Question

1. In 1995, the Food and Drug Administration (FDA) published new labeling standards for bottled water. (The full text of the final rule can be found at http://cfr.vlex.com/vid/165-110-bottled-water-19705533.) Prior to that time, bottlers could sell regular tap water under a bottled water label. In fact, the FDA estimated that approximately 25 percent of the supply of bottled water was nothing more than ordinary tap water.

(a) Consider how these tougher standards eliminated 25 percent of the supply of bottled water. If market demand is unaffected, what qualitative impact would this labeling change have on equilibrium price and quantity for bottled water? Support your answer with a graphical model.

(b) Let the market demand and market supply equations are QD = −100P+ 1, 150 and QS = 400P − 100. How much of bottled water would be supplied in a static efficient allocation and at what price?

Now, suppose the change in standards results in a new market supply of QS new = 400P − 350 with no change in market demand.

(c) Determine the new static efficient allocation for bottled water and new market price. Do your results agree with your intuitive answer to part (a)? (d) Graphically illustrate the market for bottled water before and after the change in labeling standards. Be sure to label all relevant points.

(e) Compare the values of consumer surplus and producer surplus before and after the change in labeling standards. Is this result expected? Why or why not?

Answer 1

a)

In the new situation, supply would decrease in the short run. Supply curve would shifts to left (SS shifts to S’S’). New equilibrium quantity (Q1) will be lower than equilibrium quantity (Qo) in earlier scenario. New equilibrium price (P1) will be higher than the earlier equilibrium price(Po).

b)

QD =−100P+1150

QS = 400P – 100

In equilibrium, Put QD =QS

-100P+1150=400P-100

500P=1250

P=1250/500 =2.5

QD=-100*2.5+1150=900

QS=400*2.5-100=900

900 units of bottled water would be supplied at a price of 2.5 per unit.

c)

QD =−100P+1150

QS = 400P − 350

In equilibrium, Put QD =QS

-100P+1150=400P-350

500P=1500

P=3

QD =−100*3+1150=850

QS = 400*3−350=850

850 units of bottled water would be supplied at a price of 3 per unit in the new scenario.

d) We can make the following schedules to draw demand and supply curves.

P	QD=-100P+1150	QS = 400P – 100	QS = 400P − 350
0	1150	0	0
0.25	1125	0	0
0.5	1100	100	0
0.875	1062.5	250	0
1	1050	300	50
1.5	1000	500	250
2	950	700	450
2.5	900	900	650
3	850	1100	850
3.5	800	1300	1050
4	750	1500	1250
4.5	700	1700	1450
5	650	1900	1650
5.5	600	2100	1850
6	550	2300	2050
6.5	500	2500	2250
5	650	1900	1650
11.5	0	4500	4250

Supply curve shift and equilibrium parameters are in line with the intuitive predictions

e)

Consumer surplus is equal to the area of triangle formed below demand line but above the equilibrium price. Producer surplus is equal to the area of triangle formed above supply curve but below the equilibrium price.

Case 1

Consumer Surplus=1/2*(11.50-2.50)*(900)= 4050.00

Producer Surplus=1/2*(2.50-0.25)*900=1012.5

Case 2

Consumer Surplus=1/2*(11.5-3)*(850)= 3612.5

Producer Surplus=1/2*(3-0.875)*850=903.125

We find that consumer surplus has decreased. It is in line with expected result as consumer surplus decreases as price increases and quantity decreases.

We find that producer surplus has decreased. It is difficult to predict the changes in producer surplus as increase in price increases the producer surplus but decrease in quantity decreases the producer surplus.