Queen s University Department of Economics ECON 111*S

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1 Queen s University Department of Economics ECON 111*S Take-Home Midterm Examination May 24, 25 Instructor: Sharif F. Khan Suggested Solutions PART A TRUE/FALSE/UNCERTAIN QUESTIONS Explain why each of the following statements is TRUE, FALSE, or Uncertain according to economic principles. Use diagrams where appropriate. Unsupported answers will receive no marks. It is the explanation that is important. [Total 15 marks] A-1. A decrease in the price of coffee and an increase in the wage of workers in the tea industry jointly lead to an increase in both the equilibrium price and quantity of tea. [5 marks] False Coffee is a close substitute of tea. So, a decrease in the price of coffee would lead to a decrease in the demand of tea as people substitute tea for relatively cheaper coffee. The demand curve in the tea market would shift to the left. At the same time, an increase in the wage of workers in the tea industry would increase the cost of production of tea. The profitability of tea industry would decline. The tea industry would respond to this higher production cost by producing less. So, the supply of tea would decrease. This means the supply curve in the tea market would shift to the left. Consequently, the equilibrium quantity of tea would decrease but the effect on equilibrium price of tea is ambiguous. Depending on the magnitudes of the shifts, the equilibrium price can increase, decrease or remain unchanged. In the following figures, I have shown three possible cases. In Figure 1- A, the supply and demand curves shifted in equal size. Consequently, the equilibrium quantity decreased with no change in the equilibrium price. In Figure 1-B, the demand curve shifted to the left relatively more than the supply curve. As a result, both the equilibrium quantity Page 1 of 9 Pages

2 and price decreased. In Figure 1-C, the supply curve shifted to the left relatively more than the demand curve. Consequently, the equilibrium quantity decreased with an increase in the equilibrium price. Since in no case the equilibrium quantity increases, we can conclude that the statement is false. D1 S2 S1 D1 S2 S1 D2 E2 E1 D2 E2 E1 Figure 1-A Figure 1-B D1 S2 D2 S1 E2 E1 A-2. A tax levied on buyers increases the price paid by buyers, while a tax levied on sellers increases the price received by sellers [5 marks]. False Figure 1-C The tax burden is shared by both buyers and sellers depending on the relative elasticity of the demand and supply curves. The inelastic side of the market bears relatively more burden of the tax. It does not matter whether the tax is imposed on buyers or sellers. Consider the standard case where neither of the demand and supply curves is perfectly elastic or perfectly inelastic. Now consider a tax levied on buyers of a good. The initial impact of the tax is on the demand for the good. The supply curve is not affected because, for any given price, sellers have the same incentive to Page 2 of 9 Pages

3 provide the good to the market. By contrast, buyers now have to pay a tax to the government (as well as the price to the sellers) whenever they buy the good. Thus, the tax on buyers makes buying the good less attractive and buyers demand a smaller quantity of the good at every price. Consequently, the demand curve shifts downward from D 1 to D 2 by exactly the size of the tax, as shown in the left panel of Figure-2. The intersection of new demand curve D 2 and the supply curve S determines the new market equilibrium price which is received by the sellers. The buyers are paying this new market price to sellers plus the tax (the vertical distance between D 1 and D 2 ) to the government. Thus, the tax on buyers increases the price paid by buyers and decreases the price received by sellers. Now consider a tax levied on sellers of a good. The initial impact of the tax is on the supply of the good. The demand curve is not affected because, for any given price, buyers have the same incentive to buy the good from the market. By contrast, the tax on sellers raises the cost of selling the good, and leads sellers to supply a smaller quantity of the good at every price. Consequently, the supply curve shifts upward from S 1 to S 2 by exactly the size of the tax, as shown in the right panel o Figure-2. The intersection of new demand curve S 2 and the demand curve D determines the new market equilibrium price which is paid by the buyers. The sellers are receiving this new market price from the buyers. But out of this new higher market price the sellers pay a tax (the vertical distance between S 1 and S 2 ) to the government. So, to determine the effective price (after paying the tax) for sellers we have to subtract the tax from the new market price. Thus, the tax on sellers increases the price paid by buyers and decreases the price received by sellers. FIGURE-2 A Tax on Buyers A Tax on Sellers Higher price paid by buyers S Higher price paid by buyers S 2 S 1 Equilibrium Rise in Market Drop in Market D 2 D 1 D Lower price received by sellers Lower price received by sellers Page 3 of 9 Pages

4 If the supply the curve is perfectly elastic but the demand curve is not perfectly elastic, buyers bear the entire burden of the tax. The price paid by buyers increases exactly by the size of the tax and the price received by sellers remain unchanged. By contrast, if the demand curve is perfectly elastic but the supply curve is not perfectly elastic, sellers bear the entire burden of the tax. The price received by sellers decreases exactly by the size of the tax and the price paid by buyers remain unchanged. It does not matter whether the tax is levied on buyers or sellers. In no case, the price received by sellers (after paying the tax) increases with tax. Therefore, we can conclude that the statement is false. A-3. A tariff imposed by a small importing country benefits both the producers and consumers of that country. [5 marks] False. A tariff imposed by a small importing country benefits the producers but hurts the consumers of that country. We can explain this by comparing consumer surplus and producer surplus before tariff and after tariff. Figure-3 shows the case where a small country imports a good from the world market. Since the country imports the good from the world market, the world price of the good must be lower than the domestic equilibrium price without trade. With free trade at the world price, the domestic demand for the good is Q D 1 and domestic supply of the good is Q S 1. To meet the excess demand for the good, the country imports (Q S 1-Q D 1) units of the good from the world market. Thus, with free trade, consumer surplus is (A+B+C+D+E+F), the area under the demand curve and above the world price, and producer surplus is g, the area above the supply curve and below the world price. After the government imposes a tariff, the domestic price exceeds the world price by the amount of the tariff. Because of the higher price after tariff, consumers buy less and the domestic quantity demanded decreases from Q D 1 to Q D 2. Consequently, consumer surplus falls by (C+D+E+F). By contrast, producers take advantage of the higher price resulted from the tariff and produce more. The domestic quantity supplied increase from Q S 1 to Q S 2. As a result, the producer surplus rises by C. With tariff the country imports only (Q S 2-Q D 2) units of the good. Government tariff revenue, the quantity of after-tariff imports times the size of the tariff, is area E. The area D+F shows the fall in total surplus and represents the deadweight loss of the tariff. Thus, consumers lose and producers gain because of the tariff. The county, as a whole, also lose due to the deadweight loss of tariff. So, we can conclude that the statement is false. Page 4 of 9 Pages

5 FIGURE-3 Domestic Supply A Equilibrium without trade with tariff B without tariff g C D E F Tariff World Imports with tariff Domestic Demand Q S 1 Q S 2 Q D 2 Q D 1 Imports without tariff Page 5 of 9 Pages

6 PART B Problem Solving Question Read each part of the question very carefully. Answer all parts to get the full marks on it. Use diagrams where required. [Total 15 marks] B-1. Consider the market for milk in Saskatchewan. If the P is the price of milk (dollars per litre) and Q is the quantity of litres (in millions per month), suppose that demand and supply curves for milk are given by: Demand: P = Q D Supply : P = Q S a. Graph the supply and demand curves. Identify the P and Q intercepts for the demand and supply curves. Assuming there is no form of government price support in this market, what is the equilibrium price and quantity? Show the equilibrium in the graph. [5 marks] Demand: P = Q D Supply: P = Q S Let P = Let P = = Q D = Q S or,.15 Q D = 2.25 or, -. 35Q S =.25 or, Q D = 15 or, Q S = -.71 Let Q D = Let Q S = P = 2.25 P =.25 Therefore, the P-intercept for the demand curve is P = 2.25 and Q-intercept for the demand curve is Q D = 15. The P-intercept for the supply curve is P =.25 and Q-intercept for the supply curve is Q S = At the equilibrium price, P, the quantity demanded Q D is equal to the quantity supplied Q S. So, to the find the equilibrium price, we have to set Q D = Q S. Rearrange the demand and supply equations, Q D = P Q S = P Page 6 of 9 Pages

7 Now, impose the equilibrium condition, Q D = Q S : P-2.25 = P or,(p-2.25)*.35=(p-.25)*(-.15) or,.35p-.7875=-.15p+.375 or,.35p+.15p= or,.5p=.825 P=1.65 Substituting P=1.65 into Q D, Q D = (1.65) Q D =4 Therefore, the equilibrium price is $1.65 per litre and the equilibrium quantity is 4 million litres (per month). FIGURE- 4 Supply Consumer Surplus 1.65 Producer surplus 1.25 Demand Page 7 of 9 Pages

8 b. Now suppose that the government guarantees milk producers a price of $2 per litre and promises to buy any amount of milk that producers cannot sell. What are the quantity demanded and quantity supplied at this guaranteed price? How much milk would the government purchase (per month) with this system? Show the results in the graph. [5 marks] At the guaranteed price =2, Demand: P = Q D Supply: 2 = Q D Q D = 1.67 P = Q S 2 = Q S Q S = 5 Therefore, at the guaranteed price the quantity demanded is 1.67 million litres and the quantity supplied is 5 million litres. The government would purchase (per month) with this system: Q S - Q D = = 3.33 million litres FIGURE demanded at this guaranteed price. Supply supplied at this guaranteed price. Guaranteed The distance between the quantity supplied and demanded (3.33) shows the amount of government purchase Demand Page 8 of 9 Pages

9 c. Who pays for the milk that government buys? Who is helped by this policy and who is harmed? Explain your answers by computing consumer surplus and producer surplus both with the policy and without the policy. [5 marks] The tax payers pay for the milk that government buys. Consumer surplus and producer surplus without the policy: (See Figure 4) Consumer surplus, the area under the demand curve and above the equilibrium price, is = (( )*4)/2 = 1.2 Producer surplus, the area above the supply curve and below the equilibrium price, is = (( )*4)/2 = 2.8 Consumer surplus and producer surplus with the policy: (See Figure 6) Consumer surplus, the area under the demand curve and above the guaranteed price, is = ((2.25 2)*1.67)/2 =.21 Producer surplus, the area above the supply curve and below the guaranteed price, is = ((2.25)*5)/2 = 4.38 Because of the government policy, the consumer surplus decreased from 1.2 to.21 and the producer surplus increased from 2.8 to So, we can conclude that milk producers are helped by the policy and milk consumers are harmed. FIGURE-6 Supply Consumer Surplus Guaranteed 1.65 Producer surplus 1.25 Demand Page 9 of 9 Pages