Mod 1 Prices, Externalities & Taxes

Question 1

What is a price ceiling?

Answer 1

It is the maximum legal price a seller can charge.

Question 2

Why do governments impose price ceilings?

Answer 2

To enable consumers to obtain some essential good or service that they would be unable to afford at the equilibrium price.

Question 3

Do price ceilings result in shortages or surpluses?

Answer 3

Shortages

Question 4

Name 4 situations where price ceilings have been implemented in Australia and the results?

Answer 4

• wartime price controls -a ceiling price on butter was introduced because the demand was high & supply was low, which meant that only the wealthy could afford to buy. This was deemed unfair and the price was dropped so all could afford it. However this lead to another problem: shortage
• rationing problem: A ration was introduced so the butter was spread evenly over the population (a wealthy family of 4 got the same portion of butter as the poor family of 4) this lead to another problem: black markets.
• black markets: because there were so many buyers willing to pay more (inelastic) for butter this created an illegal market, which could not be controlled nor taxed - back to square one except the government was worse off because they received no income from the the illegal market.
• rent controls: in a desire to keep housing affordable for everyone, the English controlled rent for many years. Because price was low, demand was high and the shortage worsened. Those investing in housing refused to build more and refused to maintain them because it was unprofitable. Even with the price ceiling matters had become worse.

Question 5

Draw a properly labeled graph indicating price ceilings and shortages?

Answer 5

See graph 1 - actually recreate graph when answering

Question 6

What is a price support or ‘price floor’?

Answer 6

This is a minimum price fixed by government that is ABOVE equilibrium prices.

Question 7

Do price floors result in shortages or surpluses?

Answer 7

Surpluses

Question 8

Give two examples where price floors have been used in Australia?

Answer 8

• minimum wage legislation

- agricultural support prices

Question 9

Draw a correctly labeled graph showing price floors and the resulting surpluses?

Answer 9

See drawn graph 2 for example - actually recreate it to answer this question

Question 10

Why set price floors?

Answer 10

To provide sufficient income for certain groups. Usually implemented when society feels the free market functions do not provide sufficient incomes.

(One current example is the milk industry - though they have not implemented it the government could set a floor price that ensures dairy farmers earn enough to at least cover the cost of producing milk)

Question 11

Discuss equilibrium in competitive markets?

Answer 11

Competitive markets are free of govt intervention and the price is set by the natural forces of supply and demand.

This is because the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production.

Question 11

What is consumer surplus?

Answer 11

This is the ‘net’ benefit to consumers from participating in the market.

It is the difference between the highest price a consumer is willing to pay and what they actually pay.

For example, Sam is willing to pay $8 for a bottle of wine. When she goes to Dan Murphy’s and the bottle is $6, her consumer surplus if the $2 difference.

Question 12

Graphically represent consumer surplus?

Answer 12

See graph 3 - recreate it.

Question 13

What is producer surplus?

Answer 13

The difference between the amount that a producer receives for the good/service and the minimum amount they will accept.

The difference, or the surplus amount, is the benefit they receive for for selling it in the market.

(Graph this using p3)

Question 14

Marginal benefit to customers and marginal cost of production in which consumer surplus (CS) and producer surplus (PS) is at a maximum is called?

Answer 14

Equilibrium.

Question 15

What is it called when a market is not in equilibrium and benefits to society are reduced?

Answer 15

A dead weight loss.

Question 16

DWL, or dead weight loss, is caused by?

Answer 16

A change in prices away from equilibrium.

Question 17

Define DWL?

Answer 17

The reduction in economic surplus.

This is a result of the market not being in competitive equilibrium

Question 18

Show DWL in a graph?

Answer 18

See graph 4 - recreate graph

Question 19

What does it mean when a price is elastic?

Answer 19

Consumers are price sensitive and buy less of a product if the price goes up, and more of it if the price drops.

Toothpaste is an example. You need it, but if the price were to suddenly increase dramatically you may buy one instead of two, switch to another brand - but if the price decreased dramatically you may buy several.

Question 20

What is price in-elasticity?

Answer 20

The consumer is not so sensitive to price. No matter how much it costs they will still generally buy it.

Common examples include cigarettes and alcohol (addiction issues) or medication - you still have to buy it regardless of cost.

Question 21

If the government were to increase the tax on an elastic good/service, who would bear the brunt of the cost… Seller or consumer?

Answer 21

The seller, because consumers are sensitive to price changes.

Question 22

If a tax was placed on an inelastic item would the seller or buyer bear the brunt?

Answer 22

Buyer, because they are less sensitive to price changes and sellers know that you will pay whatever is necessary for the good/service.

Question 23

True or false.

The burden of tax falls more heavily on the side of the market that is LESS ELASTIC?

Answer 23

True

Question 24

The more INELASTIC the Demand and the more ELASTIC the supply ,who bears the the larger share of tax?

Answer 24

The buyer

Question 25

The more ELASTIC the demand, and the more INELASTIC the Supply, who bears the brunt of the tax?

Answer 25

The supplier.

If the consumers are price sensitive and suppliers have the same quantity to sell they cannot pass that onto the consumer, otherwise they lose profits. Therefore they have to absorb the tax.

Question 26

What is market failure?

Answer 26

When the competitive price system either:

1) produces the wrong amount of goods/services (spillovers)
2) fails to provide ANY resources to goods/services whose output is economically justified (public/social goods)

Question 27

What are spillovers/externalities?

Answer 27

Costs or benefits associated with the production or consumption of a good/service that spillover to unintended third parties.

These can be positive or negative.

Question 28

Name some negative and positive spillovers?

Answer 28

A manufacturing plant pollutes the local river.
A paint factory’s odour drifts into the neighbouring suburb.
Perhaps one house owner makes their house so aesthetically pleasing it raises the value of houses surrounding it.

Question 29

Describe spillover costs, describe the graph?

Answer 29

A normal demand and supply curve shows equilibrium output where the lines cross but this only shows the marginal private cost. It does not capture all costs that are spilling over to third parties.

In this case the some of their costs shift to the community who deal with spillover and are not compensated. In reality the supply curve shifts to the left to reflect on over allocation to production, they don’t deal with environmental factors at all.

Similarly the supply curve will shift right to show an under allocation of resources in the case of spillover benefits.

Question 30

Why are firms able to impose spillover costs, like pollution to the community?

Answer 30

• common property to society, like air and water have no clear property rights. They belong to society.
• some business’s or individual’s make selfish choices for short term gain.
• resources are likely to suffer from misuse or misallocation in the process.

Question 31

Name some spillover benefits?

Answer 31

Payment or compensation is not always conferred.
Immunisation for example gives widespread benefits to society.
Your uni degree is going to come out of your pocket but the spillover to society is that you are making more educated choices, earning more money, paying more tax and contributing to society.
This is a MARGINAL SOCIAL BENEFIT.

Question 32

What are public goods?

Answer 32

Ex: the building of a lighthouse on the coast. It saves boats from being wrecked and it an economically justifiable option. It is not something that can be charged for - this is called a free rider problem - as many benefit from it but private enterprise would not build it because they would not profit from it.

This is why taxes are charged and used to benefit the community. Also it is too expensive for those using it (ships captains) to build it off their own back.

Question 33

How does the government intervene in spillover?

Answer 33

The exclusion principle, when those who cannot pay for something benefit from it, distinguishes between public and private goods. The government provides goods and services like police, fire departments, education, medicine sewerage etc though technically the exclusion principle could apply.