.) Solution 7. Quantity demanded falls: This is just moving along the fixed demand curve. The re¬duced supply pushes up the price, and, at a higher price, buyers reduce their quantity demanded. 8. a. When demand increases, what happens to price and quantity in equilibrium? b. When supply increases, what happens to price and quantity in equilibrium? c. When supply decreases, what happens to price and quantity in equilibrium? d. When demand decreases, what happens to price and quantity in equilibrium? Solution 8. a. When demand increases, price and quantity both rise in equilibrium. b. When supply increases, price falls and quantity rises in equilibrium. c. When supply decreases, price rises and quantity falls in equilibrium. d. When demand decreases, price and quantity both fall in equilibrium. 9. a. When demand increases, what happens to price and quantity in equilibrium? b. When supply increases, what happens to price and quantity in equilibrium? c. When supply decreases, what happens to price and quantity in equilibrium? d. When demand decreases, what happens to price and quantity in equilibrium? No, this is not a mistake. Yes, it is that important. Solution 9. Same as 8. 10. What’s the best way to think about the rise in oil prices in the 1970s, when wars and oil embargoes wracked the Middle East? Was it a rise in demand, a fall in de¬mand, a rise in supply, or a fall in supply? Solution 10. A fall in supply. The price spiked up, since it was tougher to get oil out of the Middle East. That fits the fall in supply story. 11. What’s the best way to think about the rise in oil prices in the last 10 years, as China and India have become richer. Was it a rise in demand, a fall in demand, a rise in supply, or a fall in supply? Solution 11. A rise in demand. The price spiked up, but more oil has been produced each year. The United States is using a bit less than before, especially since late 2007, but China and India are using more. When the price and quantity both rise, that’s because of a rise in demand. Thinking and Problem Solving 12. Suppose the market for batteries looks as follows: What are the equilibrium price and quantity? Solution 12. Price: $4; Quantity: 20 13. Consider the following supply and demand table for bread. Draw the supply and demand curves for this market. What are the equilibrium price and quantity? Solution 13. Price: $2; Quantity: 35 14. If the price of a one-bedroom apartment in Washington, DC, is currently $1,000 per month, but the supply and demand curves look as follows, then is there a shortage or surplus of apartments? What would we expect to happen to prices? Why? Solution 14. There is a shortage of apartments. We would expect rents to rise as buyers who are willing to pay more than $1,000 for an apartment begin to offer higher rents just to secure an apartment; they’d rather pay more than not get an apartment at all. 15. Determine the equilibrium quantity and price without drawing a graph. Solution 15. Quantity: 150; Price: $32 16. In the following figure, how many pounds of sugar are sellers willing to sell at a price of $20? How much is demanded at this price? What is the buyer’s willingness to pay when the quantity is 20 pounds? Is this combination of $20 per pound and quantity of 20 pounds an equilibrium? If not, identify the unexploited gains from the trade. Solution 16. At a price of $20 sellers are willing to supply 20 pounds and buyers are demanding 40 pounds. The buyer’s willingness to pay at a quantity of 20 is $45, so the buyers are willing to pay more than the $20 sellers require to sell an additional pound of sugar. Thus, this is not an equilibrium. Unexploited gains from trade are shaded. 17. The market for marbles is represented in the graph. What is the total producer surplus? The total consumer surplus? What are the total gains from trade? Solution 17. Consumer Surplus = (50)($11 − $5)/2 = $150; Producer Surplus = (50)($5 − $1)/2 = $100; Total Surplus = $250 18. Suppose you decided to follow in Vernon Smith’s footsteps and conducted your own experiment with your friends. You give out 10 cards: 5 cards to buyers with the figures for willingness to pay of $1, $2, $3, $4, and $5, and 5 cards to sellers with the amounts for costs of $1, $2, $3, $4, and $5. The rules are the same as Vernon Smith implemented. a. Draw the supply and demand curves for this market. At a price of $3.50 how many units are demanded? And supplied? b. Assuming the market works as predicted, and the market moves to equilibrium, will the buyer who values the good at $1 be able to purchase? Why or why not? Solution 18. a. At a price of $3.50, two units will be demanded and 3 units will be supplied. The surplus of one unit will tend to drive the price down. b. The buyer who values the good at $1 will not be able to purchase the good because in equilibrium no one will be willing to offer the good for such a low price. Perhaps this is surprising, since there is a supplier who would be willing to sell his good for only $1 if that was his only alternative. But since there are other buyers who are willing to pay more, the buyers who value the good at just $1 will be out-competed by buyers who value the good more highly. Notice that this process of buyers with a high willingness to pay outcompeting buyers with a low willingness to pay is Part 1 of our three-part condition for maximizing the gains from exchange. Namely, the supply of goods is bought by the buyers with the highest willingness to pay. 19. If the price of margarine decreases, what happens to the demand for butter? What happens to the equilibrium quantity and price for butter? What would happen if butter and margarine were not substitutes? Use a supply and demand diagram to support your answer. Solution 19. The equilibrium price and quantity of butter would decrease. If they were not sub¬stitutes, there would be no change in the demand for butter. 20. The market for sugar is diagrammed: a. What would happen to the equilibrium quantity and price if the wages of sugar cane harvesters increased? b. What if a new study was published that emphasized the negative health effects of consuming sugar? Solution 20. a. If the wage of sugar cane harvesters increased, then the cost of producing sugar will increase, which shifts the supply curve up and to the left, thereby increasing price and decreasing the equilibrium quantity. b. If a new study emphasized the negative health effects of sugar, then the demand for sugar would decrease. That is, the demand curve would shift down and to the left, causing the equilibrium price and quantity to decrease. 21. If a snowstorm was forecast for the next day, what would happen to the demand for snow shovels? Is this a change in quantity demanded or a change in demand? This shift in the demand curve would affect the price; would this cause a change in quantity supplied or a change in supply? Solution 21. Demand for snow shovels would increase. This is a change in demand – people want a greater number of snow shovels at any price. The subsequent increase in price would cause a change in quantity supplied (a movement along the supply curve). 22. In recent years, the Paleo diet, which emphasizes eating more meat and fewer grains, has become very popular. What do you suppose that did to the price and quantity of bread? Use supply and demand analysis to support your answer. Solution 22. Demand for bread decreases and thus equilibrium price and quantity decrease. 23. In recent years, there have been news reports that toys made in China are unsafe. When those news reports show up on CNN and Fox News, what probably hap¬pens to the demand for toys made in China? What probably happens to the equi¬librium price and quantity of toys made in China? Are Chinese toymakers probably better or worse off when such news comes out? Solution 23. Such reports probably reduce the demand for Chinese-made toys, so in equilibrium the price and quantity of Chinese-made toys fall. The bad news makes the Chinese toymakers worse off. 24. Here’s a quick problem to test whether you really understand what producer surplus and consumer surplus mean, rather than just relying on the geometry of demand and supply. For each of the two diagrams that follow, calculate producer surplus, consumer surplus, and total surplus. Assume the curves are perfectly vertical and perfectly horizontal. Solution 24. In the diagram on the left, the consumer surplus (as drawn) is infinite, and the pro¬ducer surplus is $0. In the diagram on the right, the consumer surplus is $0, and the producer surplus is $100. 25. The diagram that follows shows the market for agricultural products. The shift from the old supply curve to the new supply curve is the result of technological and scientific advances in farming, including the production of more resilient and productive seeds. Calculate the change in consumer surplus and the change in producer surplus caused by these technological advances. Are buyers better or worse off as a result of these advancements? What about sellers? (Note that you cannot calculate consumer surplus directly with the information given in the diagram, but you don’t need that information to calculate the change in consumer surplus.) Solution 25. The change in consumer surplus is shown by the trapezoid between $11 and $8 all the way out from the price axis to the demand curve. The area of this trapezoid is ($11 − $8) × [(3 million + 3.3 million)/2] = $3 × 3.15 million × $9.45 million. (This can also be calculated as the area of a rectangle plus the area of a triangle.) Be-fore the technological advance, producer surplus is ($11 − $5.50) × 3 million × ½ = $8.25 million. After the technological advance, producer surplus is ($8 − $2) × 3.3 million × ½ = $9.9 million. Therefore the change in producer surplus is $1.65 million. Both buyers and sellers have benefited from the technological advance because both have seen an increase in surplus. 26. Now that you’ve mastered interpreting shifts in demand and supply, it’s time to add an¬other wrinkle: simultaneous shifts in both demand and supply. Most of the time, when we explore simultaneous shifts of demand and supply, we can determine the impact on either equilibrium price or equilibrium quantity, but not both. Fill in the missing cells in the table to see why. Because two curves can shift in two directions, there are four cases to consider. The first column is done for you as an example. Solution 26. See the completed table here. 27. In the last problem, you saw how simultaneous shifts in demand and supply can leave us with uncertainty about the impact on price or on quantity. An increase in both demand and supply will increase equilibrium quantity but have an ambiguous effect on equilibrium price. However, if we knew that there was a significant increase in demand and only a small increase in supply, we could conclude that the price would probably rise overall, albeit not by as much as would have been the case if supply had not increased slightly. In each of the following examples, there are a major event and a minor event. Deter¬mine whether each change relates to demand or to supply, and then figure out the impact on price and quantity; be sure to say something about the relative magni¬tudes of the price and quantity changes. a. Market: Rock salt Major event: A bitterly cold and unusually snowy winter season has significantly depleted the amount of available rock salt. Minor event: There is another snowstorm, and roads and sidewalks need to be salted. b. Market: Smartphones Major event: The proliferation of fast, reliable, affordable (or free) wi-fi and cellular signals increases the usability of smartphones. Minor event: The production of smartphones is marked by modest technological advances. c. Market: Canned tomatoes Major event: A large canned-tomato manufacturer begins to use cheap imported tomatoes from Mexico rather than domestic tomatoes. Minor event: This causes a public relations fiasco, resulting in an organized effort to boycott canned tomatoes. Solution 27. a. The major event leads to a decrease in supply, and the minor event leads to an increase in demand. Therefore, equilibrium price will go up substantially, and equilibrium quantity will fall less substantially. b. The major event leads to an increase in demand, and the minor event leads to an increase in supply. Therefore, equilibrium quantity will go up substantially, and equilibrium price will rise less substantially. c. The major event leads to an increase in supply, and the minor event leads to a decrease in demand. Therefore, equilibrium price will go down substantially, and equilibrium quantity will rise less substantially. Challenges 28. For many years it was illegal to color margarine yellow (margarine is naturally white). In some states, margarine manufacturers were even required to color mar¬garine pink! Who do you think supported these laws? Why? (Hint: Your analysis in question 8 from the previous section is relevant!) Solution 28. The dairy industry wanted to prevent margarine from being a good substitute for butter in order to keep butter prices high. Yellow-colored margarine is a better sub¬stitute for butter than white or pink margarine! Thus, the dairy industry lobbied for laws to prevent margarine manufacturers from making their product look more like butter. It is still illegal to sell colored margarine in Québec, Canada. 29. Think about two products, “safe cars” (a heavy car such as a BMW 530xi with infrared night vision, four-wheel antilock brakes, and electronic stability control) and “dangerous cars” (a lightweight car such as _____ [name removed for legal reasons, but you can fill in as you wish]). a. Are these two products substitutes or complements? b. If new research makes it easier to produce safe cars, what happens to the supply of safe cars? What will happen to the equilibrium price of safe cars? c. Now that the price of safe cars has changed, how does this impact the demand for dangerous cars? d. Now let’s tie all these links into one simple sentence: “In a free market, as engineers and scientists discover new ways to make cars safer, the number of dangerous cars sold will tend to _______________.” Solution 29. a. They are substitutes. b. If it becomes easier to produce safe cars, the supply of safe cars will rise. This will push down the price of safe cars. c. Because the two kinds of cars are substitutes, the fall in the price of safe cars will reduce the demand for dangerous cars. d. decrease. 30. Many clothing stores often have clearance sales at the end of each season. Using the tools you learned in this chapter can you think of an explanation why? Solution 30. At the end of the season, the quantity demanded of some items will be less than the quantity supplied in the form of inventory stocks. To get rid of the excess supply of clothes, producers will have a sale (reduce the price). 31. a. If oil executives read in the newspaper that massive new oil supplies have been discovered under the Pacific Ocean but will likely only be useful in 10 years, what is likely to happen to the supply of oil today? What is the likely equilibrium impact on the price and quantity of oil today? b. If oil executives read in the newspaper that new solar-power technologies have been discovered but will likely only become useful in 10 years, what is likely to happen to the supply of oil today? What is the likely equilibrium impact on the price and quantity of oil today? c. What’s the short version of these above scenarios? Fill in the blank: If we learn today about promising future energy sources, today’s price of energy will _______ and today’s quantity of energy will __________. Solution 31. a. The supply of oil is likely to rise today. If oil is going to become cheaper in the future, then firms are more willing to pump it out of the ground and sell it today. This will push today’s price down and push today’s quantity of oil up. b. The same thing happens. Oil and solar power are substitutes in many cases (not in all cases!), so cheap solar energy in the future means that oil will be less desir¬able in the future. Time to pump the oil and sell it today while people are still willing to pay a lot for it! c. The answers are “fall” and “rise.” Naturally, the size of the effect depends on how large and certain future increases are and how easy it is to pump out more oil in the short run. But the direction of the effect is clear. 32. Economists often say that prices are a “rationing mechanism.” If the supply of a good falls, how do prices “ration” these now-scarce goods in a competitive market? Solution 32. Because the price rises, only those people willing to pay the higher price will get the good. The higher price does all the heavy lifting. 33. When the crime rate falls in the area around a factory, what probably happens to wages at that factory? Solution 33. Wages probably fall. There are two ways of thinking about this. First, if working conditions get better, then the employer can pay lower wages and still find employees. Second, and closely related, when working conditions improve, more people are will¬ing to work in the area and the increased supply pushes wages down. 34. Let’s take the idea from the previous question and use it to explain why businesses sometimes try to make their employees happy. If a business can make the job seem fun (by offering inexpensive pizza lunches) or at least safe (by nagging the city government to put police patrols around the factory), what probably happens to the supply of labor? What happens to the equilibrium wage if a factory or office or laboratory becomes a great place where people “really want to work”? How does this explain why the hourly wage for the median radio or television announcer is only $14.88 per hour, lower than almost any other job in the entertainment or broadcasting industry? Solution 34. When jobs become more fun or more safe, more people want to work in those jobs. This pushes down the wage in the jobs. It means that business owners have a strong incentive to find inexpensive ways to make their jobs fun, safe, and desirable. This also helps explain why TV and radio announcers earn very little money: Because lots of people want to be on TV or the radio. People like the attention and the fame. CHAPTER 5 Modern Principles of Economics: Elasticity and Its Applications Facts and Tools 1. For each of the following pairs, which of the two goods is more likely to be inelastically demanded and why? Table 5.1 should help: a. Demand for tangerines vs. demand for fruit b. Demand for beef next month vs. demand for beef over the next decade c. Demand for Exxon gasoline at the corner of 7th and Grand vs. demand for gasoline in the entire city d. Demand for insulin vs. demand for vitamins Solution 1. a. Fruit is more inelastically demanded because the overall category of fruit has fewer good substitutes than any one item in that category. b. More inelastic over the next month because people are usually more inelastic (inflexible) in the short run. c. Brand-named goods are more elastic than categories, especially when there are very good substitutes for Exxon gasoline available at close distances. d. Insulin is probably more of a necessity; demand for insulin from buyers is thus more inelastic than demand for vitamins for buyers of vitamins. 2. For each of the following pairs, which of the two goods is more likely to be elastically supplied? Table 5.3 should help: a. Supply of apples over the next growing season vs. supply of apples over the next decade b. Supply of construction workers in Binghamton, New York, vs. supply of construction workers in New York State c. Supply of breakfast cereal vs. supply of food d. Supply of gold vs. supply of computers Solution 2. a. Supply of apples over the next decade is more elastic. If the price permanently rises, you can plant some trees or buy them from someone else or invest more in effective horticulture. The time horizon for the next growing season is too short to make such adjustments. b. Supply in Binghamton is more elastic because it draws on a smaller labor pool compared to the whole of New York State. If the wage rises or falls there, workers can move to Binghamton or leave Binghamton, respectively, much easier than they could move to or leave from New York State. c. Supply of breakfast cereal is more elastic. If its price rises, firms can switch machines from making macaroni to making cereal more easily than transforming non–food-producing machines to food-producing machines. d. Supply of computers is more elastic. It’s easier to adjust production of a manufactured good if its price rises or falls than to adjust production of a rare material. New gold is hard to find, but new computers are relatively easy to make. 3. Indicate whether the demand for the good would become more elastic or less elastic after each of the following changes. (Note that in each of these cases the demand curve may also shift inward or outward, but in this question we are interested in whether the demand becomes more or less elastic.) Briefly justify your answer. a. The demand curve for soap after wide understanding that bacteria and other organisms cause and spread disease b. The demand curve for coal after the invention of nuclear power plants c. The demand curve for cars as more employers allow employees to telecommute d. The demand curve for a new television during an economic boom Solution 3. a. More inelastic, because soap is viewed more as a necessity for health than as a luxury b. More elastic, because nuclear power plants were a new substitute for coal power plants c. More elastic, because either (1) consumers see cars as less of a necessity and more as a luxury, or (2) consumers see telecommuting as a new substitute for a car d. Inelastic, because televisions take up a smaller portion of an average person’s budget as incomes rise 4. For each of the following, indicate if the supply for the good would become more elastic or less elastic as a result of each change, and briefly justify your answer. (Once again, in each case the supply curve will also shift, but we are interested in changes in the elasticity.) a. The supply curve for diamonds if a new process for manufacturing diamonds is created b. The supply curve for food if pesticides and fertilizers were banned c. The supply curve for plastic if a very large share of oil output was used to make plastic d. The supply curve for nurses after several years of increasing wages in nursing Solution 4. a. More elastic because mining more diamonds requires increasing costs per unit, but the number of diamond-manufacturing factories can be doubled while keeping all other things equal b. More inelastic, because with a shorter “menu” of technologies from which farms can choose, there are fewer ways to respond to a price change c. More inelastic, because increasing plastic production today will be accomplished by small decreases in other uses of oil, but if plastic production accounted for a larger share of oil production more plastic production would require getting more from the ground and that’s more costly d. More elastic, because when wages for nurses increase over several years, this gives workers and firms time to adapt, including time to allow more nurses to be produced using education 5. Let’s work out a few examples to get a sense of what elasticity of demand means in practice. Remember that in all of these cases, we’re moving along a fixed demand curve—so think of supply increasing or decreasing while the demand curve is staying in the same place. a. If the elasticity of demand for college textbooks is 20.1, and the price of textbooks increases by 20%, how much will the quantity demanded change, and in what direction? b. In your answer to part a, was your answer in percentages or in total number of textbooks? c. If the elasticity of demand for spring break packages to Cancun is 25, and if you notice that this year in Cancun the quantity of packages demanded increased by 10%, then what happened to the price of Cancun vacation packages? d. In your college town, real estate developers are building thousands of new student-friendly apartments close to campus. If you want to pay the lowest rent possible, should you hope that demand for apartments is relatively elastic or relatively inelastic? e. In your college town, the local government decrees that thousands of apartments close to campus are uninhabitable and must be torn down next semester. If you want to pay the lowest rent possible, should you hope that demand for apart¬ments is relatively elastic or relatively inelastic? f. If the elasticity of demand for ballpoint pens with blue ink is –20, and the price of ballpoint pens with blue ink rises by 1%, what happens to the quantity de¬manded? g. What’s an obvious substitute for ballpoint pens with blue ink? (This obvious substitute explains why the demand is so elastic.) Solution 5. a. Recall that elasticity = (% change in quantity)/(% change in price). So −0.1 = (% change in quantity)/(20%). That means that % change in quantity = 20% × (−0.1) = −2%. The quantity demanded falls by 2%. b. This answer is in percentages. c. −5 = +(10%)/(% change in price), so % change in price = −2%. Prices fell by 2%. d. You want demand to be relatively inelastic. If it is, then a fall in supply causes only a small increase in the rental price. e. You want demand to be relatively elastic. If it is, then a rise in supply causes a big fall in the rental price. f. Again, recall that elasticity = (% change in quantity)/(% change in price). So −20 = (% change in quantity)/(1%). That means % change in quantity = −20%. Quantity demanded falls by 20%. g. An obvious substitute is ballpoint pens with black ink. 6. It’s an important tradition in the Santos family that they eat the same meal at their favorite restaurant every Sunday. By contrast, the Chen family spends exactly $50 for their Sunday meal at whatever restaurant sounds best. a. Which family has a more elastic demand for restaurant food? b. Which family has a unit elastic demand for restaurant food? (Hint: How would each family respond to an increase in food prices?) 6. a and b. The Santos family commits themselves to demanding food from the same restaurant each week regardless of price. This results in a highly inelastic demand curve and thus a low elasticity. The Chen family on the other hand spends the same amount each week, so that a doubling of prices would result in half the amount of restaurant meals being eaten each week. The elasticity of demand for the Chen family must be unit elastic at that point of consumption. This can easily be seen with the midpoint formula for calculating elasticity: [(Change in Q)/(Average Q)]/[(Change in P)/(Average P)]. If the Chens bought ten $5 meals and now buy five $10 meals, elasticity equals (−5/7.5)/(5/7.5), or −1. 7. The U.S. Department of Agriculture (USDA) has been concerned that Americans aren’t eating enough fruits and vegetables, and they’ve considered coupons and other subsidies to encourage people—especially lower-income people—to eat these healthier foods. Of course, if people’s demand for fruits and vegetables is perfectly inelastic, then there’s no point in giving out coupons (thought question: why?). If instead the demand is only somewhat elastic, there may be better ways to spend taxpayer dollars. This is clearly a situation where you’d want to know the elasticity of fruit and vegetable demand: If people respond a lot to small changes in price, then government-funded fruit and vegetable coupons could make poorer Americans a lot healthier, which might save taxpayers money if they don’t have to pay for expensive medical treatments for unhealthy eaters. There are a lot of links in this chain of reasoning—all of which are covered in more advanced econom¬ics courses—but the first link is whether people actually have elastic demand for fruits and vegetables. The USDA’s Economic Research Service employs economists to answer these sorts of questions, and a recent report contained the following estimated elasticities (Source: Diansheng Dong and Biing-Hwan Lin. 2009. Fruit and vegetable consumption by low-income Americans: Would a price reduction make a difference? Economic Research Report 70, USDA). a. Based on these demand elasticity estimates, which fruit is most inelastically demanded? Which is most elastically demanded? b. For which of these fruits would a 10% drop in price cause an increase in total revenue from that sale of that fruit? c. If the government could offer “10% off” coupons for only three of these fruits, and it wanted to have the biggest possible effect on quantity demanded, which three fruits should get the coupons? d. Overall, the authors found that for the average fruit, the elasticity of demand was about 20.5. Is the demand for fruit elastic or inelastic? Solution 7. a. Apples are the most inelastically demanded, and oranges are the most elastically demanded. b. For grapefruit and oranges, a fall in price would cause a rise in total revenue (absolute elasticity >1). c. The most elastic: grapefruit, grapes, and oranges; they would create the biggest effect. d. Since the elasticity’s absolute value is between 0 and 1, demand is inelastic. 8. On average, old cars pollute more than newer cars. Therefore, every few years, a politician proposes a cash for clunkers program: The government offers to buy up and destroy old, high-polluting cars. If a cash for clunkers program buys 1,000 old, high-polluting cars, is this the same as saying that there are 1,000 fewer old, high-polluting cars on the road? Why or why not? Solution 8. It is not the same—it’s just another version of the slave redemption story or the gun buyback story. People will bring cars from out of state, from their backyard, or from the junkyard to sell to the government. Some of these cars were probably being driven very little, if at all. Such rarely used cars are just the ones you’d expect people to sell to the government. 9. As we noted in the chapter, many economists have estimated the short-run and long-run elasticities of oil demand. Let’s see if a rise in the price of oil hurts oil revenues in the long run. Cooper, the author cited in this chapter, found that in the United States, the long-run elasticity of oil demand is –0.5. a. If the price of oil rises by 10%, how much will the quantity of oil demanded fall: by 5%, by 0.5%, by 2%, or by 20%? b. Does a 10% rise in oil prices increase or decrease total revenues to the oil pro¬ducers? c. Some policymakers and environmental scientists would like to see the United States cut back on its use of oil in the long run. We can use this elasticity estimate to get a rough measure of how high the price of oil would have to permanently rise in order to get people to make big cuts in oil consumption. How much would the price of oil have to permanently rise in order to cut oil consumption by 50%? d. France has the largest long-run elasticity of oil demand (–0.6) of any of the large, rich countries, according to Cooper’s estimates. Does this mean that France is better at responding to long-run price changes than other rich countries, or does it mean France is worse at responding? Solution 9. a. Recall that elasticity = (% change in quantity)/(% change in price). So –0.5 = (% change in quantity)/(10%). That means % change in quantity = –5%. Quantity demanded falls by 5%. b. It will increase total revenues because the change is occurring along an inelastic point on the demand curve. c. The price of oil would have to permanently rise by 100% to do this. d. It means that France is more responsive since more elastic means more flexible. One reason may be that France is also one of the countries that makes the most use of nuclear power, making it a more viable substitute for oil. 10. Guess whether the demand for cigarettes is elastic or inelastic. Explain your reasoning. Solution 10. A good guess is that the demand for cigarettes is inelastic because cigarettes are addictive; people will thus keep consuming a lot even if the price goes up. In fact, economists have estimated an elasticity of demand of –0.5, so if this was your guess, it was a good one. Thinking and Problem Solving 11. Suppose that 200,000 Uber trips are taken every day in New York City and suppose that the elasticity of demand for an Uber trip is –0.5. If the price increased by 10% how many Uber trips would be taken in a day? Solution 11. We know that Ed = –0.5 and that %ΔP is 10%, so we fill in what we know: −0.5 = (%ΔQ)/(10%) −5% = %ΔQ A 5% decline in 200,000 trips is a decline of 10,000 trips. Therefore, the quantity of trips will decline to 190,000. 12. A movie theatre owner runs an experiment. She decreases prices 2% and discovers that ticket sales increased by 5%. Also, she increases prices by 1% and discovers that sales decrease by 2%. What should the owner do to maximize revenue? Solution 12. Perhaps the easiest way to solve this problem is to substitute some numbers. Suppose that sales are 100 tickets and that the ticket price is $1—we choose numbers that make our calculations easy. Thus, initial revenues are $100. In the first experiment the price falls to $0.98 and sales increase to 105 so revenues are $102.90, an increase of $2.90. In the second experiment the price increased to $1.01 and sales decreased to 98, so revenues are $98.98, a decrease of $1.02. Another way to solve this problem is to make use of a convenient mathematical approximation. If we have a number R = X*Y, then %ΔR ≅ %ΔX + %ΔY. In words, the growth rate of the product is approximately equal to the sum of the growth rates of the components. Thus, since R = P*Q, then %ΔR ≅ %ΔP + %ΔQ. So, in the first experiment, we have %ΔR ≅ –2% + 5% = 3%, and in the second case %ΔR ≅ 1% – 2% = –1%. Our approximation says revenues increase by approximately $3 in the first case and decrease by approximately $1 in the second case. You can see that our approximations are pretty accurate. The approximation rule works best for growth rates that are not too large. 13. In Figure 5.1 we showed two demand curves. On the demand curve labeled E, for more elastic, the quantity demanded was 100 at a price of $40 and 20 at a price of $50. For the demand curve labeled I, for less elastic or inelastic, the quantity demanded was 100 at a price of $40 and 95 at a price of $50. Using the mid-point formula, calculate the elasticity of demand for these two curves and check that they were labeled correctly. Solution 13. The curve labeled E should be 6, and the curve labeled I should be 0.23, thus the curves were correctly labeled. 14. During the Middle Ages, the African city of Taghaza quarried salt in 200-pound blocks to be sent to the salt market in Timbuktu, in present-day Mali. Travelers report that Taghazans used salt instead of wood to construct buildings. Compared with other towns without big salt mines, was the demand for wood more elastic or less elastic in Taghaza? How do you know? Solution 14. The demand for wood was more elastic than in other places because substitutes for wood were easier to find in Taghaza than in other places. 15. Suppose that drug addicts pay for their addiction by stealing: So the higher the total revenue of the illegal drug industry, the higher the amount of theft. If a government crackdown on drug suppliers leads to a higher price of drugs, what will happen to the amount of stealing if the demand for drugs is elastic? What if the demand for drugs is inelastic? Solution 15. If the demand for drugs is elastic, a higher price of drugs will mean less consumer expenditure on drugs. While some people will steal more to pay the higher price, more than enough people will steal less, as they move away from drugs in favor of other recreation, to outweigh those stealing more. The overall amount of stealing will decrease. On the other hand, if the demand for drugs is inelastic, a higher price of drugs will mean greater consumer expenditure on drugs. Since the drug consumers get money for their addiction by stealing, the amount of stealing will increase. 16. Henry Ford famously mass-produced cars at the beginning of the twentieth century, starting Ford Motor Company. He made millions because mass produc¬tion made cars cheap to make, and he passed some of the savings to the con¬sumer in the form of a low price. Cars became a common sight in the United States thereafter. Keeping total revenue and its relationship with price in mind, do you expect the demand for cars to be elastic or inelastic given the story of Henry Ford? Solution 16. Total revenue clearly went up for Ford Motor Company as the price of cars decreased. Thus, the demand for cars was elastic. 17. In Chapter 10, you’ll see that we recently purchased permits to pollute the air with sulfur dioxide (SO2). We didn’t use the permits: Instead, we threw them out. In other words, we bought permits for the same reason the government buys guns in gun buyback programs—to prevent what we bought from being used. As we discussed in the chapter, gun buyback programs have failed. So why is our plan to buy permits more likely to get SO2 out of the air than the government’s plan to get guns off the street? Solution 17. The supply of guns to Washington, D.C., is close to perfectly elastic so every gun bought by the government is quickly replaced by a gun on the street. In contrast, the number of pollution permits is fixed, so the supply is perfectly inelastic. When the supply is perfectly inelastic every permit bought by us is one less permit available to firms to pollute the air. Thus, our plan to reduce SO2 is much more likely to work than the government’s plan to reduce the number of guns on the street. You just knew our plan was more likely to succeed, didn’t you? 18. How might elasticities help to explain why people on vacation tend to spend more for food and necessities than the local population? Solution 18. Tourists tend to be less familiar with a location other than their hometown, causing them to be ignorant of the availability of substitutes at other stores or the qual¬ity of unknown brands within stores. Even knowing that other stores exist may be insufficient because tourists highly value their time, making the other stores no longer close substitutes. 19. In the short run the price elasticity of the demand and supply of electricity can be very low. a. How might revenue for the electricity industry change if one power plant were shut down for maintenance, reducing supply? b. If one power company owned many power plants, would it have a short-term incentive to keep all of its plants running, or could it have a short-term incentive to shut down a power plant now and then? Solution 19. a. A shutdown of a power plant would shift the supply curve to the left, resulting in a large change in price relative to the reduction in the quantity sold. Total revenue would increase. b. The occasional shutdown could increase the revenues for the power company, so it will be sorely tempted to shut down some power plants now and again. We take up this issue in more detail in Chapter 11 when we look at California’s electricity crisis. 20. Immigration is a fact of life in the United States. This will lead to a big boost in the labor supply. What field would you rather be in: A field where the demand for your kind of labor is elastic or a field where the demand for your kind of labor is inelastic? Solution 20. I want to be in a field where the demand for my labor is elastic because a big increase in supply won’t push down my wage much. 21. In the world of fashion, the power to imitate a trendy look is the power to make money. Stores like H&M and Forever 21 focus on imitating fashions wherever possible: As soon as they see that a new look is coming along, something people are willing to pay a high price for, they start cranking out that look. Do these imitation-centered stores make the supply of clothing more elastic or more inelastic? How can you tell? Solution 21. They make the supply of clothing more elastic because a rise in price causes a much larger change in quantity supplied. 22. The relationship between elasticity of demand and total revenue can be a helpful shortcut, particularly if your professor likes to give multiple-choice exams. For each of the following examples, calculate how much money each consumer spends at the low price and at the high price, and decide whether the right answer for a ques¬tion asking for the price elasticity of demand on a multiple-choice exam would be (a) −2.33, (b) −1.17, (c) −1.00, or (d) −0.56. Remember, if the consumer spends more money at the lower price, demand must be elastic. (Warning: Two of these will require a bit of guesstimation.) a. When the price of a movie ticket rises from $6 to $8 for senior citizens, Gary (a senior citizen) decides to go to the movies every other day (15 times per month) instead of every day (30 times per month). b. When the price of a large specialty coffee drink rises from $3 to $4, Martha reduces her weekly consumption from 7 to 5. c. When PX = $10.00, QDX = 30. When PX = $7.50, QDX = 40. Solution 22. a. At the low price, he spends $180 per month, and at the high price, he spends $120. Since he spends more at the low price, demand must be elastic: a or b. This is a huge increase (from $120 to $180), however, so the answer is probably a. b. At the low price, she spends $21, and at the high price, she spends $20. Since she spends more at the low price, demand must be elastic: a or b. However, this is a small increase (from $20 to $21), so the answer is probably b. c. At the low price, revenue is $300. At the high price, revenue is $300. There¬fore, demand is unit elastic: c. 23. Let’s practice the midpoint formula. Calculate the elasticity of demand for each of the goods or services that follows. Solution 23. . Challenges 24. In this chapter, we’ve emphasized that the elasticity of supply is higher in the long run than in the short run. In lots of cases, this is surely true: If you see that jobs pay more in the next state over, you won’t move there next week but you might move there next year. But, sometimes the short-run elasticity will be higher than the long-run elasticity. Austan Goolsbee found an interesting example of this when he looked at the elasticity of income of highly paid executives with respect to taxes. In 1993, then President Clinton passed a law raising income taxes. This tax hike was fully expected: He campaigned on it in 1992. a. What do you expect happened to executive income in the first year of the tax increases? What about in subsequent years? Here’s a hint: Top executives have a lot of power over when they get paid for their work: They can ask for bonuses a bit earlier, or they can cash out their stock options a bit earlier. Literally, this isn’t their “labor supply,” it’s more like their “income supply.” (Source: Goolsbee, Austan. 2000. What happens when you tax the rich? Evidence from executive compensation. Journal of Political Economy 108(2): 352–378. For a book on the topic written by leading economists, see Joel Slemrod (Ed.), 2000. Does Atlas Shrug? Cambridge, MA: Harvard University Press.) b. Goolsbee estimated that the short-run elasticity of “income supply” for these ex¬ecutives was 1.4, while the long-run elasticity of “income supply” was 0.1. (Note: Goolsbee used a variety of statistical methods to look for these elasticities, and all came to roughly the same result.) If taxes pushed down their take-home income by 10%, how much would this cut the amount of income supplied in the short run? In the long run? c. You are a newspaper reporter. Your editor tells you to write a short story with this title: “Goolsbee’s research proves that tax hikes make the rich work less.” Make your case in one sentence. d. You are a newspaper reporter. Your editor tells you to write a short story with this title: “Goolsbee’s research proves that tax hikes have little effect on work by the wealthy.” Make your case in one sentence. e. Which story is more truthful? Solution 24. a. Income went down a lot in the first year of the tax increase because executives had pulled their income into the previous year when taxes were low. In the long run, however, through time, executives have fewer options to move their income. Thus, as time continued, executive income returned to close to its previous level. b. In the short run this would push income down by 14%, but in the long run it would only push it down by 1%. c. In the first year of the Clinton tax increase executive income went down a lot. One could use this fact to argue that executives were responding to the tax by working a lot less. d. A tax increase causes executives to move as much of their income as possible to a low-tax year, but even though income changes by a lot, executives continue to work about the same amount as before, which is why income recovers in subsequent years. e. Based on Goolsbee’s research the story in part d is more truthful. 25. We saw that a gun buyback program was unlikely to work in Washington, D.C. If the entire United States ran a gun buyback program, would that be better at elimi¬nating guns or worse? Why? What about if the gun buyback was also accompanied by a law making (at least some) guns illegal? Solution 25. A national gun buyback would probably be more effective, since the supply of guns is more inelastic at the national level. It’s harder to import guns from else¬where to sell in the United States than to import guns from Maryland to sell in Washington, D.C. There still is the important problem of people just selling use¬less guns, long-forgotten guns, and so forth, but it weakens the problem of imports. If the gun buyback problem were accompanied by a law making it illegal to own (or produce more) guns, the program would likely be even more effective at get-ting guns off the street. Australia enacted just such a program in 1997. Economists Andrew Leigh and Christine Neill found that the program was successful at reduc¬ing the number of guns in Australia and that it reduced firearm deaths, especially firearm suicides. 26. Using the data from the ANWR example, what will be the percentage increase in quantity supplied if ANWR raises supply by 1%? No, this isn’t a trick question, and the formula is already there in the chapter. Why isn’t this number just 1%? Solution 26. Ed(Shift in supply)/(Ed + Es) = 0.5 × 1%/(0.8) = 2.5%/4 = 0.625%. This is the formula for a shift in equilibrium quantity caused by a shift in the supply curve. This is less than 1% because part of the effect of the rise in supply is a lower price. And that lower price reduces the quantity supplied by other suppliers, crowding them out. To see this, notice that if the demand curve were vertical, then Ed would be 0. In this case, a rise in supply would push the price of oil down so much that other suppliers would reduce their quantity supplied by exactly the increase in ANWR supply, with no effect on equilibrium quantity. Our equation agrees with this intuition: The numerator would equal zero, so the quantity shift would equal zero. At the other extreme, if demand were infinitely elastic—so people eat up all the oil at a given price—then there would be no price decline and the 1% ANWR in¬crease would also be a 1% world increase. In terms of the equation, loosely speaking the result would be (infinity × 1%)/(infinity + 0.3) = (infinity × 1%)/(infinity) = 1%. The infinities in the numerator and denominator cancel out, and all of the extra supply would go toward raising the equilibrium quantity of oil. 27. Using the FRED economic database (https://fred.stlouisfed.org/) let’s compare expenditures on cell phones with the price of phones. Unfortunately, as is often the case, it’s difficult to find data on exactly what we want but if you search for “real expenditures telephone” you will find a series for expenditure on telephone and facsimile equipment (faxes—maybe you have heard of them?). Then click Edit Graph and Add Line. Search for “expenditures telephone price” and you should find a price series (make sure it says price index) for telephones and facsimile equipment. To make comparisons easier, change the units to Index and set the index equal to 100 around 2001 for both series. a. Between 2001 and 2015, what happened to expenditures? Prices? b. Is the demand for telephones elastic or inelastic? Solution 27. a. Between 2001 and 2015, expenditures increased from an index of 100 to 900—a massive increase—while at the same time price fell from an index of 100 to 35. b. Since expenditures rose as prices fell, the demand for telephones over this time period was elastic. Chapter 5 Appendix Using the FRED economic database (https://fred.stlouisfed.org/) let’s compare people’s purchases of groceries with their purchases of electronics and appliances. At FRED, search for “retail trade grocery,” then Edit Graph and Add Line and search for “retail trade electronics.” Both series should be in millions of dollars but since grocery stores sell much more than electronics stores, the scales make it difficult to see the changes. Switch units to Index and the set the index equal to 100 in December of 2007, the beginning of the 2007–2009 recession. Do this for both series. Print the graph. a. What happened to food sales over the 2007–2009 recession? What about sales of electronics? b. What does your answer to part (a) suggest about the income elasticity of food and electronics? c. The data includes electronics and appliance stores. Why might appliance purchases be especially income elastic compared to food, at least over the short run? Solution a. Food sales were flat over the recession, while electronics sales plummeted from an index of 100 to 85, a decline of about 15%. b. Since prices were probably not changing much during this period, the main driving force would have been a decline in income due to the recession. Thus, the graph suggests that electronics and appliance purchases are much more income elastic than food purchases. c. Appliances are durable goods so one can more easily delay buying an appliance (keeping the old unit a bit longer, for example) than one can delay purchases of food. CHAPTER 6 Modern Principles of Economics: Taxes and Subsidies Facts and Tools 1. As we saw in Chapter 4, economists’ idea of equilibrium borrows a lot from physics. Let’s push the physics metaphors a bit further. Here, we focus just on the supply side. For each set of words in brackets, circle the correct choice: a. When the government subsidizes an activity, resources such as labor, machines, and bank lending will tend to gravitate [toward/away from] the activity that is subsidized and will tend to gravitate [toward/away from] the activity that is not subsidized. b. When the government taxes an activity, resources such as labor, machines, and bank lending will tend to gravitate [toward/away from] the activity that is taxed and will tend to gravitate [toward/away from] the activity that is not taxed. Solution 1. a. Toward the activity that is subsidized and away from the activity that is not subsidized b. Away from the activity that is taxed and toward the activity that is not taxed 2. Junk food has often been criticized for being unhealthy and too cheap, enticing the poor to adopt unhealthy lifestyles. Suppose that the state of Oklakansas imposes a tax on junk food. a. What needs to be true for the tax to actually deter people from eating junk food: Should junk food demand be elastic or should it be inelastic? b. If the Oklakansas government wants to strongly discourage people from eating junk food, when will it need to set a higher tax rate: When junk food demand is elastic or when it is inelastic? c. But hold on a moment: The supply side matters as well. If junk food supply is highly elastic—perhaps because it’s not that hard to start selling salads with low-fat dressing instead of mayonnaise- and cheese-laden burgers—does that mean that a junk food tax will have a bigger effect than if supply were inelastic? Or is it the other way around? d. Let’s combine these stories now. If a government is hoping that a small tax can actually discourage a lot of junk food purchases, it should hope for: I. Elastic supply and inelastic demand II. Elastic supply and elastic demand III. Inelastic supply and elastic demand IV. Inelastic supply and inelastic demand Solution 2. a. Demand should be elastic, which means sensitive to price. b. The government will need to set a higher tax rate when consumers have inelastic junk food demand—only an extremely high price will discourage these stubborn consumers. c. Elastic supply is better from the government’s point of view, just as elastic demand is better. As long as the goal is getting the quantity to move a lot, you want elasticity. d. II: Both should be elastic. 3. As we saw in the chapter, a lot turns on elasticity. Decades ago, Washington, D.C., a fairly small city, wanted to raise more revenue by increasing the gas tax. Washington, D.C., shares borders with Maryland and Virginia, and it’s very easy to cross the borders between these states without even really noticing: The suburbs just blend together. a. How elastic is the demand for gasoline sold at stations within Washington, D.C.? In other words, if the price of gas in D.C. rises, but the price in Maryland and Virginia stays the same, will gasoline sales at D.C. stations fall a little, or will they fall a lot? b. Take your answer in part a into account when answering this question. So, when Washington, D.C., increased its gasoline tax, how much revenue did it raise: Did it raise a little bit of revenue, or did it raise a lot of revenue? c. How would your answer to part b change if D.C., Maryland, and Virginia all agreed to raise their gas tax simultaneously? These states have heavily populated borders with each other, but they don’t have any heavily populated borders with other states. Solution 3. a. Washington, D.C., gas sales are very elastic: It’s easy to drive across the border to buy gas where it’s cheapest. Hence, we can say that gasoline sales at D.C. stations will fall a lot. b. Gasoline sales in Washington, D.C., plummeted and the tax raised very little revenue. c. If they all raised the gas tax simultaneously, they could raise a lot of revenue. The demand within these three states is more inelastic, since drivers don’t have many good alternatives to filling up within the tri-state area. 4. In Figure 6.5, what is the total revenue raised by the tax, in dollars? What is the deadweight loss from the tax, in dollars? (Note: You’ve seen the formula for the latter before. We’ll let you look around a little for this one.) Solution 4. Tax revenue: 500 × $1 = $500. Deadweight loss = $1 tax × 200 apples × ½ (because it’s a triangle) = $100. 5. a. Once again: Why does the chapter say that elasticity = escape? (This is worth remembering: Elasticity is one of the toughest ideas for most economics students.) b. Which two groups of workers did we say have a relatively high elasticity of labor supply? Keep this in mind as politicians debate raising or lowering taxes on dif¬ferent types of workers: These two groups are the ones most likely to make big changes in their behavior. Solution 5. a. Elasticity = escape because someone with high elasticity is someone who can easily escape to another market, either as a supplier or as a demander. b. Men nearing retirement and married women have the highest labor supply elasticity. They respond to labor-market incentives the most, while middle-aged men tend to work the same hours even when the wage changes. 6. Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is willing to accept as little as $25 for a haircut. a. What possible prices for the haircut would be beneficial to both Maria and Juan? How much total surplus (i.e., the sum of consumer and producer surplus) would be generated by this haircut? b. If the state where Maria and Juan live instituted a tax on services that included a $5 per haircut tax on stylists and barbers, what happens to the range of haircut prices that benefit both Maria and Juan? Will the haircut still happen? Will this tax alter the total economic benefit of this haircut? c. What if instead the tax was $20? Solution 6. a. Any price greater than $25 will make Juan better off; any price lower than $40 will make Maria better off. No matter what the price is, the sum of consumer and producer surplus (the total gains from trade) will be $15. b. If Juan has to pay a $5 tax for every haircut he gives, then his willingness-to-accept price will rise to $30. At a price of $30, he will give $5 to the govern¬ment and have $25 left over for himself, which was originally the minimum he was willing to accept. Now Juan and Maria must find a price greater than $30 but less than $40. There are a lot of prices in between these numbers, so it is still likely that the haircut would take place. The tax will not necessarily alter the total economic benefit of the haircut. While the benefit to Maria and Juan will sum only to $10, the government also receives $5 in tax revenue, so the total eco¬nomic benefit generated by the haircut is still $15. c. If the tax was $20, Juan’s minimum willingness-to-accept price rises to $25 + $20 = $45. Now, there are no prices high enough to satisfy Juan (higher than $45) but low enough to satisfy Maria (lower than $40). Therefore, the haircut will not take place. It will, therefore, not generate any tax revenue. The total economic benefit will be reduced to $0. Thinking and Problem Solving 7. Some people with diabetes absolutely need to take insulin on a regular basis to survive. Pharmaceutical companies that make insulin could find a lot of other ways to make some money. a. If the U.S. government imposes a tax on insulin producers of $10 per cubic cen¬timeter of insulin, payable every month to the U.S. Treasury, who will bear most of the burden of the tax: insulin producers or people with diabetes? Or can’t you tell from the information given? b. Suppose instead that because of government corruption, the insulin manufacturers convince the U.S. government to pay the insulin makers $10 per cubic centimeter of insulin, payable every month from the U.S. Treasury. Who will get most of the benefit of this subsidy: Insulin producers, people with diabetes, or can’t you tell from the information given? Solution 7. a and b: In both cases, it’s the diabetes patients who are affected: Inelastic buyers face a steep price hike under a tax and so bear the burden of the tax, and inelastic buyers reap the benefits of the insulin subsidy. 8. Let’s see if we can formulate any real laws about the economics of taxation. Which of the following must be true, as long as supply and demand curves have their normal shape (i.e., they aren’t perfectly vertical or horizontal, and demand curves have a negative slope while supply curves have a positive slope)? More than one may be true. If there is a tax: a. The equilibrium quantity must fall, and the price that buyers pay must rise. b. The equilibrium quantity must rise, and the price that sellers pay must rise. c. The equilibrium quantity must fall, and the price that sellers receive must fall. d. The equilibrium quantity must rise, and the price that buyers receive must fall. (Note: The correct answer[s] to this question was [were] actually controversial until Nobel Laureate Paul Samuelson created a simple mathematical proof in his legend¬ary graduate textbook, Foundations of Economic Analysis.) Solution 8. Both a and c are correct: Quantity falls, the price received by suppliers falls, and the price paid by the buyer rises. 9. Using the following diagram, use the wedge shortcut to answer these questions: a. If a tax of $2 were imposed, what price would buyers pay and what price would suppliers receive? How much revenue would be raised by the tax? How much deadweight loss would be created by the tax? b. If a subsidy of $5 were imposed, what price would buyers pay and what price would suppliers receive? How much would the subsidy cost the government? How much deadweight loss would be created by the subsidy? Solution 9. a. The answers can be found in this diagram. b. The answers can be found in this diagram. 10. When government is trying to raise tax revenue, it sometimes attempts to target higher-income people, because they are in a better position to bear the burden of a tax. However, it can be very difficult to earn tax revenue from wealthy people. a. Consider the progressive nature of the U.S. federal income tax system: It’s designed so that higher incomes are taxed at higher tax rates. Thinking about the elasticity of labor supply, why might it be more difficult to collect tax revenue from a wealthy individual than from a poor person, all else equal? b. Another way governments have tried to collect taxes from the wealthy is through the use of luxury taxes, which are exactly what they sound like: taxes on goods that are considered luxuries, like jewelry or expensive cars and real estate. What is true about the demand for luxuries? Consider jewelry. Is a luxury tax more likely to hurt the buyers of jewelry or the sellers of jewelry? c. The chapter began by discussing another tax that targets wealthy individuals: the estate tax. Comment on the effectiveness of this tax (in terms of government revenue), considering the demand of wealthy individuals for leaving an inheritance. Solution 10. a. We might expect the wealthy to have a more elastic labor supply. One reason might be related to mobility: A wealthy person may have the resources necessary to move in order to find a better job, while a poorer person may not. Likewise, a poorer person cannot take time out of the labor market to wait for a bet¬ter opportunity, but a wealthy person can. If a wealthy person has a greater labor supply elasticity, then this means he or she is in a better position to escape the impact of an income tax. Likewise, the total compensation of higher-paying jobs generally involves more components than just a wage or salary, such as benefits, vacation days, comfortable and clean working environments, and so on. So, if a person at a higher-paying job faces an increase in income taxes, he or she can simply substitute lower income but with more fringe benefits and other job amenities; they avoid paying the income tax by switching their “compensation” from income to some other thing. Low-skilled workers in low-paid work do not have these op¬tions, and they cannot avoid income taxes simply by changing the nature of their total compensation. b. The demand for luxuries is necessarily elastic. If the supply of these goods is not likewise elastic, then the buyers of luxuries will escape the luxury tax and it will be borne primarily by the sellers of luxuries, for example, sellers of jewelry. c. Although the text points out that in some cases people are able to time deaths to accommodate estate tax changes, in reality no one can avoid dy¬ing forever. Further, when considering whether to leave an inheritance, a wealthy person is choosing between using all of their wealth while alive or passing some of it on. There is good reason to believe that the estate tax would have to be quite high for a person (especially a wealthy person) to feel that it is better to spend all of their wealth while alive. For a poor per¬son, the “wealth” may be needed to purchase necessities, but this is not the case for a wealthy person. In this sense, the estate tax represents a method of taxing wealthy people that could be more effective than the other two mentioned above. 11. As we learned in Chapter 4, the competitive market equilibrium maximizes gains from trade. Taxes and subsidies, by altering the market outcome, reduce the gains from trade. Does this happen primarily because of the impact of taxes and subsidies on prices or the impact of taxes and subsidies on quantities? Solution 11. The gains from trade are reduced primarily through the impact of taxes and subsidies on the market quantity. In the case of taxes, too few transactions take place, which means that there are some unexploited opportunities to exchange goods with value higher than their costs. In the case of subsidies, too many transactions take place, so that some goods are exchanged that have costs higher than their value. So quantity is the key, and economic welfare can be reduced if too many or too few transactions take place. 12. Consider the following diagram of a tax. The triangular area representing dead¬weight loss is highlighted, and its dimensions are labeled “Base” and “Height” (recall that the formula for the area of a triangle is 1/2 × Base × Height). a. In order to calculate the deadweight loss of a tax, you don’t need the entire demand and supply diagram; you just need to know two numbers, the base and height of the deadweight loss triangle. What is the real-life meaning of the base? What about the height? b. Can you turn your answers to part a into general rules about the deadweight loss associated with taxes? Try phrasing it like this but replacing the part in brackets: “The larger the [base or height], the more deadweight loss is generated by a given tax.” c. Holding the base constant, the height and thus the deadweight loss would get larger if the demand curve or the supply curve were more ______. d. Without having a diagram as a reference, can you answer the preceding ques¬tions for a subsidy? Solution 12. a. The base represents the per-unit size of the tax, and the height represents the decrease in quantity caused by the tax. b. The larger the per-unit size of the tax, the more deadweight loss is generated by a given tax. The larger the decrease in quantity caused by a tax, the more deadweight loss is generated by a given tax. c. Holding the base (per-unit tax) constant, the height and thus the deadweight loss would get larger if the demand curve or the supply curve were more elastic. d. For a subsidy, the base would be the per-unit size of the subsidy, and the height would be the increase in quantity caused by the subsidy. The general rules would be: The larger the per-unit size of the subsidy (or the larger the increase in quantity caused by a subsidy), the more deadweight loss is generated by a given subsidy. 13. Suppose your state government has decided to tax donuts. Currently in your state, 300,000 donuts are sold every day. Three possible taxes are being considered by law¬makers: a 20-cent per donut tax, which would decrease donut sales by 50,000 per day; a 25-cent per donut tax, which would decrease donut sales by 100,000 per day; and a 50-cent per donut tax, which would decrease donut sales by 150,000 donuts per day. a. Calculate the amount of tax revenue generated by each tax and the deadweight loss caused by each tax. b. If the goal of your state government is simply to raise the most tax revenue, which tax is preferable? c. If the goal of your state government is to raise tax revenue in the most efficient manner (with the least deadweight loss per dollar of revenue), which tax is pref-erable? d. What other goal might your state government have when creating this kind of tax besides raising tax revenue? Solution 13. a. The tax revenues generated by the three taxes are $50,000, $50,000, and $75,000 per day, respectively. The deadweight losses caused by the three taxes are $5,000, $12,500, and $37,500 respectively. b. The $0.50 tax raises the most tax revenue. c. This question can be answered by calculating the deadweight loss per dollar of revenue for each tax, using the numbers calculated in part a. The values are $0.20, $0.25, and $0.50 for the three taxes, respectively (in other words, the $0.50 tax increases government revenues by $75,000, but it decreases consumer and producer surplus by a total of $112,500). Therefore, the most efficient tax is the $0.20 tax, which raises $50,000 in revenue with only $5,000 in deadweight loss. d. Another goal might simply be to reduce donut consumption. In that case, the biggest tax would be the most preferred because it reduces quantity the most. 14. How is it that a tax creates a deadweight loss by decreasing quantity, but a subsidy creates a deadweight loss by increasing quantity? Solution 14. One way to answer this is that the free market equilibrium quantity maximizes total gains from trade, so that any other quantity (whether higher or lower) necessarily causes a reduction in the gains from trade (causes a deadweight loss). Going a step further, a tax reduces the quantity below the free market equilibrium quantity and therefore causes some transactions not to take place that would have generated gains for trade. Thus the deadweight loss associated with a tax is from unrealized potential gains from trade. A subsidy, on the other hand, leads to a greater quantity than the free market equilibrium quantity, causing some transactions to take place that should not take place because the cost of the unit(s) in question exceeds the value of the unit(s). The deadweight loss associated with a subsidy is thus from wasted resources— resources used to produce goods that are not valued enough by consumers to justify their production. 15. Go to the FRED Economic Database (https://fred.stlouisfed.org/) and find tobacco taxes in Texas. In what year (1991–2016) would you guess Texas raised the sales tax on tobacco? Solution 15. The sales tax very likely increased in 2007 (2006 would also be an acceptable answer, but 2007 is the first year of the higher sales tax revenue). Challenges 16. Let’s apply the economics of taxation to romantic relationships. a. What does it mean to have an inelastic demand for your boyfriend or girlfriend? How about an elastic demand? b. Sometimes relationships have taxes. Suppose that you and your boyfriend or girlfriend live one hour apart. Using the tools developed in the chapter, how can you predict which one of you will do most of the driving? That is, which one of you will bear the majority of the relationship tax? Solution 16. a. An inelastic demand means you can’t live without him or her. An elastic demand means that there are good substitutes for the current boyfriend or girlfriend. b. All other things being equal, the more inelastic party will do most of the driving—the other party has good substitutes. 17. a. In the opening scene of the classic Eddie Murphy comedy Beverly Hills Cop, Axel Foley, a Detroit police officer, is stopping a cigarette smuggling ring. Of course, smugglers don’t pay the tax when the cigarettes cross state lines. Which way do you suspect the smugglers were moving the cigarettes, based on economic theory? From the high-tax North to the low-cost South, or vice versa? b. In our discussion of taxation, we’ve acted as if it were effortless to pass and enforce tax laws. But, of course, law enforcement officials, including the Internal Revenue Service, put a lot of effort into enforcing tax laws. Let’s think for a moment about what kind of taxes are easiest to collect, just based on the basic ideas we’ve covered. Who will make the most effort to escape a tax: the party who is elastic or the party who is inelastic? (Hint: It doesn’t matter whether we’re talking about suppli¬ers or demanders.) (Note: Public administration researchers know the most about this topic. Carolyn Webber and Aaron Wildavsky’s surprisingly enjoyable classic, The History of Taxation and Expenditure in the Western World, sets out just how dif¬ficult it’s been for most Western governments to collect taxes.) Solution 17. a. The smugglers were quite likely moving cigarettes from the low-tax South to the high-tax North. There was money to be made in avoiding taxes. b. The party who is inelastic will make the most effort, because he or she bears most of the tax burden. So if the supplier is inelastic, she will go to great efforts to find a way around the tax. People want to “escape” the tax, but if they can’t escape by choosing a substitute, they’re more likely to try to “escape” through tax avoidance. 18. Let’s get some practice with the “wedge trick” and use it to learn about the relationship between subsidies and lobbying. The U.S. government has many subsidies for alternative energy development: Some are just called subsidies, some are called tax breaks instead. Either way, they work just like the subsidies we studied in this chapter. We’ll look at the market for windmills. a. In the two figures, one is a case where the sellers of windmills have an elastic supply and the buyers of windmills (local power companies) have inelastic demand. In the other case, the reverse is true. Which is which? b. In which case will a subsidy cut the price paid by the buyers the most: When demand is elastic or when it is inelastic? (It’ll be easiest if you use the wedge trick.) Is this the first or second graph? c. In which case will a subsidy increase the price paid to the sellers more: When supply is elastic or when it is inelastic? Again, which graph is this? d. Now look at how producer surplus and consumer surplus change in these two cases. To see this, remember that producer surplus is the area above the supply curve and below the price, and consumer surplus is the area below the demand curve and above the price. So in the first graph, who gets the lion’s share of any subsidy-driven extra surplus: suppliers or demanders? Is that the inelastic group or the elastic group? In other words, whose surplus triangle gets bigger faster as the quantity increases? (You might try shading in these triangles just to be sure.) e. Now it’s time for the second graph. Again, who gets the lion’s share of any subsidy-driven extra surplus: suppliers or demanders? Is that the inelastic group or the elastic group? f. There’s going to be a pattern here in parts d and e: The more [elastic or inelastic?] side of the market gets more of the extra surplus from the subsidy. g. When Congress gives subsidies for the alternative energy market, it is hoping that a small subsidy can get a big increase in output: In other words, they are hoping that the equilibrium quantity will be elastic. At the same time, the groups most likely to lobby Congress for a big alternative energy subsidy are going to be the groups that get the most extra surplus from any subsidy. After all, if the subsidy doesn’t give them much surplus, they’re not likely to ask Con¬gress for it. So here’s the big question: Will the groups that are most likely to lobby for a subsidy be the same groups that are mostly likely to respond to the subsidy? (Note: This is a general lesson about the incentives for lobbying: It’s not just a story about the alternative energy industry.) Solution 18. a. In the first graph, supply is relatively elastic and demand is relatively inelastic. In the second graph, supply is relatively inelastic and demand is relatively elastic. b. The price paid by the buyers will fall the most if demand is inelastic (first graph). c. The price received by the sellers will rise the most if supply is inelastic (second graph). d. The party who is more inelastic gets the biggest boost to surplus as the subsidy grows. In the first group, that’s the demanders, with a steep demand curve and hence an inelastic demand for windmills. e. This time, it’s the suppliers, who again have an inelastic supply. f. The more inelastic side of the market gets most of the benefit from the extra surplus. g. No, the reverse is true. Groups that lobby for the subsidy are those who are least likely to respond to the subsidy. Therefore, if a group is lobbying heavily for a subsidy, that group is unlikely to change their behavior much if they actually get the subsidy. They are lobbying not because they plan to change their ways, but because they won’t change it. They want to reap the reward of the higher supplier price or lower demander price without changing their behavior very much. 19. As you learned in the chapter, the elasticities of demand and supply are crucial in determining how the burden of a tax (or the benefit of a subsidy) is divided between buyers and sellers. Under what conditions for supply or demand would a seller actually be able to avoid bearing any of the burden of a tax? Under what conditions would a subsidy benefit only the sellers of a good? Solution 19. For the seller to completely escape the tax, the elasticity of supply would have to be totally, or perfectly, elastic. This means that the supply curve would have to be hori¬zontal, as in Panel A below. In this case, the tax wedge would simply increase the price paid by buyers, and not affect the seller price. Alternately, sellers could avoid the tax if buyers had no ability to escape—that is, if demand was perfectly inelastic, or vertical, as in Panel B below. In this case, the wedge would just sit right on top of the old equilibrium and drive up the buyer price without reducing the seller price. The conditions would have to be reversed for a seller to enjoy all of the benefits of a subsidy: either perfectly elastic demand (shown in Panel C below) or perfectly inelastic supply (shown in Panel D below). 20. In the chapter, most of the taxes we discussed were equal to a certain dollar amount per unit. In this case, a tax on sellers results in a parallel upward shift of the supply curve; a tax on buyers results in a parallel downward shift of the demand curve. In reality, however, many taxes are expressed as a percentage. Graphically, how would you show a 100% tax on the sellers of a good? How would you show a 100% tax on the buyers of a good? One of the results of this chapter is that it doesn’t matter on whom the tax is levied—the result is the same. Show graphically that this also applies to percentage taxes. Solution 20. A proportional tax would rotate the curves, not just shift them parallel. For a 100% tax, the sellers’ costs would double at every quantity, so it would rotate counterclockwise. Notice that at Q1 on the diagram below, with no tax, the supply curve is at $20. Once the tax is imposed, sellers would require 100% more (or $40) in order to supply the same quantity. If the tax were applied to buyers, their willingness to pay for the good itself would be cut in half, so the demand curve would also rotate counterclockwise. Notice that quantity demanded at a price of $40 is Q2 before the tax. However, after the tax, buyers would not pay $40 for Q2 units of output because they would then owe $40 in taxes. Since the most they are willing to give up to get this good is $40, they will reduce the price they are willing to pay to $20 for Q2 units. This way, when they pay the 100% tax, they will have paid a total of $40 for the good. The drawing below shows that the effect on equi-librium quantity is the same either way, just like with a per-unit tax. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766