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Economic Policies and Efficiency: Exercises and Applications Lecture 6 – academic year 2014/15 Introduction to Economics Fabio Landini

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If the equilibrium price on the market for cigarettes is equal to 10 Euro a packet, and the State imposes a MINIMUM price equal to 12 Euro, we have… A) … An excess supply: the quantity supplied is greater than the quantity demanded. B)... Scarcity: the quantity demanded is greater than the quantity supplied. C)... No effect on the market. Ex. 6.1 – The market for cigarettes

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If the equilibrium price on the market for cigarettes is equal to 10 Euro a packet, and the State imposes a MINIMUM price equal to 12 Euro, we have… A) … An excess supply: the quantity supplied is greater than the quantity demanded. B)... Scarcity: the quantity demanded is greater than the quantity supplied. C)... No effect on the market. Ex. 6.1 – The market for cigarettes

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Question The European Parliament decides that the EU must decrease the level of air pollution by reducing the use of petrol in road transports. Therefore, it introduces a tax on petrol of 0.50 € a litre. Should the EU introduce a tax on consumption or production? Explain in detail by using a graphical representation (S&D model). Ex. 6.2 – Tax on petrol (I)

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P* neat of the tax Quantity of petrol 0 Price of petrol Q* D1D1 Supply, S 1 Equilibrium without the tax Tax on consumption Equilibrium with the tax Q*Q* P*P* PtPt T D2D2 Ex. 6.2 – Tax on petrol (I)

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P* neat of the tax Quantity of petrol 0 Price of petrol Q* D1D1 Supply, S 1 Equilibrium without the tax Tax on production Equilibrium with the tax Q*Q* P*P* S2S2 T Ex. 6.2 – Tax on petrol (I)

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Taxes on consumption or production generates the same effects on the market A positive difference is created between the price paid by the consumer and the one paid by the producer This difference is indeed the same, independently on whether the tax is imposed on production or consumption Ex. 6.2 – Tax on petrol (I)

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Question If the demand for petrol were more elastic, would this tax be more or less efficient in reducing the quantity of petrol that is consumed? Explain in detail by using a graphical representation (S&D model). Ex. 6.2 – Tax on petrol (II)

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P* Quantity of petrol 0 Price of petrol Q* D1D1 Supply, S 1 Equilibrium without the tax Elastic demand Equilibrium with the tax Q*Q* P*P* D2D2 Ex. 6.2 – Tax on petrol (II) PtPt T Q2 P*P* T

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With a higher elasticity E D (p), the same tax would induce a greater reduction in the equilibrium quantity Ex. 6.2 – Tax on petrol (II)

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Question Do the consumers of petrol obtain some benefits from the introduction of the tax? Do the workers of the petrol industry obtain some benefits from the introduction of the tax? Ex. 6.2 – Tax on petrol (III)

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Answer Consumers suffer a cost from the introduction of the tax, because the latter has anyway a negative effect by increasing the market price. Workers of the petrol industry suffer a cost too, by reducing the quantity produced (in addition to the cost as consumers) Ex. 6.2 – Tax on petrol (III)

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Question Two market equations: Q S = 2P Q D = 12 – P a) Find the equilibrium price and quantity; b) What happen if the Government imposes a tax T on producers? Ex. 6.3 – Tax and prices

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14 Answer a)Equilibrium price and quantity: Q S = Q D 2P = 12 – P -> 3P = 12 -> P = 4 and Q S = Q D = 8 Ex. 6.3 – Tax and prices

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15 Answer b) Equilibrium after the tax T, steps: 1.Find equilibrium with the new supply curve 2.Compute the price received by producers 3.Compute the price paid by the consumers 4.Compute the new quantity sold in equilibrium Ex. 6.3 – Tax and prices

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16 If a tax T is introduced the price received by the producers is: Q S = Q D 2(P – T) = 12 – P 2P – 2T = 12 – P 3·P = 12 + 2·T P = 4 + 2/3·T Ex. 6.3 – Tax and prices

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17 The price paid by the consumers is: P - T = (4 + 2/3·T) – T P - T = 4 + T(2/3 – 1) Therefore, P – T = 4 – 1/3·T Ex. 6.3 – Tax and prices

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18 The quantity sold is equal to: Q O = 2(P – T) = 2 ·(4 + 2/3·T – T) = 8 – 4/3·T Comments: as we could expect, in because of the tax the dimension of the market reduces and the tax burden is shared ( 2/3 is paid by the producer and 1/3 by the consumer) Ex. 6.3 – Tax and prices

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19 8 4 Supply Demand 4 - 1/3 T 4 + 2/3 T Amount of the tax T 8 - 4/3 T Ex. 6.3 – Tax and prices

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Question Two market equations: Q D = 9 – P Q S = 3P – 3 Compute the surplus of the consumer and the surplus of the producer in equilibrium. Ex. 6.4 – More on cheese market (I)

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Price of cheese Quantity of cheese 3 6 D S In equilibrium Q D = Q D = 6, and P is equal to 3 9 1 Ex. 6.4 – More on cheese market (I)

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To compute the surplus of consumer (R C ) we must compute the size of the area between the demand curve and the equilibrium price. To compute the surplus of producer (R P ) we must compute the size of the are between the supply curve and the equilibrium price. Ex. 6.4 – More on cheese market (I)

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Price of cheese Quantity of cheese 3 6 D S A B C D Consumer surplus: Area of triangle ABC = (BC · AB)/2 BC = 6 and AB = 9-3= 6, therefore Area of ABC = (6·6)/2 = 18 9 1 Ex. 6.4 – More on cheese market (I)

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Price of cheese Quantity of cheese 3 6 D S A B C D 9 1 Ex. 6.4 – More on cheese market (I) Producer surplus: Area of triangle BCD =(BC · BD)/2 BC = 6 and BD = 3-1= 2, therefore Area of BCD = (6·2)/2 = 6

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In conclusion: – R C is equal to 18 – R P is equal to 6 – The total surplus (R = R P +R C ) is equal to 24 Ex. 6.4 – More on cheese market (I)

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Question The government decides that the price of cheese that is determined on the market is too low. Suppose that the Government introduces a minimum price. Draw the S&D graph and show the effect of such policy on the market price and on the quantity sold. Does this intervention induce scarcity or excess supply? Ex. 6.4 – More on cheese market (II)

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Quantity of cheese 0 Price of cheese Demand Supply Equilibrium price = P* Q* Ex. 6.4 – More on cheese market (II) Minimum price QdQo Excess supply

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Question The farmers of a given country complains that the imposition of the minimum level of price on cheese has reduced their total revenue. Is it possible? Explain why. Ex. 6.5 – More on cheese market (III)

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Answer The sign of the reduction in total revenue for farmer depends on the elasticity of demand with respect to price The total revenue before the introduction of the minimum level of prise is equal to (A+B+C+D) (next slide) Ex. 6.4 – More on cheese market (III)

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B A D C Quantity of cheese 0 Price of cheese Demand Supply Equilibrium price = P* Q* Ex. 6.4 – More on cheese market (III) Minimum price QdQo Excess supply

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With the minimum level of price (Q D, P min ): total revenue is equal to area (A+D+E) (next slide) Gain/ loss of revenue = E – (B+C) (next slide) Ex. 6.4 – More on cheese market (III)

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B A D C Quantity of cheese 0 Price of cheese Demand Supply Equilibrium price = P* Q* Ex. 6.4 – More on cheese market (III) Minimum price QdQo Excess supply E F

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Question In response to the farmers’ complaints, the Government to buy all the excess supply of cheese from farmer at the limit price. In comparison with the introduction of the minimum price, a) Who benefits from this new intervention? b) Who is damaged? Ex. 6.4 – More on cheese market (IV)

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B A D C Quantity of cheese 0 Price of cheese Demand Supply Equilibrium price = P* Q* Ex. 6.4 – More on cheese market (IV) Minimum price QdQo Excess supply E F

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Answer The new intervention benefits farmers and damages taxpayers (if we assume that the Government finance the new policy by increasing taxes). Ex. 6.4 – More on cheese market (IV)

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Question The (usual) chilling destroys part of the lemon harvest in Sicily. a) Which is the effect on the consumer surplus in the market for lemonade? b) What happen to the surplus of the lemonade producers? Ex. 6.5 – Lemonade

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Answer a) In the market for lemonade lemons are inputs –> the lemonade supply curve shifts leftward Ex. 6.5 – Lemonade

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Quantity of lemonade Price of lemonade 0 Demand, D P* A C Q* S2S2 P1P1 Q1Q1 B D E F G Ex. 6.5 – Lemonade S1S1 Before the chilling, consumer surplus= A + B + C + D

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Quantity of lemonade Price of lemonade 0 Demand, D P* A C Q* S2S2 P1P1 Q1Q1 B D E F G Ex. 6.5 – Lemonade S1S1 After the chilling, consumer surplus= A

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Answer b) Effects on the lemonade producers surplus Ex. 6.5 – Lemonade

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Quantity of lemonade Price of lemonade 0 Demand, D P* A C Q* S2S2 P1P1 Q1Q1 B D E F G Ex. 6.5 – Lemonade S1S1 Before the chilling, producer surplus= E + F + G

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Quantity of lemonade Price of lemonade 0 Demand, D P* A C Q* S2S2 P1P1 Q1Q1 B D E F G Ex. 6.5 – Lemonade S1S1 After the chilling, producer surplus= E +B

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Therefore: the effect on the consumer surplus in UNCERTAIN. It depends on the price elasticity of the demand curve. If the curve is flat (high elasticity), it is more likely that the producer will loose (area B gets smaller) Ex. 6.5 – Lemonade

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