# 1. Suppose that policymakers have been convinced that the market price of cheese is too low.

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1 ECNS 251 Homework 3 Supply & Demand II ANSWERS 1. Suppose that policymakers have been convinced that the 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 imposition of a binding price floor in the cheese market is shown in the figure below. In the absence of the price floor, the price would be P1 and the quantity would be Q1. With the floor set at Pf, which is greater than P1, the quantity demanded is Q2, while quantity supplied is Q3, so there is a surplus of cheese in the amount Q3 Q2.

2 b. Suppose the government agrees to purchase all the surplus cheese at the price floor, who benefits from this new policy? Who loses? If the government purchases all the surplus cheese at the price floor, 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.

3 2. A recent study found that the demand and supply schedules for Frisbees are as follows: Price (\$ per Frisbee) Quantity Demanded (millions per period) Quantity Supplied (millions per period) a. What are the equilibrium price and quantity of Frisbees? What are producer and consumer surplus at equilibrium? The equilibrium price of Frisbees is \$8 and the equilibrium quantity is six million Frisbees. CS =.5*6,000,000*\$(11-8) = \$9 million per period PS =.5*6,000,000*\$(8-6) = \$6 million per period b. Frisbee manufacturers persuade the government that Frisbee production improves scientists understanding of aerodynamics and thus important for national security. A concerned Congress votes to impose a price floor \$2 above the equilibrium price. What is the new market price? How many Frisbees are sold? What is the deadweight loss from this policy? Who wins and who loses from the policy?

4 With a price floor of \$10, the new market price is \$10 because the price floor is binding. At that price, only two million Frisbees are sold, because that is the quantity demanded. CS =.5*2,000,000*\$(11-10) = \$1 million per period PS =.5*2,000,000*\$(6.67-6)+(2,000,000*( )) = \$ \$6,660,000 = \$7,327,000 per period The deadweight loss is the loss in CS+TS = 15,000,000-8,327,000 = \$6,673,000 Consumers are worse off because of this policy by \$8 million per period Producers are better off by \$1.327 million per period. c. Irate college students march on Washington and demand a reduction in the price of Frisbees. An even more concerned Congress votes to repeal the price floor and impose a price ceiling \$1 below the former price floor. What is the new market price? How many Frisbees are sold? What is the deadweight loss from this policy? Who wins and who loses from the policy? If there s a price ceiling of \$9, it has no effect, because the market equilibrium price is \$8, which is below the ceiling. So the market price is \$8 and the quantity sold is six million Frisbees. 3. A friend of yours is considering two cell phone service providers. Provider A charges \$120 per month for the service regardless of the number of phone calls made. Provider B does not have a fixed service fee but instead charges \$1 per minute for calls. Your friend s monthly demand for minutes of calling per month is given by the equation Q D =150-50P, where P is the price of a minute. a. With each provider, what is the cost to your friend of an extra minute on the phone? With Provider A, the cost of an extra minute is \$0. With Provider B, the cost of an extra minute is \$1 b. In light of your answer to (a), how many minutes would your friend talk on the phone with each provider? With Provider A, my friend will purchase 150 minutes [= 150 (50)(0)]. With Provider B, my friend would purchase 100 minutes [= 150 (50)(1)]. c. How much would he end up paying each provider every month?

5 With Provider A, he would pay \$120. The cost would be \$100 with Provider B d. How much consumer surplus would he obtain with each provider? (Hint: Graph the demand curve and recall the formula for the area of a triangle) The figure above shows the friend s demand. With Provider A, he buys 150 minutes and his consumer surplus is equal to (1/2)(3)(150) 120 = 105. With Provider B, his consumer surplus is equal to (1/2)(2)(100) = 100. e. Which provider would you recommend that your friend choose? Why? I would recommend Provider A because he receives greater consumer surplus 4. A subsidy is the opposite of a tax. With a \$0.50 tax on the buyers of ice-cream cones, the government collects \$0.50 for each cone purchased; with a \$0.50 subsidy for the buyers of ice-cream cones, the government pays buyers \$0.50 for each cone purchased. a. Show the effect of a \$0.50 per cone subsidy on the demand curve for ice-cream cones, the effective price paid by consumers, the effective price received by sellers, and the quantity of cones sold.

6 The effect of a \$0.50 per cone subsidy is to shift the demand curve up by \$0.50 at each quantity, because at each quantity a consumer's willingness to pay is \$0.50 higher. The effects of such a subsidy are shown in Figure 12. Before the subsidy, the price is P1. After the subsidy, the price received by sellers is PS and the effective price paid by consumers is PD, which equals PS minus \$0.50. Before the subsidy, the quantity of cones sold is Q1; after the subsidy the quantity increases to Q2. b. Do consumers gain or lose from this policy? Do producers gain or lose? Does the government gain or lose? Because of the subsidy, consumers are better off, because they consume more at a lower price. Producers are also better off, because they sell more at a higher price. The government loses, because it has to pay for the subsidy.

7 5. Suppose that the government subsidizes a good: For each unit of the good sold, the government pays \$2 to the buyer. How does the subsidy affect consumer surplus, producer surplus, tax revenue, and total surplus? Does a subsidy lead to a deadweight loss? Explain. The figure and table below illustrate the effects of the \$2 subsidy on a good. Without the subsidy, the equilibrium price is P0 and the equilibrium quantity is Q0. With the subsidy, buyers pay price PC producers receive price PP, and the quantity sold is Q1. Prices PC - PP =\$2. The following table illustrates the effect of the subsidy on consumer surplus, producer surplus, government revenue, and total surplus. Because total surplus declines by area D + H, the subsidy leads to a deadweight loss in that amount. OLD NEW CHANGE Consumer Surplus A + B A + B+ C + F + G +(C+ F + G) Producer Surplus C + D B + C + D + E +(B + E) Government Revenue 0 (B + C + E + F + G + H) (B + C + E + F + G + H) Total Surplus A + B + C + D A + B + C + D - H H

8 6. Consider how health insurance affects the quantity of healthcare services performed. Suppose that the typical medical procedure has a cost of \$100, yet a person with health insurance pays only \$20 out of pocket. Her insurance company pays the remaining \$80. (The insurance company recoups the \$80 through premiums, but the premium a person pays does not depend on how many procedures that person chooses to undertake.) a. Draw the demand curve in the market for medical care. (In your diagram, the horizontal axis should represent the number of medical procedures.) Show the quantity of procedures demanded if each procedure has the price of \$100. The figure below illustrates the demand for medical care. If each procedure has a price of \$100, quantity demanded will be Q1 procedures.

9 b. On your diagram, show the quantity of procedures demanded if the consumers pay only \$20 per procedure. If the cost of each procedure to society is truly \$100, and if individuals have health insurance as described, will the number of procedures performed maximize total surplus? Explain. If consumers pay only \$20 per procedure, the quantity demanded will be Q2 procedures. Because the cost to society is \$100, the number of procedures performed is too large to maximize total surplus. The quantity that maximizes total surplus is Q1 procedures, which is less than Q2 c. Economists often blame the health insurance system for excessive use of medical care. Given your analysis, why might the use of care be viewed as excessive? The use of medical care is excessive in the sense that consumers get procedures whose value is less than the cost of producing them. As a result, the economy s total surplus is reduced d. What sort of policies might prevent this excessive use? To prevent this excessive use, the consumer must bear the marginal cost of the procedure. But this would require eliminating insurance. Another possibility would be that the insurance company, which pays most of the marginal cost of the procedure (\$80, in this case) could decide

10 whether the procedure should be performed. But the insurance company does not get the benefits of the procedure, so its decisions may not reflect the value to the consumer 7. The equations below give the demand and supply of designer blue jeans per week. Demand: Supply: P = 240 4Q P = Q a. Graph these equations. Indicate their intercepts. D S Price Per Pair Pairs per period b. What is the equilibrium price and quantity? 240-4Q = Q 10Q = 200 Q* = 20 P* = (20) = \$160

11 c. Suppose the government imposes a tax of \$20 per pair of jeans on the buyers this market. What is the new equilibrium quantity? How much do demanders now pay for each pair of jeans? How much do suppliers receive for each pair sold? How much tax revenue does the government earn? See the graph below. The demand curve associated with this tax is: D': P = 240 4Q (- 20) = 220-4Q Supply: P = Q The new equilibrium price along the supply curve is: 220-4Q = Q 10Q = 180 Q = 18 P s = (18) = 148 The equilibrium price along the demand curve is \$20 higher than on the supply curve or 168 We can also compute this along the original demand curve, since when Q = 18, P on the original demand curve is: P = 240-4Q = 240-4(18) = 168 D S D' Price Per Pair Pairs per period The government earns Q = 18 * Tax = \$20 or \$360 in tax revenue per period.

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14 d. The deadweight loss of a tax is the area of the triangle between the supply and demand curves. Recalling that the area of a triangle is ½ BH, solve for deadweight loss as a function of T. Graph this relationship for T between 0 and 300. (Hint: Looking sideways, the base of the deadweight loss triangle is T, and the height is the difference between the quantity sold with the tax and the quantity sold without the tax.) As the figure above shows, the area of the triangle (laid on its side) that represents the deadweight loss is 1/2 base height, where the base is the change in the price, which is the size of the tax (T) and the height is the amount of the decline in quantity (2T/3). So the deadweight loss equals 1/2 T 2T/3 = T 2 /3. This rises exponentially from 0 (when T = 0) to 30,000 when T = 300, as shown in the figure below.

15 e. The government now levies a tax on this good of \$200 per unit. Is this a good policy? Why or why not? Can you propose a better policy? A tax of \$200 per unit is a bad idea, because it is in a region in which tax revenue is declining. The government could reduce the tax to \$150 per unit, get more tax revenue (\$15,000 when the tax is \$150 versus \$13,333 when the tax is \$200), and reduce the deadweight loss (7,500 when the tax is \$150 compared to 13,333 when the tax is \$200). 9. Read, "Nurse practitioner patients less costly to Medicare than physician patients," (MSU News Service 1/16/2016) and answer the following: a. What are some of the factors that have increased demand for primary healthcare services? How have those factors impacted the cost of healthcare? b. Why might, "the cost of care for patients with a nurse practitioner primary provider [range] between 11 to 29 percent less than physician patients"? c. Healthcare scope of practice laws are state-level policies that define the types of services they can provide and other parameters of healthcare providers' professional activities. What are the tradeoffs associated with scope of practice laws? Illustrate one of these in a supply and demand framework. Answers will vary

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