Microeconomics 1 Rizki Nauli Siregar, Ph.D.

Odd Semester 2023 Universitas Indonesia

Problem Set 3 - Solutions

Notes

• Most answers here show you the final results of the calculation for brevity. In exams, you
have to provide your calculations, graphs, and economic intuition in a clear and complete
manner.

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Microeconomics 1 Rizki Nauli Siregar, Ph.D.
Odd Semester 2023 Universitas Indonesia

1. Suppose the supply of labor in Narnia is given by:

LS = 20w (1)

where LS is the quantity of labor in millions of people employed each year in Narnia, and
w is the wage rate in dollars per hour. The demand for labor is given by:

LD = 60 − 10w (2)

(a) What will be the free-market wage rate and employment level?

Solution: The free-market wage rate would be 2 dollars per hour. The free-market
employment level would be 40 millions people employed per year.

(b) Suppose the government sets a minimum wage of $3 per hour. How many people
would then be employed?

Solution: If the minimum wage is $3 per hour, then LS = 60 while LD = 30. The
number of people employed will equal the labor demand, i.e., 30 million people
being employed per year.

(c) Suppose instead of a minimum wage, the government pays a subsidy of $0.5 per hour
for each employee. What will the total level of employment be now? What will the
equilibrium wage rate be?

Solution:

• Let ws denote the wage received by employed labor, while wd denote the
wage paid by employers.

• Due to the subsidy, the labor demand shifts to the right by $0.5. We would
like to find a new equilibrium with such a shift.

• In the equilibrium, labor market clears, that is the amount of labor demand
equals to labor supply. In addition the difference between the wage received
by an employee and paid by an employer equals to the size of the subsidy of
$0.5. Mathematically:

LD (wd ) = LS (ws ) (3)

ws − wd = 0.5 (4)

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Microeconomics 1 Rizki Nauli Siregar, Ph.D.
Odd Semester 2023 Universitas Indonesia

• From (4), we have:

wd = ws − 0.5 (5)

• Substitute in (5) into the labor demand function.

LD (wd ) = 60 − 10wd (6)

⇔ LD = 60 − 10(ws − 0.5) (7)
D
⇔ L = 65 − 10ws (8)

• Equate labor demand with labor supply using (8) as the labor demand, we
get the equilibrium wage would be $2.167. This is the wage received by
employees. Meanwhile, the wage paid by employers would be $1.67, as the
government pays $0.5 for each labor employed. The total level of employment
would be 43.34 million people employed per year.

Link to the graphs: https://www.desmos.com/calculator/d2elgoa7l5

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Microeconomics 1 Rizki Nauli Siregar, Ph.D.
Odd Semester 2023 Universitas Indonesia

2. Suppose the market for ice latte is characterized by the following equations:

• Demand: P = 8 − Q
• Supply: P = Q − 4

where P is the price in dollars per glass of ice latte and Q is the quantity in thousands of
glasses.
(a) What is the equilibrium price and quantity?

Solution: The equilibrium price is 2 while the equilibrium quantity is 6 thousand

glasses of ice latte.

(b) Suppose the government imposes a tax of $1 per glass of ice latte to reduce ice latte
consumption and raise government revenue. What will the new equilibrium quantity
be? What price will the buyer pay? How many dollars per glass will the seller receive?
How much tax revenue does the government receive? Compute the loss of consumer
surplus due to this policy.

Solution:

• Let Pb as the price paid by buyers and Ps as the price received by sellers.

• With tax, the new equilibrium occurs when

Pb − P s = 1 (9)
Qb = Qs (10)

where Qb is quantity demanded and Qs is quantity supplied.

• Let Q stand for the common value of quantity when Qb = Qs , then substitute
the demand and supply function into (9):

(8 − Q) − (Q − 4) = 1 (11)

• Then the equilibrium quantity with tax is 5,500 glasses of ice latte.

• The price paid by consumers: $2.5.

• The price received by sellers: $1.5

• The amount of tax revenue received by the government: $5,500.

• The loss of consumer surplus: $2875.

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Microeconomics 1 Rizki Nauli Siregar, Ph.D.
Odd Semester 2023 Universitas Indonesia

(c) Suppose now the government considers the importance of ice latte consumption to
labor productivity. The tax is removed and a subsidy of $1 per glass is granted to
coffee shops. What will the equilibrium quantity be? What price will the buyer
pay? How many dollars (including the subsidy) will coffee shops receive per glass of
iced latte? What will the total cost to the government? Compute the change in the
consumer surplus in comparison to the free-market equilibrium.

Solution:

• With subsidy, the equilibrium occurs when:

Ps − Pb = 1 (12)
Qb = Qs (13)

• The equilibrium quantity with the subsidy is 6500 glasses of iced latte.

• The amount received by seller per glass: $2.5

• The price paid by consumers per glass: $1.5

• The total cost to the government: $6500.

• In comparison to the free-market equilibrium, the consumer surplus increases

by $3125 with the implementation of the subsidy policy.

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Microeconomics 1 Rizki Nauli Siregar, Ph.D.
Odd Semester 2023 Universitas Indonesia

Link to the graphs: https://www.desmos.com/calculator/xexwictrre.