Question

Question 4 The small island of Usagishima has a perfectly competitive market for petrol. The supply curve for petrol is upward sloping and the demand curve for petrol is downward sloping. The equilibrium price of petrol is $3 per litre with 10,000 litres bought and sold per month. (a) Using a diagram, illustrate the perfectly competitive equilibrium in the Usagishima petrol market. Use your diagram to label the level of consumer surplus, producer surplus and social surplus at this equilibrium. [4 marks] (b) The government of Usagishima has decided that the price of $3 per litre for petrol is too high. Misaki argues for a subsidy, “If we subsidise the price of petrol by $1 per litre, then buyers will only have to pay $2 per litre, and it will only cost the government $1 on the 10,000 litres, which is $10,000 per month”. Do you agree with Misaki’s statement? Justify your answers. Use a diagram to show the likely outcome of a $1 subsidy on petrol. Explain (and show in a table) the “before-and-after” effects of the subsidy on consumer surplus, producer surplus, and social surplus. [6 marks]

Answer 1

A).

Consider the following fig.

So, here “D” and “S1” are the demand and the supply curve for “petrol market” and “E1” be the initial equilibrium, => the equilibrium “P” and “Q” are given by “P1=3” and “Q1=10,000”. Now, the “CS” and “PS” are given by “A1P1E1” and “A2P1E1” respectively.

So, the total social surplus is given by the sum of CS and PS, => A1A2E1”.

B).

Now, if a subsidy of “$1” is imposed, => the supply curve will shift down ward by “$1” to “S2”, => the new equilibrium is “E2”, => the equilibrium “P” and “Q” are given by “2 < P2 < 3” and the “Q2 > 10,000”. So, here we can see that the price paid by buyer is still more than “$2” and the equilibrium quantity is more than “10,000”, => the government have to pay more than “$10,000” as a total subsidy, => we are not agreed with “Misaki’s” statement.

So, here CS is given by the area “A1P2E2” < “A1P1E1”, => CS increases. Now, PS is given by the area “OP2E2” < “A2P1E1”, => PS also increases and the total subsidy is given by the area “OA2E4E2”.

Now, the Social surplus is given by, “CS + PS – subsidy = A1P2E2 + OP2E2 - OA2E4E2.

=> Social surplus = A1A2E1 – E1E2E4 < A1A2E1, => the social surplus decreases.

So, if we compare these two situation then we can see that “CS” and “PS” both increases but the “social surplus” decreases.