EC1000 Question Sheet 1 Tutorial 1 Week 4

Answers

1. a. Berts total willingness to pay is:

Quantity Total willingness to pay

0 0
1 1
2 12
3 15
4 16

b. Berts demand schedule is:

Price Quantity Demanded

More than 7 0
5 to 7 1
3 to 5 2
1 to 3 3
1 or less 4

Berts demand curve is shown in Figure 1.

Figure 1

c. When the price of a bottle of water is 4, Bert buys two bottles of water. His consumer
surplus is shown as area A in the figure. He values his first bottle of water at 7, but pays
only 4 for it, so has consumer surplus of 3. He values his second bottle of water at 5, but
pays only 4 for it, so has consumer surplus of 1. Thus Berts total consumer surplus is 3 +
1 = 4, which is the area of A in the figure.

d. When the price of a bottle of water falls from 4 to 2, Bert buys three bottles of water, an
increase of one. His consumer surplus consists of both areas A and B in the figure, an
 EC1000 Question Sheet 1 Tutorial 1 Week 4

increase in the amount of area B. He gets consumer surplus of 5 from the first bottle (7
value minus 2 price), 3 from the second bottle (5 value minus 2 price), and 1 from the
third bottle (3 value minus 2 price), for a total consumer surplus of 9. Thus consumer
surplus rises by 5 (which is the size of area B) when the price of a bottle of water falls from
4 to 2.

2. a. Figure 2 illustrates the effect of the drought. The supply curve shifts to the left, leading
to a rise in the equilibrium price from P1 to P2 and a decline in the equilibrium quantity from
Q1 to Q2.

b. If the price cannot change and must stick to P1, there will be a shortage equal to the
segment EB.

c. The efficient way of rationing demand is by raising the price, so that at the margin all
consumers have the same willingness to pay for the last unit of water consumed. Any other
rationing system, included that described by the Los Angeles Time, either leads to the same
outcome of an increase of the price or is bound to be inefficient. As for fairness, it all depends
on which notion of fairness is used. For example, one could make a case for a rationing
mechanism in which each consumer can consume up to the same maximum amount of water,
irrespective of his or her consumption in the previous year.
d. The market solution with a flexible price is the most efficient. As for fairness, the same
comments as above apply.

E
P2

P1 E
B

Q2 Q1

Figure 2

3. a. The statement, "A tax that has no deadweight loss cannot raise any revenue for the
government," is incorrect. An example is the case of a tax when either supply or demand is
perfectly inelastic. The tax has neither an effect on quantity nor any deadweight loss, but it
does raise revenue.
EC1000 Question Sheet 1 Tutorial 1 Week 4

b. The statement, "A tax that raises no revenue for the government cannot have any
deadweight loss," is incorrect. An example is the case of a 100 percent tax imposed on
sellers. With a 100 percent tax on their sales of the good, sellers won't supply any of the
good, so the tax will raise no revenue. Yet the tax has a large deadweight loss, since it
reduces the quantity sold to zero.

4. a. The deadweight loss from a tax on heating oil is likely to be greater in the fifth year
after it is imposed rather than the first year. In the first year, the price elasticity of demand is
fairly low, as people who own oil fuelled heating systems are not likely to get rid of them
right away. But over time they may switch to other energy sources and people buying new
heating systems for their homes will be more likely to choose gas or electric, so the tax will
have a greater impact on quantity.

b. The tax revenue is likely to be higher in the first year after it is imposed than in the fifth
year. In the first year, demand is more price inelastic, so the quantity does not decline as
much and tax revenue is relatively high. As time passes and more people substitute away
from oil, the equilibrium quantity declines, as does tax revenue.
5. Since the demand for food is price inelastic, a tax on food is a good way to raise revenue
because it does not lead to much of a deadweight loss; thus taxing food is less inefficient than
taxing other things. But it is not a good way to raise revenue from an equity point of view,
since poorer people spend a higher proportion of their income on food, so the tax would hit
them harder than it would hit wealthier people

6. a. Figure 3 illustrates the market for socks and the effects of the tax. Without a tax, the
equilibrium quantity would be Q1, the equilibrium price would be P1, total spending by
consumers equals total revenue for producers, which is P1 x Q1, which equals area
B+C+D+E+F, and government revenue is zero. The imposition of a tax places a wedge
between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS + tax. The
quantity sold declines to Q2. Now total spending by consumers is PB x Q2, which equals area
A+B+C+D, total revenue for producers is PS x Q2, which is area C+D, and government tax
revenue is Q2 x tax, which is area A+B.
b. Unless supply is perfectly price elastic, the price received by producers falls because of
the tax. Total receipts for producers fall, since producers lose revenue equal to area B+E+F.
EC1000 Question Sheet 1 Tutorial 1 Week 4

Figure 3

c. The price paid by consumers rises, unless demand is perfectly price elastic. Whether total
spending by consumers rises or falls depends on the price elasticity of demand. If demand is
price elastic, the percentage decline in quantity exceeds the percentage increase in price, so
total spending declines. If demand is price inelastic, the percentage decline in quantity is less
than the percentage increase in price, so total spending rises. Whether total consumer
spending falls or rises, consumer surplus declines because of the increase in price and
reduction in quantity.

7. Tom's price elasticity of demand is zero, since he wants the same quantity regardless of the price.
Jerry's price elasticity of demand is one, since he spends the same amount on gas, no matter what the
price, which means his percentage change in quantity is equal to the percentage change in price.

8. A worldwide drought could increase the total revenue of farmers if the price elasticity of demand
for grain is inelastic. The drought reduces the quantity of grain, but if demand is inelastic, a one
percent decrease in quantity is associated with a larger than one percent increase in price. Total farm
revenue would rise as a result. If there is only a drought in Ukraine, however, Ukraine production is
not a large enough proportion of the total farm product to have much impact on the price. As a result,
price does not change (or changes by only a slight amount), while the output of Ukraine farmers
declines, thus reducing their income.

9.

Since computer software is a complement to computers, the lower equilibrium price of computers
increases the demand for software. Since typewriters are substitutes for computers, the lower
equilibrium price of computers reduces the demand for typewriters. In fact, the market for typewriters
has shrunk drastically with the advent of computers.
EC1000 Question Sheet 1 Tutorial 1 Week 4

10. a. Efficiency: The market failure comes from the monopoly power of telecom companies.

b. Equity

c. Efficiency: An externality arises because second-hand smoke harms non-smokers.

d. Efficiency: The market failure occurs because of Microsoft's monopoly power.

e. Equity