Ace Institute of Management

Managerial Economics
Question No 4

1. Suppose that the government subsidies a good. For each unit of the good sold, the government pays $2 to the buyer. How does the subsidy affect consumer surplus, producer a surplus, tax revenue and total surplus? Does the subsidy lead to a deadweight loss? Explain The sum of consumer and producer surplus, which we call total surplus. Consumer surplus is the benefit that buyers receive from participating in a market, and producer surplus is the benefit that sellers receive. It is therefore natural to use total surplus as a measure of societys economic wellbeing. To better understand this measure of economic wellbeing, recall how we measure consumer and producer surplus. We define consumer surplus as Consumer surplus = Value to buyers Amount paid by buyers. Similarly, we define producer surplus as Producer surplus = Amount received by sellers Cost to sellers. When we add consumer and producer surplus together, we obtain Total surplus = (Value to buyers Amount paid by buyers) + (Amount received by sellers Cost to sellers) Hence, total surplus, Total surplus =Value to buyers Cost to sellers. If subsidy isnot provisioned in a good, the equilibrium of supply and demand will be maintained and the equilibrium quantity Q1 and equilibrium price P1 is maintained. Hence, the price received by the supplier is equal to the price charged to the consumer, which is equal to P1 i.e there is no difference between the price received by the producer and seller and Quantity of beer sold is Q1. Hence, the area of triangle MP1E is called consumer surplus and the area of triangle NP1E is called producer surplus and total sum of two triangle MNE gives total surplus also called Society's well being.

M Price

Consumer Surplus P1 Producer Surplus E

Supply Curve (S1)

Demad Curve (D1)

N Q1 Quantity

If $2 subsidy is offered by the government, then, the demand curve shifts up (right) by $2 from D1 to D2.

Price

Equilibrium with subsidy Supply Curve (S1) B E I C F G

A P2 $2 P1 P3 J K D H

A subsidy on buyer shifts the demand Curve upward by the size of subsidy $2 D2 D1

Q1

Q2

Quantity

If $2 subsidy is offered to buyers of a good by the government, first of all letus evaluate how this affect the buyers and sellers. The initial impact of the subsidy is on the demand for goods. The supply curve is not affected because, for any given price of goods, sellers have the same incentive to provide goods to the market. By contrast, buyers now have to get subsidy offered by the government whenever they buy goods. Thus, the subsidy on goods shifts the demand curve up (right). The subsidy on buyers makes buying goods more attractive; buyers demand a larger quantity of goods at every

price. As a result, the demand curve shifts to the right (or, equivalently, upward by $2), as shown in figure above. We can, in this case, be precise about how much the curve shifts. Because of the $2 subsidy is given on buyers, the effective price to buyers is now $2 lower than the market price. Because buyers look at their total cost including the subsidy, they demand a quantity of goods as if the market price were $2 lower than it actually is. In other words, to induce buyers to demand any given quantity, the market price must now be $2 higher to make up for the offer of the subsidy. Thus, the subsidy shifts the demand curve upward from D1 to D2 by exactly the size of the subsidy ($2). Now due to the effect of subsidy, the equilibrium point changes from E to E1. The quantity demanded is shifted from Q1 to Q2 which is finally equal to the quantity supplied and final equilibrium price shifted to P2 (which is a price to the seller) but a subsidy ($2) is beared by the government to the consumer. So the price beared by the consumer is P2 $2 = P3. Because buyers buy more and sellers sell more and in the new equilibrium, the subsidy on goods increases the size of the goods market as shown in figure. The effect of the subsidy on the price paid by the demanders and the price received by the suppliers.
Price paid by the demanders (Consumers): P3 Price paid by the suppliers (Producers): P2 Amount of subsidy provided by government = P2 P3 = $2

The consumer surplus and producer surplus after the subsidy

CS after subsidy = A + B + E + F + G + J + K. PS after subsidy = B + C + E + I + J + K.

Consumer Surplus after subsidy After Subsidy, the demand curve shift by $2, equilibrium point shift, quantity demanded increased, price increased to P2 in which government shared $2 and price to buyer will be P3 (P2$2). So consumer surplus is area between P3 curve and demand curve shown by hatched area in figure. D2 D1 Q1 Q2 Quantity Price A P2 $2 P1 P3 I B E J K C F G D H

Producer Surplus after subsidy Price

A P2 $2 P1 P3 I B E J K C F G D H

After Subsidy, the demand curve shift by $2, equilibrium point shift, quantity demanded increased, price increased to P2 in which government shared $2 and price to buyer will be P3 (P2$2). So producer surplus is area between P2 (price taken by producer) curve and supply curve shown by hatched area in figure. D2 D1

Q1

Q2

Quantity

Total surplus after the government subsidy.

TS after subsidy = Consumer Surplus (CS) after subsidy + Producer Surplus (PS) after subsidy Governtment PaidOut = (A + B + E + F + G + J + K ) + (B + C + E + I + J + K) (J+K+C+F+G+D+H) = A + B + E + I + J + K D H.

Deadweight loss due to subsidy

Change in total surplus (TS) = TS after subsidy TS before subsidy = (D + H). Therefore, Deadweight Loss is (D + H).

Government subsidies are almost always a bad idea. They destroy competition which lowers the quality and availability of a product. Lets use toasters as an example. There are 4 companies that manufacture toasters. Each company charges $12 per toaster, what the free market will bear. They will thrive or fail because of the quality of their toasters. If one company produces bad toasters it will soon be out of business. But there are still 3 companies to compete and this means at least one of them will produce a quality product to avoid failure. Now enters the federal government. And they pick one toaster company to subsidies. trust me they will pick only one. The one most politically reliable to the politicians in charge of the decision. Now we have 3 companies that sell toasters for $12 and one government subsidized one that charges $10. A huge number of consumers will buy the lower cost toaster. The 3 free market companies have limited resources and cannot compete with unlimited tax dollars for subsidies. So soon the 3 free market companies are out of business and no new toaster companies will form because they cannot compete with the government. Now we have only one toaster company. They are protected by the government, have no competition and soon are producing poor quality products. It's not like you can go to their competition because there is none. Consider the Dept of Agriculture. Every year it subsidizes farmers to produce corn, wheat, cheese, honey, and many other products. The result is billions of dollars spent to produce huge surpluses of these foods which the federal government then takes charge of and most of it is destroyed. Some of it they give away to food pantries, homeless shelters, etc, but the vast majority of it is destroyed to keep up the price of food in America. The free market balances itself through free trade. Companies do not produce that which the public will not buy and competition weeds out the inefficient. When the government gets involved they spend billions of dollars of our tax money in an inefficient and wasteful way because they don't care about the market or the people, they

Question No 10 of Assignment Consider total cost and total revenue given in the following table.

Quantity Total Cost ($) Total Revenue ($)

0 8 0

1 9 8

2 10 16

3 11 24

4 13 32

5 19 40

6 27 48

7 39 56

a) Calculate profit for each quantity. How much should the firm produce to maximize profit? b) Calculate marginal revenue and marginal cost for each quantity .Graph them. At what quantity do these curves cross? How does this relate to your answer to part (a)? c) Can you tell whether this firm is in a competitive Industry? If so, can you tell whether the Industry is in a longrun equilibrium? Solu tion Here is the table showing costs, revenues, and profits:

a. The firm should produce five or six units to maximize profit. b. Marginal revenue and marginal cost are graphed in Figure 4. The curves cross at a quantity between five and six units, yielding the same answer as in Part (a). c. This industry is competitive because marginal revenue is the same for each quantity. The industry is not in longrun equilibrium, because profit is not equal to zero.