Chapter 7.Tutorial

7/30/2019 Chapter 7.Tutorial

1/61

Chapter 7

Efficiency and Exchange

Even-numbered Qs.


2/61

Efficient (or Pareto efficient):A situation is efficient if no change is possible that will helpsome people without harming others. Efficient (or Paretoefficient) - any change to make any person better off is impossiblewithout making someone else worse off.

Is market equilibrium an efficient situation? Yes, the market equilibrium price leads to the largest possible

surplus for both sellers and buyers.

The market equilibrium price is the only price at which sellersand buyers cannot design a surplus-enhancing transaction.


3/61

Market equilibrium is said to be efficient:- If market is at disequilibrium, a transaction that will make at

least some people better off without harming others canalways be found. All mutually beneficial transactions havetaken place.-i.e. if the market price is below the equilibrium price Excess demand.-A transaction can always take place to obtain more economic surplus andnone of the buyers or sellers is harmed by this transaction, i.e. increase theprice such that the market is back to the equilibrium price and quantitylevel.

Market equilibrium is said to be efficient:- If demand curves capture all relevant benefits and supplycurves capture all relevant costs.


4/61

Regardless the government imposes the tax on thesellers or the buyers, the tax burden and deadweightwill be the same.

The tax burden and deadweight loss depends on therelative elasticity of supply and demand curve

Tax and Deadweight loss


5/61

P

P E

QE Q

D

S

Tax on producers can be viewed as a "costof doing business" for the producers

The supply curve shifts to the left, S+T

After tax is imposed, the new equilibrium isat P 1 , Q 1

The new market equilibrium price is higher ,P 1, and the buyers are paying a higher priceto purchase this good

However, the producers are not receivingthis higher price,P1. Part of this higher pricegoes to government as the tax andproducers are receiving a lower price, P 2

Government tax revenue is the rectanglearea between P 1 and P 2

S+T

P 1

Q1

T

So, who is really paying the tax? Buyers? Or producers?Generally, both buyers and producers share the tax burden Buyers pay P 1 , Producers receive P 2.Therefore, part of the tax is paid by buyers. Buyers tax burden is Part of the tax is paid by producers. Producers tax burden is

P 2


6/61

Who bears the tax?

The tax burden is not always equally share between buyers

and producers. It depends on the relative elasticity of supplyand demand. The more elastic demand is, the more of the tax falls on

producers. (This also applies if government imposes tax onbuyers)

P

Q

S

Q E

E P E

D

S +T

P

P

consumers

producers

Q


7/61

Who bears the tax? The tax burden is not always equally share between buyers

and producers. It depends on the relative elasticity of supplyand demand.

The more elastic supply is, the more of the tax falls onconsumers. (This also applies if government imposes tax onbuyers)P

Q

D

S

Q E

E P E

S + T

P

P

Q

Consumers

Producers


8/61

Deadweight loss DWL is the reduction in the sum of consumer surplus and

producer surplus results from the adoption of a policy.

The size of deadweight loss depends on the reduction in thequantity sold

The reduction in the quantity sold will depend upon theelasticity of demand and supply The more elastic demand or supply is, the larger the decrease in

quantity, the larger the deadweight loss will be The more inelastic demand or supply is, the smaller the decrease in

quantity, the smaller the deadweight loss will be and could be zero if perfectly inelastic (no change in the quantity sold and consumed)


9/61

How much deadweight loss?

P

Q

D

S

Q E

E P E T

P

P

Q

P

Q

D

S

Q E

E P E T

P

P

Q

If Demand is price elastic, buyers are relatively sensitive tothe price change

-A small change in price leads to a large change in quantity-Tax imposition, either on buyers or producers, will increase theequilibrium price; thus, it leads to a relatively large decrease inquantity-The larger the change in quantity, the larger is the deadweight loss

S S


10/61


P

Q

S

Q E

E P E T

P

P

Q

P

Q

S

Q E

E P E T

P

P

Q

D D

S

S

If Supply is price inelastic, sellers are relatively insensitive tothe price change

-A small change in price leads to a small change in quantity-Tax imposition, either on buyers or producers, will increase theequilibrium price; thus, it leads to a relatively small decrease inquantity-The smaller the change in quantity, the smaller is the deadweightloss


11/61


P

Q

S

Q E

E P E = P

P

Q

D

Perfectly Elastic Demand:Producers bear all tax burden

S

T

Perfectly Elastic SupplyConsumers bear all tax burden

P

Q

S

Q E

E P E = P

T P

Q

D

S

If Demand or Supply curve is perfectly elastic or inelastic, only one party willbear all the tax burden.

Tax

Tax


12/61


P

Q

S

Q = Q E

E P E = P T P

D

Perfectly inelastic SupplyProducers bear all tax burdenDWL equals to zero

Perfectly Inelastic Demand:Consumers bear all tax burdenDWL equals to zero

P

Q

S

Q E

E P E = P

T

Q =

D S

P Tax

Tax


13/61

The concept of efficiency is illustrated by which of the following statements?

A) The production of the good generates very little pollution.B) At equilibrium, all mutually beneficial transactions have

taken place.C) The production of the good generates very few by-products.D) The consumption of the good produces very little waste.E) At disequilibrium, no mutually beneficial transactions have

occurred.

Additional Question #1

Ans: B


14/61

In economics, efficiency denotes a state at which all potentialgains from exchange have been captured.

Recall that the definition of Pareto Optimality is a state atwhich one cannot be made better off without making othersworse off.

Any pollution or by-products related to exchange orproduction are taken into account. There can be little, ormuch pollution, as long as efficiency is attained.


15/61

E.g. Hong Kong vs AfricaHK is a place with terrible pollution, while Africa still has cleanair. Is the situation regarded as inefficient/ disequilibrium/ not

optimal in Economics?

Should we balance/ equalize the pollution level between Africaand HK? The ans is NO obviously, WHY?

We chose to sacrifice the clean air in HK in exchange for theamazing economic development. Thus, econ surplus woulddefinitely drops if we move some of our industries to Africa.

Therefore, B is the correct answer.


16/61

Compared to the first-come-first-served allocation schemeairlines used in the past, the voluntary compensationscheme now in place

A) Discriminates against the poor.B) Improves efficiency for only the wealthy.C) Tricks the poor into unnecessarily delaying their travel.D) Improves efficiency for all travellers.E) Encourages passengers to show up early.


Ans: D


17/61

Airlines usually have their flights overbooked.

That means, airlines accept more reservations than the actualno. of seats on each flight.

When a flight is overbooked, at the time of check-in, theairline company has to find some ways to settle who willboard the plane, and who will not.


18/61

In the past, it is done according to the first -come- first servedprinciple.

The ones arriving at the check-in counter early can get theboarding pass. (some can even be upgraded!)

The few that are relatively late will get an apology from theairline, and will be arranged onto another flight, which usuallyresults in a delay.


19/61

Some time ago, airline companies ditched the first -come-firstserved scheme, and took up the voluntarycompensation scheme.

Airlines realise that among the passengers, some valuepunctuality of arrival more than others.

Those who can postpone their plans are likely to be willing toaccept some compensation from the airline for not taking theplanned flight.


20/61

People would be willing to delay their plans as long as thecompensation is enough to cover the costs (e.g. time cost)

Whether a passenger is poor or wealthy is not the directreason to evaluate his costs of delays.

It is his own valuation of time cost that counts.


21/61

Therefore, by offering a voluntary compensation when a flightis overbooked, those who have a lower reservation price forpunctuality are willing to be delayed.

(who are they? People with low time cost)

Those who values punctuality most can arrive at thedestination on time. They are people with high time cost. E.g.

Bill Gates

This improves efficiency for all travellers (D).

FCFS scheme is designed to help the poor and to improve theeconomic surplus.

However, this scheme does not generate the highest possibleeconomic surplus.


22/61

i.e. The following is the arrival time for passengers and the mostthey are willing to pay to fly now. Since the flight is overbooked, only2 passengers can get onto the flight.

Under FCFS, Consumer A and B will be served, Total consumer surplus is $9.

Under Cash compensation, if the Airline offers at least $1 more to

those consumers with the lowest reservation price, i.e. $6, consumer A and B will volunteer to wait for another flight. Now, the Airline is only serving those consumers with the highest

reservation price, consumer C and D. Total consumer surplus is$30.

A 1:00pm $5

B 1:05pm $4

C 1:30pm $10

D 2:00pm $20


23/61

It is more efficient under the cash compensation scheme, asthe compensation policy generates a higher total economic

surplus ($30) rather than just $9 under the first-come, firstserved policy

Consumer A and B are now $1 and $2 better off.

Consumer C and D are now able to get onto the flight.

Therefore, under Cash compensation scheme, everyone isbetter off.


24/61

Demand for cigarettes is price inelastic for adults,

but price elastic for teenagers. Therefore, a tax oncigarettes will

A) Not raise very much tax revenue.

B) Not generate deadweight loss.C) Generate more tax revenue from adults and have a greater

effect on the number of cigarettes smoked by teenagers.D) Have a greater effect on the number of cigarettes smoked

by adults than by teenagers.E) Generate more tax revenue from teenagers than from

adults.


Ans: C


25/61

We can almost immediately eliminate options A andB.

A: not raise very much tax revenue. How much ismuch?

B: a tax always generates some deadweight lossunless the demand/supply curve is perfectlyinelastic/elastic.

Therefore, options A and B are not the answers.


26/61

Option D is also very obviously wrong.

Adults demand is price inelastic; teenagers demand is priceelastic.

That means adults are less sensitive to price changes thanteenagers.

Therefore, a tax should have greater effect on no. of cigarettessmoked by teenagers, not adults.


27/61

Option C is the answer.

A tax imposed on a good whose demand is price inelasticresults in a higher tax revenue than in the case where demandis price elastic.

When demand is price elastic, a small increase in price will

lead to a huge drop in quantity demanded. Therefore, taxrevenue from the teenagers market would be smaller.


28/61

P

Q

DAdults

DTeenagers

S

S

Tax revenuefrom Adults

Tax revenuefrom Teenagers


29/61

Suppose that instead of taxing the producers, a tax of anequal dollar amount per unit is imposed on consumers inthe market shown. Relative to the tax on producers,

A) The tax on consumers would generate more deadweight

loss.B) The burden of the tax on consumers would be more equally

shared between consumers and producers.C) Consumers would bear a greater share of the tax burden.

D) The effect on deadweight loss and tax burdens would bethe same.E) The price paid by consumers would increase by more.


Ans: D


30/61

When a per-unit tax isimposed, supply curve shiftsleftwards,

If the same tax is imposedon consumers, consumerdemand curve shifts downby the same vertical

distance Thus, new equilibrium price

and quantity will be thesame under the 2 types of

tax.

Hence, D.

Price

9

Supply plus tax 8

7 Supply

6

5

4

3

2

1

Demand 0 10 20 30 40 50 60 70 Units per day


31/61

A tax on Commodity A will generate ? deadweight lossrelative to an equivalent tax on Commodity B.

A) More

B) LessC) EqualD) ZeroE) An in determinate amount of


Ans: B


32/61

Commodity A Commodity B

PA

QA

P B

QB

S A S B

DA

DB

Tax

S A S B


33/61

Deadweight loss is the result of distortion from Paretoefficient allocation because of anything but price (e.g. tax).

The larger the distortion, the higher the deadweight loss.

Therefore, we need to identify, when a tax is imposed,distortion from which market would be higher.


34/61

DB is more price elastic than D A.

That means consumers of Commodity B is more sensitive to

price changes than consumers of Commodity A.

When % P A = %P B, %Qd B > %Qd A. (Larger drop in Qdfor B)

In other words, the distortion caused by a tax would besmaller in Market A than in Market B.

Hence, the answer is B.


35/61

Chapter 7 Problem 22) Refer to problem 1. Suppose a coalition of students from Lincoln

High School succeeds in persuading the local government to imposea price ceiling of $7.50 on used DVDs, on the grounds that localsuppliers are taking advantage of teenagers by charging exorbitantprices.a) Calculate the weekly shortage that result from this policy.

12

10.5

6 18 48

7.5

2

6

Quantity (DVDs/week)

P r i c e

( $ / D V D )

S

D


36/61

a) Calculate the weekly shortage of used DVDs that will result from thispolicy.

With price ceiling of $7.50, the quantity supplied from sellers is 2 DVDsper week.

By using vertical interpretation, with quantity of 2 DVDs per week,buyers are willing to pay a higher price for an additional DVDs.

The quantity demanded at the current price of $7.50 is 18 DVDs perweek.

Thus, the price ceiling leads to an Excess Demand of 16 DVDs perweek (18 DVDs/wk 2 DVDs/wk). Buyers cannot buy as much asthey are willing to at the current price of $7.50.

Therefore, the weekly shortage of used DVDs result from the priceceiling policy is 16 DVDs per week.


37/61

b) Calculate the total economic surplus lost every week as a result of the priceceiling.2 methods to find the lost in economic surplus.

12

10.5

18 48

7.5

2 6

6


Price ($/DVD)S

D

12

10.5

18 48

7.5

2 6

6


Price ($/DVD)

x

S

D

x


38/61

Method 1:With price ceiling of $7.50, sellers will sell only 2 DVDs/wk. Therefore, total economic

surplus will be reduced by the shaded area.

12

10.5

18 48

7.5

2 6

6


P r i c e

( $ / D V D )

S

D

Weekly economic surplus lostis the area of the shadedtriangle.

x

To find the area of the shaded triangle, we need to calculate the value of Xin the graph.

First, derive the Demand Curve:Demand Curve: P = 12 0.25Q At Q = 2, P = 12 0.25(2)

P = 11.5Weekly economic surplus lost is,(11.5 7.5)(6-2) (1/2) = $8/wk

Economicsurpluslost


39/61

Method 2:With price ceiling of $7.50, sellers will sell only 2 DVDs/wk.

12

10.5

18 48

7.5

2 6

6


Price ($/DVD)S

D

Without Price ceiling, sellers sell 6 DVDs at P = $10.5 .Consumer surplus: $4.5/wkProducer surplus: $13.5/wkTotal Economic Surplus = $18/wk

With Price ceiling of $7.5, only 2 DVDs/wk will

be sold.Consumer surplus:(12-11.5)(2) (1/2) + (11.5-7.5)(2) = $8.5/WKProducer surplus:(7.5-6)(2) (1/2) = $1.5/wkTotal Economic Surplus = $10/wk

11.5

Therefore, total economic surplus lost as a result of price ceiling is,$18/wk - $10/wk = $8/wk


40/61

4) Suppose the weekly demand for a certain good, in thousands of

units, is given by the equation P = 8 Q, and the weekly supply of the good is given by the equation P = 2 + Q, where P is the price indollars.

Chapter 7 Problem 4

P = 2 + Q

P = 8 - Q

P r i c e

( $ / u n

i t )

Quantity (1000s/wk)

8

2

P*

Q* 8


41/61

a) Calculate the total weekly economic surplus generated at the marketequilibrium.

P = 2 + Q

P = 8 - Q

P r i c e

( $ / u n

i t )

Quantity (1000s/wk)

8

2

P*

Q* 8

Find the equilibrium price, P*, and quantity, Q*: At equilibrium, Supply = Demand

2 + Q = 8 QQ* = 3

P* = 5


42/61

Equilibrium Price, P*, is $5/unit.Equilibrium Quantity, Q*, is 3,000 units/wk.

P = 2 + Q

P = 8 - Q P r i c e

( $ / u n

i t )

Quantity (1000s/wk)

8

2

5

3 8

C.S

P. S

Consumer surplus: ($8 - $5)(3/wk) (1/2) = $4.5/wk ($4,500/wk)Producer surplus: ($5 - $2) (3/wk) (1/2) = $4.5/wk ($4,500/wk)Therefore, total economic surplus is $9,000/wk.


43/61

b) Suppose a pre-unit tax of $2, to be collected from sellers, isimposed in this market. Calculate the direct loss in economicsurplus experienced by participants in this market as a result of thetax.

The tax of $2 is equivalent to the increase of $2 in the cost of production to sellers.Supply curve shift to left from $2 to $4.

S P = 2 + Q

P = 8 - Q

P r i c

e ( $ / u n

i t )

Quantity (1000s/wk)

8

2

5

3 8

S P = 4 + Q

4

Tax

P**

Q**


44/61

Initially, the equilibrium price, P*, is $5; equilibrium quantity, Q*, is3,000units/wk.

After the tax of $2, the equilibrium price increases and equilibriumquantity decreases. The Total Economic Surplus will be decreased.

New supply curve after the tax is now: P = 4 + Q At equilibrium, SC = DC

4 + Q = 8 QQ** = 2P** = 6

The new equilibrium price, P** = $6/unitThe new equilibrium quantity, Q** = 2,000 units/wk


45/61

P = 2 + Q

P = 8 - Q

P r i c e

( $ / u n

i t )

8

2

5

3 8

S P = 4 + Q

4

Tax

6

2

With the tax, buyers now pay $6/unit; pay $1/unit more than before.

CS = (8-6)(2) (1/2) = $2,000/wk

Net of the $2 tax, sellers now receive $4/unit; receive $1 less than before.

PS = (4-2)(2) (1/2) = $2,000/wk

Suppose the tax revenue simply evaporates after collection, the tax revenue is notgoing to offset other taxes. Both sellers and buyers together are now getting lessTotal Economic Surplus than without tax.

CS

PS

Total Economic Surplus =$4,000/wk.

Initially, Total EconomicSurplus is = $9,000/wk

Therefore, the direct loss inTotal Economic Surplus is$9,000/wk - $4,000/wk =$5,000/wk .


46/61

c) How much government revenue will this tax generate each week?If the revenue is used to offset other taxes paid by participants inthis market, what will be their net reduction in total economicsurplus?

A pre-unit tax of $2 will generate a tax revenue of $4,000/wk ($2x 2,000/wk).

If this tax revenue is used to offset other tax paid by participants inthe market, then the participants can reduce other tax by the sametax amount.


47/61

Counting the revenue from the tax as part of total economic surplus,the new total economic surplus is thus:

CS + PS + Tax$2,000/wk + $2,000/wk + $4,000/wk= $8,000/wk

Or $1,000/wk less than without the tax


48/61

P = 2 + Q

P = 8 - Q

P r i c e

( $ / u n

i t )

Quantity (1000s/wk)

8

2

5

8

S P = 4 + Q

4

Tax

6

2 3

Deadweight loss

That is, the Deadweight Loss the reduction in total economicsurplus that results from the adoption of policy, e.x., tax.

Area of the Deadweight loss = ($6/unit - $4/unit)(3/wk 2/wk) (1/2)= $1/wk, or $1,000/wk.


49/61

6) In Charlotte, North Carolina, citizens can get their electric powerfrom two sources: a hydroelectric generator and a coal-fired steamgenerator. The hydroelectric generator can supply up to 100 unitsof power per day at a constant marginal cost of 1 cent per unit.The steam generator can supply any additional power that isneeded at a constant marginal cost of 10 cents per unit. Whenelectricity costs 10 cents per unit, residents of Charlotte demand200 units per day.

a) Draw the marginal cost curve of electric power production inCharlotte.

Chapter 7 Problem 6


50/61

a) Draw the marginal cost curve of electric power production inCharlotte.

P r i c e

( c e n

t s

/ u n i t

)

Units of power per day

10

100

1

Hydroelectric

Steam

Marginal cost of power

b) H h h ld th it h g f l t i ? E l i


51/61

b) How much should the city charge for electric power? Explain.Should it charge the same price for a family whose power comesfrom the hydroelectric generator as it does for a family whosepower comes from the steam generator?

Governments goal is to maximized the total economic surplus. Total economic surplus is maximized when market price equals to

the MC.

According to low-hanging-fruit principle, the government should first use the cheapest source, e.g., hydroelectric generator. Only when the quantity demanded exceeds the units that hydroelectric generator could provided,the city will turn to the next least expensive source, e.g., steam generator.

Total demand for electricity is 200 units per day


52/61

Total demand for electricity is 200 units per day.It is 100 units per day more than it could be supplied byhydroelectric generator.

Therefore, Steam generator was needed to supply the extra 100units per day.

All marginal contributions to supply after 100 units per day must

come from steam generator, and the marginal cost of steamgenerator is 10 cents per unit.

Therefore, the city should charge 10 cents per unit for electricpower since that is the marginal cost when residents use at least

100 units per day.


53/61

The government should charge the same price, 10 cents per unit, toall users, even those who are receiving their power from the lessexpensive supplier, the hydroelectric facility.

If those hydroelectric users were to cut their 100 units of consumption, they would free up 100 units of hydroelectric capacity.

The cut back of their electricity consumptions will enable the city todivert that 100 units of power per day to some other householdsthat are currently getting its electricity from steam generator forwhich the cost of production is high, 10 cents per unit.

By diverting the 100 units of power, it will decrease the consumptionof steam generator by 100 units of power. The cost of saving fromsteam generator is exactly equal to 10 cents per day, the marginalcost of electricity.

That is, Resources are used efficiently.


54/61

If government charges the hydroelectric generator consumers atprice less than 10 cents per unit, say, 1 cents per unit, they willexpand their usage until the MB equals exactly the MC. They will

over use the citys electricity.

Resources are used inefficiently.

That unit of electricity could have been used to serve the consumerswho are currently using the steam generator, 10 cents per unit.Thus, it leads to a loss in economic surplus of 9 cents per unit if setprice at 1 cent per unit.


55/61

8) Phils demand curve for visits to the Gannett walk -in medical clinic isgiven by P = 48 8Q, where P is the price per visit in dollars and Qis the number of visits per semester. The marginal cost of providingmedical services at Gannett is $24 per visit. Phil has a choicebetween two health policies, A and B. Both policies cover all thecosts of any serious illness from which Phil might suffer. Policy A also covers the cost of visits to the walk-in clinic, whereas policy Bdoes not. Thus, if Phil chooses policy B, he must pay $24 per visitto the walk-in clinic.

Chapter 7 Problem 8

Phils Demand Curve


56/61

P ($/visit)

48

Q (visits/semester)

24

P = 48 8Q

Phil s Demand Curve

a) If the premiums the insurance company charges for policies A and B


57/61

a) If the premiums the insurance company charges for policies A and Bmust cover their respective costs, by how much will the two premiumsdiffer, and what will be the difference in Phils total expenditure for medical care under the two policies?

Policy A covers the cost of visits; Policy B does not.Therefore, the premiums will be differ by the numbers of visiting the clinic.

P ($/visit)48

Q (visits/semester)

24

P = 48 8Q At P=$24/visit, Phil will demand 3visits/semester. At P=$0/visit, Phil will demand 6visits/semester.

3 6

Phil will make 3 morevisits/semester to the clinic atP=$0/visit (policy A).


58/61

Phil will make 3 more visits/semester to the clinic at P=$0/visit(policy A).

Phils total expenditure on medical care (insurance premiumsplus payments for office visits) will thus differ by the cost of those three extra visits, namely $72/semester.

Since policy A covers the cost of visit, it has to reimburse thecost of 6 visits. The premium under policy A will be(6visit/semester)($24/visit) = $144/semester, greater thanpolicy Bs.

b) Which policy will Phil choose?


59/61

MB>MC Policy A and B differ by the 3 extra visits.

Under Policy A: His extra expense to the 3 extra visits is 3($24/visit), $72/semester. His value to the 3 extra visits is the area of ABC (consumer surplus at

P=0), $36/semester. Since that is less than his extra expense under policy A, he will choose

policy B.P ($/visit)

48

Q (visits/semester)

24

63

P = 48 8Q

A

CB

b) Which policy will Phil choose?

c) What is the most Phil would be willing to pay for the right to continue


60/61

P ($/visit)

48

Q (visits/semester)

24

63

Consumer surplus, difference between a buyers reservation price and theprice actually paid.

Policy B, he visits up to 3 visits/semester and needs to pay the $24/visit. His reservation price up to 3 visits/semester is $48/visit. The cost of visit is

$24/visit. Therefore, the most that Phil would be willing to pay for the right to continue

buying policy B is $36/semester.

P = 48 8Q

c) What is the most Phil would be willing to pay for the right to continuebuying that policy?


61/61

End of Chapter 7

Documents

Chapter 7.Tutorial