SIMON FRASER UNIVERSITY Department of Economics Economics Fall by liaoqinmei

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            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.

First Name:
Last Name:                     ANSWER KEY                          Mark      ______
Student Number:

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
            much less.

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.
       [7 marks]

                             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]
                                       gains                      losses
            CS                                                  A+B+C+D
            PS                           A
            Gov'Revenue                  C
            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?
            [3 marks]

            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
            public good.

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
            they receive

       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


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