Question

Assume that the demand for oranges is represented by the equation P = 50 - Qd and supply by the equation P = 25 + Qs, where Qd and Qs are quantity demanded and quantity supplied, respectively and P is price. Using the equilibrium condition Qs = Qd, solve the equations to determine the equilibrium price. Now determine equilibrium quantity. Graph both equations.

1. Compute and show graphically consumer surplus and producer surplus if government imposes a price floor of $42.

2. Compute and show graphically the deadweight loss if the if government imposes a $2/unit subsidy for the consumers of oranges
3. Compute and show graphically consumer surplus and producer surplus in this market when the government allows free trade & the world price is $30

(Explain the gains from trade.)

4. Illustrate and calculate the loss of consumer surplus and the new producer surplus if the government decides to levy a 15% tariff on the imported goods.

What are the arguments that a government can use to justify a tariff?

(Assess the merits of one of the arguments in the previous question.)

5. Now suppose the authorities impose a quota of 10 units to be imported. Using the same equations, show the impact of this measure on the market by computing deadweight loss associated with this policy and the new producer due to this quota. Illustrate this with a graph.

6. Instead of a quota the government decided to provide a subsidy to import competing firms. The subsidy is $5. Determine and illustrate graphically the values of the DWL and the new producer surplus.

7. What are the arguments in favor of free trade? What are the limitations of the principle of comparative advantage?

8. Assume that the world price is now $40. Illustrate graphically the effects of an export subsidy by identifying the consumer surplus, the producer surplus and the DWL

1. Producing the commodity generates a negative externality. The external cost is ½ (QS)

Determine the efficient level of output.

Is there a market failure? If so, why?

What is the total value of the market failure?

Show the market failure with a graph.

What kind of policies can be used to internalize the external cost?

Explain the mechanism of cap and trade and the disadvantages / advantages of implementing this method.

Answer 1

1. demand for oranges is given by: P = 50 - Qd

Supply for oranges is given by : P = 25 + Qs

Equilibrium occurs at a price where quantity demanded = quantity supplied

50 - Q = 25 + Q

Q=12.5

At Q = 12.5, P = 25 +12.5 = $37.5

Therefore, at Equilibrium price $337.5, 12.5 units of oranges are sold and purchased

In order to graph supply and demand, we need two point. (12.5, 37.5) would lie on both supply and demand. When Qd=0, then P = $50 (another point on demand curve)

When Qs = 0, then price = $25 (another point on supply curve)

Figure 1 shows the supply and demand of oranges.

Figure 1

2. Government imposes a price floor of $42, this means market price of oranges now becomes $42. Figure 2 depicts what happens when the price floor is imposed.

At price = $42, quantity demanded of oranges = 8 units (put P=$42 in demand equation)

At price = $42, quantity supplied of oranges = 17 units (put P=$42 in supply equation)

Consumer surplus = area below the demand curve and above the price line = Area highlighted in green = 1/2 * 8 * (50-42) = 32

When quantity supplied = 8 units, price = $33

Producer surplus = area above the supply line and below the price line = area highlighted in red = (42 - 33) * 8 + 1/2 * 8 * (33-25) = 72+32 = 104

Figure 2

3. If the if government imposes a $2/unit subsidy for the consumers of oranges. When a subsidy of $2/unit is given to the consumers, it shifts the demand curve outward by $2 as shown by red line in figure 3.

New demand curve = (P-2) = 50 -Qd

P = 52 - Qd

Supply curve : P = 25 + Qs

quantity demanded by the customers : 52 - Q = 25+ Q

Q = 13.5 units

Therefore, the new equilibrium occurs at a output of 13.5 units.

At that quantity, price received by the producers = $38.5

Now, price which consumers have to pay +subsidy = price producers receives

Price consumers pay = $38.5 - $2 = $36.5

Deadweight loss = area highlighted in blue = 1/2 * (13.5-12.5) * (38.5-37.5) + 1/2 * (13.5-12.5) * (37.5-36.5) = 1

Figure 3

4. Compute and show graphically consumer surplus and producer surplus in this market when the government allows free trade & the world price is $30

If the world wide price is $30, then the market price in the economy becomes $30. Figure 4 shows what happens when market price is $30.

When price = $30, quantity demanded = 20 (put P=$30 in demand equation)

When price = $30, quantity supplied = 5 (put P=$30 in supply equation)

Consumer surplus = area below the demand curve and above the price line = Area highlighted in green + area highlighted in yellow = 1/2 *20 * (50-30) = 200

Producer surplus = area above the supply line and below the price line = area highlighted in red = 1/2 * 5 * (30-25) = 12.5

Total surplus after trade = 200+12.5 = 212.5

Gains from trade = area highlighted in yellow = 1/2 * (20-5) * (37.5-30) = 15

Figure 4

5. Illustrate and calculate the loss of consumer surplus and the new producer surplus if the government decides to levy a 15% tariff on the imported goods.

Government decides to levy a 15% tariff on the imported goods. Therefore, the new price becomes = $30 + 15% of $30 = $34.5. Figure 5 shows the results

When price = $34.5, quantity demanded = 15.5 (put P=$34.5 in demand equation)

When price = $34.5, quantity supplied = 9.5 (put P=$34.5 in supply equation)

Consumer surplus = area below the demand curve and above the price line = Area highlighted in green = 1/2 * 15.5 * (50-34.5) = 15.5

Producer surplus = area above the supply line and below the price line = area highlighted in red + area highlighted in blue= 1/2 * 9.5 * (34.5-25) = 9.5

Loss of consumer surplus = area highlighted in yellow + area highlighted in blue

= 15.5 * (34.5-30) + 1/2 * (34.5-30) * (20-15.5)

=69.75+4.5

=74.25

Therefore, loss of consumer surplus after a 15% tariff is introduced = 74.25

Figure 5