PROBLEM SET 4 — SOLUTIONS

Section A
1. (a) Tax revenue is represented by areas A + B. Deadweight loss is represented by areas C + D.
Tax Revenue = 1,000 × ($500 − $380) = $120,000
DWL = !" × (1,200 − 1,000) × ($500 − $380) = $12,000

(b) Tax revenue is represented by areas A + B. Deadweight loss is represented by areas C + D.

Tax Revenue = 800 × ($600 − $360) = $192,000
DWL = !" × (1,200 − 800) × ($600 − $360) = $48,000
When the tax is doubled, tax revenue less than doubles while deadweight loss more than
doubles.

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2. The answers are in the article.

3. (a) The externalities associated with public goods are positive. Because the benefits from the
public good received by one person do not reduce the benefits received by anyone else, the
social value of public goods is substantially greater than the private value. Because public
goods are not excludable, the free-market quantity is zero, so it is less than the efficient
quantity. Examples include national defense, knowledge, uncongested non-toll roads, and
uncongested parks.

(b) The externalities associated with common resources are generally negative. Because common
resources are rival in consumption but not excludable, the use of the common resources by
one person reduces the amount available for others. Because common resources are not
priced, people tend to overuse them — their private cost of using the resources is less than
the social cost. Examples include fish in the ocean, clean air, congested non-toll roads, and
congested parks.

4. (a) Police protection is a natural monopoly, since it is excludable (the police may ignore some
neighborhoods) and not rival (unless the police force is overworked, they’re available
whenever a crime arises). You could make an argument that police protection is rival, if the
police are too busy to respond to all crimes, so that one person’s use of the police reduces
the amount available for others; in that case, police protection is a private good.

(b) Street cleaning is most likely a common resource. A street that has been cleaned is not
excludable. But street cleaning is rival, especially right after a major festive event where streets
are often heavily littered, since cleaning one street means not cleaning another street.

(c) Rural roads are public goods. They are neither excludable nor rival since they are
uncongested.

(d) City streets are common resources when congested. They are not excludable, since anyone
can drive on them. But they are rival, since congestion means every additional driver slows
down the progress of other drivers. When they are uncongested, city streets are public goods,
since they are not rival.

5. The answers are in the article.

6. (a) The statement is false. An example is the case of a tax when either supply or demand is
perfectly inelastic. The tax has neither an effect on quantity nor any deadweight loss, but it
raises revenue.

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(b) The statement is false. An example is the case of a 100 percent tax imposed on sellers. With
a 100 percent tax on their sales of the good, sellers will not supply any amount of the good,
so the tax will raise no revenue. Yet the tax has a large deadweight loss because it reduces the
quantity sold to zero.

(c) The statement is false. Corrective taxes reduce the inefficiency of pollution by reducing the
quantity of the good being produced that has pollution as a by-product. Corrective taxes do
not increase deadweight loss; they reduce deadweight loss.

(d) The statement is false. It does not matter whether the tax is imposed on consumers or
producers — the tax incidence is identical. Whether the externality is caused by consumers
or producers, a tax on either consumers or producers will lead to the same reduction of
quantity, the same increase in the price paid by consumers, and the same decrease in the
price received by producers.

Section B
1. (a) In equilibrium, 𝑄 ! = 𝑄"
650 + 20𝑃 = 1,400 − 10𝑃
𝑃 = $25

Therefore, 𝑄 ! = 650 + 20𝑃 = 650 + 20(25) = 1,150

𝑄" = 1,400 − 10𝑃 = 1,400 − 10(25) = 1,150

(b) The price ceiling is binding since the price ceiling of $15 is below the equilibrium price of
$25. Find 𝑄" and 𝑄 ! at 𝑃 = $15.
𝑄" = 1,400 − 10(15) = 1,250
𝑄 ! = 650 + 20(15) = 950

Shortage = 𝑄" − 𝑄 ! = 1,250 − 950 = 300

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Since 𝑄" > 𝑄 ! at 𝑃 = $15, 950 pairs of jeans are bought and sold.

To find the black market price, plug 𝑄 = 950 into the demand equation.
𝑄 = 1,400 − 10𝑃
950 = 1,400 − 10𝑃
𝑃#$ = $45

(c) Given 𝑃# = 15, find 𝑄 using the demand curve.

𝑄 = 1,400 − 10𝑃 = 1,400 − 10(15) = 1,250

At 𝑄 = 1,250, find 𝑃! using the supply curve.

𝑄 = 650 + 20𝑃
1,250 = 650 + 20𝑃
𝑃! = $30

The subsidy, z, is the difference between the price that sellers receive (𝑃! ) and the price that
buyer pay (𝑃# ).
z = 𝑃! − 𝑃# = 30 − 15 = $15

The deadweight loss is the area below the supply curve and above the demand curve, between
the new quantity and the equilibrium quantity.
%
𝐷𝑊𝐿 = & (1,250 − 1,150)(30 − 15) = $750

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2. (a) In equilibrium, 𝑄 ! = 𝑄"

25𝑃 = 12,500 − 100𝑃
𝑃 = $100

Therefore, 𝑄 ! = 25(100) = 2,500

𝑄" = 12,500 − 100(100) = 2,500

(b) Consumer surplus = !" × 2,500 × ($125 − $100) = $31,250

Producer surplus = !" × 2,500 × $100 = $125,000
Total surplus = $31,250 + $125,000 = $156,250

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(c) A price ceiling of $60 is below the equilibrium price of $100, and hence binding. Producers
will supply:
𝑄 ! = 25(60) = 1,500

At a quantity of 1,500, the last consumer’s WTP is derived from the demand curve:
𝑄" = 12,500 − 100𝑃
1,500 = 12,500 − 100𝑃
𝑃 = $110

Deadweight loss = !" × (2,500 − 1,500) × ($110 − $60) = $25,000

(d) A price floor of $105 is above the equilibrium price of $100, and hence binding. Consumers
will demand:
𝑄" = 12,500 − 100(105) = 2,000

At a quantity of 2,000, the last producer’s cost is derived from the supply curve:
𝑄 ! = 25𝑃
2,000 = 25𝑃
𝑃 = $80

Deadweight loss = !" × (2,500 − 2,000) × ($105 − $80) = $6,250

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(e) Student’s own answer.

3. Initially, the government raises $10,000 + $10,000 = $20,000 from widgets and gadgets. If the
tax on gadgets is eliminated, all tax revenue must now come from the tax on widgets. In order to
raise the same amount of money as today ($10,000 from widgets and $10,000 from gadgets),
the tax revenue from widgets would have to double from $10,000 to $20,000.

Case 1: Neither the supply curve nor the demand curve for widgets is perfectly price inelastic.
Tax Revenue on Widgets = Tax per Widget × Quantity of Widgets
The tax per widget doubles from $1 to $2. Consequently, the quantity of widgets falls from 𝑄'
to 𝛼𝑄' where 𝛼 < 1.

We can show this graphically by focusing on the Tax Revenue from Widgets.

Initially, Tax Revenue from Widgets = $1 × 𝑄%

If the tax rate is doubled, Tax Revenue from Widgets = (2 ∙ $1) × 𝑄&

A doubling of the Tax Revenue from Widgets implies that the new Tax Revenue from Widgets
is 2($1 × 𝑄% ). Since 𝑄& < 𝑄% , the new Tax Revenue from Widgets is less than double the initial
Tax Revenue from Widgets. The government would raise less money than today.

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We can also show this mathematically. We shall refer to Total Revenue as 𝑇𝑅.

Initially, 𝑇𝑅% = ($1 × 𝑄' ) + ?$10 × 𝑄( @

= $10,000 + $10,000
= 2 ∙ $1 ∙ 𝑄'

If the tax rate on widgets is doubled, 𝑇𝑅& = (2 ∙ $1 × 𝛼𝑄' ) + ?$0 × 𝑄( @

= 𝛼(2 ∙ $1 ∙ 𝑄' )

We can compare 𝑇𝑅% and 𝑇𝑅& . Since 𝛼 < 1,

𝑇𝑅& = 𝛼(2 ∙ $1 ∙ 𝑄' ) < 1(2 ∙ $1 ∙ 𝑄' ) = 𝑇𝑅%

Case 2: Either the supply curve or the demand curve for widgets is perfectly price inelastic.
Tax Revenue on Widgets = Tax per Widget × Quantity of Widgets
The tax per widget doubles from $1 to $2. The quantity of widgets is unchanged.
We can show this graphically by focusing on the Tax Revenue from Widgets.

Initially, Tax Revenue from Widgets = $1 × 𝑄%

If the tax rate is doubled, Tax Revenue from Widgets = (2 ∙ $1) × 𝑄&

A doubling of the Tax Revenue from Widgets implies that the new Tax Revenue from Widgets
is 2($1 × 𝑄% ). Since 𝑄& = 𝑄% , the new Tax Revenue from Widgets is double the initial Tax
Revenue from Widgets. The government would raise the same amount of money as today.

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We can also show this mathematically. We shall refer to Total Revenue as 𝑇𝑅.

Initially, 𝑇𝑅% = ($1 × 𝑄' ) + ?$10 × 𝑄( @

= $10,000 + $10,000
= 2 ∙ $1 ∙ 𝑄'

If the tax rate on widgets is doubled, 𝑇𝑅& = (2 ∙ $1 × 𝑄' ) + ?$0 × 𝑄( @

= 𝑇𝑅%

4. (a) The price floor is set above the equilibrium price; thus, at the price floor, quantity supplied
exceeds quantity demanded. In order to maintain the price floor, the government is
compelled to buy up the surplus (𝑄 ! − 𝑄" ).

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(b) When the Thai government sells off its stockpile of rice, the supply curve in the global rice
market shifts right. Equilibrium price falls and equilibrium quantity rises.

However, demand from Africa and China might shift right, which would mitigate the fall in
equilibrium price.

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5. A good is a public good if it is non-rival and non-excludable. Rivalry is not defined by scarcity;
rather, rivalry refers to diminishing utility (either in terms of quantity or quality). Excludability
depends on property rights and can be a policy choice. Note that public provision of a good does
not make it a public good.
(a) Potable water is rival (my consumption of a gallon of water is one gallon that you will not be
able to consume) and excludable (your water supply gets turned off if you forget to pay your
water bill). Potable water is a private good.
The provision of potable water, due to high fixed costs and low marginal costs, is a natural
monopoly (to be discussed in Lecture 6).
Should potable water be excludable? Are there moral grounds for non-excludability? What
are the consequences of non-excludability?

(b) Education is a private good (with a positive externality). It is usually excludable, since
someone who doesn’t pay can be prevented from taking classes. It is usually rival, since the
presence of an additional student in a class reduces the benefits to others.
Justifications for the public provision of education include, but are not limited to:
(i) Education is crucial in economic growth.
(ii) Underconsumption of education is usually due to financial constraints, and not because
parents fail to account for external benefits. Private benefits easily outweigh private costs.
(iii) If we are at all concerned about equity, education can equalize opportunities.

(c) The dissemination of news, due to high fixed costs and low marginal costs, was traditionally
a natural monopoly (to be discussed in Lecture 6). With advances in information and
communications technology, the costs of disseminating news have been driven down.
The consumption of news is arguably non-rival (except when exploiting information for
financial gain) and excludable to a certain degree (e.g., the cost of a newspaper, broadband
subscription, data plan).
Classifying the dissemination of news as a public good implies that news dissemination is
funded or subsidized by the government. In many countries, politicians or political parties
own or control mass media companies. However, political independence is crucial for good
journalism. Is political independence possible with public funding?

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6. (a) The extra traffic is a negative externality because it imposes costs on other drivers.

(b) The external marginal cost is the vertical distance between the private marginal cost curve (as
depicted by the supply curve) and the social marginal cost curve.

(c) The increased foot traffic is a positive externality because it provides benefits to those who
reside near the theater.

(d) The external marginal cost is the vertical distance between the private marginal cost curve (as
depicted by the supply curve) and the social marginal cost curve. The external marginal
benefit is the vertical distance between the private marginal benefit curve (as depicted by the
demand curve) and the social marginal benefit curve.

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(e) A subsidy of $3 will lead to the efficient outcome where the market equilibrium quantity
(Qmarket) will equal the social optimum (Qoptimum).

(f) Student’s own answers.

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