Ch. 6/8 Price Controls and Taxation

Question 1

Suppose that market demand is given by QD = 1000 - 5 P, while market supply is given by QS = 15 P - 600. If a price ceiling of $60 is imposed on this market, which of the following is incorrect?

Answer 1

A deadweight loss of $24,000 occurs.

The market clearing price is 1600 = 20P, which is P = $80. Since the ceiling is below $80, it is binding.

In the free market, consumer surplus is 1/2 * 600 * (200 - 80) = $36,000. With the price ceiling, CS = 300 * (140-60) + 300 * (200-140)/2 = $33,000.

DWL = 1/2 * (600-300) * (140-60) = $12,000.

With the ceiling, quantity supplied is 300 and quantity demanded is 700, creating a shortage of 400 units.

PS = 1/2 * 300 * (60-40) = $3,000.

Question 2

If the equilibrium price of corn is $5 per bushel but the minimum legal price is $6 per bushel,

Answer 2

any possible increase in producer surplus would be smaller than the loss of consumer surplus.

Question 3

Suppose the equilibrium price of a physical examination (“physical”) by a doctor is $200, which has some-what elastic supply and demand. If the government imposes a price floor of $250 per physical,

Answer 3

the quantity demanded of physicals decreases and the quantity of physicals doctors want to give increases.

Question 4

Suppose the federal government places a binding price ceiling on tuition prices. Which of the following could not happen as a result?

Answer 4

Colleges may offer discounts through “scholarships” not based on scholastic achievement.

Question 5

A candidate promises to tax cosmetic surgery. He promises that all of the tax will be borne by cosmetic surgeons, not their patients. He also promises that it will not create any inefficiency in cosmetic surgery. These claims are

Answer 5

only true if supply is perfectly inelastic.

The party with less elasticity feels most of the tax burden. If cosmetic surgeons feel the full burden of the tax, either supply is perfectly inelastic or demand is perfectly elastic.

If demand is elastic, then quantity will change after the tax. Supply must be perfectly inelastic.

Question 6

A senator claims: “US consumers drink 20 billion bottles of soda per year. A $1 / bottle tax will raise $20 billion of tax revenue, and fight obesity by reducing soda consumption by 20%.” This statement is

Answer 6

contradictory for any degree of elasticity.

To raise $20 billion of tax revenue, the quantity of soda must not change after the tax. This contradicts the senator’s second claim of reducing soda consumption by 20%.

Question 7

Suppose the City of Provo is debating whether to impose an tax increase on auto sales or on boat sales. A study determines that both markets have about the same market price and quantity and elasticity of demand, but that supply for boats is significantly more elastic than supply for autos. If the City wants to maximize _______ they should tax ________.

Answer 7

consumer surplus; autos

Boats are more elastic, so quantity will fall by more, producing less revenue and more DWL (less efficiency) compared to a tax on cars.

However, this does force consumers to pay a larger fraction of the tax. Producers pay a larger fraction of the tax on cars.

Since demand is similar in the markets and the quantity changes less in the car market, consumer surplus is larger in the car market than boat market.

Question 8

Assume that the demand for milk is relatively inelastic and that the demand for orange juice is relatively elastic, while their supply and equilibrium price and quantity are similar. Compared to a tax of similar size on orange juice, a tax on milk would create

Answer 8

More tax revenue

Question 9

The mayor is considering taxing bike repair or ski repair. Both share the same price, same quantity, and same elasticity of supply, but the demand for bike repair is more inelastic. He says that he wants to raise as much tax revenue as possible while having suppliers pay most of the tax. You should advise him that

Answer 9

he cannot achieve both goals taxing one good.

Ski repair is more elastic, so quantity will fall by more, producing less revenue and more DWL (less efficiency) compared to a tax on bike repairs.

However, this does force producers to pay a larger fraction of the tax. Producers pay a smaller fraction of the tax on bike services.

The mayor’s goals are conflicting: to raise more revenue he should tax bike repair; to have suppliers pay most of the tax he should tax ski repair.

Question 10

Suppose demand in a market is depicted by Qd = 200 - 4 P and supply is depicted by Qs = 2 P - 40. If a price ceiling of $50 is imposed, then the market will

Answer 10

clear. (reach equilibrium)

The market clearing price would be where 200 - 4P = 2P - 40, or P* = 40. Since the price ceiling is above this, it is non-binding and thus the market behaves as if there is no price control (and clears).

Question 11

Compared to equilibrium, a binding price floor will always generate larger

Answer 11

Deadweight Loss

Question 12

If the government removes a binding price ceiling from a market, then the price received by sellers will

Answer 12

increase, and the quantity sold in the market will increase.

A binding price ceiling means the price was held below its market clearing level.

On removing the ceiling, price will rise. This will encourage sellers to produce more, and this will be purchased by the consumers who had been unable to buy it under the shortage.

Question 13

A candidate promises to tax cosmetic surgery. He promises that all of the tax will be borne by cosmetic surgeons, not their patients. He also promises that it will not create any inefficiency in cosmetic surgery. These claims are

Answer 13

only true if supply is perfectly inelastic.

The party with less elasticity feels most of the tax burden. If cosmetic surgeons feel the full burden of the tax, either supply is perfectly inelastic or demand is perfectly elastic.

If demand is elastic, then quantity will change after the tax. Supply must be perfectly inelastic.

Question 14

Suppose that app purchases and music purchases have similar price, quantity, and demand elasticity, but the supply of apps is more elastic than the supply of music. If a $1 tax is added for each song or app purchased, we would expect to see:

Answer 14

greater inefficiency in the apps market.

a larger portion of the tax paid by song producers than app producers.

Apps are more elastic, so quantity will fall by more, producing less revenue and more DWL (less efficiency).

However, this does force consumers to pay a larger fraction of the tax. Song producers pay a larger portion of the tax than app producers.

Question 15

The State of Utah has decided to tax all goods but not services. Suppose that supply elasticities are the same for goods and services, but that services have a demand elasticity of -2, compared to that of goods with an elasticity of -5. Which of the following goals are achieved by taxing goods but not services?

Answer 15

Sellers pay a larger percentage of the goods tax than they would of the services tax.

Goods are more elastic, so quantity will fall by more, producing less revenue and more DWL (less efficiency) compared to a tax on services.

However, this does force producers to pay a larger fraction of the tax. Producers pay a smaller fraction of the tax on services.

Question 16

Many European nations impose price ceilings on medical services. All of the following are predictable consequences of those price controls except

Answer 16

Disposal of large quantities of surplus medicines.

A binding price ceiling on medical services is shown. Compared to equilibrium, quantity supplied decreases and quantity demanded decreases. There is a shortage of medical services.

Question 17

Suppose the demand for food truck meals is perfectly elastic, while supply has an elasticity of 3. If a 10% tax is imposed on each food truck meal,

Answer 17

all of the tax is paid by sellers of food truck meals.

The elastic demand will ensure that all of the tax falls on sellers, but there will be deadweight loss.

Question 18

The city council chose to tax physical goods more heavily than intangible services. If these have similar demand elasticity but physical goods are more elastic in their supply, which of the following could be the city council’s reasoning for this difference in taxes?

Answer 18

The council wants buyers to pay more of the tax than sellers.

Physical goods are more elastic, so quantity will fall by more, producing less revenue and more DWL (decreasing total welfare) compared to taxing intangible services.

However, this does force consumers to pay a larger fraction of the tax. Sellers pay more of the tax in the intangible services market.

Question 19

When a binding price ceiling is in effect in the market for wheat, all of the following could potentially occur except

Answer 19

the government disposes of unsold wheat.

A binding price ceiling will result in shortages. This allows producers to be selective on which customers to serve, gives incentives to cheat on the prices, and may require the government to run lotteries to decide which customers get the wheat.

Question 20

Suppose the state of Utah places a binding price floor on movie theater tickets. We would expect any of the following could occur except

Answer 20

movie patrons would frequently have to enter lotteries to obtain scarce tickets.

All of these are true except lotteries, because the price floor will lead to a surplus, not a shortage.

Question 21

Senator B says that he only cares about the well being of students, and therefore wants to provide a subsidy of $10,000 per student per year for their college education. Under which of the following scenarios will his plan provide no change in the consumer surplus of students?

Answer 21

Demand for college is perfectly elastic, while supply is unit elastic.

If demand for college is perfectly elastic, then price students pay will be unchanged after equilibrium is restored. CS will be the same (0 in fact) before and after the subsidy.

Question 22

Suppose that eBooks and smartphone apps have a similar market price and quantity and the same elasticity of supply, but the eBooks are more elastic in their demand. If a $2 tax per book or app is imposed on both markets, we can conclude that

Answer 22

The eBook market will generate less tax revenue.

eBook buyers will pay less of the tax than app buyers.

eBooks are more elastic, so quantity will fall by more, producing less revenue and more DWL (less efficiency) than the market for apps.

However, this does force producers to pay a larger fraction of the tax in the market for eBooks than apps.

Question 23

When a binding price floor is imposed on a market, buyers (as a group) are ___________ and sellers (as a group) are _________.

Answer 23

always worse off; possibly better or worse off.

A binding price floor will reduce the quantity and increase the price.

That means buyers will have a narrower and shorter CS triangle, making it unambiguously smaller.

Producers have a taller but narrower trapezoid area. This has competing effects, so we cannot be sure whether it is bigger or smaller without more data.

Question 24

Binding minimum-wage laws create inefficiencies in all of the following ways except:

Answer 24

They produce labor shortages, further driving up wages.

Minimum wage laws (when binding) create a surplus of labor, not a shortage as in B.

The surplus allows firms to pick and choose who they hire, and usually they avoid inexperienced workers.

The value of labor is seen on the demand curve, and the willingness to work is on the supply curve. Since the minimum wage is imposed, it will ensure that the former is strictly bigger than the latter.

The net effect of benefits and harms is seen in DWL. Since the DWL increases after a wage control, it will help less than it hurts.

Question 25

Suppose the supply of dish soap is perfectly elastic, while demand has an elasticity of -0.5. This market sells one million bottles a month at an average price of $4. Imposing a $2 tax on dish soap will

Answer 25

None of the above.

Quantity drops after the tax, so tax revenue will be strictly less than $2 million.

The party with less elasticity feels most of the tax burden. Supply is perfectly elastic, so firms will bear $0 of the tax, not $2.

For DWL, we need to compute how much quantity falls. The buyer’s price went up by $2, which is a 40% increase. With buyer elasticity of -0.5, that means quantity falls by about 20% (or 200,000 soaps).

Deadweight loss is the height (the $2 tax) times the width (the 200K lost soaps) divided by 2 = $200,000

Question 26

Suppose the president proposes a tax of $20 on each of the 300 million phones sold each year. The Congressional Budget Office (CBO) then estimates that will cause retailers to lower phone prices by $20, and will raise $5 billion in revenue. These estimates must means that the CBO analysis of the phone market

Answer 26

assumes demand is perfectly elastic while supply is somewhat elastic.

The fact that the price falls by the amount of the tax suggests that either demand is perfectly elastic or supply is perfectly inelastic.

However, the tax revenue of $5 billion means only 250 million phones are sold after the tax. That rules out inelastic supply, but is consistent with perfectly elastic demand.

Question 27

Buyers of a product will bear the larger part of the tax burden, and sellers will bear a smaller part of the tax burden, when the

Answer 27

supply of the product is more elastic than the demand for the product.

The party with more elasticity bears a smaller part of the tax burden, as shown in the graph.

Legal assignment of the tax does not change who bears the tax burden. Prices adjust so the burden is split between buyers and sellers.

Question 28

Suppose the demand for outdoor recreation jobs is more elastic than the demand for retail (e.g. clothing store) jobs, even though the wages and numbers employed are roughly equal. If the same income tax is imposed on both jobs, the labor market for outdoor recreation will have ________ compared to the labor market for retail jobs.

Answer 28

greater deadweight loss

Outdoor recreation is more elastic, so quantity will fall by more, producing less revenue and more DWL (less efficiency).

After tax wages for workers falls more with the bigger quantity change in outdoor recreation.

Question 29

Suppose a local government wants to raise the most revenue they can while passing on the burden of the tax entirely onto sellers. They should impose the tax on a good with somewhat elastic

Answer 29

demand and perfectly inelastic supply.

The more elastic demand of outdoor recreation will cause a greater reduction in quantity of workers, and thus more DWL.

This also means less tax revenue.

The after-tax wage (price to suppliers) will be smaller because of the elastic demand.