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Economic Policies and Efficiency:
Exercises and Applications
Lecture 6 – academic year 2014/15
Introduction to Economics
Fabio Landini
Ex. 6.1 – The market for cigarettes
If the equilibrium price on the market for
cigarettes is equal to 10 Euro a packet, and the
State imposes a MINIMUM price equal to 12
Euro, we have…
A) … An excess supply: the quantity supplied is
greater than the quantity demanded.
B) ... Scarcity: the quantity demanded is greater
than the quantity supplied.
C) ... No effect on the market.
Ex. 6.1 – The market for cigarettes
If the equilibrium price on the market for
cigarettes is equal to 10 Euro a packet, and the
State imposes a MINIMUM price equal to 12
Euro, we have…
A) … An excess supply: the quantity supplied is
greater than the quantity demanded.
B) ... Scarcity: the quantity demanded is greater
than the quantity supplied.
C) ... No effect on the market.
Ex. 6.2 – Tax on petrol (I)
Question
The European Parliament decides that the EU must
decrease the level of air pollution by reducing the use
of petrol in road transports. Therefore, it introduces a
tax on petrol of 0.50 € a litre.
Should the EU introduce a tax on consumption or
production? Explain in detail by using a graphical
representation (S&D model).
Ex. 6.2 – Tax on petrol (I)
Price of petrol
Supply, S1
Pt
P* neat of the tax
P*
Equilibrium
without the tax
T
Equilibrium
with the tax
Tax on
consumption
D2
0
Q* Q*
D1
Quantity of
petrol
Ex. 6.2 – Tax on petrol (I)
Price of petrol
Equilibrium
with the tax
S2
Supply, S1
P*
P* neat of the tax
Equilibrium
without the tax
T
Tax on
production
D1
0
Q* Q*
Quantity of
petrol
Ex. 6.2 – Tax on petrol (I)
Taxes on consumption or production generates
the same effects on the market
A positive difference is created between the
price paid by the consumer and the one paid by
the producer
This difference is indeed the same,
independently on whether the tax is imposed on
production or consumption
Ex. 6.2 – Tax on petrol (II)
Question
If the demand for petrol were more elastic, would
this tax be more or less efficient in reducing the
quantity of petrol that is consumed?
Explain in detail by using a graphical
representation (S&D model).
Ex. 6.2 – Tax on petrol (II)
Price of petrol
Supply, S1
Pt
T
P*
Equilibrium
without the tax
T
P*
P*
Equilibrium
with the tax
Elastic demand
D2
0
Q2 Q* Q*
D1
Quantity of
petrol
Ex. 6.2 – Tax on petrol (II)
With a higher elasticity ED(p), the same
tax would induce a greater reduction in
the equilibrium quantity
Ex. 6.2 – Tax on petrol (III)
Question
Do the consumers of petrol obtain some
benefits from the introduction of the tax?
Do the workers of the petrol industry obtain
some benefits from the introduction of the tax?
Ex. 6.2 – Tax on petrol (III)
Answer
Consumers suffer a cost from the introduction of
the tax, because the latter has anyway a
negative effect by increasing the market price.
Workers of the petrol industry suffer a cost too,
by reducing the quantity produced (in addition
to the cost as consumers)
Ex. 6.3 – Tax and prices
Question
Two market equations:
QS = 2P
QD = 12 – P
a) Find the equilibrium price and quantity;
b) What happen if the Government imposes a
tax T on producers?
Ex. 6.3 – Tax and prices
Answer
a) Equilibrium price and quantity:
QS = Q D
2P = 12 – P -> 3P = 12 ->
P = 4 and QS = QD = 8
14
Ex. 6.3 – Tax and prices
Answer
b) Equilibrium after the tax T, steps:
1.
2.
3.
4.
Find equilibrium with the new supply curve
Compute the price received by producers
Compute the price paid by the consumers
Compute the new quantity sold in
equilibrium
15
Ex. 6.3 – Tax and prices
If a tax T is introduced the price received by the
producers is:
QS = Q D
2(P – T) = 12 – P
2P – 2T = 12 – P
3·P = 12 + 2·T
P = 4 + 2/3·T
16
Ex. 6.3 – Tax and prices
The price paid by the consumers is:
P - T = (4 + 2/3·T) – T
P - T = 4 + T(2/3 – 1)
Therefore,
P – T = 4 – 1/3·T
17
Ex. 6.3 – Tax and prices
The quantity sold is equal to:
QO = 2(P – T) = 2 ·(4 + 2/3·T – T) = 8 – 4/3·T
Comments: as we could expect, in because of
the tax the dimension of the market reduces
and the tax burden is shared ( 2/3 is paid by the
producer and 1/3 by the consumer)
18
Ex. 6.3 – Tax and prices
Amount of
the tax
Supply
4 + 2/3 T
4
4 - 1/3 T
T
Demand
8 - 4/3 T
8
19
Ex. 6.4 – More on cheese market (I)
Question
Two market equations:
QD = 9 – P
QS = 3P – 3
Compute the surplus of the consumer and the
surplus of the producer in equilibrium.
Ex. 6.4 – More on cheese market (I)
Price of
cheese
In equilibrium QD = QD = 6,
and P is equal to 3
9
S
3
1
D
6
Quantity
of cheese
Ex. 6.4 – More on cheese market (I)
To compute the surplus of consumer (RC) we
must compute the size of the area between the
demand curve and the equilibrium price.
To compute the surplus of producer (RP) we
must compute the size of the are between the
supply curve and the equilibrium price.
Ex. 6.4 – More on cheese market (I)
Price of
cheese
Consumer surplus:
9 A
Area of triangle ABC = (BC·AB)/2
BC = 6 and AB = 9-3= 6, therefore
Area of ABC = (6·6)/2 = 18
S
3
B
1
C
D
D
6
Quantity
of cheese
Ex. 6.4 – More on cheese market (I)
Price of
cheese
Producer surplus:
9 A
Area of triangle BCD =(BC·BD)/2
BC = 6 and BD = 3-1= 2, therefore
Area of BCD = (6·2)/2 = 6
S
3
B
1
C
D
D
6
Quantity
of cheese
Ex. 6.4 – More on cheese market (I)
In conclusion:
– RC is equal to 18
– RP is equal to 6
– The total surplus (R = RP+RC) is equal to 24
Ex. 6.4 – More on cheese market (II)
Question
The government decides that the price of cheese
that is determined on the market is too low.
Suppose that the Government introduces a
minimum price.
Draw the S&D graph and show the effect of such
policy on the market price and on the quantity sold.
Does this intervention induce scarcity or excess
supply?
Ex. 6.4 – More on cheese market (II)
Price of cheese
Supply
Excess
supply
Minimum
price
Equilibrium
price = P*
Demand
0
Q*
Qd
Qo
Quantity of
cheese
Ex. 6.5 – More on cheese market (III)
Question
The farmers of a given country complains that
the imposition of the minimum level of price on
cheese has reduced their total revenue.
Is it possible? Explain why.
Ex. 6.4 – More on cheese market (III)
Answer
The sign of the reduction in total revenue for
farmer depends on the elasticity of demand
with respect to price
The total revenue before the introduction of the
minimum level of prise is equal to (A+B+C+D)
(next slide)
Ex. 6.4 – More on cheese market (III)
Price of cheese
Supply
Excess
supply
Minimum
price
B
Equilibrium
price = P*
A
C
Demand
D
0
Q*
Qd
Qo
Quantity of
cheese
Ex. 6.4 – More on cheese market (III)
With the minimum level of price (QD, Pmin):
total revenue is equal to area (A+D+E)
(next slide)
Gain/ loss of revenue = E – (B+C)
(next slide)
Ex. 6.4 – More on cheese market (III)
Price of cheese
Supply
Excess
supply
Minimum
price
E
F
B
Equilibrium
price = P*
A
C
Demand
D
0
Q*
Qd
Qo
Quantity of
cheese
Ex. 6.4 – More on cheese market (IV)
Question
In response to the farmers’ complaints, the
Government to buy all the excess supply of
cheese from farmer at the limit price. In
comparison with the introduction of the
minimum price,
a) Who benefits from this new intervention?
b) Who is damaged?
Ex. 6.4 – More on cheese market (IV)
Price of cheese
Supply
Excess
supply
Minimum
price
E
F
B
Equilibrium
price = P*
A
C
Demand
D
0
Q*
Qd
Qo
Quantity of
cheese
Ex. 6.4 – More on cheese market (IV)
Answer
The new intervention benefits farmers and
damages taxpayers (if we assume that the
Government finance the new policy by increasing
taxes).
Ex. 6.5 – Lemonade
Question
The (usual) chilling destroys part of the lemon
harvest in Sicily.
a) Which is the effect on the consumer
surplus in the market for lemonade?
b) What happen to the surplus of the
lemonade producers?
Ex. 6.5 – Lemonade
Answer
a) In the market for lemonade lemons are
inputs –> the lemonade supply curve shifts
leftward
Ex. 6.5 – Lemonade
Before the chilling,
consumer surplus=
S2
Price of
lemonade
A+B+C+D
S1
A
P1
B
C D
P*
E
G
F
Demand, D
0
Q1
Q*
Quantity of
lemonade
Ex. 6.5 – Lemonade
After the chilling,
consumer surplus=
S2
Price of
lemonade
A
S1
A
P1
B
C D
P*
E
G
F
Demand, D
0
Q1
Q*
Quantity of
lemonade
Ex. 6.5 – Lemonade
Answer
b) Effects on the lemonade producers surplus
Ex. 6.5 – Lemonade
Before the chilling,
producer surplus=
S2
Price of
lemonade
E+F+G
S1
A
P1
B
C D
P*
E
G
F
Demand, D
0
Q1
Q*
Quantity of
lemonade
Ex. 6.5 – Lemonade
After the chilling,
producer surplus=
S2
Price of
lemonade
E +B
S1
A
P1
B
C D
P*
E
G
F
Demand, D
0
Q1
Q*
Quantity of
lemonade
Ex. 6.5 – Lemonade
Therefore: the effect on the consumer surplus
in UNCERTAIN.
It depends on the price elasticity of the
demand curve.
If the curve is flat (high elasticity), it is more
likely that the producer will loose (area B gets
smaller)