ECON 101 Tutorial: Week 3

1. ECON 101 Tutorial: Week 3 Shane Murphy s.murphy5@lancaster.ac.uk Office Hours: Monday 3:00-4:00 – LUMS C86

2. Outline • Roll Call • Problems • Discussion

3. Chapter 7: Exercise 7 Why might we want to think about market price as the outcome of a bargaining model? • Market price is really an outcome of the bargaining model. Suppliers are offering goods to consumers at different prices and consumers have to make decisions about whether the prices they are offered represents a net economic benefit to them. There is an interaction between suppliers and consumers, therefore, which can be seen as a bargaining process – an agreed outcome between two interested and competing economic agents. For example suppliers respond to the decisions made by consumers – if too few people buy their product then they will be forced to take action to improve the product offering, lower the price or even drop out of the market altogether.

4. Chapter 8: Exercise 2 The government has decided that the free market price of tobacco is too low. • Suppose the government imposes a binding price floor in the tobacco market. Use a diagram to show the effect on the price and quantity. Is there a shortage or surplus? What does the market outcome depend on? • Tobacco producers complain that he price floor has reduced their total revenue. Is this possible? Why? • In response to producers’ complaints, the government agrees to purchase all of the surplus tobacco at the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses?

5. Chapter 8: Exercise 2 The government has decided that the free market price of tobacco is too low. • Suppose the government imposes a binding price floor in the tobacco market. Use a diagram to show the effect on the price and quantity. Is there a shortage or surplus? What does the market outcome depend on? The imposition of a binding price floor in the tobacco market is shown. 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.

6. Chapter 8: Exercise 2 The government has decided that the free market price of tobacco is too low. • Tobacco producers complain that he price floor has reduced their total revenue. Is this possible? Why? The tobacco producers complaint that their total revenue has declined is correct if demand is price elastic. With price elastic demand, the percentage decline in quantity would exceed the percentage rise in price, so total revenue would decline.

7. Chapter 8: Exercise 2 The government has decided that the free market price of tobacco is too low. • In response to producers’ complaints, the government agrees to purchase all of the surplus tobacco at the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses? If the government purchases all the surplus tobacco at the price floor, producers benefit and taxpayers lose. Producers would produce quantity Q3 of tobacco, and their total revenue would increase substantially. But consumers would buy only quantity Q2 of tobacco, so they are in the same position as before. Taxpayers lose because they would be financing the purchase of the surplus tobacco through higher taxes.

8. Chapter 9: Exercise 6 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 CS, PS, TR, TS? Is the a DL?

9. Chapter 9: Exercise 6 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 CS, PS, TR, TS? Is the a DL?

10. Chapter 9: Exercise 9 Suppose the market is described by: Qs = 2P Qd = 300-P • Solve for the equilibrium price and quantity. • Suppose that a tax of T is placed on buyers so demand is Qd = 300 – (P+T). Solve for the new equilibrium. What happens to the price receivd by sellers, the price paid by buyers, and the quantity? • Tax revenue is TxQ. Use your answer to part (b) to solve for tax revenue as a function of T. Graph the relationship for T between 0 and 300. • The deadweight loss of a tax is the area of the triangle between the supply and demand curves. Graph the relationship between DL and T between 0 and 300. • 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?

11. Chapter 9: Exercise 9 Suppose the market is described by: Qs = 2P Qd = 300-P • Solve for the equilibrium price and quantity. Setting quantity supplied equal to quantity demanded gives 2P = 300 – P. Adding P to both sides of the equation gives 3P = 300. Dividing both sides by 3 gives P = 100, which is the equilibrium price. Plugging P = 100 back into either equation for quantity demanded or supplied gives Q = 200 as the equilibrium quantity.

12. Chapter 9: Exercise 9 Suppose the market is described by: Qs = 2P Qd = 300-P • Suppose that a tax of T is placed on buyers so demand is Qd = 300 – (P+T). Solve for the new equilibrium. What happens to the price received by sellers, the price paid by buyers, and the quantity? Now P is the price received by sellers and P+T is the price paid by buyers. Equating quantity demanded to quantity supplied gives 2P = 300 - (P+T). Adding P to both sides of the equation gives 3P = 300 – T. Dividing both sides by 3 gives P = 100 - T/3. This is the price received by sellers, and is clearly less than before the tax was imposed. The buyers pay a price equal to the price received by sellers plus the tax (P+T = 100 + 2T/3). The quantity sold is now Q = 2P = 200 – 2T/3.

13. Chapter 9: Exercise 9 Suppose the market is described by: Qs = 2P Qd = 300-P • Tax revenue is TxQ. Use your answer to part (b) to solve for tax revenue as a function of T. Graph the relationship for T between 0 and 300. Since tax revenue is equal to T x Q and Q = 200 - 2T/3, tax revenue equals 200T - 2T2/3. Tax revenue is zero at T = 0 and at T = 300.

14. Chapter 9: Exercise 9 Suppose the market is described by: Qs = 2P Qd = 300-P • The deadweight loss of a tax is the area of the triangle between the supply and demand curves. Graph the relationship between DL and T between 0 and 300. The area of the triangle (laid on its side) that represents the deadweight loss is 1/2 x base x 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 x T x 2T/3 = T2/3. This rises exponentially from 0 (when T = 0) to 45,000 when T = 300.

15. Chapter 9: Exercise 9 Suppose the market is described by: Qs = 2P Qd = 300-P • 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's in a region in which tax revenue is declining. Tax revenue is calculated as 200T - 2T2/3 = 2002 – 2/3(2002) = 40,000 – 26,666 = €13,333. The government could reduce the tax to €150 per unit and get more tax revenue (€15,000). The lower tax would also cause a smaller deadweight loss. The deadweight loss is calculated as T2/3 so when T is €200 the deadweight loss is €13,333 and when T is €150 the deadweight loss is only €7,500. A tax of €150 per unit is therefore a better policy.

16. Discussion Is deadweight loss always bad? How much should we concern ourselves with avoiding deadweight loss? When is deadweight loss acceptable? How can Santa be described as a deadweight loss?