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Assignment 8: Supply, Demand, and Government Policies
Reading: Economics for Today, 3rd edition, Irvin B. Tucker, Chapter 4.
Date Due:
November 16, 2003 by 6:00 PM
General Instructions:
The homework assignment is designed to help you understand the material. Some of the
questions are easy, others are more difficult. You are expected to complete the
assignment in your group without help from other class members or any of the faculty.
Once you have answered all the questions, please send them as an attachment to me at the
following e-mail address: [email protected]. Your grade will be
determined by the accuracy and completeness of your answers as well as the quality of
your presentation.
Principles to be Learned
1.
2.
3.
4.
5.
Price ceilings and price floors are two types of price controls.
To be effective, price floors have to be set above the market equilibrium price.
Likewise, price ceilings must be set below the market equilibrium price.
Effective price floors lead to excess supply or surplus of the good or service.
Effective price ceilings lead to excess demand or shortage or the good or service.
Taxes on goods raise the prices and decrease the quantity sold of the goods.
Taxes are not necessarily borne where they are levied.
Technical Details to be Mastered
1.
2.
3.
4.
Learn how to demonstrate the impact of a price ceiling in the demand and supply
model.
Learn how to demonstrate the impact of a price floor in the demand and supply
model.
Learn how to measure surpluses and shortages in the demand and supply model.
Learn how to demonstrate the impact of a tax increase or decrease in the demand
and supply model.
Assignment:
1.
Suppose you are seeking housing in a rent controlled city and have been unable to
locate an apartment. Since you are a prudent saver and investor, you have some
money saved for a down payment for a condominium. You are aware of a
forthcoming referendum to repeal rent-control laws, and you believe that passage
is imminent.
a.
What do you expect will happen to the value of the condominium you are
purchasing approximately one year from now?
b.
What do you expect will happen to supply and prices of condominiums in
the long-run?
2.
The government has decided that the free-market price of cheese is too low.
a.
Suppose the government imposes a price floor in the cheese market. Use a
supply and demand diagram to show the effect of this policy on the price
of cheese and the quantity of cheese sold. Is there a shortage or surplus of
cheese?
b.
Farmers complain that the price floor has reduced their total revenue. Is
this possible? Explain.
c.
In response to farmers’ complaints, the government agrees to purchase all
of the surplus cheese at the price floor. Who benefits from this new
policy? Who loses?
3.
If the government places a $500 tax on luxury cars, will the price paid by
consumers rise by more than $500, less than $500, or exactly $500? Using the
concept or price elasticity of demand, explain your answer.
4.
Consider the following polices, each of which aims at reducing violent crime by
reducing the use of guns. Illustrate each of these proposed policies in a supply
and demand diagram of the gun market.
a.
a tax on gun buyers
b.
a tax on gun sellers
c.
a price floor on guns
d.
a tax on ammunition
5.
Suppose the federal government requires beer drinkers to pay a $2 tax on each
case of beer purchased. (In fact, both the federal and state governments impose
beer taxes of some sort.)
a.
Draw a supply and demand diagram of the market for beer without the tax.
Show the price paid by consumers, the price received by producers, and
the quantity of beer sold. What is the difference between the price paid by
consumers and the price received by producers?
b.
Now draw a supply and demand diagram for the beer market with the tax.
Show the price paid by consumers, the price received by producers, and
the quantity of beer sold. What is the difference between the price paid by
consumers and the price received by producers? Has the quantity of beer
sold increased of decreased?
6.
During the 1980s, the U.S. Congress imposed a high sales tax on yachts, figuring
that the rich could afford to pay for this luxury. But so many jobs were lost in the
boat building industry that the measure was finally repealed. What did Congress
get wrong in imposing this luxury tax?
7.
The following questions are designed to test your understanding of demand and
supply, elasticity, and price floors.
a.
Suppose the minimum wage is above the equilibrium wage in the market
for unskilled labor. Using a supply and demand diagram of the market for
b.
c.
d.
unskilled labor, show the market wage, the number of workers who are
employed, and the number of workers who are unemployed. Also, show
the total wage payments to unskilled workers.
Now suppose the secretary of labor proposes an increase in the minimum
wage. What effect would this increase have on employment? Does the
change in employment depend on the elasticity of demand, the elasticity of
supply, both elasticities, or neither?
What effect would this increase in the minimum wage have on
unemployment? Does the change in unemployment depend on the
elasticity of demand, the elasticity of supply, both elasticities, or neither?
If the demand for unskilled labor were inelastic, would the proposed
increase in the minimum wage raise or lower total wage payments to
unskilled workers? Would your answer change if the demand for
unskilled labor were elastic?
Application
An Investigation of Electricity Deregulation
Objective:
To improve your understanding of the effects of government price controls and to
practice applying this concept to the real world.
Instructions:
Read the article “Too Much Regulation Keeps California in the Dark” by William P.
Kucewicz and answer the questions that follow.
Wall Street Journal
Commentary
August 7, 2000
Too Much Regulation Keeps California in the Dark
William P. Kucewicz
Editor of the Global Investment Web site GeoInvestor.com.
What goes bump in the dark? The answer: California! Starting today, the state is
almost certain to be hit by power blackouts, thanks to the administrative body charged, of
all things, with ensuring reliable electricity service. Electricity prices in California are
rising because power is in woefully short supply. And power is in short supply because
of years of regulation. Yet as Californians swelter, they will have to endure politicians
trying to blame this shortage on deregulation.
The California Independent System Operator (Cal-ISO) has elected to halve the
maximum price utilities can pay for electric power, despite warnings from suppliers that
electricity and power-plant investors would shun the state if the wholesale price cap were
lowered. California already imports a fifth or more of its power and relies on expensive
"peaking" units to meet excess demand. In spite of that, Cal-ISO's board last week voted
to lower the ceiling on wholesale power prices to $250 a megawatt hour from $500,
effective today. This followed an earlier cut from $750 per megawatt hour. The board
said it was responding to calls from state officials, who fault deregulation for California's
current electricity woes. But electricity decontrol is not the problem. Anyone who lived
through the U.S. oil price controls of the 1970s would know that.
The root cause of California's electricity crisis is regulation, not deregulation. No
major power plants were built for a decade, in part because regulators didn't anticipate the
state's Silicon Valley-driven economic boom of the late 1990s. Stringent environmental
rules and bureaucratic red tape made electricity-related construction nearly impossible.
As a result, electric demand has risen by 25% in the past eight years, while in-state power
generation has increased by a paltry 6%.
California's shortages of power-generating plants and long-distance transmission
lines have left it vulnerable to any sizeable increase in electricity demand -- witness this
year's heat wave. In fact, Cal-ISO has declared eight Stage Two emergencies already this
year, requiring large power users to curtail consumption. In 1999, by contrast, there was
only one such alert. The next step, Stage Three, entails "rolling blackouts." San
Francisco had one of these in June.
Of the 42 states now moving toward electricity deregulation, California is
procedurally furthest along. However, a more robust example of decontrol came recently
from New York. Its independent system operator decided to reject a recommended
$1,000 per megawatt hour price cap in favor of a $1,300 one. The New York board opted
for a price cap that exceeds the limits in neighboring states and thus virtually guarantees
the Empire State will be blackout-free this summer.
Californians, meanwhile, now face the worst kind of political demagogy. San
Diego county officials have declared a "financial state of emergency," and Democratic
Sen. Barbara Boxer has called on President Clinton to extend federal assistance to
prevent "a financial problem" from becoming "a public health emergency."
Forces other than political pressure are also at work. Cal-ISO's decisions to lower
the wholesale price cap on electricity amount to a bailout of California's utilities, which
took a gamble on deregulation legislation that some are losing. In the decontrol debate in
1996, high on the utilities' agenda were so-called "stranded costs" -- i.e., the uneconomic
capital expenditures and financial obligations incurred under regulation. The utilities
therefore agreed to a 10% electric rate reduction for residences and small businesses in
exchange for a refinancing of their stranded costs. They need to recoup these costs by
March 31, 2002, or eat the rest.
San Diego Gas & Electric has already recovered its costs, thereby eliminating the
mandated rate reduction, which is why its customers are receiving higher bills. Other
utilities, notably Pacific Gas & Electric and Southern California Edison, have not.
Fearing they may not recoup all their stranded costs by the deadline, utilities have lobbied
hard for lower price caps to help keep their costs down.
Appreciate, too, that the headline-making rise in electric bills has affected only
SDG&E's 1.2 million customers, whose typical household electric bill has risen to $105
or so a month from about $55 this time last year. Consumers elsewhere in the state have
seen no such increase, because they're still enjoying the 10% rate reduction mandated by
the 1996 deregulation law. This has exacerbated California's woes, because these price
controls offer no incentive to conserve electricity.
There's hope yet for California. The Federal Energy Regulatory Commission
could overrule the Cal-ISO board. It has already launched a study into the "volatile price
fluctuations" in the bulk power sales in the U.S. The findings are due in November, the
same month all wholesale price controls on electricity in California are supposed to
expire. Given the political climate, however, few expect the caps to vanish anytime soon.
The lesson of energy price controls and utility regulation seems lost on California. But it's
one that state officials will likely ponder -- after the lights go out.
1.
Why are electricity prices in some parts of California rising?
2.
Are the price controls in California an example of a price floor or a price ceiling.
Briefly explain.
3.
Draw a supply and demand diagram for electricity in California and do the
following:
a.
Determine the equilibrium price and quantity.
b.
Introduce the current price cap of $500 per megawatt of electricity and
determine the quantity demanded and quantity supplied at this price. How
do they differ from the equilibrium quantity demanded and supplied?
c.
Show how lowering the price cap to $250 per megawatt will affect
quantity demanded and quantity supplied in the future.
4.
According to the article, what is the current difference between quantity
demanded and quantity supplied?
5.
Why would lowering the price cap cause power plant investors to “shun the
state?”
6.
Briefly discuss the changes in demand for and supply of electricity in California
that have occurred during the 1990s.
7.
Draw a supply and demand diagram for electricity in California and do the
following:
a.
Determine the equilibrium price and quantity.
b.
Show how the change in demand that occurred during the 1990s coupled
with the change in supply affected the equilibrium price and quantity.
8.
Why are the California utilities lobbying to lower the price caps? Do you think
these caps should be lowered? Explain your position.