# Problem Set 5. The price will be higher than the equilibrium price. There will be a surplus of cheese.

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1 Problem Set 5 I. 1. The government has decided that the free-market price of cheese is too low. a) Suppose the government imposes a binding price floor in the cheese market. Draw a supply-and-demand diagram to show the effect of this policy on the price of cheese and the quantity of cheese sold. Is there a shortage or surplus of cheese? The price will be higher than the equilibrium price. There will be a surplus of cheese. b) Farmers complain that the price floor has reduced their total revenue. Is this possible? Explain. It can happen if demand is elastic. With elastic demand, the percentage decline in quantity would exceed the percentage rise in price, so total revenue would decline. c) In response to farmers complaints, the government agreed to purchase all the surplus cheese at the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses? (hint: try to think of ways how the government finances its purchases) producers benefit and taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue would increase substantially. However, consumers would buy only quantity Q2 of cheese, so they are in the same position as before. Taxpayers lose because they would be financing the purchase of the surplus cheese through higher taxes. 2. Suppose the minimum wage is above the equilibrium wage in the market for unskilled labor. Using a supply-and-demand diagram of the market for unskilled labor, show the market wage, the number of workers who are employed, and the number of workers who are unemployed. Also show the total wage payments to unskilled workers. 1

2 w w M L D L S L Market wage and wage payed to unskilled workers: w M, Number of employed individuals: L D, number of unemployed individuals: L S -L D a) Now suppose the secretary of labor proposes an increase in the minimum wage. What effect would this increase have on employment? Does the change in employment depend on elasticity of demand, the elasticity of supply, both elasticities, or neither? An increase in the minimum wage would decrease employment. The size of the effect on employment depends only on the elasticity of demand. The elasticity of supply does not matter, because there is a surplus of labor. b) What effect would this increase in the minimum wage have on unemployment? Does the change in unemployment depend on elasticity of demand, the elasticity of supply, both elasticities, or neither? The increase in the minimum wage would increase unemployment. The size of the rise in unemployment depends on both the elasticities of supply and demand. The elasticity of demand determines the change in the quantity of labor demanded, the elasticity of supply determines the change in the quantity of labor supplied, and the difference between the quantities supplied and demanded of labor is the amount of unemployment. c) If the demand for unskilled labor were inelastic, would the proposed increase in the minimum wage raise or lower total wage payments to unskilled labor? Would your answer change if the demand for unskilled labor were elastic? If the demand for unskilled labor were inelastic, the rise in the minimum wage would increase total wage payments to unskilled labor. With inelastic demand, the percentage decline in employment would be lower than the percentage increase in the wage, so total wage payments increase. However, if the demand for unskilled labor were elastic, total wage payments would decline, because then the percentage decline in employment would exceed the percentage increase in the wage. 2

3 4. Suppose that in a particular market, the supply curve is highly elastic and the demand curve is highly inelastic. If a tax is imposed in this market, then the a) buyers will bear a greater burden of the tax than the sellers. b) sellers will bear a greater burden of the tax than the buyers. c) buyers and sellers are likely to share the burden of the tax equally. d) buyers and sellers will not share the burden equally, but it is impossible to determine who will bear the greater burden of the tax without more information. a 5. A tax on a market with elastic demand and elastic supply will shrink the equilibrium quantity more than a tax on a market with inelastic demand and inelastic supply will shrink the equilibrium quantity. Is it true or false? True 7. Below we describe willingness to pay of 4 consumers and costs of 4 suppliers on the markets for haircuts: Consumer 1: 7\$ Supplier 1: 3\$ Consumer 2: 2\$ Supplier 2: 6\$ Consumer 3: 8\$ Supplier 3: 4\$ Consumer 4: 5\$ Supplier 4: 2\$ Each firm has capacity to produce only one haircut. For efficiency, how many haircuts should be given? Which suppliers should cut hair and which consumers should have their hair cut? How large is the total maximum surplus? Price of Haircuts Quantity of Haircuts 3

4 Supply equals demand at a quantity of three haircuts and a price between \$4 and \$5. Firms 1, 3, and 4 should cut the hair of 3, 1, and 4. 2 s willingness to pay is too low and firm 2 s costs are too high, so they do not participate. The maximum total surplus is the area between the demand and supply curves, which totals \$ Oil is used to produce gasoline. If the price of oil increases, consumer surplus in the gasoline market a) decreases. b) is unchanged. c) increases. d) may increase, decrease, or remain unchanged. a 9. If the government imposes a binding price ceiling in a market, then the producer surplus in that market will increase. True or false? False. Plus 1. Consider the following policies, each of which is aimed at reducing violent crime by lowering the use of guns. Illustrate each of these proposed polices in supply-and-demand diagram of the gun market. a) A tax on gun buyers 4

5 b) A tax on gun sellers c) A price floor on guns d) A tax on ammunition 5

6 The tax on ammunition reduces the demand for guns from D1 to D2, because ammunition and guns are complements. 2. The U.S. government administers two programs that affect the market for cigarettes. Media campaigns and labeling requirements are aimed at making the public aware of the dangers of cigarette smoking. At the same time, the Department of Agriculture maintains a price-support program for tobacco farmers, which raises the price of tobacco above the equilibrium price. a) How do these two programs affect cigarette consumption? Use a graph of the cigarette market for your answer. Programs aimed at making the public aware of the dangers of smoking reduce the demand for cigarettes. The price support program increases the price of tobacco, which is the main ingredient in cigarettes. As a result, the supply of cigarettes shifts to the left, from S1 to S2. 6

7 The effect of both programs is to reduce the quantity of cigarette consumption from Q1 to Q2. b) What is the combined effect of these two programs on the price of cigarettes? The combined effect of the two programs on the price of cigarettes is ambiguous. The education campaign reduces demand for cigarettes, which tends to reduce the price. The tobacco price supports raise the cost of production of cigarettes, which tends to increase the price. c) Cigarettes are also heavily taxed. What effect does the tax have on cigarette consumption? The taxation of cigarettes further reduces cigarette consumption, since it increases the price to consumers. As shown in the figure, the quantity falls to Q3. 3. Suppose a technological advance reduces the cost of making computers. a) Draw a supply-and-demand diagram to show what happens to price, quantity, consumer surplus, and producer surplus in the market for computers. As a result, the equilibrium price of computers declines and the equilibrium quantity increases. The decline in the price of computers increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. 7

8 b) Computers and adding machines are substitutes. Use a supply-and-demand diagram to show what happens to price, quantity, consumer surplus, and producer surplus in the market for adding machines. Should adding machine producers be happy or sad about the technological advance in computers? The decline in the price of computers means that people substitute computers for adding machines, shifting the demand for adding machines to the left.. Consumer surplus in the adding-machine market changes from area A + B to A + C, a net change of C B. Producer surplus changes from area C + D + E to area E, a net loss of C + D. Adding machine producers are sad about technological advance in computers because their producer surplus declines. c) Computers and software are complements. Use a supply-and-demand diagram to show what happens to price, quantity, consumer surplus, and producer surplus in the market for software. Should software producers be happy or sad about the technological advance in computers? 8

9 the decline in the price and increase in the quantity of computers means that the demand for software increases. Consumer surplus in the software market changes from B + C to A + B, a net change of A C. Producer surplus changes from E to C + D + E, an increase of C + D, so software producers should be happy about the technological progress in computers. d) does this analysis help explain why software producer Bill Gates is one of the world s richest man? Yes, this analysis helps explain why Bill Gates is one the world s richest men, since his company produces a lot of software that is a complement with computers and there has been tremendous technological advance in computers II. 1. If the government removes a binding price ceiling from a market, then the price paid by buyers will a. increase, and the quantity sold in the market will increase. b. increase, and the quantity sold in the market will decrease. c. decrease, and the quantity sold in the market will increase. d. decrease, and the quantity sold in the market will decrease. a 9

10 Figure 1 2. Refer to Figure 1. Which of the following statements is not correct? a. A government-imposed price of \$8 would be a binding price floor if market demand is Demand A and a binding price ceiling if market demand is Demand B. b. A government-imposed price of \$10 would be a binding price ceiling if market demand is either Demand A or Demand B. c. A government-imposed price of \$4 would be a binding price ceiling if market demand is either Demand A or Demand B. d. A government-imposed price of \$10 would be a binding price floor if market demand is Demand A and a non-binding price ceiling if market demand is Demand B. b 3. Suppose there is currently a tax of \$50 per ticket on airline tickets. Sellers of airline tickets are required to pay the tax to the government. If the tax is reduced from \$50 per ticket to \$30 per ticket, then the a. demand curve will shift upward by \$20, and the effective price received by sellers will increase by \$20. b. demand curve will shift upward by \$20, and the effective price received by sellers will increase by less than \$20. c. supply curve will shift downward by \$20, and the price paid by buyers will decrease by \$20. d. supply curve will shift downward by \$20, and the price paid by buyers will decrease by less than \$20. c 4. Suppose buyers of vodka are required to send \$5.00 to the government for every bottle of vodka they buy. Further, suppose this tax causes the effective price received by sellers of vodka to fall by \$3.00 per bottle. Which of the following statements is correct? a. This tax causes the demand curve for vodka to shift downward by \$5.00 at each quantity of vodka. b. The price paid by buyers is \$2.00 per bottle more than it was before the tax. 10

11 c. Sixty percent of the burden of the tax falls on sellers. d. All of the above are correct. d 5. Suppose the demand for macaroni is inelastic, the supply of macaroni is elastic, the demand for cigarettes is inelastic, and the supply of cigarettes is elastic. If a tax were levied on the sellers of both of these commodities, we would expect that the burden of a. both taxes would fall more heavily on the buyers than on the sellers. b. the macaroni tax would fall more heavily on the sellers than on the buyers, and the burden of the cigarette tax would fall more heavily on the buyers than on the sellers. c. the macaroni tax would fall more heavily on the buyers than on the sellers, and the burden of the cigarette tax would fall more heavily on the sellers than on the buyers. d. both taxes would fall more heavily on the sellers than on the buyers. a 6. Suppose your own demand curve for tomatoes slopes downward. Suppose also that, for the last tomato you bought this week, you paid a price exactly equal to your willingness to pay. Then a. you should buy more tomatoes before the end of the week. b. you already have bought too many tomatoes this week. c. your consumer surplus on the last tomato you bought is zero. d. your consumer surplus on all of the tomatoes you have bought this week is zero. c 7. Which of the following will cause an increase in consumer surplus? a. an increase in the production cost of the good b. a technological improvement in the production of the good c. a decrease in the number of sellers of the good d. the imposition of a binding price floor in the market b 8. Ronnie operates a lawn-care service. On each day, the cost of mowing the first lawn is \$15, the cost of mowing the second lawn is \$25, and the cost of mowing the third lawn is \$40. His producer surplus on the first three lawns of the day is \$100. If Ronnie charges all customers the same price for lawn mowing, that price is a. \$20. b. \$60. c. \$80. d. \$180. b 11

12 9. Kristi and Rebecca sell lemonade on the corner for \$0.50 per cup. It costs them \$0.10 to make each cup. On a certain day, their producer surplus is \$20. How many cups did Kristi and Rebecca sell? a. 40. b c. 8. d. 50. d Seller Cost Marcia \$200 Jan \$250 Cindy \$350 Greg \$400 Peter \$700 Bobby \$800 Table Refer to Table 1. You wish to purchase 10 piano lessons for yourself and for your brother, so you take bids from each of the sellers. You will take lessons at the same time, so one teacher cannot provide lessons to both of you. You must pay the same price for both sets of lessons, and you will not accept a bid below a seller s cost because you are concerned that the seller will not provide all 10 lessons. What bid will you accept? a. \$351 b. \$349 c. \$201 d. \$199 b 11. Which of the following will cause a decrease in producer surplus? a. the imposition of a binding price ceiling in the market b. an increase in the number of buyers of the good c. income increases and buyers consider the good to be normal d. the price of a complement decreases a 12. Suppose that the equilibrium price in the market for tomatoes is \$3 per pound. If a law reduced the maximum legal price for tomatoes to \$2 per pound, a. any possible increase in consumer surplus would be larger than the loss of producer surplus. b. any possible increase in consumer surplus would be smaller than the loss of producer surplus. c. the resulting increase in producer surplus would be larger than any possible loss of consumer surplus. d. the resulting increase in producer surplus would be smaller than any possible loss of consumer 12

13 surplus. b 13. Tomato sauce and spaghetti noodles are complementary goods. A decrease in the price of tomatoes will a. increase consumer surplus in the market for tomato sauce and decrease producer surplus in the market for spaghetti noodles. b. increase consumer surplus in the market for tomato sauce and increase producer surplus in the market for spaghetti noodles. c. decrease consumer surplus in the market for tomato sauce and increase producer surplus in the market for spaghetti noodles. d. decrease consumer surplus in the market for tomato sauce and decrease producer surplus in the market for spaghetti noodles. b Figure 2. III. 1. Refer to figure 2. What are equilibrium price, quantity, producer surplus, and consumer surplus? If the market price increases to \$130 due to an increase in demand what are new producer surplus and consumer surplus? What if the government imposes a price ceiling of \$50 in this market? Suppose a \$70 per-unit tax is imposed on the sellers of this good. What price will buyers and sellers pay for the good after the tax is imposed? Equilibrium quantity=10, equilibrium price=90. PS=(90\$-10\$)*1/2*10=400\$. 13

14 CS=(150\$-90\$)*1/2*10=300\$. Assuming that the demand increased by 35/3 quantity demanded for each price, one can arrive that PS1=(130\$-10\$)*1/2*15=900\$ and CS1=(220\$-130\$)*1/2*15=675\$. If price ceiling of \$50 is imposed, it will be binding and the quantity supplied will be 5 and quantity demanded will be 18. PS2=(50\$-10\$)*1/2*5=100\$. The value of consumer surplus is ambiguous, as there is a shortage of the good and it is unclear which consumers will obtain these 5 quantities. When 70\$ per-unit tax is imposed, new equilibrium quantity will be 5, Pb=120, and Ps=50. Price (\$) Quantity Demanded Quantity Supplied Table 2 2. Refer to Table 2. If the government set a price ceiling at \$2, would there be a shortage or surplus, and how large would be the shortage/surplus? In this market, over what range of prices would a price floor set by the government be binding? Equilibrium price is 3. Therefore, there will be a shortage=15-8=7 units. Price floor will bind for any price >3. 14

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