econ1101: week 8 tutorial 7

7/30/2019 ECON1101: Week 8 Tutorial 7

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Chapter 7 Efficiency and Exchange

Answers to review questions

1 Economists emphasise efficiency because an efficient outcome means that the size ofthe economic pie, or total surplus, is maximised. This means that all of our othereconomic goals could potentially be fulfilled to their greatest possible extent. With alarger pie, everyone can have a larger slice. Economists support of efficiency as a goaldoes not, however, mean that they support the existing distribution of income.

2 To ensure that everyone is better off as a result of the policy you could introduce ameasure that transfers income from workers to retirees. For example, a policy whichtransferred $1 million per year from workers to retirees would leave retirees no worseoff and workers better off by the tune of $99 million per year as a result.

3 The tax raises revenue for the government and the value of the additional revenuecollected must be counted as a gain when evaluating the welfare effect of the tax. Thismeans that the loss associated with the tax will be less than the loss of consumer and

producer surplus.

4 False. While it is true that those travellers who volunteer under a compensation schemeto wait for a later flight probably on average have a lower income than those who dontvolunteer, these passengers give up their seats under the voluntary policy only whenthey find the payment offered sufficient to compensate them for the inconvenience ofwaiting. Under the first-come, first-served policy there will be low-income passengerswho are forced to wait, but who receive no compensation.

5 When market supply and demand capture all relevant costs and benefits associated with

consuming and producing a product any policy that prevents the market reachingequilibrium leaves cash on the table. Since a price floor restricts the level of exchangein a market to be below its equilibrium level there will be opportunities for trade thatwould increase economic surplus in the market that remain unexploited. In other words,there will be cash on the table.

6 False. A tax on an activity that causes harm to people other than those directly involvedin the activity can increase efficiency by simultaneously generating governmentrevenue and discouraging people from undertaking the activity.


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Answers to problems

1 a Consumer surplus is the triangular area between the demand curve and the

price line. Its area is equal to 0.5bh, where b is the base of the triangle and h is theheight. In this example, the base is 6 units and the height is 1.5 units, measured in

dollars. Therefore, consumer surplus is:

0.5($1.50/unit)(6 units/week), or $4.50 per week.

b Producer surplus is the triangular area between the supply curve and the priceline. Using the base-height formula, it is:

(0.5)($4.50/unit)(6 units/week), or $13.50 per week.

c The maximum weekly amount that consumers and producers together would bewilling to pay to trade in used DVDs is the sum of gains from trading in usedDVDs namely, the total economic surplus generated per week, which is $18 perweek.

2 a At a price of $7.50, the quantity supplied per week equals 2 units. The

quantity demanded at this price is 18 per week, which implies a weekly shortageof 16 used DVDs.

b The weekly economic surplus lost as a result of the price ceiling is the area of thedark-shaded triangle in the diagram, or the sum of the areas of the two trianglesABC and ACD. Using the information given in the graph, this amount iscalculated as (0.5)(4)(1) + (0.5)(4)(3) = $8/week.

3 a When there is no charge for the tour, the surplus enjoyed by someone who

takes it equals his or her reservation price for the tour. If the warden operates thetour on a first-come-first served basis, Faith, Penny, and Fran will be turnedaway. The combined consumer surplus when the four who arrive first take thetour is $20 + $14 + $30 + $15=$79.

b An offer of $15 compensation generates three volunteers to return another day:Fran, Jack and Jon. The four who go on the tour receive a total consumer surplusof $40 + $30 + $20 + $17 = $107. The warden pays $45 in compensation

payments to the three volunteers, which causes him a loss in economic surplus of$45 that is exactly offset by the gain in economic surplus to the three volunteers.Total economic surplus from the tour operation is now $107, which is $28 higherthan before.

12

48

6

6Quantity

Price

P=6+0.75Q

P=12-0.25Q

16

2

3

A

B

C

D

4


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c The compensation policy is more efficient than the first-come-first-served policybecause it establishes a market for a scarce resource that would otherwise beallocated by non-market means. People who choose not to miss the tour that dayare paying an opportunity cost of $15 not to miss it. Therefore, only those peopleto whom the tour is worth more than $15 will actually take it.

d Suppose the warden auctions off the right to take the tour by increasing the tourprice by $1 increments until only four people (Faith, Penny, Herman, and Kate)are willing to pay. The auction will stop when the price reaches $16. The wardenwill collect $64 from the auction. He can then give refunds to Herman and Kate,who would have gone for free under the first-come-first-served scheme, so theywill be just as well off as before. He can give $16 to Jack ($1 more than enoughto compensate him for not going), and $15 to Jon (also $1 more than enough tocompensate him). That leaves the warden with $1, so he too is better off than

before. Faith is $1 better off than before, and Penny is $24 better off than before.All others are exactly as well off as before.

4 a & b The equilibrium price is $5 and the equilibrium quantity is 3000 units per week.

The consumer surplus is the area between the demand curve and the price line triangle ABC in the diagram which is $4500/week. The producer surplusgenerated is the area of triangle ABD, which is also $4500/week. Therefore, thetotal economic surplus is $9000/week.

3 8Quantity

(1000s per wk)

Price($/unit)

P = 8 - Q2

5

8

P = 2 + Q

C

B A

D


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c & d The tax shifts the vertical intercept of the supply curve up by $2 to $4. The newequilibrium price and quantity are $6 and 2000 respectively. The tax revenue is$2(2000), or $4000/week. Consumer surplus is now the area of the triangleA'B'C, which is $2000/week. Net of the $2 tax, sellers receive a price of $4 perunit. Their surplus is the area of the triangle D'ED, which is $2000/week. The tax

revenue collected is ($2/unit)(2000 units/week) = $4000/week. Counting therevenue from the tax as part of total economic surplus, the new total economicsurplus is thus:

$2000/week + $2000/week + $4000/week = $8000/week

or $1000/week less than without the tax.

2 8Quantity

(1000s per wk)

Price($/unit)

P = 8 - Q2

4

8

P = 2 + Q

C

B'A'

D'

6

P = 4 + Q

E

D

5 a The marginal cost curve for electric power in the town would look like this:

100

10

1

Unitsofpowerperday

Price(cents/unit)

Marginalcostofpower


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b The city should charge 10 cents per unit, since that is the marginal cost whenresidents use at least 100 units/day, which they will if the city charges 10 cents orless. It should charge 10 cents per unit to all users, even those who are receivingtheir power from the hydroelectric facility, since if those users were to cut theirconsumption, they would free up hydroelectric capacity, which could then be

used to serve others who are currently receiving their power from the more costlysteam generator.

6 The winter demand (DW in the diagram) can be served entirely by the undergroundspring, so the price should be two cents per hundred litres in the winter months. Watermust be drawn from the lake to meet demand in the summer months (D S in thediagram), so the price should be four cents per hundred litres in summer.

7 a As shown by the demand curve in the following diagram, Phil would make

three more visits per semester to the walk-in clinic at a price of $0 than he wouldat a price of $24/visit. Phils total expenditure on medical care (insurance

premiums plus payments for office visits) will thus differ by the cost of thosethree extra visits, namely $72/semester. Since policy A has to reimburse the costof six visits, its premium will be 6($24) = $144/semester greater than policy Bs.

b The value to Phil of the three extra visits he would take under policy A is givenby the area of triangle BFE, which is $36/semester. Since that is less than hisextra expense under policy A, he will choose policy B.

P ($/visit)

Q (visits/semester)3

48

6

24

A

C B

ED F


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c If his alternative were to switch to policy A at a price of $72/semester more thanthe current price of B, Phil would pay up to $36/semester for the right to continue

buying policy B at its current price.

8 At a price of $1 per litre, the islands citizens will consume five million litres of oil peryear. The true marginal cost of oil for the nation is the international price, which is $2

per litre. If citizens had been charged this price they would have consumed only fourmillion litres per year. The lost surplus from consuming the larger amount of oil is thecumulative difference between the cost of the oil and the most they would have beenwilling to pay for it. This difference is the area of the shaded triangle in the diagram, or$500 000 per year.

9 a Each individual households demand curve is as shown in the diagram.

b With the subsidy, each family receives consumer surplus equal to the area oftriangle ADE. Without the subsidy, consumer surplus equals the area of triangleABC. The difference is the area BCED, which equals $4.50/year.

c The governments oil subsidy per family is ($1/litre)(5 litres/year) = $5/year. Thegovernment could therefore cut each familys taxes by $5/year by not subsidisingoil.

d The familys net gain would be the $5 it saves in taxes minus the $4.50 it loses inconsumer surplus from its heating oil purchases, or $0.50/year.

e The aggregate gain from the tax cut and the removal of the subsidy is $500 000per year, the same as the loss in total consumer surplus that resulted from the

subsidy.


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econ1101: week 8 tutorial 7

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