Transcript solution - Ka

ECON 1001
Tutorial 7
Q1)The concept of efficiency is illustrated by which
of the following statements?
A)
The production of the good generates very little
pollution.
B) At equilibrium, all mutually beneficial transactions have
taken place.
C) The production of the good generates very few byproducts.
D) The consumption of the good produces very little
waste.
E) At disequilibrium, no mutually beneficial transactions
have occurred.
Ans: B
• In economics, efficiency denotes a state at
which all potential gains from exchange
have been captured.
• Recall that the definition of Pareto
Optimality is “a state at which one cannot
be made better off without making others
worse off”.
• Any pollution or by-products related to
exchange or production are taken into
account. There can be little, or much
pollution, as long as efficiency is attained.
• E.g. Hong Kong vs Africa
HK is a place with terrible pollution, while Africa still has
clean air. Is the situation regarded as ‘inefficient/
disequilibrium/ not optimal’ in Economics?
• Should we ‘balance/ equalize’ the pollution level between
Africa and HK? The ans is ‘NO’ obviously, WHY?
• We chose to sacrifice the clean air in HK in exchange for
the amazing economic development. Thus, econ surplus
would definitely drops if we ‘move’ some of our industries
to Africa.
• Therefore, B is the correct answer.
Q2) A market equilibrium is only efficient
when…
A) Buyers and sellers each earn equal surplus
from the transaction.
B) Consumer surplus and producer surplus are
both zero.
C) All relevant costs, including those imposed on
others, are accounted for.
D) Income is distributed equitably.
E) Firms are earning positive profits.
Ans:C
• Options A ,B and E are not correct all the
time. We will illustrate this in a diagram.
• In this case, CS and PS
are not equal, but
Efficient
efficiency is reached.
P
Consumer
Surplus
• Therefore, A is wrong.
• B is also wrong as both
CS and PS are positive.
S
Producer
Surplus
• Recall that the Supply
curve is the MC of
production.
• Here, firms are earning
profits. Hence E is not
true.
D
Q
• Option D is also not the right answer.
• When we talk about market equilibrium, income
equality is not relevant.
• In fact, if income is determined by the demand
and supply of labour…
• The wages of workers in different sectors would
be different.
• This is because wages are determined by the
demand and supply of labour in each individual
sector.
• Hence, there is no basis to say income is
distributed equitably when efficiency is attained.
• Option C is the correct answer.
• This is similar to what we have discussed
in Question 1.
• When all relevant costs, including those
imposed on others (e.g. pollution), are
accounted for…
• The equilibrium determined by the market
would be efficient. That is, one cannot be
made better off without making others
worse off.
Q3) When the price ceiling is set at $4,
what is the total economic surplus?
A)
B)
C)
D)
E)
$18
$20
$24
$32
$48
Ans:C
• A Price Ceiling
at $4.
P
S
• What is the
quantity
transacted?
$4
• 4
D
4
Q
• The question asks us to calculate the
TOTAL ECONOMIC SURPLUS.
• Total Economic Surplus is the SUM of the
Consumer Surplus and Producer Surplus.
• CS is the difference between the
consumer’s reservation price for each of
the 4 units and the price of the good.
• PS is the difference between the price and
the producers’ reservation price for each of
the 4 units of goods.
• CS is …
P
• $20
S
• PS is …
CS
• $4
$4
PS
D
4
Q
• So the Total
Econ Surplus is
$24 (C).
Q4)Visitors to Disneyland now only have to pay a
single fee, which allows them to go on any ride
as often as they wish. Once inside the gates,
the current price of a ride at Disneyland is
A) Entry price divided by no. of rides taken.
B) 0 because entry price is a sunk cost.
C) Cost of the time spent in line plus entry price divided
by no. of rides taken.
D) Cost of the time spent in line.
E) Cost of the time spent in line minus the utility gained
from the ride.
Ans: D
• Assume a visitor has paid the entrance fee
and has stepped inside the gates.
• We now have to determine his or her
opportunity cost of each ride in the theme
park.
• This is a question about the economic
concept of costs.
• First of all, does the visitor have to pay any
more money for each ride he takes?
• No.
• And can he get back the entrance fee
once he is inside the gate?
• No.
• Since the entrance fee will not return to the
visitor’s wallet, we say that it is a SUNK COST.
• Sunk Costs do not affect a person’s current
decision in anyway, because it is already nonretrievable.
• Whether a person does / buy something
depends on his own evaluation of the current
cost and benefit from his actions.
• Therefore, options A and C can be eliminated.
• So what is the extra cost a visitor has to bear
once he is inside the gates?
• Since he does not have to pay extra money for
rides, all he has to do is to queue up in line and
wait for his turn.
• In other words, he has to give up time to wait in
line.
• Therefore, the current price of a ride in the
theme park is the cost of the time spent in line
(D).
Q5) Compared to the first-come-first-served
allocation scheme airlines used in the
past, the voluntary compensation
scheme now in place
A) Discriminates against the poor.
B) Improves efficiency for only the wealthy.
C) Tricks the poor into unnecessarily delaying
their travel.
D) Improves efficiency for all travellers.
E) Encourages passengers to show up early.
Ans:D
• Airlines usually have their flights
overbooked.
• That means, airlines accept more
reservations than the actual no. of seats
on each flight.
• When a flight is overbooked, at the time of
check-in, the airline company has to find
some ways to settle who will board the
plane, and who will not.
• In the past, it is done according to the
‘first-come-first served’ principle.
• The ones arriving at the check-in counter
early can get the boarding pass. (some
can even be upgraded!)
• The few that are relatively late will get an
apology from the airline, and will be
arranged onto another flight, which usually
results in a delay.
• Some time ago, airline companies ditched
the ‘first-come-first-served’ scheme, and
took up the ‘voluntary compensation
scheme’.
• Airlines realise that among the passengers,
some value punctuality of arrival more
than others.
• Those who can postpone their plans are
likely to be willing to accept some
compensation from the airline for not
taking the planned flight.
• People would be willing to delay their
plans as long as the compensation is
enough to cover the costs (e.g. time cost)
• Whether a passenger is poor or wealthy is
not the direct reason to evaluate his costs
of delays.
• It is his own valuation of time cost that
counts.
• Therefore, by offering a voluntary
compensation when a flight is overbooked,
those who have a lower reservation price
for punctuality are willing to be delayed.
(who are they? People with low time cost)
• Those who values punctuality most can
arrive at the destination on time. They are
people with high time cost. E.g. Bill Gates
• This improves efficiency for all travellers
(D).
Q6)The loss in efficiency due to a per-unit tax,
represented by S’, is measure by the area ?
And stems from ? .
A)
B)
C)
D)
E)
IJC; the trades that do not occur because of the tax.
IHC; consumer unrest about higher prices.
HJC; producer dissatisfaction with lower revenues.
EGJI; wasteful use of the tax revenue by government.
EAHI; consumers paying more for goods than they are
worth.
Ans: A
Price
• Before tax was
imposed, the
original
equilibrium was
at point C.
S’
S
I
• The tax shifts
Supply leftwards.
C
D
Quantity
• The new
equilibrium is at
point I.
• Less quantities are
transacted now.
Price
S’
• CH is the reduction in
quantity transacted.
S
• Hence, the loss in CS
is IHC.
I
H
• And the loss in PS is
JHC.
C
• Total loss in efficiency
is IJC.
J
D
Quantity
• This is because more
quantities could have
been traded but are
not, due to the tax.
Q7) If demand is perfect price INELASTIC,
A)
B)
C)
D)
The burden of a tax is shared equally.
The burden of a tax falls entirely on the seller.
The burden of a tax falls entirely on the buyer.
The burden of a tax will depend on the legal
assignment of duty to pay.
E) Deadweight loss will be infinite.
Ans:C
• First of all, let us
examine the effect
of a per-unit tax
when demand is
perfectly price
inelastic.
• Demand curve is a
vertical line.
• A per-unit tax (t)
imposed will shift
the supply to the
left like this.
P
D
S’
t
S
Q
• The initial price was
P1.
P
D
• The new price is P2.
• Because D is
vertical, P2-P1 is
exactly t.
S’
S
P2
t
• That means, all of
the tax burden is
born by the buyers
(C).
P1
Q
Q8)Demand for cigarettes is price inelastic for
adults, but price elastic for teenagers.
Therefore, a tax on cigarettes will
A) Not raise very much tax revenue.
B) Not generate deadweight loss.
C) Generate more tax revenue from adults and have a
greater effect on the number of cigarettes smoked by
teenagers.
D) Have a greater effect on the number of cigarettes
smoked by adults than by teenagers.
E) Generate more tax revenue from teenagers than from
adults.
Ans: C
• We can almost immediately eliminate options A
and B.
• A: not raise very much tax revenue. How much
is ‘much’?
• B: a tax always generates some
deadweight loss unless the demand/
supply curve is perfectly inelastic/elastic.
(why? Draw diagrams and prove it by
yourself)
• Therefore, options A and B are not the answers.
• Option D is also very obviously wrong.
• Adults’ demand is price inelastic;
teenagers’ demand is price elastic.
• That means adults are less sensitive to
price changes than teenagers.
• Therefore, a tax should have greater effect
on no. of cigarettes smoked by teenagers,
not adults.
• Option C is the answer.
• A tax imposed on a good whose demand
is price inelastic results in a higher tax
revenue than in the case where demand is
price elastic.
• When demand is price elastic, a small
increase in price will lead to a huge drop in
quantity demanded. Therefore, tax
revenue from the teenagers’ market would
be smaller.
P
DAdults
Tax revenue
from Adults
Tax revenue
from Teenagers
S’
S
DTeenagers
Q
Q9)Suppose that instead of taxing the producers,
a tax of an equal dollar amount per unit is
imposed on consumers in the market shown.
Relative to the tax on producers,
A)
The tax on consumers would generate more
deadweight loss.
B) The burden of the tax on consumers would be more
equally shared between consumers and producers.
C) Consumers would bear a agreater share of the tax
burden.
D) The effect on deadweight loss and tax burdens would
be the same.
E) The price paid by consumers would increase by more.
Ans: D
• When a per-unit tax is
imposed, supply curve
shifts leftwards,
• If the same tax is
imposed on consumers,
consumer demand curve
shifts down by the same
‘vertical distance’
• Thus, new equilibrium
price and quantity will be
the same under the 2
types of tax.
Price
9
Supply plus tax
8
Supply
7
6
5
4
3
2
1
Demand
• Hence, D.
0
10 20 30
40
50
60
70
Units per day
Q10)A tax on Commodity A will generate ?
deadweight loss relative to an
equivalent tax on Commodity B.
A)
B)
C)
D)
E)
More
Less
Equal
Zero
An indeterminant amount of
Ans:B
• Deadweight loss is the result of distortion
from Pareto efficient allocation because of
anything but price (e.g. tax).
• The larger the distortion, the higher the
deadweight loss.
• Therefore, we need to identify, when a tax
is imposed, distortion from which market
would be higher.
• DB is more price elastic than DA.
• That means consumers of Commodity B is more
sensitive to price changes than consumers of
Commodity A.
• When %↑PA = %↑PB, %↓QdB > %↓QdA. (Larger
drop in Qd for B)
• In other words, the distortion caused by a tax
would be smaller in Market A than in Market B.
• Hence, the answer is B.
Commodity B
Commodity A
PB
PA
DA
SA’
SB’
SA
SB
DB
QA
Tax
QB
Test your understanding , find the
deadweight loss in the following situations
•
•
•
•
Vertical supply and downward sloping demand
Vertical demand and upward sloping supply
Horizon demand and upward sloping supply
Horizon supply and downward sloping demand