ME Problem Set – III

PGP 2017-19

1. In 2007, Americans smoked 19.2 billion packs of cigarettes. They paid an average
retail price of $4.50 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.

b. Cigarettes are subject to a federal tax, which was about 40 cents per pack in 2007.
What does this tax do to the market-clearing price and quantity?

c. How much of the federal tax will consumers pay? What part will producers pay?

2. The domestic supply and demand curves for hula beans are as follows:
Supply: P = 50 + Q Demand: P = 200 – 2Q
where P is the price in cents per pound and Q is the quantity in millions of pounds. The U.S. is
a small producer in the world hula bean market, where the current price (which will not be
affected by anything Americans do) is 60 cents per pound.
Congress is considering a tariff of 40 cents per pound. Find the domestic price of hula beans
that will result if the tariff is imposed. Also compute the dollar gain or loss to domestic
consumers, domestic producers, and government revenue from the tariff.

3. Among the tax proposals regularly considered by U.S. 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?
(b) Assuming that beer supply is infinitely elastic, how will the new tax affect the beer
market?

1
 4. A particular metal is traded in a highly competitive world market at a world price of $9
per ounce. Unlimited quantities are available for import into the United States at this
price. The supply of this metal from domestic U.S. mines and mills can be represented
by the equation QS = 2/3P, where QS is U.S. output in million ounces and P is the
domestic price. The demand for the metal in the United States is Q D = 40 – 2P, where
QD is the domestic demand in million ounces.
In recent years the U.S. industry has been protected by a tariff of $9 per ounce. Under
pressure from other foreign governments, the United States plans to reduce this tariff to zero.
Threatened by this change, the U.S. industry is seeking a voluntary restraint agreement that
would limit imports into the United States to 8 million ounces per year.
(a) Under the $9 tariff, what was the U.S. domestic price of the metal?
(b) If the United States eliminates the tariff and the voluntary restraint
agreement is approved, what will be the U.S. domestic price of the metal?

5. The United States currently imports all of its coffee. The annual demand for coffee
by U.S. consumers is given by the demand curve Q = 250 – 10P, where Q is quantity
(in millions of pounds) and P is the market price per pound of coffee. World
producers can harvest and ship coffee to U.S. distributors at a constant marginal (=
average) cost of $8 per pound. U.S. distributors can in turn distribute coffee for a
constant $2 per pound. The U.S. coffee market is competitive. Congress is
considering a tariff on coffee imports of $2 per pound.
(a) If there is no tariff, how much do consumers pay for a pound of coffee? What is
the quantity demanded?
(b) If the tariff is imposed, how much will consumers pay for a pound of coffee?
What is the quantity demanded?
(c) Calculate the lost consumer surplus.
(d) Calculate the tax revenue collected by the government.
(e) Does the tariff result in a net gain or a net loss to society as a whole?

6. About 100 million pounds of jelly beans are consumed in the United States each year,
and the price has been about 50 cents per pound. However, jelly bean producers feel
that their incomes are too low and have convinced the government that price supports
are in order. The government will therefore buy up as many jelly beans as necessary to
keep the price at $1 per pound. However, government economists are worried about
the impact of this program because they have no estimates of the elasticities of jelly
bean demand or supply.
(a) Could this program cost the government more than $50 million per year? Under
what conditions? Could it cost less than $50 million per year? Under what
conditions? Illustrate with a diagram.

2
 (b) Could this program cost consumers (in terms of lost consumer surplus) more than
$50 million per year? Under what conditions? Could it cost consumers less than
$50 million per year? Under what conditions? Again, use a diagram to illustrate.

7. Japanese rice producers have extremely high production costs, due in part to the high
opportunity cost of land and to their inability to take advantage of economies of large-
scale production. Analyze two policies intended to maintain Japanese rice production:
(1) a per-pound subsidy to farmers for each pound of rice produced, or (2) a per-pound
tariff on imported rice. Illustrate with supply-and-demand diagrams the equilibrium
price and quantity, domestic rice production, government revenue or deficit, and
deadweight loss from each policy. Which policy is the Japanese government likely to
prefer? Which policy are Japanese farmers likely to prefer?

8. In 1983, the Ronald Reagan Administration introduced a new agricultural program

called the Payment-in-Kind Program. To see how the program worked, let’s consider
the wheat market.

a. Suppose the demand function is QD = 28 – 2P and the supply function is Q S = 4 + 4P,

where P is the price of wheat in dollars per bushel, and Q is the quantity in billions of
bushels. Find the free-market equilibrium price and quantity.
b. Now suppose the government wants to lower the supply of wheat by 25 percent from
the free-market equilibrium by paying farmers to withdraw land from production.
However, the payment is made in wheat rather than in dollars – hence the name of the
program. The wheat comes from vast government reserves accumulated from previous
price support programs. The amount of wheat paid is equal to the amount that could
have been harvested on the land withdrawn from production. Farmers are free to sell
this wheat on the market. How much is now produced by farmers? How much is
indirectly supplied to the market by the government? What is the new market price?
How much do farmers gain? Do consumers gain or lose?
c. Had the government not given the wheat back to the farmers, it would have stored or
destroyed it. Do taxpayers gain from the program? What potential problems does the
program create?

9. In the spring of 2008, Senators John McCain and Hillary Clinton (who were then
running for president) proposed a temporary elimination of the federal gasoline tax,
effective only during the summer of 2008, in order to help consumers deal with high
gasoline prices.
(a) During the summer, when gasoline demand is high because of vacation driving,
gasoline refiners are operating near full capacity. What does this fact suggest
about the price elasticity of supply?
(b) In light of your answer to (a) who do you predict would benefit from the
temporary gas tax holiday?

3
10. Ann consumes five goods. The prices of all goods are fixed. The price of good x is px.
She spends 25 percent of her income on good x, regardless of the size of her income.
a) Show that her income elasticity of demand of good x is the same for any level of income,
and determine its value.
b) Would the value of the income elasticity of demand for x be different if Ann always
spends 60 percent of her income on good x?

11. David has a quasi-linear utility function of the form U(x, y) = √x + y, with associated
marginal utility functions MUx = 1/(2√x) and MUy = 1.
a) Derive David’s demand curve for x as a function of the prices, Px and Py. Verify that the
demand for x is independent of the level of income at an interior optimum.
b) Derive David’s demand curve for y. Is y a normal good? What happens to the demand for
y as Px increases?

12. Ginger’s utility function is U(x, y) = x2y, with associated marginal utility functions MUx =
2xy and MUy = x2. She has income I = 240 and faces prices Px = $8 and Py = $2.
a) Determine Ginger’s optimal basket given these prices and her income.
b) If the price of y increases to $8 and Ginger’s income is unchanged, what must the price of
x fall to in order for her to be exactly as well off as before the change in Py?

13. Ann’s utility function is U(x, y) = x + y, with associated marginal utility functions
MUx = 1 and MUy = 1. Ann has income I = 4.
a) Determine all optimal baskets given that she faces prices Px = 1 and Py = 1.
b) Determine all optimal baskets given that she faces prices Px = 1 and Py = 2.
c) What is demand for y when Px = 1 and Py = 1? What is demand for y when Px = 1 and Py >
1? What is demand for y when Px = 1 and Py < 1? Plot Ann’s demand for y as a function of
Py.
d) Repeat the exercises in a), b) and c) for U(x, y) = 2x + y, with associated marginal utility
functions MUx = 2 and MUy = 1, and with the same level of income.

14. Suppose that a consumer’s utility function is U(x, y) = xy + 10y. The marginal utilities for
this utility function are MUx = y and MUy = x + 10. The price of x is Px and the price of y is
Py, with both prices positive. The consumer has income I.
a) Assume first that we are at an interior optimum. Show that the demand schedule for x can
be written as x = I/(2Px) − 5.
b) Suppose now that I = 100. Since x must never be negative, what is the maximum value of
Px for which this consumer would ever purchase any x?

4
c) Suppose Py = 20 and Px = 20. On a graph illustrating the optimal consumption bundle of x
and y, show that since Px exceeds the value you calculated in part (b), this corresponds to a
corner point at which the consumer purchases only y. (In fact, the consumer would purchase
y = I/Py = 5 units of y and no units of x.)
d) Compare the marginal rate of substitution of x for y with the ratio (Px/Py) at the optimum in
part (c). Does this verify that the consumer would reduce utility if she purchased a positive
amount of x?
e) Assuming income remains at 100, draw the demand schedule for x for all values of Px.
Does its location depend on the value of Py?

15. The demand function for widgets is given by D(P) = 16 − 2P. Compute the change in
consumer surplus when price of a widget increases for $1 to $3. Illustrate your result
graphically.

16. Jim’s preferences over cookies (x) and other goods (y) are given by U(x, y) = xy with
associated marginal utility functions MUx = y. and MUy = x. His income is $20.
a) Find Jim’s demand schedule for x when price of y is Py = $1.
b) Illustrate graphically the change in consumer surplus when the price of x increases from $1
to $2.

17. Suppose the market for rental cars has two segments, business travelers and vacation
travelers. The demand curve for rental cars by business travelers is Qb = 35 − 0.25P, where
Qb is the quantity demanded by business travelers (in thousands of cars) when the rental price
is P dollars per day. No business customers will rent cars if the price exceeds $140 per day.
The demand curve for rental cars by vacation travelers is Qv = 120 − 1.5P, where Qv is the
quantity demanded by vacation travelers (in thousands of cars) when the rental price is P
dollars per day. No vacation customers will rent cars if the price exceeds $80 per day.
a) Fill in the table to find the quantities demanded in the market at each price.

b) Graph the demand curves for each segment, and draw the market demand curve for rental
cars.

5
c) Describe the market demand curve algebraically. In other words, show how the quantity
demanded in the market Qm depends on P. Make sure that your algebraic equation for the
market demand is consistent with your answers to parts (a) and (b).
d) If the price of a rental car is $60, what is the consumer surplus in each market segment?