Tutorial 5 week 6: Government actions in markets: Solutions

Short answer and discussion questions

Price ceiling and price floors

Q1: Use the following graph of the market for rental

housing in Townsville to work Problems a to c.
a. What are the equilibrium rent and equilibrium
quantity of rental housing?
The equilibrium rent is $450 a month and the
equilibrium quantity is 20,000 housing units.
b. If a rent ceiling is set at $600 a month, what is the
quantity of housing rented and what is the
shortage of housing?
The quantity of housing rented is equal to 20,000
units. If the rent ceiling is set at $600 per month, it is
above the equilibrium rent and so is ineffective. The
rent stays at $450 per month and the quantity rented
remains at 20,000 housing units. There is no
shortage of housing units. Because the rent ceiling is
ineffective, the market remains at its equilibrium so
there is no shortage of housing units.
c. If a rent ceiling is set at $300 a month, what is the quantity of housing rented, the shortage of housing,
and the maximum price that someone is willing to pay for the last unit of housing available?
The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity
supplied at the rent ceiling. The shortage of housing is 20,000 housing units. At the rent ceiling, the
quantity of housing demanded is 30,000, but the quantity supplied is 10,000, so there is a shortage of
20,000 housing units. The maximum price that someone is willing to pay for the 10,000th unit available
is $600 a month. The demand curve tells us the maximum price that someone is willing to pay for the
10,000th unit.

Q2: Use the following data to work Problems a to c.

The table gives the demand and supply schedules Quantity Quantity
of teenage labour. Wage rate demanded supplied
a. Calculate the equilibrium wage rate, the (dollars per (hours per month)
number of hours worked, and the quantity hour)
of unemployment. 4 3,000 1,000
5 2,500 1,500
The equilibrium wage rate is $6 an hour and
2,000 hours a month are worked.
6 2,000 2,000
Unemployment is zero. Everyone who wants 7 1,500 2,500
to work for $6 an hour is employed. 8 1,000 3,000

b. If a minimum wage for teenagers is set at $5 an hour, how many hours do they work and how many
 hours of teenage labour are unemployed?
They work 2,000 hours a month. A minimum wage rate is the lowest wage rate that a teenager can be
paid for an hour of work. Because the equilibrium wage rate exceeds the minimum wage rate, the
minimum wage is ineffective. The wage rate will be $6 an hour and employment is 2,000 hours. There is
no unemployment. The wage rate rises to the equilibrium wage, the wage rate at which the quantity of
labour demanded equals the quantity of labour supplied. So there is no unemployment.
c. If a minimum wage for teenagers is set at $7 an hour,
i. How many hours do teenagers work and how many hours are unemployed?
At $7 an hour, 1,500 hours a month are employed and 1,000 hours a month are unemployed. The
quantity of labour employed equals the quantity demanded at $7 an hour. Unemployment is equal to the
quantity of labour supplied at $7 an hour minus the quantity of labour demanded at $7 an hour. The
quantity supplied is 2,500 hours a month and the quantity demanded is 1,500 hours a month, so 1,000
hours a month are unemployed.
ii. Demand for teenage labour increases by 500 hours a month. What is the wage rate paid to
teenagers and how many hours of teenage labour are unemployed?
The wage rate is $7 an hour, and unemployment is 500 hours a month. At the minimum wage of $7 an
hour, the quantity demanded is 2,000 hours a month and the quantity supplied is 2,500 hours a month so
500 hours a month are unemployed.

Taxation
Q3: Qantas Fuel Surcharge Hiked
Qantas will boost fuel surcharges by up to 40 per cent. Fuel levies on a return trip to Europe will
rise from $290 to $380.
Source: The Australian, 10 March 2011
Would the total price of an economy ticket rise by the amount of the surcharge? How would
consumer surplus change? Explain your answers.
The price will rise by the full amount of the surcharge only if the demand for air travel is perfectly
inelastic or the supply of air travel is perfectly elastic. Neither case occurs, so the price of an economy
ticket would rise by less than 40 % of the surcharge. The amount passed on will depend on how price
elastic the demand for air travel is. The more inelastic the demand, larger is the fraction of the surcharge
paid by the passengers. The consumer surplus would decrease. Consumers would pay a higher price and
would make fewer flights, both of which decrease consumer surplus.

Q4: Why is a tax inefficient?

The imposition of a tax on a market causes a wedge to be driven between the price received by the seller
and the price paid by the buyer. This causes the marginal social benefit from the last unit sold to be
higher than its marginal social cost, and the market will underproduce the good or service being taxed. If
more of the good or service were produced, the marginal social benefit gained would be greater than the
marginal social cost incurred, and the net benefit to society would increase.
Q5: In part as an effort to discourage smoking, Australia has some of the highest levels of cigarette
taxation in the world. Do you think a tax on cigarettes dramatically decreases the number of people
smoking? Is taxing cigarettes an effective way to raise revenue for the government from smokers? (Hint:
given that smoking is addictive, what does this imply about the elasticity of demand?)

As smoking is addictive, the demand for cigarettes is highly inelastic. This is because there are few products that
can be substituted for cigarettes, and because cigarettes are likely to be considered a necessary good by those who
are addicted. As a result the demand for cigarettes is not very responsive to price and a tax on cigarettes will not
lead to a large reduction in the number of cigarettes sold. As demand is inelastic relative to supply, the burden of
the tax falls mostly on the buyers of cigarettes, who suffer substantial increases in the prices they pay. As a result,
most of the revenue raised will be from smokers, rather than the sellers of cigarettes so it is effective in terms of
getting the revenue from the smokers. The smokers are not able to easily leave the market.

Question 6

a. What was the equilibrium price in this market before the tax? $10
b. What is the amount of the tax? $3
c. How much of the tax will the buyers pay? $1
d. How much of the tax will the sellers pay? $2
e. How much will the buyer pay for the product after the tax is imposed? $11
f. How much will the seller receive after the tax is imposed? $8
g. What is the total tax revenue? $3 * 90 = $270
h. Suppose the market was operating at equilibrium before the tax. As a result of the tax, what has
happened to efficiency in this market?
As a result of the tax, the quantity has fallen, from 100 units being bought and sold to only 90 units being
bought and sold. We have moved from efficient to inefficient point. .MSB>MSC. There is scope to
produce more and increase MSB, without unbearable increases in MSC (MSC would still rise as we
produce more but it is still below MSB until the equilibrium).

Multiple choice
Graph 1

1. According to Graph 1, the amount of the tax that sellers would pay would be:
a. $1.00
b. $1.50
c. $2.50
d. $3.00

2. In Graph above, a price ceiling that is not binding is shown in:

a. panel a
b. panel b
c. both panel a and panel b
d. neither panel a nor panel b

3. Suppose the equilibrium price of bananas is $5 and a price ceiling of $7 is implemented. This will result in:
a. a shortage, as the price ceiling is above the equilibrium price
 b. a surplus, as the price ceiling is above the equilibrium price
c. no change in the quantity of bananas sold
d. a surplus, as the price ceiling is below the equilibrium price

4. Suppliers of a good are likely to favor a binding:

a. price floor, as the quantity sold will be higher than in a competitive market
b. price floor, as the price received will be higher than in a competitive market
c. price ceiling, as the quantity demanded will be higher than in a competitive market
d. price ceiling, as the price received will be higher than in a competitive market

5. The term tax incidence refers to the:

a. division of income tax between high-income and low-income earners
b. level of tax levied on a buyer of a good
c. division of the tax burden between buyers and sellers
d. division of tax between federal and local government

Graph

6. According to Graph, the amount of the tax that buyers would pay would be:
a. $1.00
b. $1.50
c. $2.00
d. $3.00

7. If the minimum wage is below the equilibrium wage:

a. the quantity demanded of labour will be greater than the quantity supplied
b. the quantity demanded of labour will equal the quantity supplied
c. the quantity demanded of labour will be less than the quantity supplied
d. anyone who wants a job at the minimum wage can find one
8. In Graph, the per-unit burden of the tax on the sellers is:
a. P minus P
2 0
b. P minus P
2 1
c. P minus P
1 0
d. Q minus Q
1 0

9. A tax on the sellers of popcorn will:

a. reduce the equilibrium price of popcorn and increase the equilibrium quantity
b. reduce the equilibrium price of popcorn and reduce the equilibrium quantity
c. increase the equilibrium price of popcorn and increase the equilibrium quantity
d. increase the equilibrium price of popcorn and reduce the equilibrium quantity

10. According to Graph, the price sellers receive after the tax is imposed is:
a. $1.00
b. $3.50
c. $5.00
d. $6.00
11. Refer to set of Graphs. In which market will the majority of a tax be paid by the buyer?
a. market a
b. market b
c. market c
d. all of the above

12. In Graph , the price that will be paid after the tax is:
a. P
0
b. P
1
c. P
2
d. impossible to determine

13. A hot summer’s day can lead to dramatic increases in the demand for electricity. Suppose the government decides
a binding price ceiling is necessary so pensioners can continue to afford their power bills. The effect of this policy
will be such that:
a. the quantity of electricity supplied will be unchanged
 b. electricity producers will increase supply, leading to a decrease in price
c. electricity producers will supply less than demanded, leading to a shortage
d. demand will decrease, leading to a decrease in price

14. Some developing countries have used binding price ceilings to keep rice cheap to assist the poor. At the ceiling
price:
a. the quantity demanded will be greater than the quantity supplied and a shortage will result
b. the quantity demanded will be greater than the quantity supplied and a surplus will result
c. the quantity demanded will be less than the quantity supplied and a shortage will result
d. the quantity demanded will be less than the quantity supplied and a surplus will result

15. According to Graph, the amount of the tax imposed in this market is:
a. $1.00
b. $1.50
c. $2.50
d. $3.00

16. According to Graph, the price sellers receive after the tax is imposed is:
a. $8.00
b. $6.00
c. $5.00
d. $3.50

17. According to Graph, the price buyers will pay after the tax is imposed is:
a. $8.00
b. $6.00
c. $5.00
d. $3.50