Essential Foundations of Economics

7th Edition Bade Solutions Manual

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 Chapter
Government

ANSWERS TO CHAPTER CHECKPOINTS

Actions in

◼ Study Plan Problems and Applications

Markets
7
1. In Florida, sunscreen and sunglasses are vital items. If the tax on sellers
of these items is doubled from 5.5 percent to 11 percent, who will pay
most of the tax increase: the buyer or the seller? Will the tax increase
halve the quantity of sunscreen and sunglasses bought?
Because sunscreen and sunglasses are necessities, the demand for them is
inelastic. So, most of a tax imposed on them will be paid by the buyer.
Even though the tax doubles, the quantity purchased is not halved be-
cause the demand is inelastic.
2. Suppose that the government imposes a $2 a cup tax on coffee. What de-
termines by how much Starbucks will raise its price? How will the quan-
tity of coffee bought in coffee shops change? Will this tax raise much rev-
enue?
The price elasticities of demand and supply determine how much more
Starbucks charges for a coffee. The smaller the price elasticity of demand
and the larger the price elasticity of supply, the more Starbucks will raise
the price of a coffee. The quantity of coffee bought will decrease. The
amount of revenue the government raises depends on the size of the tax
and the size of the decrease in the quantity of coffee purchased. For a
given tax, the government collects more revenue the smaller the price
elasticities of demand and supply because the smaller these elasticities,
the smaller the decrease in the quantity purchased.
3. The table illustrates the market Price Quantity Quantity
for Internet service. What is the (dollars per demanded supplied
month) (units per month)
market price of Internet ser-
vice? If the government taxes 0 30 0
10 25 10
Internet service $15 a month,
20 20 20
what is the price the buyer 30 15 30
pays? What is the price the sell- 40 10 40

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74 Part 2 . A CLOSER LOOK AT MARKETS

er receives? Does the buyer or seller pay more of the tax?

The market price of an Internet service is
$20 a month because that is the price at
which the quantity demanded equals the
quantity supplied. A figure is helpful to an-
swer the questions about the tax incidence.
If the government imposes a tax of $15 a
month on Internet services, Figure 7.1
shows that the buyer pays $30 a month for
Internet services. If the government imposes
a tax of $15 a month on Internet services,
the seller receives $15 a month for Internet
services. The buyers pay more of the tax.

Use Figure 7.2, which shows the demand for on-

campus housing, to work Problems 4 to 6. The
college has 200 rooms to rent.
4. If the college puts a rent ceiling on rooms of
$650 a month, what is the rent, how many
rooms are rented, and is the on-campus hous-
ing market efficient?
The equilibrium rent is $600 a month and
the equilibrium quantity of rooms is 2,000
rooms. The rent ceiling of $650 a month is
above the equilibrium rent and does not
change the market equilibrium. The rent
remains the equilibrium rent of $600 a
month, the quantity of rooms rented re-
mains 2,000 rooms, and the market remains
efficient.
5. If the college puts a strictly enforced rent
ceiling on rooms of $550 a month, what is the rent, how many rooms are
rented, and is the on-campus housing market efficient? Explain why or
why not.
The rent ceiling of $550 a month is below the equilibrium rent, so the rent
is $550 a month. At this rent 2,250 rooms are demanded and the quantity
supplied is only 2,000 rooms, so 2,000 rooms are rented. The on-campus

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 Chapter 7 . Government Actions in Markets 75

housing market is efficient because the supply is perfectly inelastic so the

quantity remains equal to the efficient quantity. However, there is a
shortage of rooms and students spend additional time searching for hous-
ing.
6. Suppose that with a strictly enforced rent ceiling on rooms of $550 a
month, a black market develops. How high could the black market rent
be and would the on-campus housing market be fair? Explain your answer.
The black market rent could be as high as $600 a month, which is the max-
imum rent someone is willing to pay for the 2,000th room. If a black mar-
ket develops, using the “fair results” approach, the market is not fair be-
cause the poorest students cannot afford the higher black market rent. Us-
ing the “fair rules” approach, the market is not fair because the rent ceil-
ing blocks some voluntary exchanges unless the buyers and sellers are
willing to participate in the black market.
7. The table shows the demand and sup-
Wage rate Quantity Quantity
ply schedules for student workers at (dollars per demanded supplied
on-campus venues. If the college in- hour) (student workers)
troduces a strictly enforced minimum 10.00 600 300
wage of $11.50 an hour, who gains and 10.50 500 350
who loses from the minimum wage, 11.00 400 400
11.50 300 450
and is the campus labor market effi-
12.00 200 500
cient or fair? 12.50 100 550
The workers who retain their jobs and
are paid the higher wage rate gain from the minimum wage. The employ-
er, the workers who lose their job, and workers who must undertake ex-
tensive search for a job lose from the minimum wage. The minimum
wage of $11.50 an hour is not efficient. There is a surplus of workers and
the marginal benefit to firms exceeds the marginal cost to workers. A
deadweight loss is created. The minimum wage is unfair under the “fair
results” approach because some student workers lose their jobs. The min-
imum wage is unfair under the “fair rules” approach because it blocks
voluntary exchange.

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76 Part 2 . A CLOSER LOOK AT MARKETS

8. The table shows the demand and Price Quantity Quantity

supply schedules for mushrooms. (dollars per demanded supplied
Suppose that the government pound) (pounds per week)
introduces a price support for 1.00 5,000 2,000
mushrooms and sets the support price 2.00 4,500 2,500
3.00 4,000 3,000
at $6 per pound. Who gains and who
4.00 3,500 3,500
loses? What are the quantity of mush- 5.00 3,000 4,000
rooms produced, the surplus, and the 6.00 2,500 4,500
deadweight loss?
If the government introduces a price sup-
port of $6 per pound, production rises to
4,500 pounds per week. Mushroom pro-
ducers gain from the price support. Mush-
room consumers and taxpayers lose from
the price support. There is a surplus of
2,000 pounds per week. Figure 7.3 can be
used to calculate the deadweight loss. The
deadweight loss is the area of the darkened
triangle. The area of a triangle is equal to
1/2  base  height, so the deadweight loss
is 1/2  (1,000 pounds)  ($4 a pound),
which is $2,000.

Use the following news clip to work Problems 9 and 10.

Coal shortage at China plants
The government of China has set price controls on coal and gasoline in an at-
tempt to shield poor families and farmers from rising world energy prices.
Chinese power plants have run short of coal, sales of luxury, gas-guzzling
cars have increased, and gasoline consumption has risen. Oil refiners are in-
curring losses and plan to cut production.
Source: CNN, May 20, 2008
9. Are China’s price controls price floors or price ceilings? Draw a graph to
illustrate the shortages of coal and gasoline created by the price controls.
China’s price controls are price ceilings. In the face of increased demand,
China’s price controls have kept the price from rising to its equilibrium.
As a result the quantity demanded exceeds the quantity supplied and
shortages have resulted. Figure 7.4 (on the next page) illustrates the
situation in the market for coal; the figures for gasoline is similar. In

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 Chapter 7 . Government Actions in Markets 77

Figure 7.4 at the controled price of $550 per ton, the quantity of coal
demanded is 100 million tons per week, the
quantity of coal supplied is 97.5 million tons
per week so there is a shortage of 2.5 million
tons per week.
10. Explain how China’s price controls have
changed consumer surplus, producer surplus,
total surplus, and the deadweight loss in the
markets for coal and gasoline. Draw a graph
to illustrate your answer.
China’s price controls aim to keep the price
from rising to the equilibrium level. A price
ceiling decreases the quantity available to the
quantity supplied at the price ceiling. In Fig-
ure 7.5, the quantity with the price control is
97.5 million tons of coal per week. Because
the price and quantity decrease, producer
surplus decreases. Because the quantity de-
creases and search costs are incurred, con-
sumer surplus decreases. Because the quanti-
ty decreases and marginal benefit exceeds
marginal cost, a deadweight loss arises. Fig-
ure 7.5 shows the changes in consumer sur-
plus, producer surplus, and deadweight loss.
With no price ceiling the consumer surplus is
equal to area A + area B + area C. With the
price ceiling consumer surplus is equal to ar-
ea A. Search costs are area B + area E. The
producer surplus without the price ceiling is
equal to area E + area F + area G. With the
price ceiling the producer surplus is equal to
area G. Without the price ceiling there is no
deadweight loss. With the price ceiling there
is a deadweight loss equal to area C + area F
and area B + area E are resources lost to
search activity.
11. Read Eye on Price Regulation on p. 185 and explain why a mismatch
between intention and outcome is inevitable if a price regulation seeks to
block the laws of supply and demand.
Price regulations have as their purpose the goal of changing the market
outcome. For example, minimum wage laws raise the wage rate paid
lower-skilled workers and rent controls lower the rent paid for apart-

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78 Part 2 . A CLOSER LOOK AT MARKETS

ments. In both instances, the law is designed to change the equilibrium

price (the wage for the minimum wage and the rent for rent controls) de-
termined by supply and demand. Because the equilibrium price is the only
price at which there is neither a shortage nor a surplus, a law that changes
the price automatically creates either a shortage or a surplus. In the Eye
on Price Regulation, the cap on executive pay would create a shortage of
executives.

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 Chapter 7 . Government Actions in Markets 79

◼ Instructor Assignable Problems and Applications

1. Suppose that Congress caps executive pay at a level below the equilibrium.
• Explain how the quantity of executives demanded, the quantity sup-
plied, and executive pay will change, and explain why the outcome is
inefficient.
Because the price cap is below the equilibrium salary, the executive pay
falls. The quantity of executives demanded increases and the quantity of
executives supplied decreases. There is a shortage of executives. The out-
come is inefficient because the marginal benefit (to firms) exceeds the
marginal cost (to executives).
• Draw a graph of the market for corporate executives. On your graph,
show the market equilibrium, a pay cap, the quantity of executives
supplied and the quantity demanded at the pay cap, and the
deadweight loss created. Also show the highest pay that an executive
might be offered in a black market.
Figure 7.6 shows the market for executives.
In the absence of a price cap, the equilibri-
um salary is $600,000 a year and the equi-
librium quantity of executives is 60,000.
With a price cap (which is the same as a
price ceiling) of $550,000, the salary falls to
$550,000 per year. At this salary, the quan-
tity of executives demanded is increases to
65,000 per year and the quantity supplied
decreases to 55,000 per year. There is a
shortage of 15,000 executives. The price
ceiling is inefficient. The deadweight loss
is the darkened triangle. If a black market
develops, the figure shows that firms are
willing to pay $700,000 per year to hire an
executive, so executives who participate in
the black market can be paid as much
$700,000 per year.
Use the following information to work Problems 2 and 3.
The supply of luxury boats is perfectly elastic, the demand for luxury boats is
unit elastic, and with no tax on luxury boats, the price is $1 million and 240
luxury boats a week are bought. Now luxury boats are taxed at 20 percent.
2. What is the price that buyers pay? How is the tax split between the buyer
and the seller? What is the government’s tax revenue?
Because the supply is perfectly elastic, the buyers pay all the tax: the price
rises by the full amount of the tax and buyers pay $1.2 million per boat.

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80 Part 2 . A CLOSER LOOK AT MARKETS

Because the supply is perfectly elastic, the buyers pay all the tax and the
sellers pay none of the tax. The price rises 20 percent. The elasticity of
demand is 1.0, so the quantity demanded decreases by 20 percent. Before
the tax, 240 boats were bought, so the tax decreases the number of boats
sold by (240 boats)  (20 percent), which is 48 boats. So after the tax, 192
boats are bought. The government collects a tax of 20 percent on each
boat, so the government collects $200,000 tax on each. The total tax reve-
nue the government collects is ($200,000 a boat)  (192 boats), which is
$38.4 million.
3. On a graph, show the excess burden of this tax. Is this tax efficient?
The shaded area in Figure 7.7 is the excess
burden of the tax. The tax is not efficient be-
cause a deadweight loss is created.

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 Chapter 7 . Government Actions in Markets 81

4. Figure 7.8 shows the demand for and supply

of chocolate bars. Suppose that the govern-
ment levies a $1.50 tax on a chocolate bar.
What is the change in the quantity of choco-
late bars bought, who pays most of the tax,
and what is the deadweight loss?
The initial price of a chocolate bar is $3.00
per bar and the initial quantity of chocolate
bars is 6 million bars per year. Figure 7.9
shows the situation after the tax is imposed.
As Figure 7.9 shows, the tax shifts the supply
curve upward by $1.50 to the S + tax curve.
Once the tax is imposed, including the tax
consumers pay $4.00 a bar. Manufacturers
must send $1.50 to the government as the
tax, so after the tax is imposed, the suppliers
receive $2.50. The equilibrium quantity of
chocolate bars is 4 million bars per year. The
quantity of chocolate bars decreases by 2 mil-
lion bars per year. The amount that the con-
sumer pays rises by $1.00 and the amount
that the supplier receives falls by $0.50.
Hence the consumers pay most of the tax.
The deadweight loss is shown in Figure 7.9
as the area of the grey triangle. The area of a
triangle is 1/2  base  height. Hence the
deadweight loss is equal to 1/2  2 million
bars  $1.50 per bar, which is $1.5 million.

Use the following information to work Problems 5 and 6.

Concerned about the political fallout from rising gas prices, suppose that the
U.S. government imposes a price ceiling of $3.00 a gallon on gasoline.
5. Explain how the market for gasoline would react to this price ceiling if the
oil-producing nations increased production and drove the equilibrium price
of gasoline to $2.50 a gallon. Would the U.S. gasoline market be efficient?
If the equilibrium price of gasoline is $2.50 a gallon, then a price ceiling of
$3.00 a gallon has no effect on the market because it does not change the

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82 Part 2 . A CLOSER LOOK AT MARKETS

equilibrium price. The market is efficient because at the equilibrium the

marginal benefit equals the marginal cost.
6. Explain how the market for gasoline would react to this price ceiling if a
global shortage of oil sent the equilibrium price of gasoline to $3.50 a gal-
lon. Would the U.S. gasoline market be efficient?
If the equilibrium price of gasoline is $3.50 a gallon, then a price ceiling of
$3.00 a gallon results in a shortage. The quantity of gasoline demanded at
$3.00 a gallon exceeds the quantity supplied. A black market is likely to
develop, in which consumers buy gasoline at prices higher than the price
ceiling. In addition, a great deal of additional search activity arises as
drivers look for gas stations that are open and willing to sell gasoline. The
market is inefficient because the marginal benefit of a gallon of gasoline
exceeds the marginal cost and so there is a deadweight loss.
7. Suppose the government introduced a ceiling on lawyers’ fees. How
would the amount of work done by lawyers, the consumer surplus of
people who hire lawyers, and the producer surplus of law firms change?
Would this fee ceiling result in an efficient and fair use of resources?
Why or why not?
If the ceiling is set above the equilibrium fee, the ceiling has no effect on
the amount of work, consumer surplus, or producer surplus. The market
remains efficient.
If the ceiling is set below the equilibrium fee, the quantity of work sup-
plied decreases. There is a shortage and increased search. The consumer
surplus decreases and the law firms’ producer surplus decreases. This
ceiling results in an inefficient use of resources. The marginal benefit ex-
ceeds the marginal cost and a deadweight loss arises. Additionally, added
resources are used as people increase their search activity to find an attor-
ney. It also is unfair, by the “fair rules” view because it blocks voluntary
exchange and by the “fair results” view unless the allocation mechanism
allocates more law firm resources to poorer people, which is unlikely.
Use the following information to work Problems 8 and 9.
Crop prices erode farm subsidy program
High corn and soybean prices mean farmers are making the most money in
their lives. At the same time, grain prices are far too high to trigger payouts
under the U.S. primary farm-subsidy program’s “price support” formula. The
market has done what Congress couldn’t do and that is “slash farm subsidies.”
Source: The Wall Street Journal, July 25, 2011
8. Draw a graph to illustrate the soybean market when the soybean price
was low. Show the quantity of soybeans produced, the subsidy farmers
received, and the deadweight loss created.
Figure 7.10 (on the next page) illustrates the market for soybeans. In the

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 Chapter 7 . Government Actions in Markets 83

absence of the price support, the equilibrium

price is $12.00 per bushel and 2.9 billion
bushels are produced. With a price support
of $12.50 per bushel, 3.1 bushels are pro-
duced. The subsidy the farmers received is
illustrated in the figure as the light grey rec-
tangle (some of which lies behind the
deadweight loss triangle). The deadweight
loss is the dark grey triangle in the figure.
9. In the market for corn with a price support,
explain why the corn price has risen and
ended up being too high to “trigger payouts.”
The price of corn has risen because rising
demand for corn has increased the price and
because a poor growing season has de-
creased the supply, which has also boosted
the price. The equilibrium price of corn ex-
ceeds the support price, so the support price has no effect on the market.
At the equilibrium price, the quantity demanded equals the quantity sup-
plied and there is no surplus that the government needs to purchase.

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84 Part 2 . A CLOSER LOOK AT MARKETS

◼ Multiple Choice Quiz

1. If a tax of $1 a can is imposed on the buyers of sugary drinks, the demand
for sugary drinks ______ and the price that buyers pay ______.
A. doesn’t change; doesn’t change
B. doesn’t change; rises by $1 a can
C. decreases; rises by more than $1 a can
D. decreases; rises by less than $1 a can
Answer: D Figure 7.1(a) illustrates this result.

2. A tax on candy will be paid by ______.

A. only buyers if the demand for candy is inelastic
B. only sellers if the supply for candy is inelastic
C. buyers and sellers if the demand for candy is elastic
D. only buyers if the supply of candy is elastic
Answer: C While sellers pay more of the tax if demand is elastic, both
buyers and sellers part of the tax.

3. A price ceiling imposed below the equilibrium price ______.

A. creates a black market in which the price might equal or exceed the
equilibrium price
B. creates a black market in which the price equals the price ceiling
C. leads to increased search activity, which reduces the shortage of the
good
D. increases the demand for the good, which makes the shortage even
larger
Answer: A The price in black markets lies between the ceiling price and
the maximum price demanders will pay for the quantity pro-
duced.

4. A price ceiling is ______ if it is set _____ the market equilibrium price.

A. efficient and fair; below
B. unfair but efficient; equal to
C. efficient and unfair; above
D. inefficient and unfair; below
Answer: D A price ceiling set below the equilibrium price creates ineffi-
ciency and is unfair by both measures of fairness.

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 Chapter 7 . Government Actions in Markets 85

5. A price floor influences the outcome of a market if it is ______.

A. set below the equilibrium price
B. set above the equilibrium price
C. an incentive for buyers to increase demand for the good
D. an incentive for sellers to decrease supply of the good
Answer: B If the price floor is set above the equilibrium price, it makes
the equilibrium price illegal.

6. A minimum wage set above the market equilibrium wage rate ______.
A. increases both employment and the quantity of labor supplied
B. decreases unemployment and raises the wage rate of those employed
C. raises the wage rate of those employed and increases the supply of
jobs
D. increases unemployment and decreases employment
Answer: D By raising the wage rate above the equilibrium wage rate, a
minimum wage creates unemployment and decreases em-
ployment.

7. A support price set above the equilibrium price ______.

A. creates a shortage, increases farmers’ total revenue, and is efficient
B. creates a surplus, which the government buys and dumps on the rest
of the world to keep the U.S. market price equal to the price support
C. is inefficient because farmers’ marginal cost exceeds U.S consumers’
marginal benefit
D. is efficient because farmers’ marginal cost equals U.S. consumers’
marginal benefit
Answer: B Price supports set above the equilibrium price require the
government to purchase the surplus to maintain the price.

8. Choose the best statement.

A. A subsidy to peanut growers lowers peanut growers’ costs, lowers the
market price of peanuts, and increases the demand for peanuts.
B. A price support for peanut growers is a guaranteed price for peanuts,
which increases the quantity of peanuts produced.
C. A price support and a subsidy to peanut growers will make the pea-
nut market more efficient if the support price is below the market
price.
D. For a support price set above the equilibrium price to increase peanut
growers’ incomes, they must also receive a subsidy.
Answer: B By guaranteeing a higher price, a price support increases
the quantity producers supply.

© 2015 Pearson Education, Inc.