Exam 2 ReviewSupplemental InstructionIowa State University (pg. 1)

Leader: LuisCourse: Econ 101

Instructor:Date:

Elasticity1. Do you think the price elasticity of demand for Ford sport-utility vehicles (SUVs) will

increase, decrease, or remain the same when each of the following events occurs? Explain your answer.

a. Other car manufacturer, such as General Motors, decide to make and sell SUVs.b. SUVs produced in foreign countries are banned from the American market.c. Due to ad campaigns, Americans believe that SUVs are much safer than ordinary

passenger cars.d. The time period over which you measure the elasticity lengthens. During that longer

time, new models such as four-wheel-drive cargo vans appear. 2. In the United States, 2007 was a bad year for growing wheat. And as wheat supply

decreased, the price of wheat rose dramatically, leading to a lower quantity demanded (a movement along the demand curve). The accompanying table describes what happened to prices and the quantity of wheat demanded.

a. Using the midpoint method, calculate the price elasticity of demand for winter wheat. b. What is the total revenue for U.S. wheat farmers in 2006 and 2007?c. Did the bad harvest increase or decrease the total revenue of U.S. wheat farmers?

How could you have predicted this from your answer to part a?3. A recent study determined the following elasticities for Volkswagen Beetles: price elasticity

of demand = 2, income elasticity of demand = 1.5. The supply of beetles is elastic. Based on this information, are the following statements true or false? Explain your reasoning.

a. A 10% increase in the price of a Beetle will reduce the quantity demanded by 20%.b. An increase in consumer income will increase the price and quantity of Beetles sold.

Since price elasticity of demand is greater than 1, total revenue will go down.4. Worldwide, the average coffee grower has increased the amount of acreage under cultivation

over the past few years. The result has been that the average coffee plantation produces significantly more coffee than it did 10 to 20 years ago. Unfortunately for the growers, however, this has also been a period in which their total revenues have plunged. In terms of an elasticity, what must be true for these events to have occurred? Illustrate these events with a diagram, indicating the quantity effect and the price effect that gave rise to these events.

5. Pharmaceutical drugs have an inelastic demand, and computers have an elastic demand. Suppose that technological advance doubles the supply of both products (that is, the quantity supplied at each price is twice what it was).

a. What happens to the equilibrium price and quantity in each market?b. Which product experiences a larger change in quantity?c. Which product experiences a larger change in price?d. What happens to total consumer spending on each product?

Price Controls1. Suppose it is decided that rent control in New York City will be abolished and that market

rents will now prevail. Assume that all rental units are identical and so are offered at the same rent. To address the plight of residents who may be unable to pay the market rent, an

1060 Hixson-Lied Student Success Center v 515-294-6624 v sistaff@iastate.edu v http://www.si.iastate.edu

Exam 2 ReviewSupplemental InstructionIowa State University (pg. 2)

Leader: LuisCourse: Econ 101

Instructor:Date:

income supplement will be paid to all low-income households equal to the difference between the old controlled rent and the new market rent.

a. Use a diagram to show the effect on the rental market of the elimination of rent control. What will happen to the quality and quantity of rental housing supplied?

b. Use a second diagram to show the additional effect of the income0supplement policy on the market. What effect does it have on the market rent and quantity of rental housing supplied in comparison to your answers to part (a)?

c. Are tenants better or worse off as a result of these policies? Are landlords better or worse off? Is society as a whole better or worse off?

d. From a political standpoint, why do you think cities have been more likely to resort to rent control rather than a policy of income supplements to help low-income people pay for housing?

2. In order to ingratiate himself with voters, the mayor of Gotham City decides to lower the price of taxi rides. Assume for simplicity, that all taxi rides are the same distance and therefor cost the same. The accompanying table shows the demand and supply schedules for taxi rides.

a. Assume that there are no restrictions on the number of taxi rides that can be supplied (no medallion system). Find the equilibrium price and quantity.

b. Suppose that the mayor sets a price ceiling at $5.50. How large is the shortage of rides? Illustrate with a diagram. Who loses and who benefits from this policy?

c. Suppose that the stock market crashes and, as a result, people in Gotham City are poorer. This reduces the quantity of taxi rides demanded by 6 million rides per year at any given price. What effect will the mayor’s new policy have no? Illustrate with a diagram.

d. Suppose that the stock market rises and the demand for taxi rides returns to normal (that is, returns to the demand schedule given in the table). The mayor now decides to ingratiate himself with taxi drivers. He announces a policy in which operating licenses are given to existing taxi drivers; the number of licenses is restricted such that only 10 million rides per year can be given. Illustrate the effect of this policy on the market, and indicate the resulting price and quantity transacted. What is the quota rent per ride?

3. Suppose the federal government requires beer drinkers to pay an $2 tax on each case of beer purchased.

a. Draw a supply-demand diagram of the market for beer without the tax. Show the price paid by consumers, the price received by producers, and the quantity of beer

1060 Hixson-Lied Student Success Center v 515-294-6624 v sistaff@iastate.edu v http://www.si.iastate.edu

Exam 2 ReviewSupplemental InstructionIowa State University (pg. 3)

Leader: LuisCourse: Econ 101

Instructor:Date:

sold. What is the difference between the price paid by consumers and the price received by producers?

b. Now draw a supply-demand diagram for the beer market with the tax, Show the price paid by consumers, the price received by producers, and the quantity of beer sold. What is the difference between the price paid by consumers and the price received by producers? Has the quantity of beer sold increased or decreased?

4. A senator wants to raise tax revenue and make workers better off. A staff member proposes raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by workers. Would this accomplish the senator’s goal? Explain.

5. Congress and the next president decide that the United States should reduce air pollution by reducing its use of gasoline. They impose a $0.50 tax for each gallon of gasoline sold.

a. Should they impose this tax on producers or consumers? Explain carefully using a supply-demand diagram.

b. If the demand for gasoline were more elastic, would this tax be more effective or less effective in reducing the quantity of gasoline consumed? Explain with words and a diagram.

c. Are consumers of gasoline helped or hurt by this tax? Why?d. Are workers in the oil industry helped or hurt by this tax? Why?

6. In the spring of 2008, Senators John McCain and Hillary Clinton proposed a temporary elimination of the federal gasoline tax, effective only during the summer of 2008, in order to help consumers deal with high gasoline prices.

a. During the summer, when gasoline demand is high because of vacation driving, gasoline refiners are operating near full capacity. What does this fact suggest about the price elasticity of supply?

b. Who do you predict would benefit from the temporary gas tax holiday, given the answer to (a)?

Surpluses

1. The cost of producing flat-screen TVs has fallen over the past decade.a. Draw a supply-demand diagram to show the effect of falling production costs on the

price and quantity of flat-screen TVs sold.b. In your diagram, show what happens to consumer surplus and producer surplus.c. Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling

production costs – consumers or producers of the TVs?2. Hollywood screenwriters negotiate a new agreement with movie producers stipulating that

they will receive 10% of the revenue from every video rental of a movie they authored. They have no such agreement for moview shown on on-demand television.

a. When the new writers’ agreement comes into effect, what will happen in the market for video rentals (curve shift)? As a result, how will consumer surplus in the market for video rentals change? Illustrate with a diagram. Do you think writers’ agreement will be popular with consumers who rent videos?

b. Consumers consider video rentals and on-demand movies substitutable to some extent. When the new writers’ agreement comes into effect, what will happen in the market for on-demand movies (curve shift)? As a result, how ill producer surplus in

1060 Hixson-Lied Student Success Center v 515-294-6624 v sistaff@iastate.edu v http://www.si.iastate.edu

Exam 2 ReviewSupplemental InstructionIowa State University (pg. 4)

Leader: LuisCourse: Econ 101

Instructor:Date:

the market for on-demand movies change? Illustrate with a diagram. Do you think the writers’ agreement will be popular with cable television companies that show on-demand movies?

Taxes

1. The market for pizza is characterized by a downward-sloping demand curve and an upward-sloping supply curve.

a. Draw the competitive market equilibrium. Label the price, quantity, consumer and producer surplus. Is there any deadweight loss? Explain.

b. Suppose that the government forces each pizzeria to play a $1 tax on each pizza sold. Illustrate the effect of this tax on the pizza market, being sure to label the consumer and producer surplus, government revenue, and deadweight loss. How does each area compare to the pre-tax case?

c. If the tax were removed, pizza eaters and sellers would be better off, but the government would lose tax revenue. Suppose that consumers and producers voluntarily transferred some of their gains to the government. Could all parties (including the government) be better off than they were with the tax? Explain using the graphs.

2. Evaluate the following two statements. Do you agree? Why or why not?a. “A tax that has no deadweight loss cannot raise any revenue for the government.”b. “A tax that raises no revenue for the government cannot have any deadweight loss.”

3. For the market of rubber bands.a. If this market has very elastic supply and very inelastic demand, how would the

burden of a tax on rubber bands be shared between consumers and producers? Use the tools of consumer and producer surplus in your answer.

b. If this market has very inelastic supply and very elastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers? Contrast your answer to part (a).

4. Suppose that the government imposes a tax on heating oil.a. Would the deadweight loss from this tax likely be greater in the first year after its

imposed or in the fifth year? Explain.b. Would the revenue collected from this tax likely be greater in the first year after its

imposed or in the fifth year? Explain.5. Suppose the government currently raises $100 million through a 1-cent tax on widgets, and

another $100 million through a 10-cent tax on gadgets. If the government doubled the tax rate on widgets and eliminated the tax on gadgets, would it raise more, less, or equal tax revenue than it does today? Explain.

6. In the United States, each state government can impose its own excise tax on the sale of cigarettes. Suppose that in the state of North Texarkana, the state government imposes a tax of $2 per pack sold within the state. In contrast, the neighboring state of South Texarkana imposes no excise tax on cigarettes. Assume that the total cost to a resident of North Texarkana to smuggle a pack of cigarettes from South Texarkana is $1.85 a pack. Assume that the supply curve for cigarettes is neither perfectly elastic nor perfectly inelastic.

1060 Hixson-Lied Student Success Center v 515-294-6624 v sistaff@iastate.edu v http://www.si.iastate.edu

Exam 2 ReviewSupplemental InstructionIowa State University (pg. 5)

Leader: LuisCourse: Econ 101

Instructor:Date:

a. Draw a diagram of the supply and demand curves for cigarettes in North Texarkana showing a situation in which it makes economic sense for a s North Texarkanan to smuggle a pack of cigarettes from South Texarkana to North Texarkana. Explain your diagram.

b. Draw a corresponding diagram showing a situation in which it does not make economic sense for a North Texarkanan to smuggle a pack of cigarettes from South Texarkana to North Texarkana. Explain your diagram.

c. Suppose the demand for cigarettes in North Texarkana is perfectly inelastic. How high could the cost of smuggling a pack of cigarettes go until a North Texarkanan no longer found it profitable to smuggle?

International Trade

1. Mexico represents a small part of the world orange market.a. Draw a diagram depicting the equilibrium in the Mexican orange market without

international trade. Identify the equilibrium price, equilibrium quantity consumer and producer surplus.

b. Suppose that the world orange price is below the Mexican price before trade and that the Mexican orange market is now opened to trade. Identify the new equilibrium price, quantity consumed, quantity produced domestically, and quantity imported. Also show the change in the surplus of domestic consumers and producers. Has total surplus increased or decreased?

2. The world price of wine is below the price that would prevail in Canada in the absence of trade.

a. Assuming that Canadian imports of wine are a small part of total world wine production, draw a graph for the Canadian market for wine under free trade. Identify consumer surplus, producer surplus, and total surplus in an appropriate table.

b. Now suppose that an unusual shift of the Gulf Stream leads to an unseasonable cold summer in Europe, destroying much of the grape harvest there. What effect does this shock have on the world price of wine? Show the effect on consumer, producer, and total surplus in Canada. Who are the winners and losers? Is Canada as a whole better or worse off?

3. Suppose Congress imposes a tariff on imported autos to protect the US auto industry from foreign competition. Assuming that the United States is a price taker in the world auto market, show the following on a diagram: The change in the quantity of imports, the loss to US consumers, the gain to US manufacturers, government revenue, and the deadweight loss associated with tariff. The loss to consumers can be decomposed into three pieces: a gain to domestic producers, revenue for the government, and a deadweight loss. Use your diagram to identify these three pieces.

4. Imagine that winemakers in the state of Washington petitioned the state government to tax wines imported from California. They argue that this tax would both raise tax revenue for the state government and raise employment in the Washington state wine industry. Do you agree with these claims? Is it a good policy?

1060 Hixson-Lied Student Success Center v 515-294-6624 v sistaff@iastate.edu v http://www.si.iastate.edu

Exam 2 ReviewSupplemental InstructionIowa State University (pg. 6)

Leader: LuisCourse: Econ 101

Instructor:Date:

Externalities

1. Consider two ways to protect your car from theft. The Club (a steering wheel lock) makes it difficult for a car thief to take your car. Lojack (a tracking system) makes it easier for the police to catch the car thief who has stolen it. Which of these types of protection conveys a negative externality on other car owners? Which conveys a positive externality? Do you think there are any policy implications of your analysis?

2. Consider the market for fire extinguishers.a. Why might fire extinguishers exhibit positive externalities?b. Draw a graph of the market for fire extinguishers, labeling the demand curve, the

social-value curve, the supply curve, and the social-cost curve.c. Indicate the market equilibrium level of output and the efficient level of output.d. Indicate the market equilibrium level of output and the efficient level of output. Give

an intuitive explanation for why these quantities differ.e. If the external benefit is $10 per extinguisher, describe a government policy that

would yield the efficient outcome.3. Greater consumption of alcohol leads to more motor vehicle accidents, and, thus, imposes

costs on people who do not drink and drive.a. Illustrate the market for alcohol, labeling the demand curve, the social-value curve,

the social-cost curve, the supply curve, the market equilibrium level of output, and the efficient level of output.

b. On your graph, shade the area corresponding to the deadweight loss of the market equilibrium. Explain.

4. Suppose that the government decides to issue tradable permits for a certain form of pollution.a. Does it matter for economic efficiency whether the government distributes or

auctions the permits? Why or why not?b. If the government chooses to distribute the permits, does the allocation of permits

among first matter for efficiency? Explain.

1060 Hixson-Lied Student Success Center v 515-294-6624 v sistaff@iastate.edu v http://www.si.iastate.edu