Gianmarco Ottaviano London School of Economics EC102 - Economics B MT Microeconomics

Moodle Test 7 (Lectures 13 & 14)

Question 1: Consider the perfectly competitive equilibrium represented in the following figure:

In this figure consumer surplus, producer surplus and total surplus are respectively represented as areas: a) A, B, A+B b) A, B, A-B c) B, A, A+B d) A, A+B, B Explanation: When the consumer consumes X1 litres of wine at the going price of p1, consumer surplus is area A underneath the demand curve and above the price. When the producer produces X1 litres of wine at the going price of p1, producer surplus is area B underneath the price and above the supply curve. Total surplus is the sum of consumer surplus and producer surplus. It is, therefore, represented by area A+B.

Question 2: Consider the perfectly competitive equilibrium represented in the following figure:

When quantity grows from Xa to X1, the changes in the benefit from consuming and total surplus are respectively given by: a) G, G+F b) F, F+G c) G+F, G d) -G, F+G Explanation: Total surplus may also be seen as the total benefit derived from consumption of the good less the total cost of producing it. For any given quantity X the total benefit derived from consumption, i.e. the area underneath the demand curve and above the price associated with X along the demand curve. Hence, when consumption increases from Xa to X1 litres of wine, the total benefit derived from consumption increases by the area G+F. For any given quantity X the total cost of producing is the area below the supply curve and above the horizontal axis. Hence, when production increases from Xa to X1 litres of wine, the total cost of production increases by the area F. When production increases from Xa to X1 litres of wine, the change in total surplus is thus the difference between the change in total benefits from consumption G+F and the change in the total cost of production F, i.e. (G+F)F=G.

Question 3: Consider the perfectly competitive equilibrium represented in the following figure:

Total surplus is maximized at the perfectly competitive equilibrium because changing quantity: e) From X1 to Xa and from X1 to Xh reduces consumer surplus f) From X1 to Xa and from X1 to Xh reduces total surplus g) From Xa to X1 and from Xh to X1 reduces total surplus h) From Xa to X1 and from Xh to X1 reduces consumer surplus Explanation: Total surplus is maximized at the perfectly competitive equilibrium because it falls following any deviation of quantity from the perfectly competitive level X1. For any given quantity X the total benefit derived from consumption is consumer surplus, i.e. the area underneath the demand curve and above the price associated with X along the demand curve. For any given quantity X the total cost of producing is the area below the supply curve and above the horizontal axis. Hence, when consumption decreases from X1 to Xa, consumer surplus falls by the area G+F; when production decreases from X1 to Xa, the total cost of production decreases by the area F. Total surplus thus decreases by area (G+F)-F=G. Analogously, when consumption increases from X1 to Xh, consumer surplus increases by the area I; when production increases from X1 to Xh, the total costs of production increase by the area J+I. Total surplus thus decreases by area (J+I)-I=J. 3

This establishes that any deviation of quantity from the perfectly competitive level X1 reduces total surplus no matter whether the deviation entails an increase (Xh) or a decrease(Xa) in quantity.

Question 4: Consider the effects of introducing a sales tax in a perfectly competitive wine market as depicted in the following figure:

In the figure the tax is represented by: a) The vertical distance between S and S b) The horizontal distance between S and S c) The difference between p2 and p1 d) The distance between e2 and e1 Explanation: From the buyers perspective the sales tax shifts the supply curve upwards by the same amount of the tax. For example, a unit tax of 1 per litre shifts the supply curve upwards by 1. Hence, in the figure the tax is represented by the vertical distance between S and S.

Question 5: Consider the effects of introducing a sales tax in a perfectly competitive wine market as depicted in the following figure:

The figure shows that the tax: a) Increases consumer surplus, decreases producer surplus, and decreases total surplus b) Decreases consumer surplus, decreases producer surplus, and decreases total surplus c) Decreases consumer surplus, increases producer surplus, and decreases total surplus d) Decreases consumer surplus, increases producer surplus, and increases total surplus Explanation: The tax decreases consumer surplus because the price rises from p 1 to p2 and quantity demanded falls. The loss of consumer surplus is represented by area G+E1 in the figure below.

E1

The tax also decreases producer surplus because quantity produced falls and the price net of the tax also falls. The loss of producer surplus is represented in the figure below. Producer surplus in the absence of the tax is equal to the sum of areas H and I. After the tax, producer surplus is equal to the sum of areas I and J. Hence, producer surplus changes by area J minus area H. We know that the net effect is a fall in producer surplus because area H is both higher and wider than area J.

tax

E2

Note that area J in the producer figure and area G in the consumer figure are the same. So, the loss of G by the consumer is exactly compensate by the gain J by the producer. What is lost to both are areas E1 and E2. Their sum E= E1+E2 is the loss of total surplus. This is called excess burden of the tax as it is a loss above what is collected in tax revenue (i.e. tax times X2). It is also called deadweight loss because it is a loss to producer and consumer not offset by a gain to the government collecting the tax. This is represented in the figure below.

Question 6: Market failure is: a) A situation in which an economy with freely operating markets may fail to generate an efficient allocation of resources b) A situation in which an economy with regulated markets may fail to generate an efficient allocation of resources c) A situation in which an economy with freely operating markets may fail to generate a fair allocation of resources d) A situation in which an economy with regulated markets may fail to generate a fair allocation of resources Explanation: Market failure is a situation in which an economy with freely operating markets may fail to generate an efficient allocation of resources. Lack of fairness or equity is not a market failure. Market failure may arise for two reasons: market power and non-existence of markets. These provide opportunities for government to intervene and enhance economic efficiency. There is market power when some individuals or firms are price makers. In this case resources will be allocated inefficiently because prices are distorted. Market power can arise in several contexts: monopoly, oligopoly, differentiated products (monopolistic competition). Etc. A different source of market failures is when markets for certain commodities may fail to emerge because they are too costly or simply impossible to sustain. The non-existence of markets is associated with two different types of inefficiency: asymmetric information and externalities. Etc.