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Home Work 5 – Questions
1. There are four consumers willing to pay the following amounts for haircuts:
Jerry: GHC 7
Oprah: GHC 2
Ellen: GHC 8
Phil: GHC 5
There are four hair-cutting shops with following costs for haircuts:
Firm A: GHC3
Firm B: GHC 6
Firm C: GHC4
Firm: D GHC2
Each Firm has the capacity to produce only one haircut. For Efficiency, how many haircuts should be
given? Which businesses should cut hair, and which consumers should have their hair cut? How large is
the maximum total surplus?
Figure 13 shows supply and demand curves for haircuts. Supply equals demand at a quantity of
three haircuts and a price between $4 and $5. Firms A, C, and D should cut the hair of Ellen,
Jerry, and Phil. These firms earn positive producer surpluses and the consumers enjoy
positive consumer surpluses. Oprah’s willingness to pay is too low and firm B’s costs are too
high, so they do not participate as they do not enjoy any surpluses. The maximum total
surplus is the area between the demand and supply curves, which totals $11 ($8 value minus
$2 cost for the first haircut, plus $7 value minus $3 cost for the second, plus $5 value minus
$4 cost for the third).
Figure 13
2. The government has decided the free-market price of Ghana-rice is too low.
a)
Suppose the government imposes a binding price floor in the cheese market. Use a supply-anddemand diagram to show the effect of this policy on the price and quantity of Ghana-rice sold. Is there a
shortage or a surplus of Ghana-rice?
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 rice at
the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses?
a. The imposition of a binding price floor in the cheese market is shown in Figure 4. 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.
b. The farmers’ complaint that their total revenue has declined is correct if demand is elastic.
With elastic demand, the percentage decline in quantity would exceed the percentage rise in
price, so total revenue would decline.
c.
If the government purchases all the surplus cheese at the price floor, producers benefit and
taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue would
increase substantially. However, consumers would buy only quantity Q2 of cheese, so they are in
the same position as before. Taxpayers lose because they would be financing the purchase of the
surplus cheese through higher taxes.
Figure 4
3. The cost of producing stereos over the past decade has fallen. Let’s consider some implications of
this:
a) Use demand and supply diagrams to show the effect of falling production costs on the price and
quantity of stereos sold.
b) Use supply and demand diagrams to show what happens to consumer surplus and producer surplus
c) Suppose the supply of stereo is very elastic. Who benefits from falling production costs – consumers
or producers?
The effect of falling production costs in the market for stereos results in a shift to the right in the
supply curve, as shown in Figure 11. As a result, the equilibrium price of stereos declines
and the equilibrium quantity increases.
Figure 11
b. The decline in the price of stereos increases consumer surplus from area A to A + B + C
+ D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus
was areas B + E (the area above the supply curve and below the price). After the shift in
supply, producer surplus is areas E + F + G. So producer surplus changes by the amount
F + G – B, which may be positive or negative. The increase in quantity increases
producer surplus, while the decline in the price reduces producer surplus. Because
consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total
surplus rises by C + D + F + G.
c. If the supply of stereos is very elastic, then the shift of the supply curve benefits
consumers most. To take the most dramatic case, suppose the supply curve were
horizontal, as shown in Figure 12. Then there is no producer surplus at all. Consumers
capture all the benefits of falling production costs, with consumer surplus rising from
area A to area A + B.
Figure 1
4. Suppose the federal government requires Ogoglo drinkers to pay a GHC 2tax on each bottle of
Ogoglo.
a. Draw a supply and demand diagram of the market for Ogoglo without the tax. Show the price paid by
consumers, the price received by producers, and the quantity of Ogoglo sold. What is the difference
between the price paid by consumers and the price received by producers?
b. Draw a supply and demand diagram of the market for Ogoglo with the tax. Show the price paid by
consumers, the price received by producers, and the quantity of Ogoglo sold. What is the difference
between the price paid by consumers and the price received by producers? Has the quantity of Ogoglo
sold increased or decreased?
Figure 5 shows the market for beer without the tax. The equilibrium price is P1 and the equilibrium
quantity is Q1. The price paid by consumers is the same as the price received by producers.
Figure 5
Figure 6
b. When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown in
Figure 6. The price paid by consumers is P2, while the price received by producers is
P2 – $2. The quantity of Ogoglo sold declines to Q2.
5. Suppose a technological advance reduces the cost of making computers:
a)
Use a supply and demand diagram to show what happens to price, quantity, consumer surplus
and producer surplus in the market for computers?
b)
Computers and Adding machines are substitutes. Use supply and demand diagram to show what
happens to price, quantity, producer surplus, and consumer surplus in the market for adding machines.
Should adding machine producers be happy or sad about the technological advance in computers?
c) Computers and software are complements. Use supply and demand diagram to show what happens
to price, quantity, producer surplus, and consumer surplus in the market for software. Should software
producers be happy or sad about the technological advance in computers?
d)
Does this analysis help explain why software producer like Bill Gates is one of the world's richest
men?
The effect of falling production costs in the market for computers results in a shift to the right in
the supply curve, as shown in Figure 14. As a result, the equilibrium price of computers
declines and the equilibrium quantity increases. The decline in the price of computers
increases consumer surplus from area A to A + B + C + D, an increase in the amount B
+ C + D.
Figure 14
Prior to the shift in supply, producer surplus was areas B + E (the area above the supply
curve and below the price). After the shift in supply, producer surplus is areas E + F + G.
So producer surplus changes by the amount F + G – B, which may be positive or
negative. The increase in quantity increases producer surplus, while the decline in the
price reduces producer surplus. Because consumer surplus rises by B + C + D and
producer surplus rises by F + G – B, total surplus rises by C + D + F + G.
b. Because adding machines are substitutes for computers, the decline in the price of
computers means that people substitute computers for adding machines, shifting the
demand for adding machines to the left, as shown in Figure 15. The result is a decline in
both the equilibrium price and equilibrium quantity of adding machines. Consumer
surplus in the adding-machine market changes from area A + B to A + C, a net change
of C – B. Producer surplus changes from area C + D + E to area E, a net loss of C + D.
Adding-machine producers are sad about technological advances in computers because
their producer surplus declines.
Figure 15
c.
Because software and computers are complements, the decline in the price and increase
in the quantity of computers means that the demand for software increases, shifting the
demand for software to the right, as shown in Figure 16. The result is an increase in both
the price and quantity of software. Consumer surplus in the software market changes
from B + C to A + B, a net change of A – C. Producer surplus changes from E to C + D +
E, an increase of C + D, so software producers should be happy about the technological
progress in computers.
Figure 16
d. Yes, this analysis helps explain why Bill Gates is one the world’s richest people, because
his company produces a lot of software that is a complement with computers and there
has been tremendous technological advance in computers.