Question

On a small island in the Indian Ocean, the domestic market for wine is described by the following market demand curve equation: P = 28 - 0.25Q. The land is very fertile for grapes and so there are many firms producing and selling wine. The market supply of wine is described by the equation: P = 1 + 0.5Q. The quantity of wine in tons per year is Q, and P is the price per unit.

1. With the current market conditions, the price consumers pay is  and the quantity of wine bought by consumers is . (4 points)

2. Given the current market outcome, is the market efficient? (In the space provided enter is or is not). The current market outcome  efficient. (2 points)

After much lobbying from special interest groups, consider that the government imposes a price support of $21, where the government promises to subsidize the price that would clear the market.

3. With these new market conditions, the price consumers pay is  and the quantity of wine bought by consumers is . (4 points)

4. Given the new market outcome, is the market efficient?  (In the space provided enter is or is not). The current market outcome  efficient. (2 points)

5. Given the new market outcome, the level of consumer surplus is .  (4 points)

6. Given the new market outcome, the level of producer surplus is .  (4 points)

7. Given the new market outcome, the level of total surplus is . (4 points)

8. Is there any deadweight loss associated with the new market outcome?  If yes, enter in the space provided, the value of the deadweight loss. If no, enter in the space provided, $0, which is the value of no deadweight loss.

With the new market outcome, the deadweight loss is

Answer 1

1. At the current market condition, equilibrium occurs where, demand = supply

Or, 28 - 0.25Q = 1 + 0.5Q

Or, 0.75Q = 27

Or, Q = 36

At Q = 36, from any of demand or supply equation we get, P = $19

Therefore, the price Consumers pay is $19 per unit and the quantity of wine bought by Consumers is 36 units.

2. As the market operates in the equilibrium, total surplus is at it's maximum and that means the market is efficient at the current market outcome.

3. With the new market conditions, the price Consumers have to pay = support price = $21.

Now from the demand equation we get, 21 = 28 - 0.25Q

Or, 0.25Q = 7

Or, Q = 28

Therefore, quantity of wine bought by Consumers is 28 units.

4. No. The market is not efficient. Even though the government imposes a price support, it will create Deadweight loss. DWL occurs because of loss in Consumers surplus (which occurs due to high price) and loss in producers surplus (which occurs due to increased cost of production).