Solution Manual for Microeconomics, 11th Edition, David Colander

Solution Manual for Microeconomics, 11th Edition,

David Colander

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CHAPTER 7: TAXATION AND GOVERNMENT
INTERVENTION
Questions and Exercises
1. With either excess supply or excess demand, the number of trades will be lower
than if price were allowed to move to its equilibrium price. That means there is a
loss of surplus.

2. Decision making based on costs and benefits means you make purchases if the
marginal benefits are greater than the price. Thus, when you decide to make a
purchase, you are likely receiving something worth more to you than what you
had to spend to buy it, or else you wouldn’t have bought it. That net benefit is
consumer surplus.

3. If demand is inelastic, raising a tax rate increases tax revenue paid by consumers;
similarly with supply. If demand is elastic, however, raising a tax rate decreases
revenue paid by consumers. Thus, what happens to total tax revenue depends on
the elasticity of both supply and demand.

4. Because labor supply is elastic, raising the tax rate will reduce the percent of
hours worked by more than the percent decrease in wages paid. That is, total
income will decline as will total tax revenue. Social Security cannot be financed
by increasing tax rates. Source: “Why Do Americans Work So Much More than
Europeans?” Quarterly Review, July 2004.

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5. Welfare loss is shown by the bolded triangles in the figures below.
a. b.

c. d.

6. a. Before the tax, equilibrium price is $6

and equilibrium quantity is 200. After
the tax, equilibrium price is $8 and
equilibrium quantity is 100.

b. Producer surplus before the tax is the

area above the supply curve and below
price. This is a triangle with base 200
and height 4 (Areas E and F). So,
producer surplus is (1/2) (200)(4) =
400. After the tax, the triangle
representing producer surplus has a
height of 2 and base of 100 (Area G).
So producer surplus is 1/2 (100)(2) =
100.

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 c. Consumer surplus before the tax is the area below the demand curve and above
equilibrium price (Areas A, B, C, and D). This is a triangle with base 200 and
height 4. So consumer surplus is (1/2) (200)(4) = 400. After the tax, the triangle
representing consumer surplus has a height of 2 and base of 100 (Area A). So
consumer surplus is 1/2 (100)(2) = 100.

d. Total tax revenue is $4 times equilibrium quantity, 100, or $400(Area B, C, and

E).

7. If suppliers were strong lobbyists, the government would prefer demand to be

more inelastic than supply, because then consumers will bear the larger portion of
the tax (producers would bear a smaller portion). Suppliers would not lobby
against the tax as hard than if the suppliers had to bear the greater burden (supply
is more inelastic than demand).

8. Inelastic goods with a price elasticity of demand and supply as close to zero as
possible. Examples would be cigarettes, salt, required medications, a per capita
tax, and a land tax. (Other examples are possible.)

9. The consumer. The more inelastic the demand curve, the larger the percentage of
the burden is borne by the consumer (or demander).

10. With a perfectly elastic demand, suppliers will pay the entire cost of the tax
regardless of how elastic supply is—unless supply is also perfectly elastic, in
which case no goods will be bought or sold after the tax, so no one will bear the
burden. The answer would be the same if the tax were levied on suppliers.

11. The demander will pay 40 percent of the tax [0.4/(0.6 + 0.4) × 100] and the
supplier will pay the remaining 60 percent [0.6/(0.6 + 0.4) × 100].

12. If the economist wanted to get as much revenue as possible from as little output
reduction (welfare loss) as possible, he would suggest taxing goods with inelastic
supply because with an inelastic supply, equilibrium quantity would not change
much. (Pretty similar to Question 8)

13. No. Tenants shouldn’t worry too much. In the short run, the supply of apartments
is highly inelastic so the owner will bear the majority of the tax burden; it will not
be passed on to tenants. In the long run supply is more elastic so the renter will
pay some of the tax. So in the long run, tenants should worry more.

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14. The demander will pay the percent of the tax equal to [ES/(ES + ED) × 100], and
the supplier will pay the remaining percent of the tax equal to [ED/(ES + ED) ×
100].

a. Percent borne by demander = 80; percent borne by supplier = 20.

b. Percent borne by demander = 40; percent borne by supplier = 60.

c. Percent borne by demander = 67; percent borne by supplier = 33.

d. Percent borne by demander = 50; percent borne by supplier = 50.

e. Consumers with relatively more elastic demand curves bear a smaller percent of
the tax. The same is true for producers. If the elasticities of demand curves and
supply curves are equal, consumers and producers will share the tax burden
equally.

15. For an equivalent percentage reduction in price due to the price ceiling, a more
elastic demand and supply results in a greater shortage. The reason is that the
response in quantity supplied and demanded is greater when price elasticity is
greater.

16. See the accompanying graph. Given

the demand curve shown and supply
curve S0, the price floor Pf is above the
equilibrium price, Pe. The “tax” paid
by consumers is areas A and B. Area A
represents surplus transferred to
producers. Welfare loss is shown by
area C.

a. In the case of a tax with an equivalent

effect on equilibrium price, the
revenue (rectangles A and B) goes to
the government.

b. In the case of a price floor, Pf, the

“revenue” (areas A and B) goes to the suppliers who still supply the good.

17. a. At first there will be an excess supply of workers, but with time, the newly
unemployed will get discouraged and drop out of the labor force, disguising the

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 unemployment. Another possibility is that firms invest in machinery to replace
labor, increasing the long-term job shortage.

b. It is likely to decrease because demand for minimum wage earners becomes more
elastic over time, which means that more low-wage workers will lose their jobs.

18. a. The equilibrium price is $8, the

equilibrium quantity is 4.

b. Producer surplus is the area below

equilibrium price and above the
supply curve (Areas D, E, and F).
The numerical value is ½ × 4 × 4 =
8.

c. Consumer surplus is the area above

equilibrium price and below the
demand curve (Areas A, B and C).
The numerical value is ½ × 4 × 8 =
16.

d. Producer surplus is the area above the supply curve below $12 up to 2 (areas B, D
and F). Numerically this is equal to 14, 1/2(2 × 2) + (2 × 6). Consumer surplus is
the area below the demand curve above $12 up to 2 (Area A). Numerically this is
4 (1/2 × 2 × 4).

19. a. Consumers will likely complain the most

because they have fewer alternatives.
There will, however, be more suppliers
who are kept out of the market.

b. In the accompanying graph, you can see

that the suppliers decrease output
significantly, but the opportunity cost of
their doing so is not great. Those fewer
demanders who are hurt are hurt a lot; they
will likely scream loudly. The actual
number of complaints will depend on the
costs and expected benefits of
complaining.

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20. Rent seeking is attempting to transfer surplus from one group to another; for firms
it usually involves restricting supply in order to increase price. Firms have a
greater incentive to rent seek when demand is inelastic because as price rises, total
revenue rises.

21. The general rule of political of political economy is that when small groups are
helped by a government action and large groups are hurt by that same action, the
small group tends to lobby far more effectively than the large group; thus, policies
tend to reflect the small group’s interest rather than the interest of the large group.
An example from the real world is that farmers lobby the government to create a
price floor or restrict the supply for their farm products.

22. Without the restriction, Q0 suppliers earn

areas A and B in producer surplus. After
the restriction, Q1 suppliers earn areas A
and C. Suppliers would be willing to pay
at most the difference (C - B) to restrict
supply.

Questions from Alternative Perspectives

1. Austrian
a. Taxation without representation can be seen as robbery because it is not a tax that
was chosen by elected representation. To the extent that our elected
representatives follow the will of their constituents, taxes are not robbery because
those taxes will be used to fund projects supported by society.

b. Many Austrians would support a voluntary approach to government finance. This

would lead to a much smaller government and much more freedom for
individuals. Austrians are not against collective action per se, but they are against
involuntary transactions.

2. Feminist
a. The issue of taxation leaves out the fact that, to the extent that women do not
make buying decisions, their surpluses are not accounted for in the model. Also,

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 to the extent that women are not as frequently in government positions that decide
taxation, their desires regarding taxes are not represented fairly.

b. One could frame the question so that it involves normative consideration.

c. Yes, women would get less weight than men in the model of consumer surplus.

3. Institutionalist
People with the least money to spend necessarily—for example, a single dollar—
receive less surplus. Those with the most money, who are willing and able to pay
more for each unit, yet need not do so, receive a great deal of surplus. Thus, the
distribution of income, which is itself a function of access to and control of the
production process, determines whose welfare is maximized.

4. Radical
Econometric evidence suggests that the Social Security taxes are highly regressive
in both competitive and non-competitive labor markets. Empirical studies find
that in competitive markets with an inelastic labor supply and little bargaining
power, workers bear the burden of their share of the payroll tax and much of the
employers’ share in the form of wages that are lower than they would be in the
absence of the tax. If supply is perfectly inelastic, the demand curve for labor
shifts down by the amount of the tax (P1 – P0 in the graph shown below on the
left). Wages fall by the entire amount of the tax, so employees bear the entire
burden of the tax. In non-competitive markets, workers have a more elastic supply
and more bargaining power, and the employers are unable to shift as much of
their share of the payroll tax back, towards labor. If supply and demand are
equally elastic, employees and employers share the burden of the tax equally as
shown in the graph below on the right. The demand curve shifts by the amount of
the tax (P1 – P2), but wages fall by ½ of the tax, P1 – P0.

Supply

Supply

P1
Wages
Wages

P1
P0 P0 A

B
P2
D0

D1 D0
D1

Q0 Q1 Q0
Quantity of Labor Quantity of Labor

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5. Religious
Economists’ surplus approach weights people’s views by their income, and thus is
not directly consistent with this view. Although, for some types of questions,
where individuals have similar tastes regardless of income, the difference is not
that important.

Issues to Ponder
1. a. The tax structure that would bring about Mansard roofs is a tax that is based on
the number of stories a building has, which is the type of tax they had in Paris
when this roof was popular.

b. If a story were interpreted as including living space created in the attic, or if the
tax were based on square-footage of living-space, then the Mansard roof would
decline in importance.

c. There are many. One example is if taxes are based on outside appearance, then
the inside of a building would tend to be more elaborate than the outside. Another
example is taxes on the number of windows in Quebec. In Quebec City, taxes at
one point were based on the number of windows, so you see a lot of buildings
where windows have been filled in. (Other answers are possible.)

2. a. A poll tax would have no incentive effect, since there is no way to avoid paying it.
A tax on property, where supply is somewhat elastic, will reduce the quantity of
property supplied (negative incentive effect), resulting in a loss of consumer and
producer surplus.

b. Margaret Thatcher was almost thrown out of office because of this tax, and her
successor, John Major, returned to a property tax. Citizens were far more
concerned with the distributional consequences associated with a poll tax than
they were with the loss of efficiency associated with a property tax.

3. If the tax were based on street frontage or area of the ground floor/foundation
rather than square feet of living space, individuals would have an incentive to
build in this style.

4. a. The regulations of Dr. Wiley's Law were likely the result of strong lobbying by
the food industry to protect their own interests from competition under the guise
of consumer protection.

b. A skeptical economist would likely look at the effects of this law on prices and
competition to determine the motives behind passage of the law.

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Solution Manual for Microeconomics, 11th Edition, David Colander

c. This is very significant because it suggests that it was the lobbying of existing
producers that supported the law to protect their interests, not the consumers'
interests.

5. a. Because the elasticity of demand among the top students was greater than one,
lowering tuition would lead to a proportionally greater percentage increase in
enrollment. Total revenue would rise for the college.

b. The program distinguished among top students because their elasticities likely
differed. The top 10 percent were likely being offered scholarships at other
academic institutions, giving them greater choices, which made their elasticities
greater.

c. It could be that the President did not reduce tuition for all students because the
overall elasticity of demand for students was less than one. This scheme allowed
them to take advantage of differing elasticities with price discrimination. Another
reason is that price is sometimes an indicator for quality. By lowering tuition
across the board, the President could be sending a signal that the college has lost
relative academic standing. In using this scheme, he is sending a signal that he
desires to increase their relative standing.

6. a. Because there were students that were

asked to defer enrollment, there was
excess demand as shown by the distance
between Q0 and Q1 in the accompanying
graph.

b. The market solution for excess demand is

to raise tuition until excess demand is
eliminated.

c. The state may have decided not to

increase tuition in fear that lower-income
students might not be able to afford the
tuition. Another solution, however,
would be to price discriminate –
subsidizing education of those with lower income by charging higher prices to
higher-income students.

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