Homework 2

Hint: Even though you are not asked to draw any diagrams, I strongly suggest that you do so because it helps you not only to understand the concept but also to solve the problem.

1. Basic Supply and Demand

Assume that Darjeeling is the only producer of tea in India and that its supply curve is Qs = P-4. The market demand for tea is Qd = 20 - 3P.

a) Find the equilibrium price and quantity.
b) Find the consumer surplus and the producer surplus.

2. Shifts/Movements along the Supply and Demand Curve

Assume that the market is in equilibrium in both the questions.

a) Consider the markets for Coca Cola and Pepsi. Assume that a recent advertising campaign by Pepsi leads people to believe that drinking Pepsi (as opposed to Coke) is beneficial to your health. Explain the effects of this on the markets for Coke and Pepsi, explicitly stating what happens to demand, supply, equilibrium price and equilibrium quantity exchanged in each market, and why. (Hint: Drawing graphs would help you understand the effects on equilibrium price and quantity)

b) The following 5 questions deals with DVD players.
Each of the statements will change this equilibrium point by shifting either the demand or the supply curve. You are to note if the equilibrium price and quantity have increased or decreased.
1. The price of DVD discs declines.
2. Four manufacturers of DVD players build new factories in the U.S.
3. Recording artists demand a doubling of all royalties
4. Napster, an internet file sharing company that allows people to share music/movie files, is allowed to operate.

3. Price Ceiling/Floor

Consider the health club market. The demand for health club service is given by Qd = 50 - P and supply is given by Qs= P-10 where Q represents health club memberships and P represents the price of a membership.

a) Find the equilibrium price and quantity on this market.

In an attempt to increase the amount of exercise done by its citizens, the Madison City Council is considering imposing an effective price ceiling on the price of health club memberships of $20 on Health Clubs that do business within the city limits.

b) Explain the effects of such a policy on the market for Health Club services; explicitly stating what will happen to equilibrium price and quantity on this market.

c) At the price ceiling determine whether or not there is excess demand or excess supply.

d) Will this policy have the desired effect on the amount of exercise being done?

Now suppose that the managers of all Health Clubs in the city of Madison have made a petition to the City Council, complaining about the low prices and arguing that the city must protect their business by raising the minimum price of a membership, otherwise all Health Clubs will close down. Following the petition the Madison City Council decides to introduce a price floor at $40 per membership.

e) Imagine that the City Council decides to support this price floor using a price support program, where it basically buys the entire resulting surplus of memberships and than requires all of its employees to get a membership for $10 each and go to the gym. How much will this program cost the City Council? Please show your work using a graph. (In making your calculation assume that the surplus memberships purchased by the City Council equals the number of city employees that are required to purchase the memberships and none of these employees belong to the original demand curve.)

f) What if the City Council decides to support this price floor using a subsidy program, where it simply guarantees a price of $40 per membership and fully refunds the Health Clubs for any difference from the resulting market price? How much will this program cost to the City Council? Please show your work using a graph.

g) Briefly compare the two programs and their costs to the City Council.

4. An Excise Tax question

Suppose the market demand and supply for cigarette smoking in Madison are represented by the equations
P=200 - (4/5)Qd and P = 50 + (1/5) Qs .

a) Find the equilibrium price and quantity.

Suppose that the city of Madison wants to reduce smoking and therefore decides to raise revenue by imposing a $10/pack excise tax on producers.

b) Given the tax, what is the market-clearing price and quantity?

c) How much of the tax revenue is paid by consumers (what is the consumer tax incidence)?

d) How much of the tax revenue is paid by sellers (what is the producer tax incidence)?

e) What are government tax revenues?

f) What is the dead weight loss produced by the excise tax?