ECON 101 Tutorial: Week 3

Shane Murphy
s.murphy5@lancaster.ac.uk
Office Hours: Monday 3:00-4:00 LUMS C86
 Outline
Roll Call
Problems
Discussion
 Chapter 7: Exercise 7
Why might we want to think about market price as the
outcome of a bargaining model?

Market price is really an outcome of the bargaining model.

Suppliers are offering goods to consumers at different prices
and consumers have to make decisions about whether the
prices they are offered represents a net economic benefit to
them. There is an interaction between suppliers and
consumers, therefore, which can be seen as a bargaining
process an agreed outcome between two interested and
competing economic agents. For example suppliers respond
to the decisions made by consumers if too few people buy
their product then they will be forced to take action to
improve the product offering, lower the price or even drop
out of the market altogether.
 Chapter 8: Exercise 2
The government has decided that the free market price
of tobacco is too low.
a) Suppose the government imposes a binding price
floor in the tobacco market. Use a diagram to show
the effect on the price and quantity. Is there a
shortage or surplus? What does the market outcome
depend on?
b) Tobacco producers complain that he price floor has
reduced their total revenue. Is this possible? Why?
c) In response to producers complaints, the
government agrees to purchase all of the surplus
tobacco at the price floor. Compared to the basic
price floor, who benefits from this new policy? Who
loses?
 Chapter 8: Exercise 2
The government has decided that the free market price of tobacco is
too low.
a) Suppose the government imposes a binding price floor in the
tobacco market. Use a diagram to show the effect on the price and
quantity. Is there a shortage or surplus? What does the market
outcome depend on?
The imposition of a binding price floor in
the tobacco market is shown. In the
absence of the price floor, the price would
be P1 and the quantity would be Q1. With
the floor set at Pf, which is greater than P1,
the quantity demanded is Q2, while
quantity supplied is Q3, so there is a
surplus of cheese in the amount Q3 Q2.
 Chapter 8: Exercise 2
The government has decided that the free market
price of tobacco is too low.
b) Tobacco producers complain that he price floor
has reduced their total revenue. Is this possible?
Why?

The tobacco producers complaint that their total revenue

has declined is correct if demand is price elastic. With price
elastic demand, the percentage decline in quantity would
exceed the percentage rise in price, so total revenue would
decline.
 Chapter 8: Exercise 2
The government has decided that the free market price of
tobacco is too low.
c) In response to producers complaints, the government
agrees to purchase all of the surplus tobacco at the price
floor. Compared to the basic price floor, who benefits from
this new policy? Who loses?

If the government purchases all the surplus tobacco at the

price floor, producers benefit and taxpayers lose. Producers
would produce quantity Q3 of tobacco, and their total revenue
would increase substantially. But consumers would buy only
quantity Q2 of tobacco, so they are in the same position as
before. Taxpayers lose because they would be financing the
purchase of the surplus tobacco through higher taxes.
 Chapter 9: Exercise 6
Suppose that the government subsidizes a good: for
each unit of the good sold, the government pays 2 to
the buyer. How does the subsidy affect CS, PS, TR,
TS? Is the a DL?
 Chapter 9: Exercise 6
Suppose that the
government subsidizes
a good: for each unit
of the good sold, the
government pays 2 to
the buyer. How does
the subsidy affect CS,
PS, TR, TS? Is the a DL?
 Chapter 9: Exercise 9
Suppose the market is described by:
Qs = 2P Qd = 300-P
a) Solve for the equilibrium price and quantity.
b) Suppose that a tax of T is placed on buyers so demand is
Qd = 300 (P+T). Solve for the new equilibrium. What
happens to the price receivd by sellers, the price paid by
buyers, and the quantity?
c) Tax revenue is TxQ. Use your answer to part (b) to solve for
tax revenue as a function of T. Graph the relationship for T
between 0 and 300.
d) The deadweight loss of a tax is the area of the triangle
between the supply and demand curves. Graph the
relationship between DL and T between 0 and 300.
e) The government now levies a tax on this good of 200 per
unit. Is this a good policy? Why or why not? Can you
propose a better policy?
 Chapter 9: Exercise 9
Suppose the market is described by:
Qs = 2P Qd = 300-P
a) Solve for the equilibrium price and quantity.

Setting quantity supplied equal to quantity

demanded gives 2P = 300 P. Adding P to both sides
of the equation gives 3P = 300. Dividing both sides by
3 gives P = 100, which is the equilibrium price.
Plugging P = 100 back into either equation for
quantity demanded or supplied gives Q = 200 as the
equilibrium quantity.
 Chapter 9: Exercise 9
Suppose the market is described by:
Qs = 2P Qd = 300-P
b) Suppose that a tax of T is placed on buyers so demand is
Qd = 300 (P+T). Solve for the new equilibrium. What
happens to the price received by sellers, the price paid by
buyers, and the quantity?

Now P is the price received by sellers and P+T is the price paid
by buyers. Equating quantity demanded to quantity supplied
gives 2P = 300 - (P+T). Adding P to both sides of the equation
gives 3P = 300 T. Dividing both sides by 3 gives P = 100 - T/3.
This is the price received by sellers, and is clearly less than
before the tax was imposed. The buyers pay a price equal to
the price received by sellers plus the tax (P+T = 100 + 2T/3).
The quantity sold is now Q = 2P = 200 2T/3.
 Chapter 9: Exercise 9
Suppose the market is described by:
Qs = 2P Qd = 300-P
c) Tax revenue is TxQ. Use your answer to part (b) to solve
for tax revenue as a function of T. Graph the relationship
for T between 0 and 300.
Since tax revenue is equal to T x Q and Q = 200 - 2T/3, tax
revenue equals 200T - 2T2/3. Tax revenue is zero at T = 0 and
at T = 300.
 Chapter 9: Exercise 9
Suppose the market is described by: Qs = 2P Qd = 300-P
d) The deadweight loss of a tax is the area of the triangle between the supply and
demand curves. Graph the relationship between DL and T between 0 and 300.
The area of the triangle (laid on its side) that represents the deadweight loss is 1/2 x
base x height, where the base is the change in the price, which is the size of the tax
(T) and the height is the amount of the decline in quantity (2T/3). So the deadweight
loss equals 1/2 x T x 2T/3 = T2/3. This rises exponentially from 0 (when T = 0) to
45,000 when T = 300.
 Chapter 9: Exercise 9
Suppose the market is described by:
Qs = 2P Qd = 300-P
e) The government now levies a tax on this good of 200 per
unit. Is this a good policy? Why or why not? Can you
propose a better policy?

A tax of 200 per unit is a bad idea, because it's in a region in

which tax revenue is declining. Tax revenue is calculated as
200T - 2T2/3 = 2002 2/3(2002) = 40,000 26,666 = 13,333.
The government could reduce the tax to 150 per unit and get
more tax revenue (15,000). The lower tax would also cause a
smaller deadweight loss. The deadweight loss is calculated as
T2/3 so when T is 200 the deadweight loss is 13,333 and
when T is 150 the deadweight loss is only 7,500. A tax of
150 per unit is therefore a better policy.
 Discussion
Is deadweight loss always bad?

How much should we concern ourselves with

avoiding deadweight loss?

When is deadweight loss acceptable?

How can Santa be described as a deadweight loss?