Consumer surplus declines.

EXAM IN MICROECONOMICS

RETAKE

(February, 2009)

SOLUTIONS

Section 2. Free response questions.

You will have a total of 60 minutes for this section of the exam. It is strongly recommended that you spend the first 10 minutes reading the exam carefully, and the next 50 minutes working on the questions.

Please, start your answer for each question on a separate page.

1.(30 points) Assume that initially there is an unregulated competitive market for cigarettes, with linear supply and demand curves, both price-inelastic at the initial market price. The government has decided to discourage smoking and is considering three possible policies that would reduce the quantity sold (by the same amount in each case). The three policies are:

(1) a per unit tax on cigarettes;

(2) a law setting a minimum price for cigarettes (assume it is above the equilibrium price);

(3) a quota limit imposed on producers output (assume it is below the equilibrium output).

Using graphical illustrations (separate for each policy) show the effects of the policies on

A. consumer surplus

B. producer surplus

C. government revenue

D. deadweight loss.

Answer:

(1)

A. Consumer surplus before tax: P0E0Z

Consumer surplus after tax: P1E1Z

Consumer surplus declines.

B. Producer surplus before tax: P₀E₀X₀

Producer surplus after tax: P₁E₁X₁=YWX₀

Producer surplus declines.

C. Government revenue before tax = 0

Government revenue after tax P1E1WY

D. No deadweight loss before tax, E1E0W after tax.

(2)

A. Consumer surplus before minimum price policy: P0E0Z

Consumer surplus after minimum price policy: PminKZ

Consumer surplus declines.

B. Producer surplus before minimum price policy: P₀E₀X₀

Producer surplus after minimum price policy: P_minKW X₀