Handout 4

Question 1

Minimum-wage laws dictate the lowest wage that firms may pay workers.

Answer 1

True

Question 2

A price ceiling is a legal minimum on the price at which a good or service can be sold.

Answer 2

False

Question 3

A price ceiling set below the equilibrium price is nonbinding.

Answer 3

False

Question 4

When a binding price ceiling is imposed on a market for a good, some people who want to buy the good cannot do so.

Answer 4

True

Question 5

Long lines and discrimination are examples of rationing methods that may naturally develop in response to a binding price ceiling.

Answer 5

True

Question 6

A price floor set above the equilibrium price is binding.

Answer 6

True

Question 7

A price floor set below the equilibrium price causes quantity supplied to exceed quantity demanded.

Answer 7

False

Question 8

A price floor set above the equilibrium price causes a surplus in the market.

Answer 8

True

Question 9

Discrimination is an example of a rationing mechanism that may naturally develop in response to a binding price floor.

Answer 9

True

Question 10

If the equilibrium price of an airline ticket is $400 and the government imposes a price floor of $500 on airline tickets, then fewer airline tickets will be sold than at the market equilibrium.

Answer 10

True

Question 11

Refer to Figure 6-26. A price ceiling set at $30 would create a shortage of 20 units.

Answer 11

False

Question 12

Refer to Figure 6-26. A price ceiling set at $70 would create a shortage of 40 units.

Answer 12

False

Question 13

Refer to Figure 6-26. A price floor set at $60 would create a surplus of 20 units.

Answer 13

True

Question 14

Refer to Figure 6-26. A price floor set at $40 would create a surplus of 20 units.

Answer 14

False

Question 15

For any given quantity, the price on a demand curve represents the marginal buyer’s willingness to pay.

Answer 15

True

Question 16

A buyer is willing to buy a product at a price greater than or equal to his willingness to pay, but would refuse to buy a product at a price less than his willingness to pay.

Answer 16

False

Question 17

Consumer surplus is the amount a buyer actually has to pay for a good minus the amount the buyer is willing to pay for it.

Answer 17

False

Question 18

If Darby values a soccer ball at $50, and she pays $40 for it, her consumer surplus is $90.

Answer 18

False

Question 19

If Rosa is willing to pay $450 for hockey tickets and has consumer surplus of $175, the price of the tickets is $625.

Answer 19

False

Question 20

An increase in price increases consumer surplus.

Answer 20

False

Question 21

If producing a soccer ball costs Jake $5, and he sells it for $40, his producer surplus is $35.

Answer 21

True

Question 22

Connie can clean windows in large office buildings at a cost of $1 per window. The market price for window-cleaning services is $3 per window. If Connie cleans 100 windows, her producer surplus is $200.

Answer 22

True

Question 23

Total surplus in a market is consumer surplus minus producer surplus.

Answer 23

False

Question 24

Total surplus in a market can be measured as the area below the supply curve plus the area above the demand curve, up to the point of equilibrium.

Answer 24

False

Question 25

Unless markets are perfectly competitive, they may fail to maximize the total benefits to buyers and sellers.

Answer 25

True

Question 26

Markets will always allocate resources efficiently.

Answer 26

False

Question 27

Total surplus = Value to buyers - Costs to sellers.

Answer 27

True

Question 28

If the government removes a binding price ceiling in a market, then the producer surplus in that market will increase.

Answer 28

True

Question 29

The area below the price and above the supply curve measures the producer surplus in a market.

Answer 29

True

Question 30

What is a price ceiling?

Answer 30

A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the price ceiling is below the equilibrium price, then the price ceiling is binding, and the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some way ration the good or service among buyers.

Question 31

What is a price floor?

Answer 31

A price floor is a legal minimum on the price of a good or service. An example is the minimum wage. If the price floor is above the equilibrium price, then the price floor is binding, and the quantity supplied exceeds the quantity demanded. Bcause of the resulting surplus, buyers demands for the good or service must in some way be rationed among sellers.

Question 32

What happens when the government levies a tax upon a good?

Answer 32

When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a market shrinks the size of the market.

Question 33

How does a tax on a good change the market equilibrium?

Answer 33

A tax on a good places a wedge between the price paid by buyers and the price received by sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers receive less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the division of the tax burden) does not depend on whether the tax is levied on buyers or sellers.

Question 34

How does the incidence of a tax effect the price elasticities of demand?

Answer 34

The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden falls on the side of the market that is less elastic because that side of the market can respond less easily to the tax by changing the quantity bought or sold.

Question 35

Give an example of a price ceiling and an example of a price floor.

Answer 35

An example of a price ceiling is the rent control system in New York City. An example of a price floor is the minimum wage. Many other examples are possible.

Question 36

Which causes a shortage of a good - a price ceiling or a price floor? Justify your answer with a graph.

Answer 36

A shortage of a good arises when there is a binding price ceiling. A binding price ceiling is one that is placed below the market equilibrium price. This leads to a shortage because quantity demanded exceeds quantity supplied. See Figure 3.

Question 37

What mechanisms allocate resources when the price of a good is not allowed to bring supply and demand into equilibrium?

Answer 37

When the price of a good is not allowed to bring supply and demand into equilibrium, some alternative mechanism must allocate resources. If quantity supplied exceeds quantity demanded, so that there is a surplus of a good as in the case of a binding price floor, sellers may try to appeal to the personal biases of the buyers. If quantity demanded exceeds quantity supplied, so that there is a shortage of a good as in the case of a binding price ceiling, sellers can ration the good according to their personal biases, or make buyers wait in line.

Question 38

Explain why economists usually oppose controls on prices.

Answer 38

Economists usually oppose controls on prices because prices have the crucial job of coordinating economic activity by balancing demand and supply. When policymakers set controls on prices, they obscure the signals that guide the allocation of society’s resources. Furthermore, price controls often hurt those they are trying to help.

Question 39

Lovers of classical music persuade Congress to impose a price ceiling of $40 per concert ticket. As a result of this policy, do more or fewer people attend classical music concerts?

Answer 39

If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded exceeds quantity supplied, so there will be a shortage of tickets. The policy decreases the number of people who attend classical music concerts, because the quantity supplied is lower because of the lower price.

Question 40

The government has decided that the free market price of cheese is too low. Suppose the government imposes a binding price floor in the cheese market. Draw 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?

Answer 40

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.

Question 41

The government has decided that the free market price of cheese is too low. Farmers complain the the price floor has reduced their total revenue. Is this possible? Explain.

Answer 41

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.

Question 42

The government has decided that the free market price of cheese is too low. In response to farmers’ complaints, the government agrees to purchase all the surplus cheese at the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses?

Answer 42

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.

Question 43

A recent study found that the demand and supply schedules for Frisbees are as follows in the table. Frisbee manufactuers persuade the government that Frisbee production improves scientists understanding of aerodynamics and thus is important for national security. A concerned Congress votes to impose a price floor $2 above the equilibrium price. What is the new market price? How many Frisbees are sold?

Answer 43

With a price floor of $10, the new market price is $10 because the price floor is binding. At that price, only two million Frisbees are sold, because that is the quantity demanded.

Question 44

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 uskilled 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.

Answer 44

Figure 9 shows the effects of the minimum wage. In the absence of the minimum wage, the market wage would be w1 and Q1 workers would be employed. With the minimum wage (wm) imposed above w1, the market wage is wm, the number of employed workers is Q2, and the number of workers who are unemployed is Q3 − Q2. Total wage payments to workers are shown as the area of rectangle ABCD, which equals wm times Q2.

Question 45

Explain how buyers’ willingness to pay, consumer surplus, and the demand curve are related.

Answer 45

The price a buyer is willing to pay, consumer surplus, and the demand curve are all closely related. The height of the demand curve represents the willingness to pay of the buyers. Consumer surplus is the area below the demand curve and above the price, which equals the price that each buyer is willing to pay minus the price actually paid.

Question 46

Explain how sellers’ costs, producer surplus, and the supply curve are related.

Answer 46

Sellers’ costs, producer surplus, and the supply curve are all closely related. The height of the supply curve represents the costs of the sellers. Producer surplus is the area below the price and above the supply curve, which equals the price received minus each seller’s costs of producing the good.

Question 47

In a supply and demand diagram, show producer and consumer surplus in the market equilibrium.

Answer 47

Figure 4 shows producer and consumer surplus in a supply-and-demand diagram.

Question 48

What is efficiency? Is it the only goal of economic policy makers?

Answer 48

An allocation of resources is efficient if it maximizes total surplus, the sum of consumer surplus and producer surplus. But efficiency may not be the only goal of economic policymakers; they may also be concerned about equity - the fairness of the distribution of well-being.

Question 49

Melissa buys an iPod for $120 and gets a consumer surplus of $80. What is her willingness to pay?

Answer 49

Consumer surplus is equal to willingness to pay minus the price paid. Therefore, Melissa’s willingness to pay must be $200 ($120 + $80).

Question 50

Melissa buys an iPod for $120 and gets a consumer surplus of $80. If she had bought the iPod on sale for $90, what would her consumer surplus have been?

Answer 50

Her consumer surplus at a price of $90 would be $200 − $90 = $110.

Question 51

Melissa buys an iPod for $120 and gets a consumer surplus of $80. If the price of an iPod were $250, what would her consumer surplus have been?

Answer 51

If the price of an iPod was $250, Melissa would not have purchased one because the price is greater than her willingness to pay. Therefore, she would receive no consumer surplus.

Question 52

An early freeze in California sours the lemon crop. Explain what happens to consumer surplus in the market for lemons. Explain what happens to consumer surplus in the market for lemonade. Illustrate with a diagram.

Answer 52

If an early freeze in California sours the lemon crop, the supply curve for lemons shifts to the left, as shown in Figure 5. The result is a rise in the price of lemons and a decline in consumer surplus from A + B + C to just A. So consumer surplus declines by the amount B + C.

In the market for lemonade, the higher cost of lemons reduces the supply of lemonade, as shown in Figure 6. The result is a rise in the price of lemonade and a decline in consumer surplus from D + E + F to just D, a loss of E + F. Note that an event that affects consumer surplus in one market often has effects on consumer surplus in other markets.

Question 53

Suppose the demand for French bread rises. Explain what happens to producer surplus in the market for French bread. Illustrate your answer with diagrams.

Answer 53

A rise in the demand for French bread leads to an increase in producer surplus in the market for French bread, as shown in Figure 7. The shift of the demand curve leads to an increased price, which increases producer surplus from area A to area A + B + C.

Question 54

Suppose the demand for French bread rises. Explain what happens to producer surplus in the market for flour. Illustrate your answer with diagrams.

Answer 54

The increased quantity of French bread being sold increases the demand for flour, as shown in Figure 8. As a result, the price of flour rises, increasing producer surplus from area D to D + E + F. Note that an event that affects producer surplus in one market leads to effects on producer surplus in related markets.

Question 55

It is a hot day, and Bert is thirsty. Here is the value he places on a bottle of water:

Value of first bottle $7

Value of second bottle $5

Value of third bottle $3

Value of fourth bottle $1

If the price of a bottle of water is $4, how many bottles does Bert buy? How much consumer surplus does Bert get from his purchases? Show Bert’s consumer surplus in your graph.

Answer 55

When the price of a bottle of water is $4, Bert buys two bottles of water. His consumer surplus is shown as area A in the figure. He values his first bottle of water at $7, but pays only $4 for it, so has consumer surplus of $3. He values his second bottle of water at $5, but pays only $4 for it, so has consumer surplus of $1. Thus Bert’s total consumer surplus is $3 + $1 = $4, which is the area of A in the figure.

Question 56

It is a hot day, and Bert is thirsty. Here is the value he places on a bottle of water:

Value of first bottle $7

Value of second bottle $5

Value of third bottle $3

Value of fourth bottle $1

If the price falls to $2, how does quantity demanded change? How does Bert’s consumer surplus change? Show these changes in your graph.

Answer 56

When the price of a bottle of water falls from $4 to $2, Bert buys three bottles of water, an increase of one. His consumer surplus consists of both areas A and B in the figure, an increase in the amount of area B. He gets consumer surplus of $5 from the first bottle ($7 value minus $2 price), $3 from the second bottle ($5 value minus $2 price), and $1 from the third bottle ($3 value minus $2 price), for a total consumer surplus of $9. Thus consumer surplus rises by $5 (which is the size of area B) when the price of a bottle of water falls from $4 to $2.

Question 57

Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water.

Cost of first bottle $1

Cost of second bottle $3

Cost of third bottle $5

Cost of fourth bottle $7

From this information, derive Ernie’s supply schedule. Graph his supply curve for bottled water.

Answer 57

Question 58

Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water.

Cost of first bottle $1

Cost of second bottle $3

Cost of third bottle $5

Cost of fourth bottle $7

If the price of a bottle of water is $4, how many bottles does Ernie produce and sell? how much producer surplus does Ernie get from these sales? Show Ernie’s produce surplus in your graph.

Answer 58

When the price of a bottle of water is $4, Ernie sells two bottles of water. His producer surplus is shown as area A in the figure. He receives $4 for his first bottle of water, but it costs only $1 to produce, so Ernie has producer surplus of $3. He also receives $4 for his second bottle of water, which costs $3 to produce, so he has producer surplus of $1. Thus Ernie’s total producer surplus is $3 + $1 = $4, which is the area of A in the figure.

Question 59

Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water.

Cost of first bottle $1

Cost of second bottle $3

Cost of third bottle $5

Cost of fourth bottle $7

If the price rises to $6, how does the quantity supplied change? How does Ernie’s producer surplus change? Show these changes in your graph.

Answer 59

When the price of a bottle of water rises from $4 to $6, Ernie sells three bottles of water, an increase of one. His producer surplus consists of both areas A and B in the figure, an increase by the amount of area B. He gets producer surplus of $5 from the first bottle ($6 price minus $1 cost), $3 from the second bottle ($6 price minus $3 cost), and $1 from the third bottle ($6 price minus $5 price), for a total producer surplus of $9. Thus producer surplus rises by $5 (which is the size of area B) when the price of a bottle of water rises from $4 to $6.

Question 60

The cost of producing flat screen TVs has fallen over the past decade. Let’s consider some implications of this fact.

Draw a supply and demand diagram to show the effect of falling production costs on the price and quantity of flat-screen TVs sold.

Answer 60

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.

Question 61

The cost of producing flat screen TVs has fallen over the past decade. Let’s consider some implications of this fact.

In your diagram, show what happens to consumer surplus and producer surplus.

Answer 61

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.

Question 62

The cost of producing flat screen TVs has fallen over the past decade. Let’s consider some implications of this fact.

Suppose the supply of flat screen TVs is very elastic. Who benefits most from falling production costs - consumers or producers of TVs?

Answer 62

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.