Economics 105                  Berger

                      Homework #5-Answers

 

 1. Suppose the black-and-white TV industry and the color industry are both constant cost industries. Show graphically what happens to these industries as consumer tastes shift away from black-and-white TVs to color TVs. Explain your results.

 

Because of a change in consumer tastes, the demand for B&W-TVs will decrease and the demand for color-TVs will increase. As a result of these changes the prices of B&W-TVs will fall and prices of color TVs will rise. Assuming we started in LR equilibrium, this means that profits will be positive in the color TV industry and negative in the B&W-TV industry. Firms (and the resources that they control) will exit the B&W-TV industry and move to their next best alternative (causing profits to rise to zero). [NOTE: Their next best alternative may be the color TV industry] Positive profits will attract entry to the Color TV industry and drive down profits to zero. When profits are zero in both industries entry and exit will cease and both industries will be back in LR equilibrium. Note that the color TV industry produces more TVs (industry has larger # of firms) while the B&W TV industry produces fewer TVs (industry has smaller # of firms).  

                                            

                                                                                                                                                 

 2.    Assume that medical care is an increasing cost industry. Starting from LR equilibrium, suppose Congress passes a bill which grants a specific subsidy to all consumers of medical care. Given that such an action will increase demand, trace out the consequences of this subsidy to consumers using graphs and explain your results.

 

The inevitable results will be rising medical care costs. The subsidies to consumers will increase demand and raise prices so that medical care firms begin earning positive economic profit. This attracts new entry which drives up the cost of the specialized medical care resources. It also allows existing firms to purchase much more expensive technology. With LRAC shifting upwards, this eventually reduces profits to zero and entry then ceases. Notice that the subsidy gets capitalized into the value of medical care resources and causes the cost of these resources to rise. Notice also that consumers' costs of medical care have gone down because of the subsidy so they will obviously move down their old demand curve and increase the quantity demanded of medical care.

 

 

 

 

 

 

 

 

 3.    Use the numbers in Table 1 to do the following problem on farm policy.                                          

                            Table 1

 

     P     QD0(SR)    QD1(LR)      QS0(SR)     QS1(SR)     QS2(LR)

 

    $20      800          0      1,600      1,200       2,400

 

     18      900        300      1,500      1,200       2,100

 

     16    1,000        600      1,400      1,200       1,800

 

     14    1,100        900      1,300      1,200       1,500

 

     12    1,200      1,200      1,200      1,200       1,200

 

     10    1,300      1,500      1,100      1,100         900

 

      8    1,400      1,800      1,000      1,000         600

 

      6    1,500      2,100        900        900         300

 

a. Using QD0(SR) and QS0(SR), draw a graph with a price support of $16. Indicate the ES and calculate the amount that consumers spend on the good, and the amount that the USDA spends on surpluses.

ES = 1400 - 1000 = 400 = surplus purchased by USDA

Consumer: pays $16(1000) = $16,000 to farmers

    USDA: pays $16(400) = $6,400 to farmers

b. Assume production controls are imposed by the USDA in order to control the size of the surplus. Using QD0(SR) and one of the SR supply curves, draw a graph of this situation and indicate whether or not the USDA has managed to eliminate the surplus. Explain your result.

No, the USDA has not eliminated the surplus because ES = 200 (ES = 1200 - 1000). This result occurs because farmers take the worst land out of production and use inputs more intensively on the remaining acres of land. These practices tend to partially negate the purpose of the production controls.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

c. Assume the government sets a target price of $16. Using QD0(SR) and QS0(SR), draw a graph of this situation. Calculate the amount that consumers spend on the good and the USDA spends on direct payments to farmers and indicate these areas on the graph. Then calculate the welfare loss associated with this method of government subsidization and indicate the area on the graph.

        

Consumer: pays $8(1400)     = $11,200 to farmers

              USDA:  pays ($16-$8)1400 = $11,200 to farmers

                   

Farmers' total receipts: $22,400

 

              WL = ½($16-$8)(1400-1200) = $8(100) = $800

 

NOTE: CG = ΔCS = ($12-$8)1200 + ½($12-$8)(1400-1200)

                    = $4800 + $400

                    = $5200

 

                 PG = ΔPS = ($16-$12)1200 + ½($16-$12)(1400-1200)

                    = $4800 + $400

                    = $5200

 

                WL + CG + PG = $800 + $5200 + $5200 = $11,200

                Cost of subsidy to Gov't = $11,200

 

 

 

 

 

d. Repeat parts a and c using QD1(LR) and QS2(LR). What do you observe about the size of the surpluses, the size of the direct payments, and the size of the welfare losses? Explain your findings.

        

Consumer: pays farmer $16(600)      = $9,600

              USDA:  pays farmer $16(1800-600) = $19,200

 

Farmers' total receipts: $28,800

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consumer: pays farmer $8(1800)     = $14,400

               USDA: pays farmer ($16-$8)1800 = $14,400

 

Farmers' total receipts: $28,800

 

WL = ½($16-$8)(1800-1200) = $2,400

 

NOTE: PG = ΔPS = ($16-$12)1200 + ½($16-$12)(1800-1200)

                    = $4800 + $1200

      = $6,000

 

   CG = ΔCS = ($12-$8)1200 + ½($12-$8)(1800-1200)

                    = $4800 + $1200

                    = $6,000

 

 WL + CG + PG = $2,400 + $6,000 + $6,000 = $14,400

 

 

 

 

 

 

 

 

 

 

 

 

 

                           Summary Table

 

                                      SR                  LR

1. Price Supports

 

a. Consumer pays          $16,000              $9,600

 

b. USDA pays               $6,400             $19,200

 

2. Target pricing

 

a. Consumer pays          $11,200             $14,400

 

b. USDA pays              $11,200             $14,400

 

c. WL                        $800              $2,400

 

Both surplus payments (price supports) and direct payments (target pricing) tend to grow over time as confirmed by the above calculations. These payments grow over time because the subsidies attract new farms (because of the positive profits) as well as increased production by existing farms.

 

The welfare losses grow over time because the artificially higher returns in agriculture (a result of the USDA subsidies) attract resources into agriculture from higher valued uses (in the absence of the subsidy they would be employed elsewhere). That is, farming is a lower valued use of these resources. And since substitution possibilities are easier in the LR, resources will move more readily in the LR than in the SR. Thus the inefficiencies induced by the subsidies in the SR grow in the LR.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

e. Assume USDA raised the price floor (target price) to $18. If agriculture is an increasing cost industry, draw the market and firm graphs to indicate the reaction to this change in the price floor. Explain your results.

 

            

                           

       Increasing the subsidy to $18 will temporarily raise the profits of all farms. Marginal farms that were earning zero economic profit will now be earning positive economic profit. This will induce the entry of a number of new farms and this entry will increase the SR supply curve to S2SR. This entry will also increase the costs of all farms as they compete for a limited pool of resources: LRAC will rise. This increase in LRAC will reduce profits for all farmers and some profits will become negative. Farms in the latter category may not exit but may hope instead for another increase in price supports as complaints from farmers about their rising costs reach Congress.

 

 

 

 

 

 

 

 

 

 

 

4.  Assume that drugs are legalized but that they are taxed (much like alcohol is now). Start with a constant cost industry in LR equilibrium and then have the government levy a specific tax on the industry. Show graphically how this tax affects the market and how the market adjusts to the tax. Explain your graph. Also verbally explain what happens to the firm when the tax is imposed on it and how it adjusts. What would the case of a specific subsidy to producers look like?

Assume the industry is a constant cost industry. The key here is realizing that the price that firms receive directly after the tax is imposed is below the LR equilibrium level giving zero profits. The tax causes the MES firm to earn negative economic profits, inducing some firms to exit the industry. This will cause the supply curve to shift to the left until the price that firms receive after the tax is equal to the LR equilibrium price. Consumers at this point bear the entire burden of the tax in the LR. Notice also that the welfare loss of the tax in the LR is larger than the welfare loss of the tax in the SR. It is also possible that the tax may induce some black market activity if set high enough; the trick then is to set the tax low enough so that such activity does not occur.

 

 

 

 

 

 

 

FOR CONTEMPLATION PURPOSES: (1) What happens to the burden of the tax in the LR when consumers can escape the tax burden by purchasing untaxed goods such as are produced in the underground economy (the part of the economy that avoids taxes by dealing with customers on a cash basis only)? (2) What happens to the burden of the tax in an increasing cost industry? (3) What happens when a specific subsidy is given to producers in an increasing cost industry?