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TUTORIAL 1

1.

Explain why governments need to to intervene in markets.


Government tends to intervene in the economy when occurs market failure,
redistribution and political economy.
Firstly , Market failure is condition where market economy sometimes fails to
deliver on outcome that is efficient. For examples , when occurs externalities such
as carbon emission. Government will intervene by implement tax regulation toward
business firm to reduce the externalities occurs. Next, government will intervene in
imperfect competitions when firm are monopolize the market by implemented tax
regulation or ceiling price to care the welfare of society. In addition, Government
also intervene in imperfect or asymmetric information as society have incomplete
information about the risks of purchasing certain products or working in certain
occupations. For examples, society will rely on government to test news drugs and
to prevent hazardous products from being sold. Society also rely on government to
establish standards for society in the workplace. Beside that, Government will
intervene when occurs individual failure which is people is always not rational. For
examples, society knows that smoke is dangerous and will harm health, but they
still purchase and cigarette. Then, government will impose import tax toward
distributer.
Second, Redistribution where market economy generates substantial
inequality in economic resources across individuals. Then, government will
intervene by redistributing resources through taxes and transfers to help reduce
inequality.
Third, government will intervene because of political economy. It is the theory
of how the political process produces decisions that affect individuals and the
economy. Subfield of political economy that focuses on government failures are
called public choices. Governmet failures happen when the government does not
act in the benefit of society. So, to avoid such failures from happen, the goverment
must intervene in the economy.

2.

Explain by using diagrams, three (3) conditions in which market fails to achieve
efficiency.
Market fails to achieve efficiency when the marginal social benefit exceeds
marginal social cost. There are three conditions which is monopoly, taxes, and
subsidies.
i.

Monopoly
P
MSC
MSBm=Pm
E
MSCm
D=MSB
MR
0

Qm Q*

Q unit per month

Figure 2.1
Monopoly firm is inefficient because they produce less but they charge prices
higher than perfectly competitive market firm. They sets the price exceeds the
marginal cost. The demand curve or AR reflects the marginal social benefits for
monopolist.
In the Figure 2.1, monopoly firm maximize profits at level of output per month
at which marginal revenue (MR) equal to marginal social cost (MSC). So, the firm will
produce at Qm units per month and sell at Pm. At the output level Qm units per
month, the marginal social benefit (MSB) of the good exceeds its marginal social cost
(MSC). This shows the production are not efficient because the MSB > MSC , which
supposed MSB = MSC for efficient production. The area ABE is the loss of net
benefits if the production is inefficient.
Where the firm should produce when MSB = MSC at point E to achieve
efficiency and produce Q* units per month. So, the additional net benefits equal to
area ABE are possible if output were increased to Q* units per month.

ii.

Taxes
P (cent per message unit)
New Supply = MPC + T > MSC
6

Supply = MSC = MPC

5
4

Demand = MSB

billions of message units per month

Figure 2.2
A tax on the sale of a product affects incentives to supply that product, as the
price required by producers to expand service by one unit must equal the sum of the
marginal private cost of the service and the tax per unit of service, T.
The equilibrium or the efficiency achieved at point E where the marginal social
benefit (MSB) equal to marginal social cost (MSC) at level of output 4 billions of
message units per month and the price before taxes imposed is 5 cents per message
unit.
After a tax on telephone service imposed, it decreases the supply of the
product. The supply curves moves to the left (new supply). The new equilibrium
achieved at point E, the price of a message unit increases from 5 to 6 cents. The
message units per month decrease from 4 billions to 3 billions.
There is loss in net benefits from telephone service because the MSC of new
equilibrium output (E) is less than its MSB ( MSC < MSB). The loss in net benefits is
represent by the triangular area EEB. The tax costs more than RM0.06 billion in
revenue collected when the loss in net benefits is added to the amount of revenue
collected.

iii.

Subsidies
P (RM per bushel)
Supply = MSC
5

C
Demand = MSB

Q*

Qs

bushels of wheat per year

Figure 2.3

When the market price falls below the target price guaranteed by the
government, the government will pay eligible farmers a subsidy equal to the
difference between the market price of the product and the target price.
In Figure 2.3, a target price of RM5 per bushel is set by the government.
Because this price exceeds the market price of RM4 per bushel at point E, the wheat
farmers produce Qs bushels per year instead of Q*. Qs is more than the efficient
amount of wheat because its marginal social cost (MSB) is greater than its marginal
social benefit (MSB).
The loss in net benefits from resource use is represented by the area EAC.
The subsidy the government pays is RM2 per bushel multiplied by the Qs bushels
produced anually. After the subsidy, the market price of wheat falls to RM3, which is
less than the marginal social cost (MSC) of producing it.

3.

The graph below depicts the demand curve, the MR curve, and the MC curve of a
monopoly. The firms fixed cost is RM10.

i)

Find the firms profit-maximizing quantity and price.

ii)

MR = MC
Price = RM 8
Quantity = 4 Units
Find the firms revenue, variable cost, and profit.

Firm Revenue
TR = P x Q
= RM 8 x 4 Units
= RM 32
Variable Cost
VC = AC x Q
= RM 4 x 4 Units / 2
= RM 8
Profit
Profit = TR TC
= RM 32 ( RM 8 + RM 10 )
= RM 14

iii)

What is the net benefit loss (deadweight loss) associated with this monopoly?
Area AEB = x ( RM 8 4 Units ) x ( RM 6 4 Units )
= RM 4
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4.

A monopoly supplies water to the the town. The table below gives information about
the firms price, quantity, and MC. Its fixed costs are RM20.

UNIT
1
2
3
4
5
6
7
i)

P
13
12
11
10
9
8
7

MC
3
4
5
6
7
8
9

MR
13
11
9
7
5
3
1

TR
13
24
33
40
45
48
49

TC
23
27
32
38
45
53
62

( TR TC )
10
17
21
22
20
15
7

AC
3
3.5
4
4.5
5
5.5
6

What is the Pareto efficient level of output and price?


P = MC
Price = RM 8
Quantity = 6

ii)

What is the profit-maximizing quantity and price? What is the firms profit?
Profit maximizing quantity and price
Quantity = 4
Price = RM 10
Firm Profit
TR TC
RM 40 RM 38 = RM2

iii)

If the government were to regulate by marginal cost pricing, how much would
the government have to pay the monopolist to ensure it stays in business in
the long-run?

iv)

If the government were to regulate the firm by average cost pricing, how many
units would be sold and at what price?
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5.

Suppose the demand function for rice is Qd = 10 2 p, while the supply function is
Qs = 3 p 5. The government is concerned that the market equilibrium price of rice is
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too low and would like to implement a price support policy to protect the farmers. By
implementing the price support program, the government sets a support price and
purchase the extra supply at the support price. In this case, the government sets the
support price ps = 4.
i)

Calculate the original market equilibrium price and quantity in the absence of
the price support policy.
Qd = Qs
10 2p = 3p 5
5p = 15
P = RM 3
Qd = 10 2p
= 10 2(3)
Q = 4 units

ii)

At the support price ps = 4, find the quantity supplied by the farmers, the
quantity demanded by the market, and the quantity purchased by the
government.
Ps = RM 4

Qs= ?

Qs = 3p 5
= 3(4) 5
= 7 units
Qd = 10 2(4)
= 2 units

ii)

Quantity purchased by Goverment


Qd Qs = 7 2
= 5 units
Draw a diagram to show the change in the producer surplus due to the
implementation of the price support policy.
P

Producer surplus

Ss
Ps

3
Dd
0
iii)

Draw a diagram to show the change in the consumer surplus due to the
implementation of the price support policy.

P
8

Consumer surplus
5

Ss

Ps

3
Dd

iv)

Calculate the cost to the government to implement the price support policy.
Draw a diagram to show the government cost.
P = RM 4
Q = (7 2)
=5
Cost = RM 4 x 5
= RM 20
P

Ss

Ps

3
Dd
0

6.

Explain why points on the utility possibility curve represents the maximum level of
wellbeing. Describe by using a diagram the trade off between efficiency and equity.
Annual well-being of A
Ua
9

Ua1
Ua2

E1

E2
E3

Ub1

Ub2

Ub3

annual well-being of B

Figure 6.1

The utility possibility curve shows the maximum attainable level of well being
or utility for one individual, given the utility level of individuals in the economy, their
taste, resource availability, and technology.
The points on the utility possibility curve represents the maximum level of
wellbeing because the resources are allocated efficiently.
For example, based on figure above the resources are allocated in such a way
that the distribution of well being between A and B is given at point E2, then E1. This
point in efficient because at that point it is impossible increase either As or B s utility
without reducing the others.
Point Z that above the frontier is unattainable because the resources and
technology that available are not capable to produce enough goods and services to
achieve the combinations of well being.
Point X are inefficient because it is possible to reallocate resources to improve
one persons well being without decreasing anothers. The movement from X to E3
will be opposed by A because it would reduce As well being.

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