Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions

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PROBLEM SET #2 Suggested Solutions

1. (2 points total) For each of the events described below, sketch a supply and demand graph that illustrates the event. Be sure to properly label all curves and relevant points in your graph. In the area to the left of your graph, explain why you think your graph is correct. In that area, also answer the questions asked. a. Bottled Soda: A publicity campaign convinces buyers that drinking soda (Coke, 7-up, etc.) is unhealthy. What is the effect on the price of soda? On the quantity of soda sold? For all supply/demand questions like this, we assume that all other things aside from what is specified in the question stay the same (that is, we make the ceteris paribus assumption). Do not add details to the question that are not there. Assume all other factors are held constant. The question asks about the supply and demand for soda. The first step is drawing the initial equilibrium (E) at P1 and Q1. The second step: how do we capture the event? The publicity campaign that successfully convinces buyers that soda is unhappy is shown as a decrease in the demand for soda. Remember that the demand curve shows how much of a good will be purchased at any given price. When there is a decrease in demand, the demand curve shifts to the left. At every possible price, there is less soda demanded because of the successful campaign. (Note that if the campaign had been unsuccessful, it would have had no effect on the demand for soda.) The third step: what is the effect on price and quantity? The shift to the left of demand (that is, a decrease in the quantity demanded at every possible price), results in a decrease in the price and a decrease in the quantity sold at equilibrium. The graph showing the market equilibrium before and after the shift illustrates why this is the case. The demand curve shifts to the left, changing the equilibrium point from E1 to E2, decreasing the equilibrium price from P1 to P2, and decreasing the equilibrium quantity from Q1 to Q2. Note that the supply curve has not moved; it is only the quantity supplied that falls.

b. Bottled Soda: Technological change lowers the cost of keeping bottled soda cold when its in a soda machine. At the same time, more and more schools give students a free reusable water bottle and install water dispensers offering free, cold, good-tasting water. What is the effect on the price of a soda? On the quantity of soda sold? The question asks about the supply and demand for soda. The first step is drawing the initial equilibrium (E) at P1 and Q1. The second step: how do we capture the event? Notice that there are two events in this question. Other than these two specified events, we assume all else is constant. That is, we invoke the ceteris paribus assumption. Technological change lowers production costs one of the factors that shift the supply curve. There is an increase in the supply of soda. At every possible price of soda, there are more bottles of soda offered for sale after the

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions

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technological change that lowers production costs. (Equivalently: any quantity can be produced at a lower price to the consumer.) The quantity supplied increases at each and every possible price. The entire supply curve shifts to the right. At the same time, more schools give students a free reusable water bottle and install water dispensers offering free, cold, good-tasting water. Bottled water is a substitute for bottled soda. Decreasing the price of water by providing free bottles and water dispensers will decrease the quantity demanded of bottled soda at every price. There is a decrease in the demand for bottled soda which is shown by shifting the demand curve to the left. The third step: what is the effect on price and quantity? The shift to the right of supply (that is, an increase in the quantity supplied at every possible price), results in a decrease in the price and an increase in the quantity sold at equilibrium. The shift to the left of demand (a decrease in the quantity demanded at every possible price), results in a decrease in price and a decrease in the quantity sold. So technological change puts upward pressure on the quantity but new school water availability puts downward pressure on the quantity. What is the net effect on quantity? It depends. (Youll find it depends is often the answer in economics. Its never a sufficient answer, though. We need to know on what it depends.) The net effect on quantity depends on which shift is larger: the decrease in demand or the increase in supply. If you drew the shifts the same size, then you had no effect on quantity. If you shifted demand more than you shifted supply, quantity Q2 is less than quantity Q1. If you shifted supply more than you shifted demand, Q2 is greater than Q1. The three graphs illustrates why this is the case. The supply curve shifts to the right and the demand curve shifts to the left, changing the equilibrium point from E1 to E2. In all cases, equilibrium price decreases from P1 to P2. The effect on quantity depends upon which curve shifts more: neither (quantity unchanged), demand (quantity falls), or supply (quantity rises).

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions

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2. (2 points total) Your sister decided to quit her job that had paid her about $800 a week. Shes started a business watering plants. She goes to homes and businesses, and waters the plants. Her only capital is a big jug of water and a red wagon to pull it around with, both of which she already owned. a. Your sister anticipates her revenue will be about $1,000 a week and her expenses will be about $300 a week. Will your sister make a weekly profit? Explain. She will make an accounting profit but not an economic profit. Her accounting profit = total revenue ($1,000) explicit costs ($300) = $700 per week. Her economic profit deducts as well her opportunity costs. From the prompt, we know the opportunity cost of her labor: $800 a week, her income from the job she quit. The prompt also tells us that she didnt need to buy any capital (machines, buildings!), so the opportunity cost of capital = 0. Y our sisters economic profit is negative, an economic loss: Economic profit = total revenue ($1,000) explicit costs ($300) implicit costs ($800) = -$100 per week b. Your sister tells you there are lots of other plant waterers in her town, each offering the same service. Draw a graph at the right that shows the determination of the profit-maximizing quantity of plant-waterings that your sister would sell each week. Use subscripts 1" to label each of your curves. Assume the current market price is $2 per plant per week. Your sister is in a perfectly competitive market. The conditions for perfect competition are Lots of sellers Homogeneous product No barriers to entry or exit The prompt tells us there are lots of other plant waterers (lots of sellers), each offering the same service (homogeneous product). There are no barriers to entry. Because the market is perfectly competitive, each seller is a price-taker. The profit-maximizing quantity is found at the intersection of marginal cost (MC) and marginal revenue (MR). The marginal revenue curve is a horizontal line at the market price, here $2 per plant. In the graph, q* is your sisters profit-maximizing quantity of plants to water. The MC of one more plant exceeds $2, so she shouldnt water more than q* plants. The MC of one fewer plants is less than $2, so she definitely should water q* plants. c. A few months later your sister calls again. She reports that about half of the people in town who had been offering plant watering services had quit and gone on to other activities. She wonders if she should also quit. You tell her to stick with it and predict that her profit will rise. Using (English only, please) words your sister will understand, explain to her why you say this. (Your sister has not taken any Economics.) On your graph at right, draw in any new relevant curves, labeled with subscripts 2. Because there are now fewer firms in the market for plant waterers, the equilibrium price of each plant watering will rise above $2. We could show this by drawing a graph of the market for plant waterers and shifting the S curve

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions to the left due to the drop in the number of sellers.

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Your sister is in a perfectly competitive market. That means she is a price -taker she charges the market equilibrium price. Because half of the people in town have left the market, everyone remaining (including your sister) can now charge a higher price. When it was $2 per watered plant, your sister was incurring an economic loss of $100 per week. That loss is shown by the red rectangle in the graph at the right. But now with a higher price, theres a chance shell make a profit. Her costs have not changed, so we dont move AC or MC. The only thing that has changed is the market price. Here we show a higher price P2 and at that price, your sister is now earning a profit. She should stay in the plant watering business! Your task was to explain this in words that made sense to your sister, who doesnt have a background in economics. So you cant use marginal cost or marginal revenue in your explanation. Something like this would likely make sense to someone without an econ background: There are now fewer people offering the same service that you offer, but people still want their plants watered. I bet some of those folks have called/texted/contacted you and asked if you would water their plants, too. You could raise your price above $2 per plant. You might lose some of your old customers who dont want to pay more than $2, but youll gain a whole lot of customers who were willing to pay more than $2 a plant and now have dead and dying plants because so many people quit the business. In the end, youll charge more but have more customers. And if you charge more, then you would start to bring in more money each week, and youd be making more than you did at that old job you quit. I think you should stick with it! (And for such brilliant advice, sis, how about taking me out for an evening of fun and frivolity?)

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions

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3. (2 points total) About 200 million visits to tanning salons take place in the U.S. each year about 7 visits per year by each of the 30 million people who frequent such salons. This is despite the risks. According to the American Academy of Dermatology, indoor tanning before the age of 35 is linked to a 75% increase in the risk of melanoma, the deadliest form of skin cancer, which has also become more common in young females. The U.S. spends around $2 billion annually treating skin cancers. (http://money.cnn.com/2010/03/24/news/economy/tanning_tax/). As part of the health care overhaul (the U.S. Affordable Care Act, also known as Obamacare), a 10% tax was imposed on tanning salon visits starting 1 July 2010. The tax is collected by the salons, who remit the tax to the government. a. Suppose Graph A at the right depicts the market for tanning salon visits before the tax increase. The initial equilibrium price was $20 per visit, so the tax is $2 per visit. On the graph, show the effect of the tax. What is the new equilibrium price paid per tanning salon visit and the new equilibrium quantity of visits consumed?

The tax can be thought of as an increase in the cost of producing tanning salon visits. The tax increases the cost of selling a single visit by $2. Hence, the graph shows a second supply curve S1 that is $2 higher than the previous supply curve S0 at any quantity of tanning salon visits sold. This is the same as an inward, or leftward, shift of the supply curve. Note that the suppliers do not keep the additional $2 per visit; they immediately remit the $2 to the government. The producers will retain the price consumers pay, minus $2, per tanning salon visit. The initial equilibrium at point A is at a price of $20 per visit and quantity sold of 200 million salon visits per year. The new equilibrium point occurs at point B, where S1 crosses the demand curve, D. Looking at the graph, this point is located where the price paid per tanning salon visit is about $20.67 and the quantity sold is approximately 133 million tanning salon visits per year. The drop in quantity demanded is due to the higher price: $20.67 > $20.00.

b.

Suppose instead that Graph B at the lower right depicts the market for tanning salon visits before the tax increase. The initial equilibrium price was $20 per visit, so the tax is $2 per visit. On the graph, show the effect of the tax. What is the new equilibrium price paid per tanning salon visit and the new equilibrium quantity of visits consumed?

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions

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As in part (a), there is a second supply curve S 1 that is $2 higher than S0 at any quantity of tanning salon visits sold. This takes into consideration the additional $2 of cost imposed by the tax. The initial equilibrium is at point A at a price of $20 and quantity of 200 million tanning salon visits per year. The new equilibrium point occurs at point B, where S1 intersects the demand curve, D. The equilibrium price is $21.50 per visit, and the equilibrium quantity is 175 million tanning salon visits per year.

c.

In which case A or B which case A or B

(circle one)

will the imposition of the tax increase government revenue the most? In

(circle one)

will the imposition of the tax cause tanning salon visits to fall the most?

In case B the government will increase its revenue the most. Demand is less elastic (more inelastic) in case B than in case A. When demand is less elastic, as in case B, consumers reduce their consumption of a good less in response to a tax. Because consumers reduce their consumption less in case B than in case A, for the same $2 increase in the price of a tanning salon visit, the quantity demanded is greater in case B than in case A and so the government's revenue will be greater. This is a general rule- the more price-inelastic the demand for the product, the more revenue that can be raised from an excise tax. In case A, tanning salon visits will fall the most because demand is more elastic than in case B. When demand is more price-elastic, consumers are more sensitive to a change in price than they are when demand is less priceelastic and will change their quantity consumed by more. Consumers will reduce their consumption more in case A, where demand is more price-elastic, than in case B. This is a general rule: the more price-elastic the demand for the product, the more consumption will fall due to a price increase. d. In states with long dark winters and short summers places like New England and upstate New York there are lots of tanning salon customers. Which graph A or B (circle one) do you think is a better representation of the market for tanning salon visits in states with long dark winters? Why? Use the concept of elasticity in your answer.

One of the determinants of the size of the price elasticity of demand is the availability of substitutes. For some people who live in places with long dark winters and short summers, the lack of sun means there are few substitutes for tanning salons. Those who live in such states will be more insensitive (less sensitive) to price as they have few substitutes for tanning salons if they want darker skin -- making demand for tanning salon visits relatively price-inelastic. So for these consumers, Graph B may better represent the change.

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions

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A second determinant of the size of the price elasticity of demand is the share of the total budget. A $20 tanning salon visit is probably a relatively small part of an average persons total spending. Quantity demanded will show very little response to a change in the per salon visit price because an increase in the price of each visit does not affect peoples budgets by too much, so consumers do not need to adjust the quantity consumed by very much. So for this reason as well, demand would be relatively price-inelastic. The steeper demand curve graph B shows more price-inelastic demand.

4.

(1 point) A recent study of tanning salons in Illinois found that the tax had little effect on the number of visits. "When the tax first went into effect, many tanning salon owners said they would pay it themselves rather than pass it onto customers," said study author Dr. June Robinson, a research professor of dermatology at Northwestern University Feinberg School of Medicine in Chicago. . . The surprise is that almost none did this [absorb the cost]." . . . Instead, the salons are passing the tax on to customers. What's more, they found the customers don't seem to mind. . . . About the same number of customers comes to the salons now as before the tax. (http://healthfinder.gov/news/newsstory.aspx?docID=660835 ) Assume there was no change in preferences, income, wealth, or expectations over the time period of Professor Robinsons study (2010-2012). The only change was the imposition of the tax. In this case, what do the results of Professor Robinsons study tell you about the shape of the demand curve for tanning salon visits? Explain.

a.

The tanning salons passed the entire tax on to consumers and quantity demanded did not fall. If there was no shift in demand coincident with the imposition of the tax, this tells us that the demand for tanning salon visits is perfectly inelastic a vertical demand curve. When demand is perfectly inelastic, a change in price has no effect on quantity demanded. b. Assume instead that there was an increase in income and wealth over the time period of Robinsons study (2010-2012). In this case, do the results of Professor Robinsons study tell you anything definitive about the shape of the demand curve for tanning salon visits? Explain. Supplement your answer with a graph.

Now we dont know anything about the shape of the demand curve it could be elastic or inelastic. The increases in income and wealth would shift the demand for tanning salon visits to the right to demand curve D1. Demand shifts to the right because its reasonable to assume that visits to tanning salons are a normal good. The shift to the right in the demand for tanning salon visits due to income and wealth effects occurred at the same time as the shift to the left in the supply of visits due to the imposition of the tax. The increase in demand puts upward pressure on the price and results in an increase in quantity sold. The decrease in supply also puts upward pressure on the price but results in a decrease in quantity sold. Without further information, we know that the price will rise. But we dont know whether the quantity will rise or fall. However! In this case we are told what happens to the quantity: it remains the same even as the price rises by the full amount of the tax. That tells us that the graph should look like one of the graphs on the next page

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions Like this, if demand is elastic:

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Or like this, if demand is inelastic:

The conclusion: if demand increased at the same time as the tax was imposed, we cant draw any conclusion about the shape of the demand curve from the observation that two years after the imposition of the tax, the price has risen by the full amount of the tax and the quantity demanded hasnt changed. 5. (3 points total)

The price mechanism refers to how a market economy allocates goods and services to buyers and inputs to production through responses of profit-maximizing businesses to shifts in demand by utility-maximizing consumers. If goods and services are allocated (sold) to those who are willing and able to pay the market equilibrium price, we say there is price rationing. If instead there is intervention in the market so that the price mechanism is not the way that goods and services are allocated, there is s ome non-price rationing mechanism

Department of Economics University of California, Berkeley Problem Set #2 Suggested Solutions that determines for whom and by whom goods and services are produced. Write a one-page essay in which you address these questions: $

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Give an example of a good or service that is currently allocated to buyers using the price mechanism. Do not use an example that was discussed in lecture; come up with a new example. Should society use the price mechanism to determine for whom this good is produced? Why or why not? Now give an example of a good or service that is currently not allocated to buyers using the price mechanism. Do not use an example that was discussed in lecture; come up with a new example. What is the non-price rationing mechanism that determines for whom this good or service is produced? Should society not use the price mechanism to determine for whom this good is produced? Why or why not?

Remember that in economics (as in life), the conclusions you come to will depend in part on the assumptions you invoke. So be sure you make the relevant assumptions explicit. Dont invoke wildly unrealistic assumptions; the assumptions you make should be reasonable. Of course, there are lots of specific examples, so we cant provide you with this is what you should have written. Guidelines: a. Did you follow the specifications? One-page essay? 1 margins? Double-spaced? 10 or 11 or 12 pt font? Your name and date in the top right corner? Your essay stapled at the back of your problem set? If so, you remained eligible for full credit. If not, you lost a point right off the top.

b. Did you choose an example of a good or service that is allocated using the price mechanism? Did you then choose a second example of a different good or service that is not allocated using the price mechanism? Did you describe the rationing mechanism that is used to allocate this second good or service to consumers? If so, good! For example, who gets to purchase a semester at Cal? Is that determined by price? No. If it was, then education would go to the people willing and able to pay the most. Instead, we have an admissions process a non-price rationing mechanism that determines who is going to purchase a semester at Cal and who is not. Even someone with the richest parents in the world is not allowed to purchase a Cal education if they have 400 on their SATs and a 1.8 gpa in high school. But who gets to purchase a Cal sweatshirt? Anyone who is willing and able to pay the market price. The price mechanism determines who are the buyers of Cal sweatshirts. c. When you answered the questions about whether or not society should use (or not use) the price mechanism for allocating the goods you chose, did you recognize that this is a normative question? Did you remember that in order to answer any normative question, you must first explicitly state what goal we are trying to achieve? Did you explicitly state a goal, and then write up your analysis in light of that goal? If so, good!