Question

Suppose that the market for good X is free and competitive, where the equilibrium price and quantity, are $30 per ton and 10 million tons per year, respectively. The producers of good X complain to the government that the current market price is too low to provide them with sufficient income, and they want the government to set a price floor of $40 per ton and to purchase all resulting surplus in order to guarantee that the price support is maintained. Some government advisors are concerned by the fact that the elasticities of demand and supply for goodXare unknown and therefore, this price support policy could be too costly for the government, and for consumers of good X in terms of the loss of consumer surplus. The question: Could the impact of the price floor on the consumers of good X (in terms of the loss of consumer surplus) be more than $100 million, or less than $100 million, or equal to $100 million? What conditions would your answer depend on? (Hint: Make some reference to elasticity.) Explain your reasoning carefully, and illustrate with an appropriate diagram(s) using demand and supply curves.( write words more than 300 words.)

Answer 1

(1) More than $100 million:

When the demand curve and the supply curve are highly elastic then as a result the surplus that is caused by the price floor is more and hence, there is an increase in the amount of surplus. Now, the government will have to incurred expenditure of more than $100 million per year.

(2) Less than $100 million:

When the demand curve and the supply curve are relatively inelastic or less elastic then as a result the surplus that is caused by the price floor is less and hence, there is a reduction in the amount of surplus in the market for good X. Now, the government will have to incurred expenditure of less than $100 million per year.

(3) Equal to $100 million:

When the demand curve and the supply curve are unit elastic. In this situation, the price elasticty of demand and supply is equal to 1. Now in this case, the government will have to incurred expenditure of exactly $100 million per year.