Economics 102

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Economics 102. Question 1. Suppose the Kingdom of Atlantis decides to levy a tax of one shekel on the production of each widget. (a) Demonstrate that the decline in consumer and producer surplus resulting from the tax exceeds the amount of tax revenue collected.

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### Economics 102

Question 1

Suppose the Kingdom of Atlantis decides to levy a tax of one shekel on the production of each widget.

(a) Demonstrate that the decline in consumer and producer surplus resulting from the tax exceeds the amount of tax revenue collected.

(b) Given the tax, what is the relationship between the price paid by consumers and the marginal cost of production?

A Tax and Economic Welfare

S with tax

Change

No Tax

Tax

CS

ABCD

A

-(BCD)

S w/o tax

PS

-(EFG)

A

EFGH

H

P1

Tax per unit

Tax Revenue

BCEF

B

Zero

BCEF

C

D

P0

E

G

ABCD

EFGH

ABCEFH

F

W

-(DG)

P2

H

Q1

Q0

The area (DG) is the deadweight loss from the tax

The decline in CS and PS is BCDEFG while the level of tax revenue is BCEF
• The price paid by consumers (P1) exceeds the price received by producers (P2) and thus the price that consumers pay exceeds MC
Question 2
• Suppose now that the Kingdom eliminates the tax and decides instead to subsidize the widget industry. Suppose the subsidy equals one shekel for every widget produced.
• (a) Demonstrate that the increase in consumer and producer surplus resulting from the subsidy is less than the amount of money that the government gives the producers.
• (b) Given the subsidy, what is the relationship between the price paid by consumers and the marginal cost of production?
• (c) Given your answers to (1a) , (1b), (2a), and (2b), what is the “optimal” relationship (from society’s overall point of view) between price and marginal cost?

Subsidies and Economic Welfare

S w/o Subsidy

P3

Producer

S w/ Subsidy

Net Price with Subsidy

P1

Equilibrium

Price Without Subsidy

P2

Consumer

Price With Subsidy

Q1

Q2

With Subsidy

Without Subsidy

Change

AB

ABEFG

EFG

CS

BCEH

BC

PS

EH

Gov’t EXP

BCDEFG

BCDEFG

zero

S w/o Subsidy

ABEH - D

-D

W

ABEH

A

P3

Producer

S w/ Subsidy

B

C

P1

D

E

F

G

P2

Consumer

AREA “D’ represents the Deadweight loss from the

subsidy

H

Q1

Q2

The increase in CS and PS is BCEFG
• The cost of the subsidy program is BCDEFG which is larger
• The price that consumers pay(P2) is less than the net price that producers receive (P3) and thus the price that consumers pas is less than marginal cost
• The optimal outcome is when the price that consumers pay equals MC
a) Assume the price of the product is \$50. What is the profit maximizing level of output?
• b) What is the lowest price at which the firm will produce? Given this price, how many units should the firm produce? Explain.
• C) What is the break-even price? Given this price, how many units should the firm produce? Explain.

Profits are maximized when p=MC assuming P is greater than or equal to AVC.

Thus, when the price is 50, profits are maximized when Q = 10

The lowest price at which the firm will operate is the minimum AVC. In this case, this

is 18.33 when Q = 3

The breakeven price is the minimum ATC. In this case, this

is 37.86 when Q = 7

Question 4

4)Consider the nation of Atlantis which is populated by rational, perfectly informed, identical individuals.

One of the staples of the diet is fish. To keep it affordable, the price of fish is regulated below the market equilibrium price.

The Parliament of Atlantis is currently considering legislation that would eliminate the price regulation. According to the Laissez Faire party, the removal of the price control would improve resource allocation. Opponents of the policy change argue that decontrol would reduce the welfare of the typical inhabitant.

Upon hearing of your expertise in economics, the King has requested your advice. Please advise him on this proposed change in policy using the tools of analysis developed in this course.

Assume the maximum legal price is P1

Price

Control

Decontrol

Change

CS

A,C

PS

G

A

B

P2

D

W

A,C,G

C

F

E

P1

G

Price

Control

Decontrol

Change

A,B

CS

A,C

PS

G

C,D,G

A

B

P2

D

W

A,C,G

A,B,C,

D,G

C

F

E

P1

G

Price

Control

Decontrol

Change

A,B

CS

B-C

A,C

C,D

PS

G

C,D,G

A

B

P2

D

W

A,C,G

A,B,C,

D,G

B,D

C

F

E

P1

G

Question 5

5) To protect its domestic sneaker industry, the Kingdom of Atlantis currently disallows imports of sneakers.

The Laissez‑Faire party has proposed that the edict be revoked. Based on the writings of Adam Smith, it is argued that free trade will improve the allocation of resources.

The political party known as the Atlantis-First party opposes the importation of foreign sneakers. They argue that permitting foreign sneakers into Atlantis will enrich foreigners at the expense of the typical Atlantian.

The Laissez-Faire party concedes that removing the edict will hurt the domestic producers of sneakers. Yet, they maintain that Atlantis will be better off, not worse off, if the edict if revoked.

Upon hearing of your expertise in the field of economics, the King has requested your advice. Using the tools of analysis developed in this course, what would you advise the King?

Permitted

Ban

Change

Domestic Supply

A

CS

A

PS

B,E

B

A,B,E

W

C

D

World Price

E

Demand

Permitted

Ban

Change

Domestic Supply

A

A,B,C,D

CS

A

PS

B,E

E

B

A,B,E

W

A,B,C,D,E

C

D

World Price

E

Permitted

Ban

Change

Domestic Supply

A

A,B,C,D

B,C,D

CS

A

PS

B,E

-B

E

B

A,B,E

W

A,B,C,D,E

C,D

C

D

World Price

E

Question 6
• (A) (i) Briefly explain why a price taker can expected to produce at the output level where MC = Price. (ii) How does this output level compare to the point of diminishing marginal returns to labor? (iii) How does this output level compare to the point where ATC is minimized? (iv) Are there any exceptions to this “rule?”
• (B) Why is it in society’s interests for producers to operate at the point where MC = P ?

Profit = TR - TC

Δprofit = ΔTR - ΔTC

Divide both sides by the change in output, ΔQ

ΔProfit

ΔTR

ΔTC

=

ΔQ

ΔQ

ΔQ

Marginal Profit = MR - MC

When Firms are price takers
• Marginal Revenue(MR) = Price

Thus,

Marginal Profit = P - MC

The Profit Frontier

The Slope of the Curve is the change in profits when

Output increases by one unit. In other words, the slope

Represents Marginal Profit

Profit

Marginal Profit

is zero at

This point

Marginal Profit is positive

At this point

Marginal Profit

is negative

At this point

0

Q*

Q

Profit Maximization when a Firm is a Price Taker
• From the previous slide, it is clear that profit maximization requires that a price taker produce where Marginal Profits equal zero
• But Marginal Profit equals P – MC
• Thus, profit maximization for a price taker requires that a price taker produce where MC = P
How does the profit maximizing level of output compare to the point of diminishing marginal returns to labor?
• MPL is maximized at the point of diminishing marginal returns to labor
• Given the inverse relationship between MPL and MC, this means that MC is minimized at the point of diminishing marginal returns to labor

MC

P5

ATC

AVC

Note that Price exceeds MC

When Q = Q0

Thus, marginal profits are positive

at Q0 which means that profits will

rise if more is produced

MC@Q0

Q0

How does the profit maximizing level of output compare to the point of diminishing marginal returns to labor?

Based on the previous slide, the profit maximizing level of output is greater

Than the output level that corresponds to diminishing marginal returns

MC

P5

ATC

AVC

MC@Q2

Note that Price exceeds MC

When Q = Q2

Thus, marginal profits are positive

at Q2 which means that profits will

rise if more is produced

Q2

Q*

In the previous slide, ATC is minimized at Q2. This is less than the output level that maximizes profits

The next slide shows that if P < ATC, then the profit maximizing level of output will be less than the output level that minimizes ATC

MC

ATC

AVC

P4

Q*

Q2

Are there any exceptions to the rule of P=MC
• Yes, if P < AVC
• Please see the next slide. In this case, losses are minimized by not producing at all
Suppose P equals P1

ATC@Q*

MC

ATC

B

A

AVC

TR = E,F

AVC@Q*

D

VC =C,D,E,F

C

P1

PS = -(C,D)

F

FC =A,B

E

PROFIT = -(A,B,C,D)

Q*

Why is it in society’s interests for producers to operate at the point where MC = P ?
• According to the law of diminishing marginal utility, the utility that consumers receive from a good increases at a diminishing rate
• Based on the law of diminishing marginal returns to labor, the total cost of producing a good can be expected to increase at an increasing rate
Total Utility vs Total Cost

U

TC is maximized at Q*

Also note that the slope of the

Utility function and the total

Cost function are equal at Q*

The equality of the slopes means

That MU = MC at Q*

If MU = MC, then P = MC

Q*

Q

Question 7

Consider the nation of Atlantis which is populated by rational perfectly informed individuals. All markets are competitive and unregulated

Because of reduced supply due to flooding, the price of gasoline has increased sharply.

Using consumer and producer surpluses, what is the effect of the flood on economic welfare when the price of gasoline is unregulated? What happens to the profits of the gasoline producers? Why does this happen?

Change

Before

After

A,B,C,D

-(B,C,D)

CS

A

S1

E,F

B-F

PS

B,E

A,B,C,D

E,F

-(C,D,F)

A,B,E

W

A

P1

S0

B

The change in economic welfare

Equals –(CDF) and thus society is worse

Off. Observe that producers in this

Case are better off given that area

B is larger than area F.

C

D

P0

E

F

Demand

Q1

Q0

Question 8A

8) (A) The company known as Mississippi.com has just reported the following financial results.

• Sales \$ 14 million
• Fixed Costs \$ 20 million
• Variable Costs \$11 million
• profit (loss) (\$17) million
• number of units sold1 million

Given that the firm’s losses exceed its revenues, the firm has been advised to cease production. Before doing so, the CEO of the firm wants your advice. Using the tools of analysis presented in class, what advice would you provide Mississippi ?

Mississipi.com
• The firm has a net loss of 17 million
• Based on its fixed costs of 20 million, the firm would have a loss of 20 million if it closed
• Since losing 17 million is preferred to losing 20 million, the firm should stay open in the short run
• Observe that this conclusion is the result of total revenue being larger than variable costs.
Congo.com
• B) The company known as Congo.com has just reported the following financial results.
• Sales\$ 14 million
• Fixed Costs\$ 11 million
• Variable Costs \$20 million
• profit (loss) (\$17) million
• number of units sold1 million
• Given that the firm’s losses exceed its revenues, the firm has been advised to cease production. Before doing so, the CEO of the firm wants your advice. Using the tools of analysis presented in class, what advice would you provide Congo ?
Congo.com
• The firm has a net loss of 17 million
• Based on its fixed costs of 11 million, the firm would have a loss of 11 million if it closed
• Since losing 11 million is preferred to losing 17 million, the firm will minimize it losses by closing
• Observe that this conclusion is the result of total revenue being smaller than variable costs.
9) Consider the country of Atlantis. One of the key industries in the country is the widget industry. Because of its importance, the firm that makes widgets is owned by the government.

The firm currently produces at the point of diminishing marginal returns to labor.

The Laissez Faire party has proposed that the firm be privatized. Is there any merit to this proposal? Explain, using the tools of analysis presented in class.

MC

Price

Point where profits are

Maximized when the

Firm is a price taker.

Also the point of

Allocative efficiency

Q0

Q*