Economic Principles, 2020 - 2021

Week 6, Tutorial Sheet 5 ANSWERS

This tutorial sheet is based around chapter 7, 8, and 9 of Mankiw and Taylor “Economics.”
Students are required to have read these chapters before the tutorial. Your tutor may not have
time to go over all questions in tutorial; however, students are responsible for revising the
answer sheets on their own time.

Chapter 7 of the textbook relates to market efficiency, chapters 8 and 9 relate to

government intervention and taxation.

1. Lovers of classical music persuade the government to impose a price ceiling

of £40 per ticket at classical music concerts. Does this policy get more or fewer
people to attend? Is it possible this will not have any effect?

Answer: If the price ceiling of £40 per ticket is below the equilibrium price, then
quantity demanded exceeds quantity supplied, so there will be a shortage of tickets.
The policy decreases the number of people who attend classical music concerts, since
the quantity supplied is lower due to the lower price. If the price ceiling of £40 per
ticket is above the equilibrium price then it’s not binding and has no effect.

2. On a supply and demand diagram, label the equilibrium quantity as Q*.

Discuss why a market outcome in which Q < Q* is sold will lead to
deadweight loss when the market is functioning properly. Will deadweight
loss occur if Q > Q* is sold?

Answer: Recall that the supply curve reflects the sellers’ cost of production and the
demand curve reflects the buyers’ valuation. If products are not being sold even
when the sellers’ cost of production is less than the buyers’ valuation, there will be
deadweight loss. This is because there are mutually beneficial gains from trade that
are not being exploited. Both buyers and sellers can be made better off when more is
sold. See the diagram below:
When Q is greater that Q*, the cost to sellers of producing the product is greater
than the value to buyers of purchasing the product. This will also result in
deadweight loss because items are being produced where the cost to society is
greater than the benefit. Surplus could be increased by reducing production. See the
diagram below:

3. Demand for Twilight novels in Britain is given as is Qd = 80 – P. Demand for

Twilight novels in the United States is Qd =120 - 2P. P represents the price of
Twilight novels in dollars and Qd represents quantity demanded. At a price
of $20, which country enjoys a larger consumer surplus?

Answer: Consumer surplus is defined as the area below the demand curve above the
price. With linear demand curves, we can find consumer surplus simply by
calculating the area of the triangle between the demand curve and the price.

Consider Britain first. At a price of 20, quantity demanded will be 60 (this is the
width of the triangle). To find the height of the triangle, we must find where the
demand curve intersects the vertical axis. This occurs at a price of 80. The height of
the triangle is 80 – 20 = 60. The area of the triangle is then (½)(60)(60) = 1800.
Consumer surplus in Britain is $1800.

Now let’s consider the US. At a price of 20, quantity demanded will be 80. The US
demand curve intersects the vertical axis at a price of 60. The height of the triangle
is 60-20 = 40. The area of the triangle is then ½ (40)(80) = 1600. Consumer surplus in
the US is $1600. Britain enjoys a higher consumer surplus from Twilight novels.

4. Consider the market for rubber bands.

a. If this market has very elastic supply and very inelastic demand, how
would the burden of a tax on rubber bands be shared between consumers
and producers? Use the tools of consumer and producer surplus in your
answer.

Answer: With very price elastic supply and very price inelastic demand, the burden
of the tax on rubber bands will be borne largely by buyers. As the figure below
shows, consumer surplus declines considerably, by area A+B, but producer surplus
doesn't fall much at all, just by area C+D.

b. If this market has very inelastic supply and very elastic demand, how
would the burden of a tax on rubber bands be shared between consumers
and producers?

Answer: With very price inelastic supply and very price elastic demand, the burden
of the tax on rubber bands will be borne largely by sellers. As Figure 5 shows,
consumer surplus does not decline much, just by area A+B, while producer surplus
falls substantially, by area C+D. Compared to part (a), producers bear much more of
the burden of the tax, and consumers bear much less.
 5. Suppose that the government imposes a tax on heating oil.

a. Would the deadweight loss from this tax likely be greater in the first year
after it is imposed or in the fifth year? Explain

Answer: The deadweight loss from a tax on heating oil is likely to be greater in the
fifth year after it is imposed rather than the first year. In the first year, the price
elasticity of demand is fairly low, as people who own oil fuelled heating systems
are not likely to get rid of them right away. But over time they may switch to other
energy sources and people buying new heating systems for their homes will be more
likely to choose gas or electric, so the tax will have a greater impact on quantity.

b. Would the revenue collected from this tax likely be greater in the first year
after it is imposed or in the fifth year.

Answer: The tax revenue is likely to be higher in the first year after it is imposed
than in the fifth year. In the first year, demand is more price inelastic, so the
quantity does not decline as much and tax revenue is relatively high. As time passes
and more people substitute away from oil, the equilibrium quantity declines, as
does tax revenue.
 6. Using what you have learned about the relationship between taxation and
total surplus, discuss why there might be a trade-off between efficiency and
equity?

Answer: In order for the government to increase equity, it needs to redistribute

income through taxation. The larger are the taxes, the more the government can
redistribute and the more equitable is the outcome. At the same time, however, we
have learned that larger taxes generate larger deadweight loss and lower total
surplus.

7. The elected officials in a west coast university town are concerned about the
ʺexploitativeʺ rents being charged to college students. The town council is
contemplating the imposition of a $350 per month rent ceiling on apartments
in the city. An economist at the university estimates the demand and supply
curves as:

QD = 5600 - 8P
QS = - 500 + 4P,

where P = monthly rent, and Q = number of apartments available for rent. For
purposes of this analysis, apartments can be treated as identical.

a. Calculate the equilibrium price and quantity that would prevail without
the price ceiling. Calculate producer and consumer surplus at this
equilibrium (sketch a diagram showing both).

b. What quantity will eventually be available if the rent ceiling is imposed?

Calculate any gains or losses in consumer and/or producer surplus.

c. Does the proposed rent ceiling result in net welfare gains? Would you
advise the town council to implement the policy?

Answer:

a. To calculate equilibrium set QD = QS and solve for P.

5600 - 8P = - 500 + 4P
6100 = 12P
P = 508.33

Substitute P into QD to solve for Q

QD = 5600 - 8(508.33)
Q = 1533.36
 To sketch it on graph, use an inverse of demand and supply functions

QD = 5600 - 8P
P = 700 - 0.125QD
QS = - 500 + 4P
P = 125 + 0.25Q

Consumer surplus is:

C.S. = area A
C.S. = 0.5(700 – 508.33) × 1533.36
C.S. = 146,949.56
Producer surplus is:

P.S. = area B
P.S. = 0.5(508.33 - 125) × 1533.36
P.S. = 293,891.44

Sum of producer and consumer surplus is 146,949.56 + 293,891.44 = 440,841

b. Eventually the market will settle at the quantity supplied corresponding to

$350 rent.

QS = - 500 + 4(350)
QS = 900
QD at P = 350
QD = 5600 - 8(350) = 2800
There will be a shortage of 1900 apartments.

Gain in consumer surplus is area B.

Area B = (508.33 - 350) × 900 = 142,497

Area C is a loss in consumer surplus.

To find area C, first find a price that corresponds to an output of 900.

P = 700 - 0.125(900) = 587.5

Difference in the output is 1533.36 - 900 = 633.36

Area C = 0.5(587.5 – 508.33) × (1533.36 - 900)

Area C = 25,071.6

Loss in consumer surplus is 25,071.6.

Area D is loss in producer surplus not offset by gain in consumer surplus.

Area D = 0.5(508.33 - 350) × (1533.36 - 900)

Area D = 50,139.9
c. Area B is a gain in consumer surplus, but it is offset by a loss in producer
surplus. The net changes are thus C (lost C.S.) and D (lost P.S.). The policy
thus results in a deadweight loss. The deadweight loss = lost C.S. + lost P.S.
or 25,071.6 + 50,139.9 = 75,211.5.
 8. The total and marginal cost functions for a typical soft coal producer are:

TC = 75,000 + 0.1Q2 and MC = 0.2Q

where Q is measured in railroad cars per year. The industry consists of 55

identical producers. The market demand curve is:

QD = 140,000 - 425P,

where P is the price per carload. The market can be regarded as competitive.

a. Calculate the short run equilibrium price and quantity in the market.
Calculate the quantity that each firm would produce. Calculate producer
surplus, consumer surplus, and total surplus at the equilibrium values.
Calculate the firmʹs profit (or loss).

b. The Federal government is considering the imposition of a $15 per carload tax
on soft coal. Calculate the short-run equilibrium price and quantity that
would exist under the tax. What portion of the tax would be paid by
producers and what portion by consumers? Calculate the producer and
consumer surplus under the tax and analyse the efficiency consequences of
the tax. Calculate the firmʹs profit (or loss) under the tax. Could the tax be
justified despite its efficiency implications?

Answer:

Part a.

To find market supply curve begin your analysis by finding firmʹs supply curve.
Firmʹs supply curve is MC curve (in this case all of MC lies above AVC):
Solve for Q in terms of MC = P:

MC = 0.2Q
Q = 5P

Market short-run supply is the horizontal sum of firm supply. There are 55 firms in
the market, so market supply is 55 times the individual firmʹs supply.

QS = 275P

Equate QD and QS to determine P and Q.

275P = 140,000 - 425P

700P = 140,000
P = $200
Q = 275(200)
Q = 55,000
Individual firm equates P to MC

200 = 0.2Q
Q = 1,000

Firm’s profit is:

π = TR - TC
TR = (200)(1000)
TR = 200,000
TC = 75,000 + 0.1(1000)2
TC = 175,000
π = 25,000

To sketch producer and consumer surplus on the graph, use an inverse of demand
and supply functions

QS = 275P
P = 0.0036Q
QD = 140,000 - 425P
P = 329.41 - 0.0024Q

Producer surplus = 0.5(55,000)(200) = 5,500,000

Consumer surplus = 0.5(55,000)(329.41 - 200) = 3,558,775
Total of producer and consumer surplus is 3,558,775 + 5,550,000 = 9,058,775
Part b.

Pb = buyerʹs price
Ps = sellerʹs price (net of tax)
Pb - Ps = 15 = tax

QD = 140,000 - 425 Pb is market demand

QS = 275 Ps is market supply

Set supply equal to demand:

140,000 - 425 Pb = 275 Ps

Pb = Ps + 15
140,000 - 425 (Ps + 15) = 275 Ps
140,000 - 425 Ps - 6,375 = 275 Ps
Ps = 190.89
Pb = Ps + 15 = 205.89

Consumers pay:

Pb - Po = 205.89 - 200 = 5.89

Producers pay:

Po - Ps = 200 - 190.89 = 9.11

Plug Ps into the supply equation to get quantity:

Q = Qs = 275 Ps = 275(190.89) = 52,495

(If you plug into the demand equation instead your answer will differ slightly due to
rounding.)

Individual firm equates P to MC

205.89 = 0.2Q + 15
Q = 954.5

The profit of the individual firm is

π = TR - TC
TR = 205.89(954.50)
TR = 196,522
TC = 75,000 + 0.1Q2 + 15Q
TC = 180,424.53
π = 16,097.48
Profit fell from 25,000 to 16,097.48.

Producer and Consumer Surplus:

Producer surplus = 0.5(52,497)(190.89) = 5,010,576.17

Consumer surplus = 0.5(52,497)(329.41 - 205.89) = 3,242,214.72

Total of Producer and Consumer Surplus = 5,010,576.17 + 3,242,214.72 = 8,252,790.89

Total surplus fell from 9,058,775 to 8,252,790.89

There is a welfare loss as indicated by the loss in total surplus. The tax could be
justified by known externalities of soft coal.