Government Intervention

Chapter -9: Exercise Practice Set

1. From time to time, Congress has raised the minimum wage. Some people suggested that a
government subsidy could help employers finance the higher wage. This exercise examines the
economics of a minimum wage and wage subsidies. Suppose the supply of low-skilled labor is
given by LS = 10w, where LS is the quantity of low-skilled labor (in millions of persons
employed each year), and w is the wage rate (in dollars per hour). The demand for labor is
given by LD = 80 − 10w.
a. What will be the free-market wage rate and employment level? Suppose the government
sets a minimum wage of $5 per hour. How many people would then be employed?
In a free-market equilibrium, LS = LD. Solving yields w = $4 and LS = LD = 40. If the minimum
wage is $5, then LS = 50 and LD = 30. The number of people employed will be given by the labor
demand, so employers will hire only 30 million workers.
 b. Suppose that instead of a minimum wage, the government pays a subsidy of $1 per hour
for each employee. What will the total level of employment be now? What will the
equilibrium wage rate be?
Let ws denote the wage received by the sellers (i.e., the employees), and wb the wage paid by the
buyers (the firms). The new equilibrium occurs where the vertical difference between the supply
and demand curves is $1 (the amount of the subsidy). This point can be found where
LD(wb) = LS(ws), and
ws − wb = 1.
Write the second equation as wb = ws − 1. This reflects the fact that firms pay $1 less than the
wage received by workers because of the subsidy. Substitute for wb in the demand equation:
LD(wb) = 80 − 10(ws − 1), so
LD(wb) = 90 − 10ws.
Note that this is equivalent to an upward shift in demand by the amount of the $1 subsidy. Now
set the new demand equal to supply: 90 − 10ws = 10ws. Therefore, ws = $4.50, and LD = 90 −
10(4.50) = 45. Employment increases to 45 (compared to 30 with the minimum wage), but wage
drops to $4.50 (compared to $5.00 with the minimum wage). The net wage the firm pays falls to
$3.50 due to the subsidy.

2. Suppose the market for widgets can be described by the following equations:
Demand: P = 10 − Q Supply: P = Q − 4
where P is the price in dollars per unit and Q is the quantity in thousands of units. Then:
a. What is the equilibrium price and quantity?
Equate supply and demand and solve for Q: 10 − Q = Q – 4. Therefore Q = 7 thousand widgets.
Substitute Q into either the demand or the supply equation to obtain P.
P = 10 − 7 = $3.00,
or
P = 7 − 4 = $3.00.
 b. Suppose the government imposes a tax of $1 per unit to reduce widget consumption and
raise government revenues. What will the new equilibrium quantity be? What price will
the buyer pay? What amount per unit will the seller receive?
With the imposition of a $1.00 tax per unit, the price buyers pay is $1 more than the price
suppliers receive. Also, at the new equilibrium, the quantity bought must equal the quantity
supplied. We can write these two conditions as
Pb − Ps = 1
Qb = Qs.
Let Q with no subscript stand for the common value of Qb and Qs. Then substitute the demand
and supply equations for the two values of P:
(10 − Q) − (Q − 4) = 1
Therefore, Q = 6.5 thousand widgets. Plug this value into the demand equation, which is the
equation for Pb, to find Pb = 10 − 6.5 = $3.50. Also substitute Q = 6.5 into the supply equation
to get Ps = 6.5 − 4 = $2.50.
The tax raises the price in the market from $3.00 (as found in part a) to $3.50. Sellers, however,
receive only $2.50 after the tax is imposed. Therefore the tax is shared equally between buyers
and sellers, each paying $0.50.
c. Suppose the government has a change of heart about the importance of widgets to the
happiness of the American public. The tax is removed and a subsidy of $1 per unit granted
to widget producers. What will the equilibrium quantity be? What price will the buyer
pay? What amount per unit (including the subsidy) will the seller receive? What will be the
total cost to the government?
Now the two conditions that must be satisfied are
Ps − Pb = 1
Qb = Qs.
As in part b, let Q stand for the common value of quantity. Substitute the supply and demand
curves into the first condition, which yields
(Q − 4) − (10 − Q) = 1.
Therefore, Q = 7.5 thousand widgets. Using this quantity in the supply and demand equations,
suppliers will receive Ps = 7.5 − 4 = $3.50, and buyers will pay Pb = 10 − 7.5 = $2.50. The total
cost to the government is the subsidy per unit multiplied by the number of units. Thus the cost is
($1)(7.5) = $7.5 thousand, or $7500.

9. Among the tax proposals regularly considered by Congress is an additional tax on distilled
liquors. The tax would not apply to beer. The price elasticity of supply of liquor is 4.0, and the
price elasticity of demand is −0.2. The cross-elasticity of demand for beer with respect to the
price of liquor is 0.1.
a. If the new tax is imposed, who will bear the greater burden—liquor suppliers or liquor
consumers? Why?
 ES
The fraction of the tax borne by consumers is given in Section 9.6 as , where ES is the
ES − ED
own-price elasticity of supply and ED is the own-price elasticity of demand. Substituting for ES
and ED, the pass-through fraction is
4 4
=  0.95.
4 − (−0.2) 4.2
Therefore, just over 95% of the tax is passed through to consumers because supply is highly
elastic while demand is very inelastic. So liquor consumers will bear almost all the burden of
the tax.
b. Assuming that beer supply is infinitely elastic, how will the new tax affect the beer market?
With an increase in the price of liquor (from the large pass-through of the liquor tax), some
consumers will substitute away from liquor to beer because the cross-elasticity is positive.
This will shift the demand curve for beer outward. With an infinitely elastic supply for beer
(a horizontal supply curve), the equilibrium price of beer will not change, and the quantity of
beer consumed will increase.
10. In Example 9.1 (page 322), we calculated the gains and losses from price controls on natural
gas and found that there was a deadweight loss of $5.68 billion. This calculation was based on a
price of oil of $50 per barrel.
a. If the price of oil were $60 per barrel, what would be the free-market price of gas? How
large a deadweight loss would result if the maximum allowable price of natural gas were
$3.00 per thousand cubic feet?
From Example 9.1, we know that the supply and demand curves for natural gas can be
approximated as follows:
QS = 15.90 + 0.72PG + 0.05PO
and
QD = 0.02 − 1.8PG + 0.69PO,
where PG is the price of natural gas in dollars per thousand cubic feet ($/mcf) and PO is the price
of oil in dollars per barrel ($/b).
With the price of oil at $60 per barrel, these curves become,
QS = 18.90 + 0.72PG
and
QD = 41.42 – 1.8PG.
Setting quantity demanded equal to quantity supplied, find the free-market equilibrium price:
18.90 + 0.72PG = 41.42 − 1.8PG, or PG = $8.94.
At this price, the equilibrium quantity is 25.3 trillion cubic feet (Tcf).
If a price ceiling of $3 is imposed, producers would supply only 18.9 + 0.72(3) = 21.1 Tcf,
although consumers would demand 41.42 – 1.8(3) = 36.0 Tcf. See the diagram below. Area A is
transferred from producers to consumers. The deadweight loss is B + C. To find area B we must
first determine the price on the demand curve when quantity equals 21.1. From the demand
equation, 21.1 = 41.42 − 1.8PG. Therefore PG = $11.29. Area B equals (0.5)(25.3 − 21.1)
 (11.29 − 8.94) = $4.9 billion, and area C is (0.5)(25.3 − 21.1)(8.94 − 3) = $12.5 billion. The
deadweight loss is 4.9 + 12.5 = $17.4 billion.

b. What price of oil would yield a free-market price of natural gas of $3?
Set the original supply and demand equal to each other, and solve for PO.
15.90 + 0.72PG + 0.05PO = 0.02 − 1.8PG + 0.69PO
0.64PO = 15.88 + 2.52PG
Substitute $3 for the price of natural gas. Then
0.64PO = 15.88 + 2.52(3), or PO = $36.63.

14. You know that if a tax is imposed on a particular product, the burden of the tax is shared by
producers and consumers. You also know that the demand for automobiles is characterized by
a stock adjustment process. Suppose a special 20% sales tax is suddenly imposed on
automobiles. Will the share of the tax paid by consumers rise, fall, or stay the same over time?
Explain briefly. Repeat for a 50-cents-per-gallon gasoline tax.
For products with demand characterized by a stock adjustment process, short-run demand is more
elastic than long-run demand because consumers can delay their purchases of these goods in the
short run. For example, when price rises, consumers may continue using the older version of the
product that they currently own. However, in the long run, a new product will be purchased as the
old one wears out. Thus the long-run demand curve is more inelastic than the short-run one.
Consider the effect of imposing a 20% sales tax on automobiles in the short and long run. The
portion of the tax that will be borne by consumers is given by the pass-through fraction, ES/(ES − ED).
Assuming that the elasticity of supply, ES, is the same in the short and long run, as demand becomes
less elastic in the long run, the elasticity of demand, ED, will become smaller in absolute value.
Therefore the pass-through fraction will increase, and the share of the automobile tax paid by
consumers will rise over time.
Unlike the automobile market, the gasoline demand curve is not characterized by a stock adjustment
effect. Long-run demand will be more elastic than short-run demand, because in the long run
 consumers can make adjustments such as buying more fuel-efficient cars and taking public
transportation that will reduce their use of gasoline. As the demand becomes more elastic in the long
run, the pass-through fraction will fall, and therefore the share of the gas tax paid by consumers will
fall over time.

15. In 2011, Americans smoked 16 billion packs of cigarettes. They paid an average retail price of
$5.00 per pack.
a. Given that the elasticity of supply is 0.5 and the elasticity of demand is −0.4, derive linear
demand and supply curves for cigarettes.
Let the demand curve be of the general linear form Q = a − bP and the supply curve be
Q = c + dP, where a, b, c, and d are positive constants that we have to find from the information
given above. To begin, recall the formula for the price elasticity of demand
P Q
EPD = .
Q P
We know the values of the elasticity, P, and Q, which means we can solve for the slope, which
is −b in the above formula for the demand curve.
 5.00 
−0.4 =   ( −b)
 16 
 16 
b = 0.4   = 1.28.
 5.00 
To find the constant a, substitute for Q, P, and b in the demand curve formula: 16 = a − 1.28(5.00).
Solving yields a = 22.4. The equation for demand is therefore Q = 22.4 − 1.28P. To find the
supply curve, recall the formula for the elasticity of supply and follow the same method as
above:
P Q
EPS =
Q P
 5.00 
0.5 =   (d )
 16 
 16 
d = 0.5   = 1.6
 5.00 
To find the constant c, substitute for Q, P, and d in the supply formula, which yields
16 = c + 1.6(5.00). Therefore c = 8, and the equation for the supply curve is Q = 8 + 1.6P.
b. Cigarettes are subject to a federal tax, which was about $1.00 per pack in 2011. What does
this tax do to the market-clearing price and quantity?
The tax drives a wedge between supply and demand. At the new equilibrium, the price buyers
pay, Pb, will be $1.00 higher than the price sellers receive, Ps. Also, the quantity buyers demand
at Pb must equal the quantity supplied at price Ps. These two conditions are:
Pb − Ps = 1.00 and 22.4 − 1.28Pb = 8 + 1.6 Ps.
Solving these simultaneously, Ps = $4.56 and Pb = $5.56. The new quantity will be Q = 22.4 −
1.28(5.56) = 15.3 billion packs. So the price consumers pay will increase from $5.00 to $5.56
(a 56-cent increase) and consumption will fall from 16 to 15.3 billion packs per year (a drop of
700 million packs per year).
c. How much of the federal tax will consumers pay? What part will producers pay?
Consumers pay $5.56 − 5.00 = $0.56 and producers pay the remaining $5.00 − 4.56 = $0.44 per
pack. We could also find these amounts using the pass-through formula. The fraction of the tax
paid by consumers is ES/(ES − ED) = 0.5/[0.5 − (−0.4)] = 0.5/0.9 = 0.56. Therefore, consumers will
pay 56% of the $1.00 tax, which is 56 cents, and suppliers will pay the remaining 44 cents.