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1. The market for coffee beans is described by the following equations:
Qs = 2P – 8
Qd = 16 – P
a) Suppose the government sets a price ceiling at $10. Is there a shortage? Is there a
surplus?

No shortage, no surplus - The price ceiling (a maximum price) is set above the market
price, so it does not change the market equilibrium, which is P = $8 and Q = 8.
Supply: P = 20 + Qs Unit of price: $/Pack
a) Plot the demand and supply curves in both markets. Denote the area of consumer
surpluses and producer surpluses.
b) The government lowers the price ceiling to $5. Describe the changes in shortage/surplus.
Shortage of 9 - With a price ceiling of $5, producers supply only 2 units of coffee
beans. Consumers demand 11 units.
c) Now suppose a price floor/ceiling has been instituted, which causes a surplus of 9 units.
Is this a floor or a ceiling? What specific price would create this surplus?

Price floor, P = $11 - We must find the price at which the horizontal distance between
quantity supplied and quantity demanded is 9. Supply must be greater than demand for
this to be a surplus
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 Qs – Qd = 9 = (2P - 8) - (16 - P)
3P – 24 = 9
3P = 33
P = 11
2. Consider a pumpkin market where the supply depends on the weather for the year.
In bad-weather years, supply is P = 6Qs + 2
In good-weather years, supply is P = 6Qs – 58
The demand for pumpkins is Qd = 25 – ½P

Suppose that the government institutes a price support program to stabilize pumpkin
prices at $32. The government promises farmers to buy or sell all that consumers desire
or producers want to sell, at the price of $32. Assume the government has enough
storage capacity to buy all that farmers grow and enough in storage to supply all that
consumers demand. Assume storage costs $1 per pumpkin.

a) How many pumpkins do consumers consume in good-weather years?

Q = 9 - Quantity demanded at the intersection of P = 32 and Q = 25 – ½P is
characterized by Q = 25 – (½)32 = 25 – 16 = 9. After 9 units, suppliers sell to the
government instead of the consumers.

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b) How many pumpkins do consumers consume in bad-weather years?
Q = 9 - same as part (a)
c) How much does the government spend in good-weather years?

$198 - Good-weather year, consumers will buy up to Q = 9, after which there is no more
consumer surplus to be had from the purchase of additional pumpkins. However, with the
price support, producers will be willing to sell up to 15 pumpkins. Government must buy
what is left, amounting to
(15-9) × 32 = 6 × 32 = $192. Storage costs will be $1 per pumpkin, at a total of 6
pumpkins, so storage cost is $6. Total government expenditure is therefore $198.

d) How much does the government earn in bad-weather years?

$128 - Bad-weather year, suppliers will only supply the first 5 units if the price is $32.
After which, additional consumer demand will be met by the government’s supply in
storage. Government therefore earns (9-5) × 32 = $128.

Now suppose that instead of a price support program, the government begins subsidizing
pumpkins.

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e) In bad-weather years, the government spends a total of $128 on the subsidy to
pumpkin growers. What is the per-unit subsidy? What was the target price?
The per-unit subsidy is $16 and the target price must have been $50.
- With no subsidy and no price support, the equilibrium quantity is 6 units. To increase
this by one unit, the government must set a per-unit subsidy of the sum of the absolute
value of the slope for the demand and supply curves (think about why this is true). The
slopes are 6 and -2, so every $8 in subsidy shifts quantity up one unit. Letting s be the
subsidy we are left to solve:

(6 + s/8) × s = 6s + s2 /8 = 128
s2 + 48s - 1024 = 0
(s - 16)(s + 64) = 0
So s is either $16 or -$64. The negative subsidy value has no economic meaning, so
we conclude the subsidy must be $16 (and can verify this to make sense graphically).
Given a quantity supplied with the subsidy to be 8 units, we can determine the target
price by solving for price necessary to induce a supply of 8 units. In bad weather
years, P = 6Q + 2 = 6(8) + 2 = 48 + 2 = 50, so the target price is $50.
3. Suppose Latvia is a small, open economy that has a competitive steel market. The
market supply curve is:

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 Domestic supply: Qs = P/2
and the market demand in Latvia is:
Domestic demand: Qd = 120-P
On the world market, steel sells for $30 a unit. Please note that graphs will be helpful in
answering the following questions.
a) How much steel does Latvia import?
75 units of steel - First, compute the amount Latvia will demand. This is calculated
by solving for Qd given a price of $30.
Qd = 120 - 30 = 90
We can figure out how much is supplied domestically by setting Qs = (30)/2.
Domestic producers supply 15 of the 90 units of steel. This implies that Latvia is
importing 75 units of steel.

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 Above graph shows: World price, Domestic supply, Domestic demand
b) How much revenue will be raised by a tariff of $10 per unit of steel?
$600 - Compute new amount of steel imported and multiply by $10 (tariff amount)
to calculate the government revenue.
Domestic supply given new world price of $40: Qs = (40)/2 = 20
Domestic demand given new world price of $40: Qd = 120 – (40) = 80
Therefore, given the tariff, imports are 60 units of steel. Government revenue will be
$600.

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 c) What is the deadweight loss associated with the tariff?
DWL = $75 - Deadweight loss is found by calculating the lost gains from trade given
the tariff and the wasteful expenditure by domestic suppliers relative to the world
price. Graphically, this is shown by the red triangles below.

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The left triangle represents the wasteful costs associated with the additional 5 units
supplied domestically given the tariff. For these 5 units, domestic manufacturers are
producing at above the world price. The area of this triangle gives the portion of DWL
coming from this effect of the tariff, $25.

The right triangle represents the lost gains from trade. Without the tariff, 90 units steel
were sold, adding to the surplus. Raising the world price to $40 eliminates the gains to
trade
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from those last 10 units. The area of this triangle quantifies this loss at $50. DWL is the
sum of these two triangle areas, $75.
d) Suppose that instead of a tariff, Latvia creates a quota limiting the number of
imports to only 15 units. How much steel will be consumed in Latvia? Try to draw the
supply curve that consumers in Latvia will face.

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50 units of steel - Supply will follow the purple trajectory in the above graph. At quantity
below 15 units, the market supply will come completely from domestic producers. After
this point, the world price is below the supply curve for domestic steel producers in
Latvia. However, imports are limited to 15, so the world price is only effect for the 15
units between total quantity of 15 and 30. After this point, all remaining demand must be
met by domestic producers. We must shift the supply curve to the right by the size of the
quota (15 units). The original supply was P = 2Q, and the supply with a quota will be P =
2(Q – 15). We then solve for the intersection of this new supply curve and the unchanged
demand curve.
P = 2(Q – 15) = 2Q – 30 = 120 – Q
3Q = 150
Q = 50 units of steel.
4. This question walks you through the problem as a consultant for the taxation authority
in Neverneverland. You study the following information for the demand and supply
functions for two goods – Beer and Cigarettes:
Beer Demand: P = 125 – 2Qd Unit of quantity: Thousands of Cans
Supply: P = 5 + 2Qs Unit of price: $/Can
Cigarette Demand: P = 200 – 4Qd Unit of quantity: Thousands of Packs

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a) Plot the demand and supply curves in both markets. Denote the area of consumer
surpluses and producer surpluses.

b) Look graphically at the demand curves for both markets. Which market has the
lower price elasticity of demand, i.e., in which market are the consumers less
sensitive to price change?

Looking at the slope of the demand curve, clearly the demand curve for cigarette
market is steeper. Since a dollar increase in price of cigarettes results in the decrease
in quantity demanded of 0.25 thousand of packs,
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while a dollar increase in price of beer results in the decrease in quantity demanded of
0.5 thousand of cans. Hence, consumers are less sensitive to price change in the
cigarette market.
c) Find the equilibrium price and quantity in both markets.

Beer Equate the demand and supply, so 125 – 2Q = 5 + 2Q, so: Q = 30, P = 65
Cigarette Equate the demand and supply, so 200 – 4Q = 20 + Q, so: Q = 36, P = 56
d) Find the value of consumer surpluses and producer surpluses in both markets.
Use the answers from part a) and c) to find the area of consumer and producer surpluses
triangles. Consumer surplus is the area under the demand curve above the equilibrium price.
Producer surplus is the area above the supply curve below the equilibrium price.

Beer Consumer surplus: ½ × (125 – 65) × 30 = 900 thousands of dollars

Producer surplus: ½ × (65 – 5) × 30 = 900 thousands of dollars

Cigarette Consumer surplus: ½ × (200 – 56) × 36 = 2592 thousands of dollars

Producer surplus: ½ × (56 – 20) × 36 = 648 thousands of dollars

Suppose you can choose only ONE of the two goods to apply an excise tax on the producer
side of the particular market.

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Option 1 Apply the excise tax of $10/Can to beer
Option 2 Apply the excise tax of $10/Pack to cigarette
In analyzing the taxation on each good and choosing the appropriate option in each case,
you as a consultant must know the equilibrium traded price and quantity after taxation,
the price that producers receive at the new equilibrium, tax revenue, consumer's tax
incidence, producer's tax incidence and deadweight loss for both options.

e) Give the equations for the supply curves in both markets after the excise tax has been
imposed.

With the excise tax on producers, the supply curves must shift UP by the dollar amount
of tax imposed. Hence, the supply curves after tax in each market are given by:

Beer P = (5 + 10) + 2Qs = 15 + 2Qs

Cigarette P = (20 + 10) + Qs = 30 + Qs

f) Compute the consumer tax incidence (CTI), the producer tax incidence (PTI), the tax
revenue, and the deadweight loss (DWL) for each of option. Draw the appropriate
demand and supply curves in both markets after the tax has been imposed, clearly denote
the various areas (CTI, PTI, tax revenue, and DWL).

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i. Demand and supply curves after tax imposed
It is better to draw the graphs before you proceed with the questions. In the graphs,
consumer’s burden is the consumer tax incidence, producer’s burden is the producer tax
incidence, and the sum of consumer’s burden and producer’s burden is equal to tax
revenue.

ii. New equilibrium traded price and quantity

Equate the demand curve and the new supply curve after taxes, so:
Beer 125 – 2Q = 15 + 2Q, so: Q = 27.5, P = 125 – 2(27.5) = 70
Cigarette 200 – 4Q = 30 + Q, so: Q = 34, P = 200 – 4(34) = 64
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iii. Price that producers receive at new equilibrium

Producers will receive the equilibrium traded price minus taxes, so:

Beer Producers receive 70 – 10 = 60 dollars per can

Cigarette Producers receive 64 – 10 = 54 dollars per pack

iv. Tax revenue

Government receives the tax revenue equals to the amount traded multiplied by taxes:

Beer Government revenue 27.5 × 10 = 275 thousands of dollars

Cigarette Government revenue 34 × 10 = 340 thousands of dollars

v. Consumer’s burden

Consumer’s tax incidence can be found from the rectangular area between the traded price
and the original equilibrium price, below the new equilibrium quantity, so:

Beer Consumer’s tax incidence (70 – 65) × 27.5 = 137.5 thousands of dollars
Cigarette Consumer’s tax incidence (64 – 56) × 34 = 272 thousands of dollars
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vi. Producer’s burden
Producer’s tax incidence can be found from the rectangular area between the original
equilibrium and the price producers are receiving after tax paid, below the new
equilibrium quantity, so:

Beer Producer’s tax incidence (65 – 60) × 27.5 = 137.5 thousands of dollars
Cigarette Producer’s tax incidence (56 – 54) × 34 = 68 thousands of dollars

Note: The sum of consumer’s and producer’s burden must equal tax revenue

vii. Deadweight loss

Deadweight loss can be found from the triangle area between the sandwich of original
demand and supply curves and the difference between quantity traded, so:
Beer Deadweight loss ½ × (70 – 60) × (30 – 27.5) = 12.5 thousands of dollars
Cigarette Deadweight loss ½ × (64 – 54) × (36 – 34) =10 thousands of dollars

g) Motivated from the results in part f), is it true that producers can push the entire
burden, namely, tax incidence, onto consumers?
No. Clearly both producers and consumers must share the economic burden of these
excise taxes.

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h) Which option should the taxation authority choose if she wishes to maximize her tax
revenue? ? Option 2

i) Which option should the taxation authority choose if she wishes to minimize the
consumer's burden? Option 1

j) Which option should the taxation authority choose if she wishes to minimize the
producer's burden? Option 2

k) Which option should the taxation authority choose if she wishes to minimize the
deadweight loss? Option 2

l) Would the results you have analyzed in part e) - k) hold if the excise tax is imposed on
the consumer’s side? (You are not required to re-compute all questions above; a simple
set of graphs that can convince yourself is sufficed.)

Yes, all exactly hold. Instead of shifting supply curve upward, one may try to shift the
demand curve downward by the amount of excise tax. The equilibrium traded price is
projected upward back to the original demand curve. The rest of the analyses and results
are identical.

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