Answers to Study Exercises

Question 1

a) $5; 600 hats

b) price ceiling at $3

c) excess demand; 400

d) price floor at $6

e) excess supply; 200

Question 2

a) With a binding price ceiling, the excess demand means that consumers must somehow be
rationed by means other than price. This situation often encourages rationing by “sellers’
preferences”, where the seller can come up with any (often undesirable) scheme to ration the
product, such as by:

• religious beliefs or affiliation

• race

• sexual preferences

• occupation

b) With a binding price floor, the government could choose to purchase the excess supply, thus
transferring resources from taxpayers to producers. Alternatively, the government could
introduce a quota system so that the producers face an upper limit on production equal to the
quantity demanded at the floor price.

c) If the government views the product in question as a necessity, it may introduce a price ceiling
in the hope that it will improve consumers’ access to the product. However, to the extent that the
quantity supplied will fall, overall access will be reduced by such a policy.

d) If the government views the sellers of the product as deserving of support, a price floor may be
seen as a desirable policy. (This is the motivation for a legislated minimum wage.) However, to the
extent that quantity demanded for the product will fall, some sellers of the product may see their
markets disappear.

Question 3
a) The free-market equilibrium is where quantity demanded equals quantity supplied. From the
table this occurs at a price of $800 per month and a quantity of 70 000 units.

b) Any ceiling on the price of rental apartments must be below the free-market equilibrium price
to have any effect on the market. Thus the highest it can be is just below $800.

c) At a price ceiling of $500 per month, quantity demanded is 100 000 units whereas quantity
supplied is only 60 000 units. There is excess demand (a shortage) of 40 000 units. There has also
been a reduction in the equilibrium quantity exchanged (from 70 000 to 60 000 units) because of
the reduction in quantity supplied.

d) At a quantity of 60 000 units, the maximum price that consumers are willing to pay is $900 per
month for rental accommodation. If all units were supplied on the black market, $900 would be
the black-market price.

Question 7

This is a straightforward application of the concept of market efficiency in the situations of price
floors and ceilings.

a) Since p1 is below the market-clearing price of p*, a price floor at this level will have no effect on
the market equilibrium or the efficiency of the market outcome. It is not a binding price floor.

b) Since p2 is above p*, this will be a binding price floor. The equilibrium quantity will be
determined by the short-side rule, where p2 intersects the demand curve. Since quantity is less
than Q*, the market outcome is not efficient. There is a deadweight loss from the imposition of
the price floor.

c) Since p1 is below p*, this will be a binding price ceiling. The equilibrium quantity will be
determined by the short-side rule, where p1 intersects the supply curve. Since quantity is less than
Q*, the market outcome is not efficient. There is a deadweight loss from the imposition of the
price ceiling.

d) Since p2 is above p*, this will not be a binding price ceiling. It will have no effect on the market
equilibrium or the efficiency of the market outcome.

Question 8

a) With price p* and quantity Q*, the total economic surplus is given by areas 2+3+4+5+6: the
area below the demand curve and above the supply curve up to Q*.

b) With a price ceiling at p1, the quantity exchanged falls to Q1. Relative to Q*, there is a reduction
in output and transactions. On these “missing” transactions, no surplus is earned. The reduction in
surplus is given by areas 5+6. This area (measured in dollars) is the per period deadweight loss of
the price ceiling.
c) With price p* and quantity Q*, the total economic surplus is given by areas 2+3+4+5+6: the area
below the demand curve and above the supply curve up to Q*.

d) With a price floor at p2, the quantity exchanged falls to Q2. Relative to Q*, there is a reduction in
output and transactions. On these “missing” transactions, no surplus is earned. The reduction in
surplus is given by areas 5+6. This area (measured in dollars) is the per period deadweight loss of
the price floor.

e) For both the price ceiling in part (i) and the price floor in part (ii), the deadweight loss reveals a
loss of surplus for society (a combination of buyers and sellers) and thus an inefficient market.
Each of these policies creates an overall loss for society, at least as measured by total economic
surplus.

Question 9

a) With the market-clearing price of p* and quantity Q*, the total economic surplus is given by
areas 2+3+4+5+6.

b) If the government imposes an output quota of Q 1, then output is restricted to be no greater

than this amount. (The price in this case would be driven up to p1.) The reduction in output and
transactions leads to a reduction in economic surplus, as given by areas 5+6. This is the
deadweight loss of the output quota.

c) The output quota reduces market efficiency because it reduces the total economic surplus
generated by the market. Society as a whole is worse off, at least as measured by the total
amount of economic surplus.

Question 10

This question requires the student to solve a system of demand and supply curves as is done in
the box near the end of Chapter 3.

a) The free-market outcome is determined where quantity demanded equals quantity supplied,
QD = QS. Setting p from the demand curve equal to p from the supply curve, we get

225 – 15Q = 25 + 35Q

 200 = 50Q  Q* = 4

Putting Q*=4 back into the demand curve we get

p* = 225 – (154)  p* = 165

Thus the free-market price of milk is $1.65 per litre and the equilibrium quantity is 4 million litres
per month.
b) At the guaranteed price of $2.00 per litre, quantity demanded is given by

200 = 225 – (15QD)  QD = 1.67 (1.67 million litres)

At the same price, quantity supplied is given by

200 = 25 + 35QS  QS = 5 (5 million litres)

c) Since the government has guaranteed to purchase any amount that the producers cannot sell,
the producers will produce the full 5 million litres per month. Thus, at the guaranteed price of
$2.00 per litre, there is excess supply of 3.33 million litres per month. This amount (3.33 million
litres per month) will be purchased by the government at a price of $2.00 per litre -- for a total
cost (to taxpayers) of $6.66 million per month.

d) The government purchase of milk is financed by taxpayers. Taxpayers are clearly harmed since
they must pay the direct cost for this system of price supports. Consumers are also harmed since
they consume less milk and must pay a higher price than would be available in the free market.
Milk producers are clearly better off. Not only do they get a higher price per litre, but their surplus
production is all purchased by the government.