SIMON FRASER UNIVERSITY
Department of Economics
Economics 103 Fall 2005
Due: November 14, 2005 at the beginning of lecture Problem Set 2
Please write neatly in the space provided only. You can print either single-sided or
double-sided. No electronic and late assignments will be graded.
Last Name: ANSWER KEY Mark ______
Tutorial Group: (circle one) D301 D302 D303 D304 D305
1. Consider a market in which Bert from problem 3 is a buyer and Ernie from
problem 4 is the seller.
a. Use Ernie’s S schedule and Bert’s D schedule to find the QS and QD at
prices of $2, $4, and $6. Which of these prices brings S & D into
equilibrium? [5 marks]
From Ernie’s supply schedule and Bert’s demand schedule, the quantity
demanded and supplied are:
Price Quantity Supplied Quantity Demanded
$2 1 3
$4 2 2
$6 3 1
Only a price of $4 brings supply and demand into equilibrium, with an
equilibrium quantity of 2.
b. What are consumer surplus (CS), producer surplus (PS), and total
surplus in this equilibrium? [3 marks]
At a price of $4, consumer surplus is $4 and producer surplus is $4, as
shown in the tutorial. Total surplus is $4 + $4 = $8.
c. If Ernie produced and Bert consumed one fewer bottle of water, what
would happen to total surplus? [3 marks]
Q =1, cost of 1st bottle is $1 and value of 1st bottle is $7.
PS = price – cost = $4 - $1 = $3
CS = value – price = $7 - $4 = $3
Total Surplus = PS + CS = $6
Total surplus declines by $2 (compared to part b)
d. If Ernie produced and Bert consumed one additional bottle of water,
what would happen to total surplus? [2 marks]
Q = 3, cost of 3rd bottle is $5 and value of 3rd bottle is $3.
PS = $4 - $5 = -$1
CS = $3 - $ 4 = -$1
Total surplus declines by $2.
2. Four consumers are willing to pay the following amounts for haircuts:
Jerry: $7 Oprah: $2 Ricki: $8 Montel: $5
Four haircutting businesses have the following costs:
Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2
Each firm has the capacity to produce only one haircut. For efficiency, how
many haircuts should be given? Which businesses should cut hair, and which
consumers should have their hair cut? How large is the maximum possible
total surplus? Use S-D diagram. [10 marks]
The figure shows supply and
demand curves for haircuts.
Supply equals demand at a
quantity of 3 haircuts and a price
between $4 and $5. Firms A, C,
and D should cut the hair of Ricki,
Jerry, and Montel. Oprah’s
willingness to pay is too low and
firm B’s costs are too high, so they
do not participate.
The maximum total surplus is the
area between the demand and
supply curves, which totals $11
($8 value minus $2 cost for the
first haircut, plus $7 value minus $3 cost for the second, plus $5 value minus
$4 cost for the third).
3. Consider the market for rubber bands.
a. If this market has very elastic S and very inelastic D, how would the
burden of a tax on rubber bands be shared between consumers and
producers? Use the tools of CS and PS in your answer. [5 marks]
With very elastic supply and very inelastic demand, the burden of the tax
on rubber bands will be borne largely by buyers. As figure 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 S and very elastic D, how would the
burden of a tax on rubber bands be shared between consumers and
producers? Contrast your answer with your answer to part (a). [5 marks]
With very inelastic supply and very elastic demand, the burden of the tax
on rubber bands will be borne largely by sellers. As figure below 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
4. Suppose gov’t subsidizes a good: for each unit of the good sold, the gov’t 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 (DWL)? Explain with S-D diagram. Use the table below for your analysis.
w/o subsidy w/ subsidy
CS A+B A+B+E+F+G
PS E+I B+C+E+I
t ∅ -B-C-D-E-F-G-H
Total Surplus A+B+E+I A+B+E+I+D+H
Since total surplus declines by area D+H, the subsidy leads to a DWL in that
5. Suppose that Parliament imposes a tariff imported clothes to protect the
Canadian clothing industry from foreign competition. Assuming that Canada
is a price taker in world clothing market, show on a diagram change in the
quantity of imports, the loss Canadian consumers, the gain to Canadian
manufacturers, government revenue, and deadweight loss associated with the
tariff. Use cost-benefit table below to show the changes. [5 marks]
Net Effect B+D
6. Imagine that winemakers in BC petitioned the provincial gov’t to tax wines
imported from Ontario. They argue that this tax would both raise tax revenue
for provincial gov’t and raise employment in BC wine industry. Do you agree
with these claims? Is it a good policy? [5 marks]
The arguments given to support trade restrictions are:
(1) trade destroys jobs;
(2) industries threatened with competition may be vital for national security;
(3) new industries need trade restrictions to help them get started;
(4) some countries unfairly subsidize their firms, so competition isn’t fair; and
(5) trade restrictions can be useful bargaining chips.
Economists disagree with these arguments:
(1) trade may destroy some jobs, but it creates other jobs;
(2) arguments about national security tend to be exaggerated;
(3) the government cannot easily identify new industries that are worth
(4) if countries subsidize their exports, doing so simply benefits consumers in
importing countries; and
(5) bargaining over trade is a risky business, since it may backfire, making the
country worse off without trade.
7. Consider the market for fire extinguishers.
a. Why might fire extinguishers exhibit positive externality? [2 marks]
Fire extinguishers exhibit positive externalities because even though
people buy them for their own use, they prevent any fire from damaging
the property of others.
b. Draw a graph of the market for fire extinguishers, labeling the demand
curve (D), the social-value curve (SV), the supply curve (S), and the
social-cost curve (SC). [5 marks]
The figure shows the positive externality from fire extinguishers. Notice
that SV curve is above the D curve and the SC curve is the same as the S
c. Indicate the market equilibrium level of output and the efficient level of
output in the diagram above. Given an intuitive explanation for why
these quantities differ. [3 marks]
The market equilibrium level of output is denoted Qmarket and the
efficient level is denoted Qoptimum. The quantities differ because in
deciding to buy fire extinguishers, people don’t account for benefits they
provide to others.
8. It is rumoured that he Swiss gov’t subsidizes cattle farming, and that the
subsidy is larger in areas with more tourist attractions. Can you think of a
reason why this policy might be efficient? [4 marks]
If the Swiss government subsidizes cattle farming, it must be because there are
externalities associated with it. Since tourists come to Switzerland to see the
beautiful countryside, encouraging farms, as opposed to industrial
development, is important to maintaining the tourist industry. Thus, farms
produce a positive externality by keeping the land beautiful and unspoiled by
development. The government’s subsidy, thus, helps the market provide the
optimal amount of farms
9. Charlie loves watching Teletubbies on his local public TV station but he never
sends any money to support the station during its fundraising drives.
a. What name do economists have for Charlie? [2 mark]
Charlie is a free ride
b. How can the gov’t solve the problem caused by people like Charlie?
The gov’t could solve the problem by sponsoring the show and paying
for it with tax revenue collected from everyone.
c. Can you think of ways the private market can solve this problem? How
does the existence of cable TV alter the situation? [5 marks]
The private market could also solve the problem by making people
watch commercials that are incorporated into the program. The existence
of cable TV makes the good excludable, so it would no longer be a
10. Categorize each of the following funding schemes as examples of the benefits
principle or the ability-to-pay principle. [6 marks]
a. Visitors to many national parks pay an entrance fee.
The fact that visitors to many national parks pay an entrance fee is an
example of the benefits principle, since people are paying for the benefits
b. Local property taxes support elementary and secondary schools.
The fact that local property taxes support elementary and secondary
schools is an example of ability-to-pay principle, since if you own more
expensive property you must pay more tax.
c. An airport trust fund collects a tax on each plane ticket sold and uses the
money to improve airports and the air traffic control system.
The setup of airport trust funds is an example of the benefits principle,
since use of the airport generates a tax that pays for upkeep of the