NTU SSS Economics HE2001

Tutorial 8 (Simple Welfare Analysis)

1) Let us now consider the case of a per unit subsidy.

Assuming that we have linear supply curves and demand curves. Illustrate using a diagram:

(a) The effects of a per unit subsidy of 𝑠 on producers.

(b) The effects of a per unit subsidy of 𝑠 on consumers.

For a) and b), indicate in the diagram(s) consumer surplus, producer surplus and amount of
deadweight welfare loss.

(c) How do you think the elasticity of supply and demand will affect the incidence of benefits of
a per unit subsidy on producers?

a) Yellow: cost of subsidy. Green: CS. Pink: PS. Blue: DWL.

𝑝 𝑆
𝑆′

𝑝𝑠
𝑝∗ s
𝑝𝑏

𝐷
𝑞
𝑞∗ 𝑞′
Note: With a subsidy, 𝑝𝑠 = 𝑝𝑏 + 𝑠.
𝑆′ is the demand curve in terms of the before subsidy prices (𝑝𝑏 here).

(New producer surplus is equal to shaded pink portion which gives the area between the consumer’s
prices and the new supply curve. This is also equal to the dotted red area which gives the area
between the seller’s prices and the old supply curve. The new consumer and producer surplus can
be compared with the old consumer and producer surplus at 𝑝 ∗ , 𝑞∗ to obtain the deadweight
welfare loss.)

b) Yellow: cost of subsidy. Green: CS. Pink: PS. Blue: DWL.

𝑝 𝑆

𝑝𝑠
𝑝∗ s
𝑝𝑏

𝐷 𝐷′
𝑞
𝑞∗ 𝑞′
Note: D′ is the demand curve in terms of the before subsidy prices (𝑝𝑠 here).

The outcome is exactly the same as in part a).

c) Similar to our analysis on taxes, we look at the gap between the initial prices and the prices faced
by producers and consumers to get the incidence of benefits. (Subsidy accruing to consumer is
(𝑝 ∗ − 𝑝𝑏 ) ∗ 𝑞′, subsidy accruing to producer is (𝑝𝑠 − 𝑝𝑠∗ ) ∗ 𝑞′.)

The more inelastic demand is, the greater the benefit on consumers. (e.g. when demand is perfectly
inelastic, a subsidy purely lowers the price faced by consumers.)

The more inelastic supply is, the greater the benefit. (e.g. when supply is perfectly inelastic, a
subsidy just raise the price faced by the producer.

Intuitively, this is because a consumer/producer who has more inelastic supply/demand is more
“reliant” on consuming/producing the good, and thus will receive more benefits.
2) In the bubble tea market, there are 2 consumers with different preferences and 10 homogeneous
firms. Consumer 1 has inverse demand function 𝑝 = 20 − 4𝑞1 while Consumer 2 has inverse
demand function 𝑝 = 15 − 2𝑞2 . Each of the firms has inverse supply function 𝑝 = 5𝑞𝑖 .

(a) Derive the (aggregate) market supply curve and market demand curve.
(b) What is the equilibrium quantity and price in the market? Calculate the amount of producer
and consumer surplus in the market.
(c) Suppose there is a per-unit tax on firms of $0.5. What is the deadweight welfare loss from
the tax?

(a) Take the horizontal summation of all supply curves.

𝑞𝑖 = 0.2𝑝. 𝑄𝑠 = ∑𝑞𝑖 = 2𝑝.

Take the horizontal summation of both the demand curves.

For 𝑝 > 20, there is no positive demand.

𝑝
For 15≤ 𝑝 ≤ 20, demand only comes from Consumer 1, 𝑄𝑑 = 5 − 4.
𝑝 𝑝 3𝑝
For 𝑝 < 15 , demand comes from both Consumer 1 and 2, 𝑄𝑑 = 5 − 4 + 7.5 − 2 = 12.5 − .
4

9𝑝 20
(b) Assume the equilibrium price is between 15 and 20, then 𝑄𝑑 = 𝑄𝑠 gives = 5. 𝑝 = < 15.
4 9
Hence our assumption is wrong.

11𝑝 50
Hence the equilibrium price is less than 15. 𝑄𝑑 = 𝑄𝑠 gives = 12.5. 𝑝 = 11.
4
150
The equilibrium quantity is 𝑄 = 12.5 − = 12.5 − 3.41 = 9.09.
44
Both consumers have positive demand here.

Producer Surplus is the area between the price line and the inverse market supply curve
50
× 9.09 × 0.5 = 20.659.
11

Consumer Surplus is the sum of the areas between the inverse demand curves and the price line,
5 5 50
which is the green area plus yellow area 4 × 5 × 0.5 +(4 + 9.09) × (15 − 11) × 0.5 =57.175.
(c) With a tax on firms, 𝑃𝑠 = 𝑃𝐵 − 𝑡 .

In equilibrium, we need 𝑄𝐷 = 𝐷(𝑃𝐵 ) = 𝑆(𝑃𝑠 ) = 𝑄𝑆

Assume the equilibrium price is between 15 and 20, then we solve:

𝑝𝐵
5− = 2(𝑃𝐵 − 𝑡)
4

9𝑝𝐵
=6
4

8
𝑃𝐵 = < 15
3

Hence our assumption about price is wrong.

For 𝑝 < 15, we solve

3𝑝𝐵
12.5 − = 2(𝑃𝐵 − 0.5)
4

11𝑝𝐵
= 13.5
4

54
𝑃𝐵 =
11

54
𝑄 = 2( − 0.5) = 8.82
11
The deadweight loss is the triangle area ABC.

The coordinate of B is (9.09, 50

11
), C is (8.82, 54
11
), and A is (8.82, 54
11
− 0.5).

Deadweight Loss = 0.5 × (9.09 − 8.82) × 0.5 = 0.0675

3) In this question, let us try out some comparative statics methods as in the lecture.

Let the supply of bubble tea be 𝑆(𝑃𝑠 ) = 500𝑃𝑠 and the demand for bubble tea be 𝐷(𝑃𝑏 ) = 𝑎 − 𝑏𝑃𝑏 .

Here, we want to investigate the effects of demand elasticity 𝑏 on economic outcomes.

Recall that to have a proper comparison of how elasticity affects outcomes, we need to fix the initial
no-tax equilibrium price and quantities (even if 𝑏 changes); this involves changing 𝑎 depending on
values of 𝑏.

(a) To keep the no-tax equilibrium price and quantities constant at $5, and 2500 units
respectively, show that 𝑎 = 2500 + 5𝑏.

𝑎 − 5𝑏 = 2500
𝑎 = 2500 + 5𝑏

(b) Suppose there is now an excise tax of 𝑡 dollars. Write out the equilibrium prices faced by
consumers and producers, and the equilibrium quantity in terms of elasticity 𝑏.

𝑃𝑠 = 𝑃𝑏 − 𝑡
𝑆(𝑃𝑠 ) = 500𝑃𝑏 − 500𝑡
𝐷(𝑃𝑏 ) = 𝑎 − 𝑏𝑃𝑏

500𝑃𝑏 − 500𝑡 = 2500 + 5𝑏 − 𝑏𝑃𝑏

(500 + 𝑏)𝑃𝑏 = 2500 + 5𝑏 + 500𝑡
2500 + 5𝑏 + 500𝑡 2500 + 5𝑏 + 500𝑡
𝑃𝑏 = ; 𝑃𝑠 = −𝑡
500 + 𝑏 500 + 𝑏
2500 + 5𝑏 + 500𝑡 2500 + 5𝑏 − 𝑏𝑡 500𝑏𝑡
𝑄 = 500𝑃𝑠 = 5 × ( − 𝑡) = 500 × ( ) = 2500 −
500 + 𝑏 500 + 𝑏 500 + 𝑏

(c) Using part (b), for a positive tax 𝑡, how does the elasticity of demand affect the equilibrium
quantity?
𝑑𝑄 (500 + 𝑏)500𝑡 − 500𝑏𝑡 250000𝑡
=− =− <0
𝑑𝑏 (500 + 𝑏)2 (500 + 𝑏)2

(d) Using the above parts, show that the deadweight welfare loss increases with the elasticity of
demand for a fixed tax 𝑡.
𝑡
Deadweight welfare loss |Δ𝑄| ∗ 2

500𝑏𝑡
Δ𝑄 = −
500 + 𝑏

500𝑏𝑡 𝑡 250𝑏𝑡 2
DWL= 500+𝑏 × 2 = 500+𝑏
Taking the derivative wrt to 𝑏, you can get
𝑑𝐷𝑊𝐿 (500 + 𝑏)250𝑡 2 − 250𝑏𝑡 2 125000𝑡 2
= = >0
𝑑𝑏 (500 + 𝑏)2 (500 + 𝑏)2
4) King Kanuta rules a small tropical island, Nutting Atoll, whose primary crop is coconuts. If the price
of coconuts is 𝑃, then King Kanuta’s subjects will demand 𝐷(𝑃 ) = 1200 − 100𝑃 coconuts per
week for their own use. The number of coconuts that will be supplied per week by the island’s coconut
growers is 𝑆(𝑃) = 100𝑃.

(a) What will be the equilibrium price of coconuts and the equilibrium quantity supplied?
Setting quantity supplied equals to quantity demanded, we have
1200 − 100𝑃 = 100𝑃
𝑃=6
𝐷(𝑃) = 𝑆(𝑃) = 600

(b) One day, King Kanuta decided to tax his subjects in order to collect coconuts for the Royal
Larder. The king required that every subject who consumed a coconut would have to pay a
coconut to the king as a tax. Thus, if a subject wanted 5 coconuts for himself, he would have
to purchase 10 coconuts and give 5 to the king. When the price that is received by the sellers
is 𝑃𝑠 , how much does it cost one of the king’s subjects to get an extra coconut for himself?
2𝑃𝑠 .
For each coconut, a subject needs to pay 𝑃𝑠 originally. However, he needs to buy two (thus
pay 2𝑃𝑠 ) now to get one coconut.

(c) When the price paid to suppliers is 𝑃𝑠 , how many coconuts will the king’s subjects demand for
their own consumption?
Since 𝑃𝑏 = 2𝑃𝑠 , 𝐷(𝑃𝑏 ) = 1200 − 100𝑃𝐷 = 1200 − 200𝑃𝑆

(d) Since the king consumes a coconut for every coconut consumed by the subjects, the total
amount demanded by the king and his subjects is twice the amount demanded by the subjects.
Therefore, when the price received by suppliers is 𝑃𝑠 , what is the total number of coconuts
demanded per week by Kanuta and his subjects?
2400 − 400𝑃𝑆

(e) Solve for the equilibrium value of 𝑃𝑠 , the equilibrium total number of coconuts produced, and
the equilibrium total number of coconuts consumed by Kanuta’s subjects.
Setting quantity supplied equals to total quantity demanded
2400 − 400𝑃𝑆 = 100𝑃𝑆
𝑃𝑆 = 24/5
Total number of coconuts produced: 2400 − 400𝑃𝑆 = 480
Kanuta’s subjects only consume half of the coconuts produced: 240.

(f) King Kanuta’s subjects resented paying the extra coconuts to the king, and whispers of
revolution spread through the palace. Worried by the hostile atmosphere, the king changed
the coconut tax. Now, the shopkeepers who sold the coconuts would be responsible for
paying the tax. For every coconut sold to a consumer, the shopkeeper would have to pay one
coconut to the king. What is the number of coconuts being sold to the consumers due to this
plan? How much do the consumers need to pay for each coconut, and how much can the
shopkeepers receive from each coconut after paying their tax to the king?

Since for every coconut sold to a consumer, the shopkeeper would have to pay one coconut
to the king, the shopkeepers only receive half of price paid by the consumers. Thus 𝑃𝑆 =
0.5𝑃𝑏 , 𝑆(𝑃𝑆 ) = 100𝑃𝑆 = 50𝑃𝑏 .
 Setting quantity supplied equals to total quantity demanded
50𝑃𝑏 = 2400 − 200𝑃𝑏
𝑃𝑏 = 48/5

Coconuts being sold to the consumers: 0.5 × (2400 − 200𝑃𝐷 ) = 240

Consumers need to pay 𝑃𝑏 = 48/5 for each coconut, and shopkeepers can receive 1/2𝑃𝑏 =
24/5 from each coconut.

Note that the reason why the equilibrium is the same when ad-valorem taxes are implemented on
the subjects or producers is because the tax rate is different in both cases. Subjects have an implicit
100% tax while shopkeepers have an implicit 50% tax here.

(For every coconut received from the shopkeeper, consumers paid twice the normal selling price.)

(The amount received for every coconut sold by the shopkeeper, is half that was paid by the
consumer).

Why is 𝑃𝑠 = 0.5𝑃𝑏 ? Another way of thinking about this is as follows:

If in equilibrium, Q is the quantity demanded by the subjects at price p, i.e. Q=1200 - 100P. Then
producers must have also been willing to supple 2Q at the price p. I.e. 2Q=100p.
This is equivalent to Q=100 * p/2. Comparing it to the original supply curve, it is as if they are facing
an effective price of 0.5p.
5) In the market for cars, the market demand curve is given by 𝐷(𝑝) = 1200 − 100𝑃 while market
supply curve is given by 𝑆(𝑝) = 100𝑝.

(a) Suppose that there is an ad-valorem (percentage) sales tax of 5 percent paid by consumers.
I.e. 𝑃𝐵 = 1.05𝑃𝑆 , where 𝑃𝐵 is the price paid by buyers and 𝑃𝑆 is the price received by sellers.
Solve for the equilibrium 𝑃𝑆 and 𝑃𝐵 and quantity in the market.

(b) Illustrate the effects of the ad-valorem tax above in a diagram, indicating the consumer
surplus, producer surplus and deadweight welfare loss.

a)

𝐷(𝑃𝐵 ) = 1200 − 100𝑃𝐵 = 1200 − 105𝑃𝑆

𝑆(𝑃𝑆 ) = 100𝑃𝑆

Setting quantity supplied equals to quantity demanded, we have

1200 − 105𝑃𝑆 = 100𝑃𝑠

205𝑃𝑆 = 1200

1200
𝑃𝑆 = = 5.85
205

𝑃𝐵 = 1.05 × 5.85 = 6.146

𝑄𝑆 = 𝑄𝐷 = 585

The perfect competition equilibrium without taxes was 𝑄 = 600 and 𝑃 = 6.

b) Green: CS with tax. Red: PS with tax. Yellow Tax collected. Blue: DWL.
𝑝
𝑆

𝑝𝐵 = 1.05𝑝𝑆
𝑝∗
𝑝𝑆

𝐷
𝐷′
𝑞
∗
𝑞′ 𝑞
Note that in this diagram, consumer surplus must be derived from a comparison of 𝑃𝐵 with the
original 𝐷 (and not 𝑃𝑠 with 𝐷′). The reason is that 𝐷′ does not capture the consumers actual
valuations from consuming 𝑞. This is because once the equilibrium prices 𝑝𝑠 and q’ are determined
by the intersection of 𝐷′ with 𝑆, the resultant tax for all quantities consumed is always constant at
0.05𝑃𝑆 .