ECON 1001

1. ECON 1001 Tutorial 7

2. Q1) The concept of efficiency is illustrated by which of the following statements? • The production of the good generates very little pollution. • At equilibrium, all mutually beneficial transactions have taken place. • The production of the good generates very few by-products. • The consumption of the good produces very little waste. • At disequilibrium, no mutually beneficial transactions have occurred. Ans: B

3. In economics, efficiency denotes a state at which all potential gains from exchange have been captured. • Recall that the definition of Pareto Optimality is “a state at which one cannot be made better off without making others worse off”. • Any pollution or by-products related to exchange or production are taken into account. There can be little, or much pollution, as long as efficiency is attained.

4. E.g. Hong Kong vs Africa HK is a place with terrible pollution, while Africa still has clean air. Is the situation regarded as ‘inefficient/ disequilibrium/ not optimal’ in Economics? • Should we ‘balance/ equalize’ the pollution level between Africa and HK? The ans is ‘NO’ obviously, WHY? • We chose to sacrifice the clean air in HK in exchange for the amazing economic development. Thus, econ surplus would definitely drops if we ‘move’ some of our industries to Africa. • Therefore, B is the correct answer.

5. Q2) A market equilibrium is only efficient when… • Buyers and sellers each earn equal surplus from the transaction. • Consumer surplus and producer surplus are both zero. • All relevant costs, including those imposed on others, are accounted for. • Income is distributed equitably. • Firms are earning positive profits. Ans: C

6. In this case, CS and PS are not equal, but efficiency is reached. • Therefore, A is wrong. • B is also wrong as both CS and PS are positive. • Recall that the Supply curve is the MC of production. • Here, firms are earning profits. Hence E is not true. • Options A ,B and E are not correct all the time. We will illustrate this in a diagram. P Efficient Consumer Surplus S Producer Surplus D Q

7. Option D is also not the right answer. • When we talk about market equilibrium, income equality is not relevant. • In fact, if income is determined by the demand and supply of labour… • The wages of workers in different sectors would be different. • This is because wages are determined by the demand and supply of labour in each individual sector. • Hence, there is no basis to say income is distributed equitably when efficiency is attained.

8. Option C is the correct answer. • This is similar to what we have discussed in Question 1. • When all relevant costs, including those imposed on others (e.g. pollution), are accounted for… • The equilibrium determined by the market would be efficient. That is, one cannot be made better off without making others worse off.

9. Q3) When the price ceiling is set at $4, what is the total economic surplus? • $18 • $20 • $24 • $32 • $48 Ans: C

10. P • A Price Ceiling at $4. • What is the quantity transacted? • 4 S $4 D 4 Q

11. The question asks us to calculate the TOTAL ECONOMIC SURPLUS. • Total Economic Surplus is the SUM of the Consumer Surplus and Producer Surplus. • CS is the difference between the consumer’s reservation price for each of the 4 units and the price of the good. • PS is the difference between the price and the producers’ reservation price for each of the 4 units of goods.

12. P • CS is … • $20 • PS is … • $4 • So the Total Econ Surplus is $24 (C). S CS $4 PS D 4 Q

13. Q4) Visitors to Disneyland now only have to pay a single fee, which allows them to go on any ride as often as they wish. Once inside the gates, the current price of a ride at Disneyland is • Entry price divided by no. of rides taken. • 0 because entry price is a sunk cost. • Cost of the time spent in line plus entry price divided by no. of rides taken. • Cost of the time spent in line. • Cost of the time spent in line minus the utility gained from the ride. Ans: D

14. Assume a visitor has paid the entrance fee and has stepped inside the gates. • We now have to determine his or her opportunity cost of each ride in the theme park. • This is a question about the economic concept of costs.

15. First of all, does the visitor have to pay any more money for each ride he takes? • No. • And can he get back the entrance fee once he is inside the gate? • No.

16. Since the entrance fee will not return to the visitor’s wallet, we say that it is a SUNK COST. • Sunk Costs do not affect a person’s current decision in anyway, because it is already non-retrievable. • Whether a person does / buy something depends on his own evaluation of the current cost and benefit from his actions. • Therefore, options A and C can be eliminated.

17. So what is the extra cost a visitor has to bear once he is inside the gates? • Since he does not have to pay extra money for rides, all he has to do is to queue up in line and wait for his turn. • In other words, he has to give up time to wait in line. • Therefore, the current price of a ride in the theme park is the cost of the time spent in line (D).

18. Q5) Compared to the first-come-first-served allocation scheme airlines used in the past, the voluntary compensation scheme now in place • Discriminates against the poor. • Improves efficiency for only the wealthy. • Tricks the poor into unnecessarily delaying their travel. • Improves efficiency for all travellers. • Encourages passengers to show up early. Ans: D

19. Airlines usually have their flights overbooked. • That means, airlines accept more reservations than the actual no. of seats on each flight. • When a flight is overbooked, at the time of check-in, the airline company has to find some ways to settle who will board the plane, and who will not.

20. In the past, it is done according to the ‘first-come-first served’ principle. • The ones arriving at the check-in counter early can get the boarding pass. (some can even be upgraded!) • The few that are relatively late will get an apology from the airline, and will be arranged onto another flight, which usually results in a delay.

21. Some time ago, airline companies ditched the ‘first-come-first-served’ scheme, and took up the ‘voluntary compensation scheme’. • Airlines realise that among the passengers, some value punctuality of arrival more than others. • Those who can postpone their plans are likely to be willing to accept some compensation from the airline for not taking the planned flight.

22. People would be willing to delay their plans as long as the compensation is enough to cover the costs (e.g. time cost) • Whether a passenger is poor or wealthy is not the direct reason to evaluate his costs of delays. • It is his own valuation of time cost that counts.

23. Therefore, by offering a voluntary compensation when a flight is overbooked, those who have a lower reservation price for punctuality are willing to be delayed.(who are they? People with low time cost) • Those who values punctuality most can arrive at the destination on time. They are people with high time cost. E.g. Bill Gates • This improves efficiency for all travellers (D).

24. Q6) The loss in efficiency due to a per-unit tax, represented by S’, is measure by the area ? And stems from ? . • IJC; the trades that do not occur because of the tax. • IHC; consumer unrest about higher prices. • HJC; producer dissatisfaction with lower revenues. • EGJI; wasteful use of the tax revenue by government. • EAHI; consumers paying more for goods than they are worth. Ans: A

25. Price S’ • Before tax was imposed, the original equilibrium was at point C. • The tax shifts Supply leftwards. • The new equilibrium is at point I. S I C D Quantity

26. Price S’ • Less quantities are transacted now. • CH is the reduction in quantity transacted. • Hence, the loss in CS is IHC. • And the loss in PS is JHC. • Total loss in efficiency is IJC. • This is because more quantities could have been traded but are not, due to the tax. S I H C J D Quantity

27. Q7) If demand is perfect price INELASTIC, • The burden of a tax is shared equally. • The burden of a tax falls entirely on the seller. • The burden of a tax falls entirely on the buyer. • The burden of a tax will depend on the legal assignment of duty to pay. • Deadweight loss will be infinite. Ans: C

28. P D • First of all, let us examine the effect of a per-unit tax when demand is perfectly price inelastic. • Demand curve is a vertical line. • A per-unit tax (t) imposed will shift the supply to the left like this. S’ S t Q

29. P D • The initial price was P1. • The new price is P2. • Because D is vertical, P2-P1 is exactly t. • That means, all of the tax burden is born by the buyers (C). S’ S P2 t P1 Q

30. Q8) Demand for cigarettes is price inelastic for adults, but price elastic for teenagers. Therefore, a tax on cigarettes will • Not raise very much tax revenue. • Not generate deadweight loss. • Generate more tax revenue from adults and have a greater effect on the number of cigarettes smoked by teenagers. • Have a greater effect on the number of cigarettes smoked by adults than by teenagers. • Generate more tax revenue from teenagers than from adults. Ans: C

31. We can almost immediately eliminate options A and B. • A: not raise very much tax revenue. How much is ‘much’? • B: a tax always generates some deadweight loss unless the demand/ supply curve is perfectly inelastic/elastic. (why? Draw diagrams and prove it by yourself) • Therefore, options A and B are not the answers.

32. Option D is also very obviously wrong. • Adults’ demand is price inelastic; teenagers’ demand is price elastic. • That means adults are less sensitive to price changes than teenagers. • Therefore, a tax should have greater effect on no. of cigarettes smoked by teenagers, not adults.

33. Option C is the answer. • A tax imposed on a good whose demand is price inelastic results in a higher tax revenue than in the case where demand is price elastic. • When demand is price elastic, a small increase in price will lead to a huge drop in quantity demanded. Therefore, tax revenue from the teenagers’ market would be smaller.

34. P Tax revenue from Adults DAdults Tax revenue from Teenagers S’ S DTeenagers Q

35. Q9) Suppose that instead of taxing the producers, a tax of an equal dollar amount per unit is imposed on consumers in the market shown. Relative to the tax on producers, • The tax on consumers would generate more deadweight loss. • The burden of the tax on consumers would be more equally shared between consumers and producers. • Consumers would bear a agreater share of the tax burden. • The effect on deadweight loss and tax burdens would be the same. • The price paid by consumers would increase by more. Ans: D

36. When a per-unit tax is imposed, supply curve shifts leftwards, • If the same tax is imposed on consumers, consumer demand curve shifts down by the same ‘vertical distance’ • Thus, new equilibrium price and quantity will be the same under the 2 types of tax. • Hence, D.

37. Q10) A tax on Commodity A will generate ? deadweight loss relative to an equivalent tax on Commodity B. • More • Less • Equal • Zero • An indeterminant amount of Ans: B

38. Deadweight loss is the result of distortion from Pareto efficient allocation because of anything but price (e.g. tax). • The larger the distortion, the higher the deadweight loss. • Therefore, we need to identify, when a tax is imposed, distortion from which market would be higher.

39. DB is more price elastic than DA. • That means consumers of Commodity B is more sensitive to price changes than consumers of Commodity A. • When %↑PA = %↑PB, %↓QdB > %↓QdA. (Larger drop in Qd for B) • In other words, the distortion caused by a tax would be smaller in Market A than in Market B. • Hence, the answer is B.

40. Commodity B Commodity A PB PA DA SA’ SB’ SA SB DB QA QB Tax

41. Test your understanding , find the deadweight loss in the following situations • Vertical supply and downward sloping demand • Vertical demand and upward sloping supply • Horizon demand and upward sloping supply • Horizon supply and downward sloping demand