Week 4 - gov't policies and welfare

Question 1

define price celling

Answer 1

A legal maximum on the price at which a good can be sold

Question 2

what does a price celling create

Answer 2

a shortage no higher than $5
Therefore as price decreases demand increases causing a shortage
Lower price of good = lower incentive for suppliers to sell (inelastic)

Lost consumer surplus 
• Lost producer surplus 
• Lower quantity traded 
• Less consumed 
• Some producer surplus is transferred
• Most importantly, tends to adversely affect the  very people it is meant to protect! –Unintended consequence

Question 3

define a price floor

Answer 3

A legal minimum on the price at which a good can be sold

creates surplus

Question 4

3 intended objective of taxes

Answer 4

1. Health objective
2. Fiscal objectives
3. User-pays objective

Question 5

define deadweight loss

Answer 5

A reduction in the total surplus that results from a market distortion such as a tax or a monopoly price

Question 6

3 insights concerning market outcomes

Answer 6

1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
2. Free markets allocate the demand for goods to the sellers who can produce them at least cost.
3. Free markets produce the quantity of goods that maximises the sum of consumer and producer surplus.

Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.
Social planner must also consider trade off between equity + efficiency
This policy of leaving well enough alone goes by the French expression laissez‐faire.

Question 7

define world price

Answer 7

The price of a good that prevails in the world market for that good
The price of a good or service in a domestic country determined by domestic demand and supply
- if the world price of a good is lower than the domestic price one may become a importer as they offer a better price
- once trade is alloered the domestic price will fall to equal the world price (importing

Question 8

draw effects of tariff on graph

Answer 8

:P

Question 9

reasons for free trade

Answer 9

• Jobs argument – short term
• National security – e.g. during war access to key resources
• Infant industries – can create a system of dependency and inefficiency
• Unfair competition

Question 10

willingness to pay formula

Answer 10

Willingness to pay = Consumer Surplus + Pay

Question 11

Consumer surplus formula

Answer 11

Consumer surplus = Willingness to Pay – Paid

Question 12

Understand all this weeks graphs

Answer 12

Consumer surplus = Willingness to Pay – Paid

Question 13

Price elasticity of demand: Define and distinguish between price elasticity of demand and income elasticity of demand. Explain factors that determine each.

Answer 13

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, calculated as the percentage change in quantity demanded divided by the percentage change in price.
Factors that determine price elasticity are the availability of substitutes, whether the good is a luxury or a necessity, the time horizon and also the market boundaries.
Income elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in consumers’ income, calculated as the percentage change in quantity demanded divided by the percentage change in income.
Factors that determine income elasticity are whether or not the good is a normal good or inferior good and also if the good is a necessity or a luxury good.

Question 14

Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a packet of cigarettes currently costs $8 and the government wants to reduce smoking by 20 percent, by how much should it increase the price?

Answer 14

First, we obtain the necessary percentage change in price, and then use this to calculate the absolute change in price.
As the own-price elasticity is the percentage change in quantity demanded divided by the percentage change in price, we have 0.4 = %ΔQcig / %ΔPcig, which yields %ΔPcig
= %ΔQcig / 0.4; since the government targets a 20% reduction in the quantity of smoking, %ΔPcig = 20/0.4 = 50.

The government would increase the price by 50% in order to reduce smoking by 20%. As the current price is $8, a 50% increase is $4, so the price increases to $12. On an exam or in the assignment, this suffices.
For those more algebraically inclined, note that if we use the midpoint method, then we would search for a price that is a 50% difference in price. If we call this price p2, then we want 0.5 = (p2 - 8) / ((p2 +8)/2) = (p2 - 8) / (0.5p2 + 4). Multiplying both sides by the denominator, we have 0.25p2 + 2 = p2 - 8. Subtracting 0.25p2 from both sides and adding 8 to both sides gives 10 = 0.75p2. Dividing both sides by 0.75 gives p2 = 40/3 = 13.33.

Question 15

If the government permanently increases the price of cigarettes, will the policy have a larger effect on smoking one year from now or five years from now?

Answer 15

The time horizon is positively correlated with the elasticity; the longer the period, the easier it is for consumers to adjust or make substitutes. Thus, the effect is likely to be larger five years hence than one year hence.

Question 16

Studies also find that teenagers have a higher price elasticity than do adults. Why might this be true? On one graph, show the demands for a typical adult smoker and a typical teenage smoker that are consistent with this observation.

Answer 16

Teenagers generally have a smaller income. Because they are limited in where they can licitly smoke, they tend to be more casual and more easily switch between smoking cigarettes and consuming other substances.
If the two demand curves intersect, then the flatter demand curve is more elastic.

Alternatively, it is plausible that teenagers have lower demand than adults, which could be depicted as an inward shift. If the shift were parallel, then the same price change results in the same absolute change in quantity; because the base of the inner demand curve is smaller, this same absolute change is a larger percentage change in quantity demanded, which is then consistent with greater elasticity.

Thus, the typical teenager’s demand curve could be either demand curve below in blue or dark blue. Note that the prices are 6 and 8, and for the adult, the quantities are Q0 and Qa, whereas those for the teens are either Q0 and Q1, or Q0 and Qt1.

Look at one teen demand at a time: for the blue demand, note that Q1t-Q0t=Q1a-Q0, but the teen’s base is smaller and so the percentage change in quantity is larger; therefore, greater elasticity. For the dark blue demand, note that Q1t-Q0 > Q1a - Q0 and so the percentage change in quantity is larger (the “base” quantity rises 0.5 units for each unit that the change rises); therefore, greater elasticity.

Question 17

Two drivers – Tom and Jerry – each drive up to a petrol station. Before looking at the price, each places an order. Tom says: “I’d like 10 litres of petrol.” Jerry says: “I’d like $10 of petrol.” What is each driver’s price elasticity of demand?

Answer 17

Tom’s price elasticity of demand is zero, since he wants the same quantity regardless of the price. Jerry’s price elasticity of demand is one, since he spends the same amount on gas, no matter what the price, which means his percentage change in quantity is equal to the percentage change in price.

Question 18

8: Economists have observed that spending on restaurant meals declines more during economic downturns than does spending on food to be eaten at home. How might the concept of elasticity help to explain this phenomenon?

Answer 18

To explain the observation that spending on restaurant meals declines more during economic downturns than does spending on food to be eaten at home, economists look at the income elasticity of demand. In economic downturns, people have lower income. To explain the observation, the income elasticity of restaurant meals must be larger than the income elasticity of spending on food to be eaten at home.
Eating at restaurants is a normal good; eating at home is an inferior good. Consider: are all restaurant meals a normal good for all people?