Transcript ECON 1001 AB Introduction to Economics I Dr. Ka

ECON 1001 AB
Introduction to Economics I
Dr. Ka-fu WONG
Seventh week of tutorial sessions
KKL 925, KKL 1010, K812, KKL 106
Clifford CHAN
KKL 1109
[email protected]
Covered and to be covered
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Covered the week before the break
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Dr. Wong finished up to kf007.ppt
You should have at least read up to Chapter 7 Efficiency and
Exchange
If not, please press hard on it. Start reading Chapter 8 The Quest
for Profit and the Invisible Hand
To be covered in the tutorial sessions this week
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Problems in chapter 7: #1, #3, #5, #7 and #9
An extra question relevant to Chapter 7
You are advised to work on the even ones as well
Problem #1, Chapter 7 (1)
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Suppose the weekly demand and supply curves for used
DVDs in Lincoln, Nebraska, are as shown in the diagram.
Calculate
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The weekly consumer surplus
The weekly producer surplus
The maximum weekly amount that producers and consumers in
Lincoln would be willing to pay to be able to buy and sell used
DVDs in any given week
Problem #1, Chapter 7 (2)
S
Price ($/DVD)
12
10.50
7.5
6
D
0
2
6
18
Quantity (DVDs/week)
48
Solution to Problem #1 (1)
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The weekly consumer surplus
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Recall consumer surplus refers to the difference between
consumer’s reservation price and the actual market price
Graphically, it is the area under the demand curve but above the
actual market price
In this problem, the equilibrium is achieved at a a price where
Q(D) = Q(S)
 The equilibrium price is $10.50 per DVD
At an equilibrium price of $10.50 the corresponding
equilibrium quantity is 6 units of DVD per week
Solution to Problem #1 (2)
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The weekly consumer surplus
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(1/2) (Highest consumer’s reservation price – actual market price)
* actual market quantity
(1/2) ($12 - $10.50) * 6 = $4.5
The weekly producer surplus
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Recall producer surplus refers to the difference between
producer’s reservation price and the actual market price
Graphically, it is the area above the supply curve but under the
actual market price
Solution to Problem #1 (3)
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The weekly producer surplus
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(1/2) (Actual market price – lowest producer’s reservation price) *
actual market quantity
(1/2) ($10.50 - $6) * 6 = $13.5
The maximum weekly amount that producers and
consumers in Lincoln would be willing to pay in a week
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In other words, it refers to the total gains from trading in used
DVDs- the total economic surplus
Total economic surplus = consumer surplus + producer surplus
Total economic surplus = $4.5 + $13.5 = $18 per week
Problem #3, Chapter 7 (1)
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The Kubak crystal caves are renowned for their
stalactites and stalagmites. The warden of the caves
offers a tour each afternoon at 2pm sharp. The cave can
be shown to only four people per day without disturbing
their fragile ecology. Occasionally, however, more than
four people want to see the caves on the same day. The
following table lists the people who wanted to see the
caves on September 24, 2003, together with their
respective times of arrival and reservation prices for
taking that day.
Problem #3, Chapter 7 (2)
Arrival Time
Reservation Price ($)
Herman
1:48
20
Jon
1:50
14
Kate
1:53
30
Jack
1:56
15
Penny
1:57
40
Fran
1:59
12
Faith
2:00
17
Solution to Problem #3 (1)
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A) If the tour is “free” and the warden operates it on a
first-come, first served basis, what will the total
consumer surplus be for the four people who get to go
on the tour on that day?
Note that the capacity is only 4 people per day
If it serves on a first-come, first served basis, only
Herman, Jon, Kate and Jack are able to see the caves
Since the tour is free, assume both the production cost
and actual market price are zero
The consumer surplus is thus exactly to consumer’s
reservation price
Solution to Problem #3 (2)
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The total consumer surplus
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Sum of visitors’ reservation prices
= $20 + $14 + $30 + $15 = $79 per day
B) Suppose the warden solicits volunteers to postpone
their tour by offering increasing amounts of cash
compensation until four people still wish to see the caves
that day. If he gives each volunteer the same
compensation payment, how much money will he have
to offer to generate the required number of volunteers?
What is the total economic surplus under this policy?
Solution to Problem #3 (3)
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Recall reservation price refers to the maximum price that
a consumer is willing to pay for a good or service
It reflects how much does a consumer value on that
good or service
Based on the reservation prices, an offer of $15
compensation will attract Jon, Jack and Fran to postpone
their visit to the caves
After the proposal of this offer, Herman, Kate, Penny and
Faith are able to visit the caves without having to watch
out their arrival time
Solution to Problem #3 (4)
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As a result, the total economic surplus:
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= $20 + $30 + $40 +17 = $107 per day
However, all the four visitors have to pay a total of $45
($15*3) cash compensation
On the whole, the total of $45 cash compensation is not
actually cost, as the compensation represents the gains
of the non-visitors (Jon, Jack and Faith)
The cash compensation is simply a TRANSFER from the
visitors to non-visitors; it neither increases or decreases
the total economic surplus
Hence, the new total economic surplus is $107 per day
Solution to Problem #3 (5)
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C) Why is the compensation policy more efficient than
the first-come, first served policy?
It is more efficient as the compensation policy generates
a higher total economic surplus ($107 per day) rather
than just $79 per day under the first-come, first served
policy
It creates a market trading the rights on the visit to the
caves. Non-visitors’ reservation prices are compensated
by the visitors
Visitors pay an opportunity cost of $15 to ensure the visit
to the cave, and thus only those who value the visit more
than $15 will actually accept the deal
Solution to Problem #3 (6)
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D) Describe a way of financing the warden’s
compensation payments that will make everyone,
including the warden, either better off or no worse off
than under the first-come, first-served approach
Auction
Suppose the warden auctions off the admission rights
Starting zero, the auction price steadily goes up by $1
increment until only 4 people are willing to visit the caves
It will stop when the auction price reaches $16
Faith, Penny, Herman and Kate will be the four visitors
As a result, the warden will collect $64 from the auction
Solution to Problem #3 (7)
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The warden will give a refund to Herman and Kate, who
would have gotten to go for free under the first-come,
first-served policy- they will be just as well off as before
The warden will then give $16 to Jack which is $1 more
than enough to compensate him for not visiting
The warden will also give $15 to Jon, which is again $1
more than enough to compensate him for not visiting
Thus, both Jon and Jack gain $1 from the auction
Faith is $1 better off than before ($17 reservation -$16
auction fee); Penny is $24 better off ($40 reservation $16 auction fee) All others are same as well off as before
Problem #5, Chapter 7
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Is a company’s producer surplus the same as its profit?
(Hint: A company’s total cost is equal to the sum of all
marginal costs incurred in producing its output, plus any
fixed costs.)
Solution to Problem #5 (1)
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Producer surplus refers to the total difference between the
actual market price and the producer’s reservation price
Producer’s reservation price refers to the lowest price that
he or she is willing to produce
A perfectly competitive firm charges a price =MC
As a result, producer’s reservation price = marginal cost
In other words, producer surplus is the difference between
the total revenue and the sum of all marginal costs
incurred
Solution to Problem #5 (2)
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Total profit = Total revenue – total cost
Total revenue = Price * Quantity
Total cost = given in the hint – sum of all the marginal
costs plus fixed costs
Since producer surplus does not cover any of fixed costs,
it is thus not equal to profit
Problem #7, Chapter 7
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The municipal water works of Cortland draws water from
two sources: an underground spring and a nearby lake.
Water from the spring costs 2 cents per 100 gallons to
deliver, and the spring has a capacity of 1 million gallons
per day. Water from the lake costs 4 cents per 100 gallons
to deliver and is available in unlimited quantities. The
demand for water in the summer months in Cortland is P=
20 - 0.001Q, where P is the price of water in cents per 100
gallons and Q is the quantity demanded in hundreds of
gallons per day. The demand curve for water in the winter
months is P= 10 – 0.001Q. If the water works wants to
encourage efficient water use, how much should it charge
for water in the summer months? In the winter months?
Demand for summer months
20
Ds
Price per 100 gallons
Price per 100 gallons
Solution to Problem #7 (1)
Demand for winter months
10
Dw
Qw
Qs
20,000
hundreds
of gallons
10,000
hundreds
of gallons
Solution to Problem #7 (2)
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The cost of water from underground spring is cheaper
than that from lake
Therefore, the municipal water works should always to
try satisfy the demand by water from underground spring
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The application of Low-hanging Fruits Principle
The relatively small demand for water in winter months
can be served by underground spring alone
Therefore, the price should be equal to the (marginal)
cost of water from underground spring, which is 2 cents
per 100 gallons in the winter months
Solution to Problem #7 (3)
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The relative large demand for water in summer months
must be satisfied by extracting water from lake which
has a larger supply than underground spring
Again, the price should be equal to the (marginal) cost of
water from lake, which is 4 cents per 100 gallons in the
winter months
Problem #9, Chapter 7
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The government of Islandia, a small island nation,
imports heating oil at a price of $2 per gallon and makes
it available to citizens at a price of $1 per gallon. If
Islandians’ demand curve for heating oil is given by P =
6-Q, where P is the price per gallon in dollars and Q is
the quantity in millions of gallons per year, how much
economic surplus is lost as a result of the government’s
policy?
Solution to Problem #9 (1)
P ($/gal)
6
2
1
Q (millions of gal/yr)
4
5
6
Solution to Problem #9 (2)
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At a per gallon price of $1, Islandians consume 5 million
gallons of oil per year
However, this level of consumption is attributed to the
price control set of the government
The true per unit cost is actually $2 per gallon
If the government charges where P= MC, Islandians will
only demand for 4 million gallons of oil per year
Therefore, if Islandians consume 5 gallons of oil per year
at the controlled price of $1, there will be an economic
loss that is equal to the difference between the total cost
of oil and Islandians’ reservation prices for oil
Solution to Problem #9 (3)
P ($/gal)
6
Loss in total economic
surplus
2
1
Q (millions of gal/yr)
4
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5
6
That is (1/2) ($2 - $1) * (5 – 4) = $0.5 million gallon per year
Extra Question #1, Chapter 7
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Tax is always a distortion to a perfectly competitive
market; it always works to decrease the total economic
surplus
True or False, and provide an explanation
Solution to Extra #1 (1)
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Graphically, equilibrium is achieved at the intersection of
demand curve and supply curve
In general, total economic surplus is maximized at
equilibrium
P
S
CS
P*
PS
D
0
Q
Q*
Solution to Extra #1 (2)
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However, there are exceptions!
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The demand curve does not fully capture the complete benefit
(willingness to pay)
The supply curve does not fully capture the complete production
cost
Thus, if there is positive or negative externality, the total
economic surplus at equilibrium may be either
overestimated or underestimated
Solution to Extra #1 (3)
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Example
The supply curve of a manufacturing firm is often
underrepresented the true production cost
The supply curve often fails to take account of pollution
cost which is then fully bared by society
In other words, there is unaccounted negative externality
in the market
Solution to Extra #1 (4)
S with negative externality
P
P*’
S
CS’
Economic loss
P* PS’
D
0
Q
Q*’ Q*
Solution to Extra #1 (5)
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Any solution to correct the estimation of supply curve
that renders a true production cost or a true willingness
to produce?
Imposition of tax may shed some light to elimination of
negative externality
If a per unit tax that is exactly equal to the per unit
negative externality arising from the production is
imposed, the introduction of pollution tax can help
eliminate the economic loss
Solution to Extra #1 (6)
S with a per unit tax
P
P*’
S
CS’
Economic loss eliminated
P* PS’
D
0
Q
Q*’ Q*
The end
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See you next week!!!