Questions week 2

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Questions week 2

• Introductory Economics for the Treasury
• Dr. Paul Frijters

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• 1. Why doesnt your local supermarket ask 100
  dollar for a bottle of milk, even though it is
  worth 100 dollars for some customers.
• Standard answer because it fears those customers
  will go to another supermarket when you would
  charge that price.
• 2. Is the demand for cigarettes elastic or rather
  inelastic? Why do you think so?
• Inelastic. Its addictive, its consumption.
• 3. On whom does an externality occur if
• - I dam a river to keep all the water for my
  land. Anyone else who needs water.
• - I smoke. Those inhaling around me.
• - A company builds a bridge. Anyone using it or
  being confronted with one (e.g. boats). This
  could be no-one if only the company uses it.

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• 4. Why does the government produce many things
  that lead to externalities, whilst it in
  principle can hire others to do so? Specific
  products to be discussed dikes, defense, police,
  street lights.
• Standard answer because it believes itself to be
  more efficient at producing it than another
  entity, especially defense and police. Economies
  of scale underlie this.
• 5. Give an example of an Australian private
  monopoly or oligopoly.
• Mining companies. Qantas on some lines etc.
• 6. Suppose the social value of picking up a tin
  can from a park is 10 cents. Why is it unlikely
  that the government would offer 10 cents for
  every tin picked up from parks?
• The costs of monitoring such a program would be
  more than 10 cents per can.

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Application 1Lemons and Lemonade

• A plant disease in South Australia damages the
  lemon crop. What happens to consumer surplus in
  the market for lemons?
• What then happens in the market for lemonade?
• Illustrate the answers with diagrams

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Consumer Surplus in the Market for Lemons
Consumer surplus decreases
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Consumer Surplus in the Market for Lemonade
Lemons are an intermediary in the production of
lemonade. Hence the supply curve of lemonade also
shifts when lemons become more expensive, and
hence surplus decreases.
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Application 2Changing Market for Computers

• The cost of producing computers has fallen
  substantially over the past decade.
• Use a supply-and-demand analysis to show the
  effect of falling production costs on price and
  quantity. What happens to consumer and produce
  surplus?
• Suppose the supply of computers is very
  inelastic. Who benefits most from falling
  production costs consumers or producers?

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Consumer and Producer Surplus in the Market for
Computers
Consumer surplus clearly increases (area below
demand curve and above the price), as does
producer surplus in this example (area below
price and above supply). Producer surplus may
however also decrease. Key here is downward shift
of supply curve.
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Consumer and Producer Surplus in the Market for
Computers
The case of inelastic supply.
Price
Supply old
Supply new
Price before
Price after
Demand
Quantity
0
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Consumer and Producer Surplus in the Market for
Computers
The case of inelastic supply.
Price
Supply old
Supply new
Price before
A
C
Price after
Demand
B
Quantity
0
Extra consumer surplus AC. Extra producer
surplus B-A
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Conclusion on computers
The inelasticity question has an ambiguous
answer consumers clearly benefit, but whether
producers benefit or not cannot be ascertained.
In the extreme case of perfectly inelastic
supply, nothing changes with reduced production
costs because the supply curve does not
shift. One may additionally notice that the case
of very inelastic supply usually only arises if
there is a fixed amount of the good to be
supplied, and hence where there are no production
costs. Having falling production costs and
inelastic supply is hence an outlandish case.