Jagannath University

Course Title - Managerial Economics

Course Code – 6204

Assignment On - Solving of 4th, 5th, 6th, 7th Chapter Questions

Submission Date – 27/11/2020

Submitted To:
Ayesha Akter

Assistant Professor

Department of Finance

Jagannath University

Submitted by:
Manabica Datta
ID NO: M20190203362

Batch: 19th, Section: B

Department of Finance
 Chapter 4
The Market Forces of Supply and Demand
Question for review:
Question 1: what is a competitive market? Briefly describe a type of market that is not
perfectly competitive.
Answer: Competitive market is a market in which there are so many buyers and so many sellers
that each has a negligible impact on the market price. In a competitive market no single producer
and no single consumer cannot dictate how the market operates.
Monopoly is the market which is not perfectly competitive because there is only single seller
who exploits the buyers by charging higher price of its products due to non-availability of
substitutes.
Question 2: What are the demand schedule and the demand curve, how are they related?
Why does the demand curve slope downward?
Answer: Demand schedule: A table that shows the relationship between the price of a good and
the quantity demanded.

Price of a ice-cream cone Quantity of cones demanded

$0.00 10
0.50 8
1.00 6
1.50 4
2.00 2
2.50 0
 Demand curve: A graph that shows the relationship between the price of a good and
the quantity demanded.

Price of cones

2.5

2.0
1.5
Decreases
in price
1.00
Demand
0.5

0 2 4 6 8 Quantity of demand

Increases in quantity

Demand curve slopes downward because a lower price increases the quantity demanded.
Question 3: Does a change in consumers tastes lead to a movement along the demand curve
or shift in the demand curve? Does a change in price lead to a movement along the demand
curve or a shift in the demand curve?
Answer: The most obvious determinant of demand is consumer’s tastes. If consumers like any
product like ice-cream, they will buy more of it. So, consumer’s tastes shift the demand curve. A
change in taste will change the price of a good. A change in price will lead to movement along
the demand curve the change in price will move the intersection of the supply and demand curve
along the demand curve and thus the equilibrium price.
Question 4: Popeye’s income declines, and as a result he buys more spinach. Is spinach an
inferior or normal good? What happens to Popeye’s demand curve for spinach?
Answer: A lower income means that consumers have less to spend in total, so we would have to
spend less on some- and probably most goods. But a good for which, other things equal, demand
of a good rises when income falls is called Inferior good.
Popeye’s income declines and as a result, they buys more spinach. So the spinach is inferior
good. Because Popeye’s buy more spinach in their decreasing income.
We know any change that raises the quantity that buyers wish to purchase at any given price
shifts the demand curve to the right. When Popeye’s purchase more spinach at given price their
demand curve shift and the demand curve shift in right because of increasing demand
Question 5: What are the supply schedule and the supply curve and how they are related?
Why does the supply curve upward?
Answer: Supply schedule: A table that shows the relationship between the price of a good and
the quantity supplied.
Supply curve: A graph of the relationship between the price of a good and the quantity supplied.
Supply schedule interact with supply curve. Supply schedule variables shift the supply curve.
Shown below:
Supply schedule:
Price of ice-cream cones Quantity of cones supplied
$ 0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4

Supply curve:

Price of
ice-cream
cones

Supply curve
2.5

Increase 2.00
in price
1.50

1.00

0.50

0 1 2 3 4 5 Quantity of cones

Increase quantity of cones supplied

The supply curve slopes upward because a higher price increases the quantity of supplied.
 Question 6: Does a change in producer’s technology leads to a movement along the supply
curve or a shift in the supply curve? Does a change in price lead to a movement along the
supply curve or a shift in the supply curve?
Answer: A change to the technology a producer is using causes the supply curve to shift as this
will change the efficiency of production causing the price of production to change. A change in
price will lead to a move along the supply curve as the supply curve represents the market
demand given all other variables staying the same other than a change in price.
Question 7: Define the equilibrium of a market. Describe the forces that move a market
towards its equilibrium.
Answer: Equilibrium a situation in which the market price has reached the level at which
quantity supplies equals quantity demanded. At the equilibrium price, the quantity of the good
that buyers are willing and able to buy exactly balances the quantity that sellers are willing and
able to sell. The equilibrium price is sometimes called the market-clearing price because, at this
price, everyone in the market has been satisfied. Buyers have bought all they want to buy, and
sellers have sold all they want to sell.
The actions of buyers and sellers naturally move markets toward the equilibrium of supply and
demand. Suppose at a price of $2.50 per cone the quantity of supplied 10 cones where demand is
4 cones. There is a surplus of the good. Another at a price of $1.50 per cone ice-cream the
quantity of demand 6 cones where the supply is 4 cones. There is a shortage of the good. When
surplus create, suppliers try to increase sales by cutting the price of a cone and this moves the
price toward its equilibrium level. Again shortage create, buyers have to wait in long lines for a
chance to buy one of the few cones available. With too many buyers chasing too few goods,
sellers can respond to the shortage by raising their prices without losing sales. In this time the
price of per cone $2.00, demand 7 cones and supply also 7 cones. In this price, supply and
demand curve intersect. Here the equilibrium price is $2.00. Graph shown below:

Price of
ice-
cream
cone Supply

Equilibriu
m price $2.00 Equilibrium

Deman

Quantity of ice-cream
0 123456789101112
cones
Equilibrium Quantity
Question 8: Beer and pizza are complements because they are often enjoyed together.
When the price of beer rises, what happens to the supply, demand, quantity supplied,
quantity demanded and the price in the market for pizza?

Answer: When the price of beer rises, the demand for pizza declined, because beer and pizza are
complements and people want to buy less beer. When we say the demand for pizza declines, we
mean that the demand curve for pizza shifts to the left as in the figure. The supply curve for pizza
is not affected. With a shift to the left in the demand curve, the equilibrium price and quantity
both decline, as the figure shows. Thus, the quantity of pizza supplied and demanded both fall. In
sum, supply is unchanged, demand is decreased, quantity supplied declines, quantity demanded
declines, and the price falls.

Price
S
of
pizza

D1

D2
Quantity of pizza

Question 9: Describe the role of prices in market economics.

Answer: Price plays a vital role in market economies because they bring markets into
equilibrium. Price aces as a signal for shortages and surpluses which help firms respond to
changing market conditions. If the price is different from its equilibrium level, quantity supplied
and quantity demanded are not equal. The resulting surplus or shortage leads suppliers to adjust
the price until equilibrium is restored. Prices serve as signals that guide economic decisions and
allocate scarce resources.

Problems and Applications:

1. Explain each of the following statements using supply-and-demand diagrams.
a) ―When a cold snap hits Florida, the price of orange juice rises in supermarkets
throughout the country.‖
b) ―When the weather turns warm in New England every summer, the price of
hotel rooms in Caribbean resorts plummets.‖
 c) ―When a war breaks out in the Middle East, the price of gasoline rises, and the
price of a used Cadillac falls.‖
Answer: a) Cold weather damages the orange crop, reducing the supply of oranges. This can be
seen in graph as a shift to the left in the supply curve for oranges. The new equilibrium price is
higher than the old equilibrium price.

S2
S1

Price of
Oranges

Quantity of oranges

Figure: 01

B) People often travel to the Caribbean from New England to escape cold weather, so the
demand for Caribbean hotel rooms is high in the winter. In the summer, fewer people travel to
the Caribbean, because northern climes are more pleasant. The result, as shown in graph, is a
shift to the left in the demand curve. The equilibrium price of Caribbean hotel rooms is thus
lower in the summer than in the winter, as the graph figure shows.

Price of
Caribbean
hotel
rooms

D1
D2

Quantity of Caribbean hotel

rooms
Figure: 02
C) When a war breaks out in the Middle East, many markets are affected. Because a large
proportion of oil production takes place there, the war disrupts oil supplies, shifting the supply
curve for gasoline to the left, as shown in graph. The result is a rise in the equilibrium price of
gasoline. With a higher price for gasoline, the cost of operating a gas-guzzling automobile like a
Cadillac will increase. As a result, the demand for used Cadillac’s will decline, as people in the
market for cars will not find Cadillac as attractive. In addition, some people who already own
Cadillac will try to sell them. The result is that the demand curve for used Cadillac shifts to the
left, while the supply curve shifts to the right, as shown in the graph. The result is a decline in the
equilibrium price of used Cadillac.

S1
S
S2
S1
Price of Price of
Gasoline used
Cadillac

D1
D2
D
Quantity of used Cadillac
Quantity of gasoline

Figure: 03

2. ―An increase in the demand for notebooks raises the quantity of notebooks
demanded but not the quantity supplied.‖ Is this statement true or false? Explain.
Answer: The statement that "an increase in the demand for notebooks raises the quantity of
notebooks demanded, but not the quantity supplied," in general, is false. As figure 04 show, the
increase in demand for notebooks results in an increased quantity supplied. The only way the
statement would be true is if the supply curve was a vertical line, as shown in Figure 05.
 S
S

Price of
Price of
notebooks notebooks

D2
D2 D1
D1
Quantity of notebooks
Quantity of
notebooks

Figure: 04 Figure: 05

3. Consider the market for minivans. For each of the events listed here, identify which of
the determinants of demand or supply are affected. Also indicate whether demand or
supply increases or decreases. Then draw a diagram to show the effect on the price and
quantity of minivans.
a. People decide to have more children.
b. A strike by steelworkers raises steel prices.
c. Engineers develop new automated machinery for the production
of minivans.
d. The price of sports utility vehicles rises.
e. A stock-market crash lowers people’s wealth.

Answer: a) If people decide to have more children, they will want larger vehicles for
hauling their kids around, so the demand for minivans will increase. Supply will not be
affected. The result is a rise in both the price and the quantity sold, as Figure 06 shows.
 S

Price of
minivans

D2
D1

Quantity of minivans

Figure: 06

B) If a strike by steelworkers raises steel prices, the cost of producing a minivan rises and the
supply of minivans decreases. Demand will not be affected. The result is a rise in the price of
minivans and a decline in the quantity sold, as Figure 07 shows.

S2
S1

Price of
minivans

Quantity of minivans

Figure: 07

C) The development of new automated machinery for the production of minivans is an

improvement in technology. This reduction in firms' costs will result in an increase in supply.
Demand is not affected. The result is a decline in the price of minivans and an increase in the
quantity sold, as Figure 08 shows.
 S2

Price of S1
minivans

Quantity of minivans

Figure: 08

D) The rise in the price of sport utility vehicles affects minivan demand because sport utility
vehicles are substitutes for minivans. The result is an increase in demand for minivans. Supply is
not affected. The equilibrium price and quantity of minivans both raise, as Figure 06 shows.
E) The reduction in peoples' wealth caused by a stock-market crash reduces their income,
leading to a reduction in the demand for minivans, because minivans are likely a normal good.
Supply is not affected. As a result, both the equilibrium price and the equilibrium quantity
decline, as Figure 09 shows.

S
Price of
minivans

D1
D2

Quantity of minivans

Figure: 09

4. Consider the markets for DVDs, TV screens, and tickets at movie theaters.
a. For each pair, identify whether they are complements or substitutes:
  DVDs and TV screens
 DVDs and movie tickets
 TV screens and movie tickets
b. Suppose a technological advance reduces the cost of manufacturing
TV screens. Draw a diagram to show what happens in the market for TV
screens.
c. Draw two more diagrams to show how the change in the market for
TV screens affects the markets for DVDs and movie tickets.
Answer: A) DVDs and TV screens are likely to be complements because you cannot watch a
DVD without a television. DVDs and movie tickets are likely to be substitutes because a movie
can be watched at a theater or at home. TV screens and movie tickets are likely to be substitutes
for the same reason.
B) The technological improvement would reduce the cost of producing a TV screen, shifting the
supply curve to the right. The demand curve would not be affected. The result is that the
equilibrium price will fall, while the equilibrium quantity will rise. This is shown in graph.

S1

Price
of TV
screen S2

Quantity of TV screen

Figure: 10
C) The reduction in the price of TV screens would lead to an increase in the demand for DVDs
because TV screens and DVDs are complements. The effect of this increase in the demand for
DVDs is an increase in both the equilibrium price and quantity, as shown in graph.
 S
Price
of
DVD
s

D2
D1

Quantity of DVDs

Figure: 11

D) The reduction in the price of TV screens would cause a decline in the demand for movie
tickets because TV screens and movie tickets are substitute goods. The decline in the demand for
movie tickets would lead to a decline in the equilibrium price and quantity sold. This is shown in
graph.

Price of S
movie
tickets

D1

D2

Quantity of movie tickets

Figure: 12
5. Over the past 30 years, technological advances have reduced the cost of computer chips.
How do you think this has affected the market for computers? For computer software?
For typewriters?
Answer: Technological advances that reduce the cost of producing computer chips represent a
decline in an input price for producing a computer. The result is a shift to the right in the supply
of computers, as shown in Figure 13. The equilibrium price falls and the equilibrium quantity
rises, as the figure shows.

S1

Price of
computers S2

Quantity of computers

Figure: 13
6. Using supply-and-demand diagrams show the effect of the following events on the
market for sweatshirts. a. A hurricane in South Carolina damages the cotton crop. b.
The price of leather jackets falls. c. All colleges require morning exercise in
appropriate attire. d. New knitting machines are invented.
Answer: A) When a hurricane in South Carolina damages the cotton crop, it raises input prices
for producing sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in
Figure 16. The new equilibrium price is higher and the new equilibrium quantity of sweatshirts is
lower.

S2

Price of S1
sweatshirts

Figure: 14 Quantity of Sweatshirts

B) A decline in the price of leather jackets leads more people to buy leather jackets, reducing the
demand for sweatshirts. The result, shown in Figure 17, is a decline in both the equilibrium price
and quantity of sweatshirts.

S
Price of
sweatshirts

D1
D2

Quantity of sweatshirts

Figure: 15
C) The effects of colleges requiring students to engage in morning exercise in appropriate attire
raises the demand for sweatshirts, as shown in Figure 18. The result is an increase in both the
equilibrium price and quantity of sweatshirts.

S
Price of
sweatshirts

D2
D1

Quantity of sweatshirts

Figure: 16
D) The invention of new knitting machines increases the supply of sweatshirts. As Figure 19
shows, the result is a reduction in the equilibrium price and an increase in the equilibrium
quantity of sweatshirts.
 S1

S2
Price of
sweatshirts

Quantity of sweatshirts

Figure: 17

7. A survey shows an increase in drug use by young people. In the ensuing debate,
two hypotheses are proposed:
 Reduced police efforts have increased the availability of drugs on the street.
 Cutbacks in education efforts have decreased awareness of the dangers of
drug addiction.
i. Use supply-and-demand diagrams to show how each of these
hypotheses could lead to an increase in quantity of drugs consumed.
ii. How could information on what has happened to the price of drugs
help us to distinguish between these explanations?
Answer: i) Reduced police efforts would lead to an increase in the supply of drugs. As Figure 20
shows, this would cause the equilibrium price of drugs to fall and the equilibrium quantity of
drugs to rise. On the other hand, cutbacks in education efforts would lead to a rise in the demand
for drugs. This would push the equilibrium price and quantity up, as shown in Figure 20.

S1
S
Price
S2 Price
of of
illega illegal
l drugs
D2
D D1

Quantity of illegal drugs

Quantity of
illegal drugs
Figure:18&19
ii). A fall in the equilibrium price would lead us to believe the first hypothesis. If the equilibrium
price rose, we would believe the second hypothesis.
8. Suppose that in the year 2015 the number of births is temporarily high. How does this
baby boom affect the price of babysitting services in 2020 and 2030? (Hint: 5-year-
olds need babysitters, whereas 15-year-olds can be babysitters.)
Answer: A temporarily high birth rate in the year 2010 leads to opposite effects on the price of
babysitting services in the years 2020 and 2030. In the year 2015, there are more five-year olds
who need sitters, so the demand for baby-sitting services rises, as shown in Figure 20. The result
is a higher price for baby-sitting services in 2015. However, in the year 2025, the increased
number of 15-year-olds shifts the supply of baby-sitting services to the right, as shown in Figure
21. The result is a decline in the price of baby-sitting services.

S S1
Price of
babysitting Price of S2
services babysitting
services

D2 D
D1

Quantity of Quantity of
babysitting babysitting
services services

Figure: 20 & 21

9. Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot
dogs rises, what happens to the market for ketchup? For tomatoes? For tomato juice?
For orange juice?
Answer: Ketchup is a complement for hot dogs. Therefore, when the price of hot dogs rises, the
quantity demanded of hot dogs falls and this lowers the demand for ketchup. The end result is
that both the equilibrium price and quantity of ketchup fall. Because the quantity of ketchup
falls, the demand for tomatoes by ketchup producers falls, so the equilibrium price and quantity
of tomatoes fall. When the price of tomatoes falls, producers of tomato juice face lower input
prices, so the supply curve for tomato juice shifts out, causing the price of tomato juice to fall
and the quantity of tomato juice to rise. The fall in the price of tomato juice causes people to
substitute tomato juice for orange juice, so the demand for orange juice declines, causing the
price and quantity of orange juice to fall. Now you can see clearly why a rise in the price of hot
dogs leads to a fall in the price of orange juice.
10. The market for pizza has the following demand and supply schedules:
Price Quantity Quantity
Demand Supplied
$4 135 Pizzas 26 Pizzas
5 104 53
6 81 81
7 68 98
8 53 110
9 39 121
a) Graph the demand and supply curves. What is the equilibrium price
and quantity in this market?
b) If the actual price in this market were above the equilibrium price, what would
drive the market toward the equilibrium?
c) If the actual price in this market were below the equilibrium price, what would
drive the market toward the equilibrium?
Answer: The market for pizza has the following demand and supply schedules:
A) Equilibrium price = $6
Equilibrium quantity = 81

Figure: 22

B) If the actual price in this market were above the equilibrium price, what would drive the
market toward the equilibrium? The pizza seller would have to lower the price to get some of the
excess supply out of the store. This increases the quantity demand and the price will continue to
fall until equilibrium is reached.
C) If the actual price in this market were below the equilibrium price, what would drive the
market toward the equilibrium? There would end up being a shortage in the pizza supply or
excess demand. If the pizza seller raises prices then the demand will go back down and the
quantity supplied will rise, this will get them back to equilibrium.

11. Consider the following events: Scientists reveal that consumption of oranges decreases
the risk of diabetes, and at the same time, farmers use a new fertilizer that makes
orange trees more productive. Illustrate and explain what effect these changes have
on the equilibrium price and quantity of oranges.
Answer: The news of the increased health benefits from consuming oranges will increase the
demand for oranges, increasing both the equilibrium price and quantity. If farmers use a new
fertilizer that makes orange trees more productive, the supply of oranges will increase, leading to
a fall in the equilibrium price but a rise in the equilibrium quantity. If both occur at the same
time, the equilibrium quantity will definitely rise, but the effect on equilibrium price will be
ambiguous.
See completed diagram in figure 23:
S refers supply
D refers demand and F refers equilibrium

Price D2
S1
D1
S2

E2
E1

Quantity

Figure: 23
12. Because bagels and cream cheese are often eaten together, they are complements.
a) We observe that both the equilibrium price of cream cheese and the equilibrium
quantity of bagels have risen. What could be responsible for this pattern—a fall
in the price of flour or a fall in the price of milk? Illustrate and explain your
answer.
 b) Suppose instead that the equilibrium price of cream cheese has risen but the
equilibrium quantity of bagels has fallen. What could be responsible for this
pattern— a rise in the price of flour or a rise in the price of milk? Illustrate and
explain your answer.
Answer: A) Because flour is an ingredient in bagels, a decline in the price of flour would shift
the supply curve for bagels to the right. The result, shown in Figure 26, would be a fall in the
price of bagels and a rise in the equilibrium quantity of bagels.

S1
S2
Price of
bagels

Quantity of bagels
Figure: 24

Because cream cheese is a complement to bagels, the fall in the equilibrium price of bagels
increases the demand for cream cheese, as shown in Figure 25. The result is a rise in both the
equilibrium price and quantity of cream cheese. So, a fall in the price of flour indeed raises both
the equilibrium price of cream cheese and the equilibrium quantity of bagels.

S
Price of
cream
cheese

D2
D1

Quantity of cream cheese

Figure: 25

What happens if the price of milk falls? Because milk is an ingredient in cream cheese, the fall in
the price of milk leads to an increase in the supply of cream cheese. This leads to a decrease in
the price of cream cheese (Figure 26), rather than a rise in the price of cream cheese. So a fall in
the price of milk could not have been responsible for the pattern observed.
 Price of S1
cream
cheese S2

Quantity of cream cheese

Figure: 26

B) In part (a), we found that a fall in the price of flour led to a rise in the price of cream cheese
and a rise in the equilibrium quantity of bagels. If the price of flour rose, the opposite would be
true; it would lead to a fall in the price of cream cheese and a fall in the equilibrium quantity of
bagels. Because the question says the equilibrium price of cream cheese has risen, it could not
have been caused by a rise in the price of flour.
What happens if the price of milk rises? From part (a), we found that a fall in the price of milk
caused a decline in the price of cream cheese, so a rise in the price of milk would cause a rise in
the price of cream cheese. Because bagels and cream cheese are complements, the rise in the
price of cream cheese would reduce the demand for bagels, as Figure 27 shows. The result is a
decline in the equilibrium quantity of bagels. So a rise in the price of milk does cause both a rise
in the price of cream cheese and a decline in the equilibrium quantity of bagels.

S
Price
of
bagels

D1
D2

Figure: 27
Quantity of bagels
13. Suppose that the price of basketball tickets at your college is determined by
market forces. Currently, the demand and supply schedules are as follows:
Price Quantity Quantity
Demanded Supplied
$4 10,000 Tickets 8,000 Tickets
8 8000 8000
12 6000 8000
16 4000 8000
20 2000 8000
a) Draw the demand and supply curves. What is unusual about this supply
curve? Why might this be true?
b) What are the equilibrium price and quantity of tickets?
c) Your college plans to increase total enrollment next year by 5,000 students. The
additional students will have the following demand schedule:
Price Quantity
Demanded
$4 4000 Tickets
8 3000
12 2000
16 1000
20 0

Now add the old demand schedule and the demand schedule for the new
students to calculate the new demand schedule for the entire college.
What will be the new equilibrium price and quantity?
Answer: A) As Figure 28 shows, the supply curve is vertical. The constant quantity supplied
makes sense because the basketball arena has a fixed number of seats at any price.

Price of S
basketball
tickets

$8

Figure: 28 8000 Quantity of basketball

tickets
13. B) Quantity supplied equals quantity demanded at a price of $8. The equilibrium quantity is
8, 000 tickets.
13. C)

Price Quantity Demanded Quantity Supplied

$4 14,000 8,000
$8 11,000 8,000
$12 8,000 8,000
$16 5,000 8,000
$20 2,000 8,000

The new equilibrium price will be $12, which equates quantity demanded to quantity supplied.
The equilibrium quantity remains 8,000 tickets.
14. Market research has revealed the following information about the market for
chocolate bars: The demand schedule can be represented by the equation QD = 1,600 –
300P, where QD is the quantity demanded and P is the price. The supply schedule can
be represented by the equation QS = 1,400 + 700P, where QS is the quantity supplied.
Calculate the equilibrium price and quantity in the market for chocolate bars.
Answer: Equilibrium occurs where quantity demanded is equal to quantity supplied. Thus:

QD=QS
1,600 – 300P = 1,400 + 700P
200 = 1,000P P = $0.20

QD = 1,600 – 300(0.20) = 1,600 – 60 = 1,540

QS = 1,400 + 700(0.20) = 1,400 + 140 = 1,540.
The equilibrium price of a chocolate bar is $0.20 and the equilibrium quantity is 1,540 bars.

Chapter 5
Elasticity and its Application
Question for review:

Question 1: Define the price elasticity of demand and the income elasticity of demand.

Answer: Price elasticity of demand measures how much the quantity demanded of a good
responds to a change in the price of that good, computes as the percentage change in
quantity demanded divided by the percentage change in price.
Income elasticity of demand a measure of how much the quantity demanded of a good
responds to a change in consumers income, computed as the percentage change in quantity
demanded divided by the percentage change in income.

Question 2: List and explain the four determinates of the price elasticity of demand
discussed in the chapter.

Answer: The four determinates of the price elasticity of demand discussed below:

1. Availability of close substitutes Goods with close substitutes tend to have more
elastic demand because it is easier for consumers to switch from that good to others.
For example, butter and margarine are easily substitutable.
2. Necessities versus Luxuries Necessities tend to have inelastic demands, where
luxuries have elastic demands. Calling a good a necessity or luxury ultimately lies
within the buyer’s control.
3. Definition of the market Narrowly defined markets rend to have more elastic demand
while broadly defined markets tend to have less elastic demand. The elasticity all
depends on how we draw the boundaries of a market.
4. Time Horizon Items tend to have a more elastic demand over a larger timeframe. When the
price of gasoline rises, eventually people will start buying more fuel efficient cars.
Question 3: What is the main advantage of using the midpoint method for
calculating elasticity?

Answer: The main advantage of using the midpoint method for calculating elasticity is that in
that way we can avoid the problems of getting unlike answer if we calculate price elasticity
among any 2 points on a demand curve.

Midpoint method will present us exactly the same value anywhere moving from lower price
to higher price or the opposite.

Question 4: If the elasticity is greater than 1, is demand elastic or inelastic? If the

elasticity equals 0, is demand perfectly elastic or perfectly inelastic?

Answer: If elasticity is great than 1, the demand is elastic, meaning an increase in price results
to a decrease in quantity demanded. If elasticity is equal to zero, the demand is perfectly
inelastic, meaning an increase in price leaves the quantity demanded unchanged.

Question 5: On a supply-and-demand diagram, show equilibrium price,

equilibrium quantity, and the total revenue received by producers.

Answer: Present a supply-and-demand diagram, showing the equilibrium price, the equilibrium
quantity, and the total revenue received by producers. Total revenue equals the equilibrium
price times the equilibrium quantity, which is the area of the rectangle shown in the graph.
 Price S

P
Area of
rectangular=tot
al spending by
consumer
=total revenue
received by
producers D
=P×Q

Q Quantity

Question 6: If demand is elastic, how will an increase in price change total

revenue? Explain.

Answer: When demand is elastic, an increase in price will reduce total revenue. Breaking it
down, when the demand curve is elastic the extra revenue from selling at a higher price or
less than the lost revenue from selling fewer units.

Question 7: What do we call a good whose income elasticity is less than 0?

Answer: We call this type of good an inferior good. An inferior good is a product we buy more
when our income falls. Necessities have small income elasticity’s while luxuries normally have
high income elasticity.

Question 8: How is the price elasticity of supply calculated? Explain what it measures.

Answer: Price elasticity of supply is calculated as the percentage change in the quantity
supplied divided by the percentage change in the price. It measures how much the quantity
supplied of a good responds to a change in the price of that good. It also determines whether the
supply curve is steep or flat.

Question 9: What is the price elasticity of supply of Picasso paintings?

Answer: The price of elasticity is zero because in any increase of price, the production has
now stopped. There is no other production of Picasso paintings.
Question 10: Is the price elasticity of supply usually larger in the short run or in the
long run? Why?

Answer: Price elasticity of supply is usually larger in the long run because in short time
periods companies are not capable to change their factories size to change the quantity of
good(few or less), in this case the quantity is not much analog to price. During long periods
companies could build new facilities or isolates the old, and in this way quantity supplied is
much responsive to price.

Question 11: How can elasticity help explain why drug interdiction could reduce the
supply of drugs, yet possibly increase drug-related crime?

Answer: The demand of drugs in elastic so a rise unto the price will cause an increase of
total costs.

So the person who needs drugs is possible to thief or rupture in order to support their patterns.

Problem and Application:

1. For each of the following pairs of goods, which good would you expect to have
more elastic demand and why?
a) required textbooks or mystery novels
b) Beethoven recordings or classical music recordings in general
c) subway rides during the next six months or subway rides during the next
five years
d) Root beer or water.
Answer: A) Mystery novels have more elastic demand than required textbooks, because mystery
novels have close substitutes and are a luxury good, while required textbooks are a necessity with
no close substitutes. If the price of mystery novels were to rise, readers could substitute other
types of novels, or buy fewer novels altogether. But if the price of required textbooks were to
rise, students would have little choice but to pay the higher price. Thus, the quantity demanded of
required textbooks is less responsive to price than the quantity demanded of mystery novels.

B) Beethoven recordings have more elastic demand than classical music recordings in general.
Beethoven recordings are a narrower market than classical music recordings, so it is easy to find
close substitutes for them. If the price of Beethoven recordings were to rise, people could
substitute other classical recordings, like Mozart. But if the price of all classical recordings were
to rise, substitution would be more difficult (a transition from classical music to rap is unlikely!).
Thus, the quantity demanded of classical recordings is less responsive to price than the quantity
demanded of Beethoven recordings.

C) Subway rides during the next five years have more elastic demand than subway rides during
the next six months. Goods have a more elastic demand over longer time horizons. If the fare for
a subway ride was to rise temporarily, consumers could not switch to other forms of
transportation without great expense or great inconvenience. But if the fare for a subway ride was
to remain high for a long time, people would gradually switch to alternative forms of
transportation. As a result, the quantity demanded of subway rides during the next six months
will be less responsive to changes in the price than the quantity demanded of subway rides
during the next five years.

D) Root beer has more elastic demand than water. Root beer is a luxury with close substitutes,
while water is a necessity with no close substitutes. If the price of water were to rise, consumers
have little choice but to pay the higher price. But if the price of root beer were to rise, consumers
could easily switch to other sodas. So the quantity demanded of root beer is more responsive to
changes in price than the quantity demanded of water.

2. Suppose that business travelers and vacationers have the following demand for airline
tickets from New York to Boston:
Price Quantity Demanded Quantity Demanded
(business travelers) (vacationers)
$150 2100 Tickets 1000 Tickets
200 2000 800
250 1900 600
300 1800 400
a) As the price of tickets rises from $200 to $250, what is the price elasticity of
demand for (i) business travelers and (ii) vacationers? (Use the midpoint
method in your calculations.)
b) Why might vacationers have a different elasticity from business travelers?
Answer: A) For business travelers, the price elasticity of demand when the price of tickets rises
from $200 to $250 is [(2,000 – 1,900)/1,950] / [(250 – 200)/225] = 0.05/0.22 = 0.23. For
vacationers, the price elasticity of demand when the price of tickets rises from $200 to $250 is
[(800 – 600)/700] / [(250 – 200)/225] = 0.29/0.22 = 1.32.

B) The price elasticity of demand for vacationers is higher than the elasticity for business
travelers because vacationers can choose more easily a different mode of transportation (like
driving or taking the train). Business travelers are less likely to do so because time is more
important to them and their schedules are less adaptable.
3. Suppose the price elasticity of demand for heating oil is 0.2 in the short run and 0.7
in the long run.
a) If the price of heating oil rises from $1.80 to $2.20 per gallon, what happens to the
quantity of heating oil demanded in the short run? In the long run? (Use the
midpoint method in your calculations.)
b) Why might this elasticity depend on the time horizon?
Answer: A) The percentage change in price is equal to (2.20 – 1.00)/2.00 = 0.2 = 20%. If the
price elasticity of demand is 0.2, quantity demanded will fall by 4% in the short run [0.20 ×
0.20]. If the price elasticity of demand is 0.7, quantity demanded will fall by 14% in the long run
[0.7 × 0.2].
B) Over time, consumers can make adjustments to their homes by purchasing alternative heat
sources such as natural gas or electric furnaces. Thus, they can respond more easily to the change
in the price of heating oil in the long run than in the short run.

4. A price change causes the quantity demanded of a good to decrease by 30 percent,

while the total revenue of that good increases by 15 percent. Is the demand curve elastic
or inelastic? Explain.
Answer: Since the revenue increases as a result of price increase, it suggests that the demand is
inelastic. As we are aware from the law of demand, an increase in price leads to a decrease in
quantity demanded. The revenue increases by 15% even after a 30% reduction in quantity
implying the price must have increased by more than 30%. Thus the proportionate change in
quantity demanded is less than the proportionate change in price, implying inelastic demand.

5. The equilibrium price of coffee mugs rose sharply last month, but the
equilibrium quantity was the same as ever. Three people tried to explain the
situation. Which explanations could be right? Explain your logic.
Billy: Demand increased, but supply was totally inelastic.
Marian: Supply increased, but so did demand.
Valerie: Supply decreased, but demand was totally inelastic.
Answer: Both Billy and Valerie may be correct. If demand increases, but supply is ―totally‖
inelastic, equilibrium price will rise but the equilibrium quantity will remain the same. This
would also occur if supply decreases and demand is ―totally‖ inelastic. Marian is incorrect. If
supply and demand both rises, equilibrium quantity will increase, but the impact on equilibrium
price is indeterminate.

6. Suppose that your demand schedule for DVDs is as follows:

Price Quantity Demanded Quantity Demanded
(income = $10,000) (income = $12,000)

8 40 DVDS 50 DVDS

1 32 45
12 24 30
14 16 20
16 8 12

a) Use the midpoint method to calculate your price elasticity of demand as

the price of DVDs increases from $8 to $10 if (i) your income is $10,000
and (ii) your income is $12,000.
 b) Calculate your income elasticity of demand as your income increases
from $10,000 to $12,000 if (i) the price is $12 and (ii) the price is $16.
Answer: A) If your income is $10,000, your price elasticity of demand as the price of compact
discs rises from $8 to $10 is [(40 – 32)/36] / [(10 – 8)/9] =0.22/0.22 = 1. If your income is
$12,000, the elasticity is [(50 – 45)/47.5] / [(10 – 8)/9] = 0.11/0.22 = 0.5.

B) If the price is $12, your income elasticity of demand as your income increases from $10,000
to $12,000 is [(30 – 24)/27]/[(12,000 – 10,000)/11,000] = 0.22/0.18 = 1.22. If the price is $16,
your income elasticity of demand as your income increases from $10,000 to $12,000 is [(12 –
8)/10] / [(12,000 – 10,000)/11,000] = 0.40/0.18 = 2.2

7. You have the following information about good X and good Y: •

 Income elasticity of demand for good X: –3
 Cross-price elasticity of demand for good X with respect to the price
of good Y: 2
Would an increase in income and a decrease in the price of good Y
unambiguously decrease the demand for good X? Why or why not?
Answer: Yes, an increase in income would decrease the demand for good X because the income
elasticity is less than zero, indicating that good X is an inferior good. A decrease in the price of
good Y will decrease the demand for good X because the two goods are substitutes (as indicated
by a cross-price elasticity that is greater than zero). The income elasticity of demand measures
the change in the quantity demanded of a good or service with respect to a change in the
consumer's income. The cross-price elasticity of demand measures the change in the quantity
demanded due to a change in the price of other related products such as complements and
substitutes.

8. Maria has decided always to spend one-third of her income on clothing.

a) What is her income elasticity of clothing demand?
b) What is her price elasticity of clothing demand?
c) If Maria’s tastes change and she decides to spend only one-fourth of her
income on clothing, how does her demand curve change? What is her income
elasticity and price elasticity now?
Answer: A) If Maria always spends one-third of her income on clothing, then her income
elasticity of demand is one, because maintaining her clothing expenditures as a constant fraction
of her income means the percentage change in her quantity of clothing must equal her percentage
change in income.

B) Maria's price elasticity of clothing demand is also one, because every percentage point
increase in the price of clothing would lead her to reduce her quantity purchased by the same
percentage.
 C) Because Maria spends a smaller proportion of her income on clothing, then for any given
price, her quantity demanded will be lower. Thus, her demand curve has shifted to the left.
Because she will again spend a constant fraction of her income on clothing, her income and price
elasticity’s of demand remain one

9. The New York Times reported (Feb. 17, 1996) that subway ridership declined after a fare
increase: ―There were nearly four million fewer riders in December 1995, the first full
month after the price of a token increased 25 cents to $1.50, than in the previous
December, a 4.3 percent decline.‖
a. Use these data to estimate the price elasticity of demand for subway rides.
b. According to your estimate, what happens to the Transit Authority’s revenue
when the fare rises?
c. Why might your estimate of the elasticity be unreliable?
Answer: A) If quantity demanded falls by 4.3% when price rises by 20%, the price elasticity of
demand is 4.3/20 = 0.215, which is fairly inelastic.

B) Because the demand is inelastic, the Transit Authority's revenue rises when the fare rises.
C) The elasticity estimate might be unreliable because it is only the first month after the fare
increase. As time goes by, people may switch to other means of transportation in response to the
price increase. So the elasticity may be larger in the long run than it is in the short run.

10. Two drivers—Tom and Jerry—each drive up to a gas station. Before looking at the
price, each places an order. Tom says, ―I’d like 10 gallons of gas.‖ Jerry says, ―I’d
like $10 worth of gas.‖ What is each driver’s price elasticity of demand?
Answer: Tom's price elasticity of demand is zero, because he wants the same quantity regardless
of the price. Jerry's price elasticity of demand is one, because he spends the same amount on gas,
no matter what the price, which means his percentage change in quantity is equal to the
percentage change in price.

11. Consider public policy aimed at smoking.

a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a
pack of cigarettes currently costs $2 and the government wants to reduce
smoking by 20 percent, by how much should it increase the price?
b. If the government permanently increases the price of cigarettes, will the policy
have a larger effect on smoking one year from now or five years from now?
c. Studies also find that teenagers have a higher price elasticity than do
adults. Why might this be true?
Answer: A) With a price elasticity of demand of 0.4, reducing the quantity demanded of
cigarettes by 20% requires a 50% increase in price, because 20/50 = 0.4. With the price of
cigarettes currently $2, this would require an increase in the price to $3.33 a pack using the
midpoint method (note that ($3.33 – $2)/$2.67 = .50).
 B) The policy will have a larger effect five years from now than it does one year from now. The
elasticity is larger in the long run, because it may take some time for people to reduce their
cigarette usage. The habit of smoking is hard to break in the short run.

C) Because teenagers do not have as much income as adults, they are likely to have a higher
price elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it
more difficult to reduce their quantity demanded in response to a higher price.

12. You are the curator of a museum. The museum is running short of funds, so you decide to
increase revenue. Should you increase or decrease the price of admission? Explain
Answer: In order to determine whether you should raise or lower the price of admissions, you
need to know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of
admissions will increase total revenue. If demand is inelastic, an increase in the price of
admissions will cause total revenue to rise.

13. 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 price?
c. Which product experiences a larger change in quantity?
d. What happens to total consumer spending on each product?
Answer: A) As the diagram below shows, the increase in supply reduces the equilibrium price
and increases the equilibrium quantity in both markets:

Price of S1
pharmaceutical Price of S1
drugs computers
S2
S2

D D

Quantity of Quantity of
pharmaceutical computers
drugs

B) In the market for pharmaceutical drugs (with inelastic demand), the increase in supply leads to
a relatively large decline in the equilibrium price and a small increase in the equilibrium quantity.
C) Computers (with elastic demand).

D) Because demand is inelastic in the market for pharmaceutical drugs, the percentage increase
in quantity will be lower than the percentage decrease in price; thus, total consumer spending
will decline. Because demand is elastic in the market for computers, the percentage increase in
quantity will be greater than the percentage decrease in price, so total consumer spending will
increase

14. Several years ago, flooding along the Missouri and the Mississippi rivers
destroyed thousands of acres of wheat.
a. Farmers whose crops were destroyed by the floods were much worse off, but
farmers whose crops were not destroyed benefited from the floods. Why?
b. What information would you need about the market for wheat to assess
whether farmers as a group were hurt or helped by the floods?
Answer: a) Farmers whose crops were destroyed by the floods were definitely much worse off
because of the loss to their crops but at the same time their loss turned into benefits for the
farmers whose crops survived the flood. The logic is very straightforward, the loss of crops
created a shortage in the market, or we can say that there was a reduced supply in the face of
unchanged demand, as a result of which the price for these crops in the market went up and the
farmers whose crops survived made more than usual profits.

B) To tell whether farmers as a group were hurt or helped by the floods, you would need to know
the price elasticity of demand. It could be that the total revenue received by all farmers as a group
actually rose.

15. Explain why the following might be true: A drought around the world raises the
total revenue that farmers receive from the sale of grain, but a drought only in
Kansas reduces the total revenue that Kansas farmers receive.
Answer: A worldwide drought could increase the total revenue of farmers if the price elasticity
of demand for grain is inelastic. The drought reduces the supply of grain, but if demand is
inelastic, the reduction of supply causes a large increase in price. Total farm revenue would rise
as a result. If there is only a drought in Kansas, Kansas’ production is not a large enough
proportion of the total farm product to have much impact on the price. As a result, price does not
change (or changes by only a slight amount), while the output of Kansas farmer’s declines, thus
reducing their income).
 Chapter 6

Supply, Demand and Government Policies

Question for review:

Question 1: Give an example of a price ceiling and an example of a price floor.

Answer: Price floor and price ceiling are price controls, examples of government intervention in
the free market which changes the market equilibrium. They each have reasons for using them,
but there are large efficiency losses with both of them. Price ceilings are maximum prices set by
the government for particular goods and services that they believe are being sold at too high of a
price and thus consumers need some help purchasing them. Price ceilings only become a
problem when they are set below the market equilibrium price.

A price floor in economics is a minimum price imposed by a government or agency, for a

particular product or service. Government requiring gum to be sold for a minimum price at $0.50
when it was originally $0.25.

Question 2: which causes a surplus of a good-a price ceiling or a price floor? Explain.

Answer: Price floor binding causes a surplus of a good. A binding price floor is one that is
greater than the equilibrium market price. Explain below with the graph:

Here Equilibrium price is $3.

Price
of ice-
cream
Supply

Surplus
$4 Price floor
3

Demand

80 120 Quantity of ice-cream

Quantity Quantity
 demanded supplied

Here price floor becomes binding. At this price $4 producer’s supply 120 ice-creams where
consumers willing to buy 80 ice-creams .In this price some people are unable to purchase and
this exceeds create surplus. S0, a binding price floor causes a surplus.
Question 3: What mechanisms allocate resources when the price of a good is not allowed to
bring supply and demand unto equilibrium?
Answer: When the price of a good is not allowed to bring supply and demand into equilibrium,
some alternative mechanism must allocate resources. If quantity supplied exceeds quantity
demanded, so that there is a surplus of a good as in the case of a binding price floor, sellers may
try to appeal to the personal biases of the buyers. If quantity demanded exceed quantity supplied,
so that there is a shortage of a good as in the case of a binding price ceiling, sellers can ration the
good according to their personal biases, or make buyers wait in line
Question 4: Explain why economists usually oppose controls on prices.
Answer: Economics usually oppose controls on process because prices have the crucial job of
coordinating economic activity by balancing demand and supply. When policymakers set control
on prices, they obscure the signals that guide the allocation of society’s resources. Furthermore,
price controls often hurt those they are trying to help.
Question 5: Suppose the government removes a tax on buyers of a good and levies a tax of
the same size on sellers of the good. How does this change in tax policy affect the price that
buyers pay sellers for this good, the amount buyers are out of pocket including the tax, and
the quantity of the good sold?
Answer: Removing a tax paid by buyers and replacing it with a tax paid by sellers raises the
price that buyers pay sellers by the amount of the tax, has no effect on the amount buyers are out
of pocket, has no effect on the amount sellers receive net of any tax payments they make,
increases the price received by sellers, and has no effect on the quantity of the good sold.
Question 6: How does a tax on a good affect the price paid by buyers, the price received by
sellers, and the quantity sold?
Answer: A tax on good raises the price buyers pay, lower the price sellers receive, and reduces
the quantity sold.
Question 7: What determines how the burden of a tax is divided between buyers and
sellers? Why?
Answer: .The burden of a tax is divided between buyers and sellers depending on the elasticity’s
of demand and supply. Elasticity represents the willingness of buyers or sellers to leave the
market, which in turns depends on their alternatives. When a good is taxed, the side of the
market with fewer good alternatives cannot easily leave the market and thus bears more of the
burden of the tax.

Problems and Applications:

1. Lovers of classical music persuade Congress to impose a price ceiling of $40 per concert
ticket. As a result of this policy, do more or fewer people attend classical music
concerts?
Answer: If the price ceiling of $40 per ticket is below the equilibrium price, then quantity
demanded exceeds quantity supplied, so there will be a shortage of tickets. The policy decreases
the number of people who attend classical music concerts, because the quantity supplied is lower
because of the lower price.
2. The government has decided that the free market price of cheese is too low.
a. Suppose the government imposes a binding price floor in the cheese market.
Draw a supply-and-demand diagram to show the effect of this policy on the
price of cheese and the quantity of cheese sold. Is there a shortage or surplus
of cheese?
b. Farmers complain that the price floor has reduced their total revenue. Is this
possible? Explain.
c. In response to farmers’ complaints, the government agrees to purchase all
the surplus cheese at the price floor. Compared to the basic price floor, who
benefits from this new policy? Who loses?
Answer: a) The imposition of a binding price floor in the cheese market is shown in Figure 02.
In the absence of the price floor, the price would be P1 and the quantity would be Q1. With the
floor set at Pf, which is greater than P1, the quantity demanded is Q2, while quantity supplied is
Q3, so there is a surplus of cheese in the amount Q3 – Q2.
B) The farmers’ complaint that their total revenue has declined is correct if demand is elastic.
With elastic demand, the percentage decline in quantity would exceed the percentage rise in
price, so total revenue would decline.
C) If the government purchases all the surplus cheese at the price floor, producers benefit and
taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue would
increase substantially. However, consumers would buy only quantity Q2 of cheese, so they are in
the same position as before. Taxpayers lose because they would be financing the purchase of the
surplus cheese through higher taxes.

Price of
cheese
Supply

Pf

P1

Q2 Q1
Quantity of cheese
Figure: 02
3. A recent study found that the demand and supply schedules for Frisbees are as follows:
Price per Frisbee Quantity Quantity Supplied
Demanded
&11 1 Million Frisbee 15 Million Frisbee
10 2 12
9 4 9
8 6 6
7 8 3
6 10 1
a. What are the equilibrium price and quantity of Frisbees?
b. Frisbee manufacturers persuade the government that Frisbee production
improves scientists’ understanding of aerodynamics and thus is important
for national security. A concerned Congress votes to impose a price floor
$2 above the equilibrium price. What is the new market price? How many
Frisbees are sold?
c. Irate college students march on Washington and demand a reduction in the
price of Frisbees. An even more concerned Congress votes to repeal the
price floor and impose a price ceiling $1 below the former price floor. What
is the new market price? How many Frisbees are sold?
Answer: a) The equilibrium price of Frisbees is $8 and the equilibrium quantity is six million
Frisbees.
b) With a price floor of $10, the new market price is $10 because the price floor is binding. At
that price, only two million Frisbees are sold, because that is the quantity demanded.
c) If there’s a price ceiling of $9, it has no effect, because the market equilibrium price is $8,
which is below the ceiling. So the market price is $8 and the quantity sold is six million Frisbees.
4. Suppose the federal government requires beer drinkers to pay a $2 tax on each case
of beer purchased. (In fact, both the federal and state governments impose beer taxes
of some sort.)
a. Draw a supply-and-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 sold. What is the difference between the price paid by
consumers and the price received by producers?
b. Now draw a supply-and-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?
Answer: a) Figure 03 shows the market for beer without the tax. The equilibrium price is P1 and
the equilibrium quantity is Q1. The price paid by consumers is the same as the price received.
 Price
Price of Supply of
Beer Beer

P2
Supply
P1
P1
P2-$2
Deman Deman

Q1 Quantity of Q2 Q1
Quantity
Beer
of Beer

Figure: 03 Figure: 04

b) When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown in
Figure 4. The price paid by consumers is P2, while the price received by producers is P2 – $2.
The quantity of beer sold declines to Q2.

5. 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.
Answer: Reducing the payroll tax paid by firms and using part of the extra revenue to reduce the
payroll tax paid by workers would not make workers better off, because the division of the
burden of a tax depends on the elasticity of supply and demand and not on who must pay the tax.
Because the tax wedge would be larger, it is likely that both firms and workers, who share the
burden of any tax, would be worse off.

6. If the government places a $500 tax on luxury cars, will the price paid by
consumers rise by more than $500, less than $500, or exactly $500? Explain.
Answer: If the government imposes a $500 tax on luxury cars, the price paid by consumers will
raise less than $500, in general. The burden of any tax is shared by both producers and
consumers the price paid by consumers rises and the price received by producers falls, with the
difference between the two equal to the amount of the tax. The only exceptions would be if the
supply curve were perfectly elastic or the demand curve were perfectly inelastic, in which case
consumers would bear the full burden of the tax and the price paid by consumers would rise by
exactly $500.
7. Congress and the 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-and-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 both 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?
Answer: a) In order to accomplish the goal of decreasing the size of the market for gasoline
by imposing a $0.50 tax it is irrelevant who is responsible for the tax incidence because taxes
levied on consumers and producer ultimately result in the same change to equilibrium price
and the size of the market. This is displayed in figures 5, showing how tax incidence is split
between consumer and producer based on elasticity.

b) If demand for gasoline were more elastic the consumer would then bear a larger amount of
the tax incidence.
c) Consumers of gas are hurt by this tax because it is increasing the price they are paying.

D) Oil industry workers are also hurt by this tax because it is reducing the demand for the
product they produce.

8. A case study in this chapter discusses the federal minimum-wage law.

a. Suppose the minimum wage is above the equilibrium wage in the market
for unskilled labor. Using a supply and-demand diagram of the market for
unskilled labor, show the market wage, the number of workers who are
 employed, and the number of workers who are unemployed. Also show the
total wage payments to unskilled workers.
b. Now suppose the secretary of labor proposes an increase in the minimum
wage. What effect would this increase have on employment? Does the
change in employment depend on the elasticity of demand, the elasticity of
supply, both elasticities, or neither?
c. What effect would this increase in the minimum wage have on
unemployment? Does the change in unemployment depend on the
elasticity of demand, the elasticity of supply, both elasticities, or neither?
d. If the demand for unskilled labor were inelastic, would the proposed
increase in the minimum wage raise or lower total wage payments to
unskilled workers? Would your answer change if the demand for unskilled
labor were elastic?
Answer: A) Figure 06 shows the effects of the minimum wage. In the absence of the minimum
wage, the market wage would be w1 and Q1 workers would be employed. With the minimum
wage (wm) imposed above w1, the market wage is wm, the number of employed workers is Q2,
and the number of workers who are unemployed is Q3 - Q2. Total wage payments to workers are
shown as the area of rectangle ABCD, which equals wm times Q2.

Wage
Supply
Unemployment

Wm
A B
W1

D c Demand

Q2 Q1 Q3 Quantity of labor

Figure: 06
b) An increase in the minimum wage would decrease employment. The size of the effect on
employment depends only on the elasticity of demand. The elasticity of supply does not matter,
because there is a surplus of labor.
c) The increase in the minimum wage would increase unemployment. The size of the rise in
unemployment depends on both the elasticity of supply and demand. The elasticity of demand
determines the change in the quantity of labor demanded, the elasticity of supply determines the
change in the quantity of labor supplied, and the difference between the quantities supplied and
demanded of labor is the amount of unemployment.
d) If the demand for unskilled labor were inelastic, the rise in the minimum wage would increase
total wage payments to unskilled labor. With inelastic demand, the percentage decline in
employment would be lower than the percentage increase in the wage, so total wage payments
increase. However, if the demand for unskilled labor were elastic, total wage payments would
decline, because then the percentage decline in employment would exceed the percentage
increase in the wage.
9. The U.S. government administers two programs that affect the market for cigarettes.
Media campaigns and labeling requirements are aimed at making the public aware
of the dangers of cigarette smoking. At the same time, the Department of Agriculture
maintains a price-support program for tobacco farmers, which raises the price of
tobacco above the equilibrium price.
a. How do these two programs affect cigarette consumption? Use a graph of the
cigarette market in your answer.
b. What is the combined effect of these two programs on the price of cigarettes?
c. Cigarettes are also heavily taxed. What effect does this tax have on
cigarette consumption?
Answer: a) Programs aimed at making the public aware of the dangers of smoking reduce the
demand for cigarettes, shown in Figure 07 as a shift from demand curve D1 to D2. The price
support program increases the price of tobacco, which is the main ingredient in cigarettes. As a
result, the supply of cigarettes shifts to the left, from S1 to S2. The effect of both programs is to reduce
the quantity of cigarette consumption from Q1 to Q2.

Price of S1
cigarettes S2

Tax

D1
D2

Q3 Q2 Q1 Quantity of cigarettes

Figure: 07
B) The combined effect of the two programs on the price of cigarettes is ambiguous. The
education campaign reduces demand for cigarettes, which tends to reduce the price. The tobacco
price supports raising the cost of production of cigarettes, which tends to increase the price.
C) The taxation of cigarettes further reduces cigarette consumption, because it increases the price
to consumers. As shown in the figure, the quantity falls to Q3.
10. At Fenway Park, home of the Boston Red Sox, seating is limited to 39,000. Hence, the
number of tickets issued is fixed at that figure. Seeing a golden opportunity to raise
revenue, the City of Boston levies a per ticket tax of $5 to be paid by the ticket buyer.
Boston sports fans, a famously civic-minded lot, dutifully send in the $5 per ticket.

a) Draw a well-labeled graph showing the impact of the tax. On whom does the tax
burden fall—the team’s owners, the fans, or both? Why?
Answer: Since the supply of tickets is fixed at 34,000, the supply curve is completely inelastic,
i.e. vertical. Assuming a normal, downward sloping demand curve, a tax on consumers shifts the
demand curve down by a vertical distance equal to the amount of the tax—here that is $5.

S
p

Pc=p*

$5 D
Pp
D with tax

34000 Q
Without the tax, the equilibrium price would be P*--this is what consumers would pay and what
producers would receive. With the tax, the demand curve shifts down by $5 and the amount
producers receive is reduced to PP. However, the amount consumers must pay is PC, which is
exactly what they would pay without the tax, P*. Hence, the burden on consumers, PC - P*, is
p
zero, while the burden on producers is P* − P = $5.
11. A subsidy is the opposite of a tax. With a $0.50 tax on the buyers of ice-cream cones, the
government collects $0.50 for each cone purchased; with a $0.50 subsidy for the buyers
of ice-cream cones, the government pays buyers $0.50 for each cone purchased.
A) Show the effect of a $0.50 per cone subsidy on the demand curve for ice-cream
cones, the effective price paid by consumers, the effective price received by sellers, and
the quantity of cones sold.
B) Do consumers gain or lose from this policy? Do producers gain or lose? Does the
government gain or lose?

Answer: A) The effect of a $0.50 per cone subsidy is to shift the demand curve up by $0.50 at
each quantity, because at each quantity a consumer's willingness to pay is $0.50 higher. The
effects of such a subsidy are shown in. Before the subsidy, the price is P1. After the subsidy,
the price received by sellers is PS and the effective price paid by consumers is PD, which
equals PS minus $0.50. Before the subsidy, the quantity of cones sold is Q1, after the subsidy
the quantity increases
 Price of ice-
cream cone

Supply
Ps

P1

Pd

D1 D2

Q1 Q2 Quantity of ice-cream cone

Figure: 09
B) Because of the subsidy, consumers are better off, because they consume more at a lower
price. Producers are also better off, because they sell more at a higher price. The government
loses, because it has to pay for the subsidy.

Chapter 7
Consumers, Producers and the Efficiency of Markets
Question for review:

Question 1: Explain how buyers’ willingness to pay, consumer surplus, and the demand
curve are related.

Answer: The price a buyer is willing to pay, consumer surplus, and the demand curve are all
closely related. The highest of the demand curve represent the buyer’s willingness to pay.
Consumer surplus is the area below the demand curve and above the price, which equals the
price that each buyer is willing to pay minus the price actually paid.
Question 2: Explain how sellers’ costs, producer’s surplus, and the supply curve are
related.

Answer: Sellers costs, producer’s surplus, and the supply curve are all closely related. The
height of the supply represents the costs of the sellers. Producer surplus is the area below the
price and above the supply curve, which equals the price received minus each sellers costs of
producing the good.

Question 3: Why does a reduction in the price of a good increase consumer surplus?

Answer: Consumer surplus is derived whenever the price a consumer actually pays is less than
they are prepared to pay. A demand curve indicates what piece consumers are prepared to pay
for a hypothetical quantity of a good, based on their expectation of private benefit.

Question 4: What is efficiency? Is it the only goal of economic policymakers?

Answer: Efficiency

Efficiency is the property of a resource allocation of maximizing the total surplus received by all
members of society. But efficiency may not be the only goal of economic policymakers, they
may also be concerned about equity-the fairness of the distribution of well-begin.

Question 5: What does the invisible hand do?

Answer: The invisible hand of the marketplace guides the self-interest of buyers and promoting
general economic well-being. Despite decentralized decision making and self-interest decision
makers, free markets lead to an efficient outcome.

Question 6: Name two types of market failure. Explain why each cause market outcomes to
be inefficient.

Answer: Two types of market failure are market power and externalities. Market power may
cause market outcome to be inefficient because firms may cause price and quantity to differ from
the levels they would be under perfect competition, which keeps total surplus from being
maximized. Externalities are side effects that are not taken into account by buyers and sellers. As
a result, the free market does not maximize total surplus.

Problems and Applications:

1. Melissa buys an iPod for $120 and gets consumer surplus of $80.
a. What is her willingness to pay?
b. If she had bought the iPod on sale for $90, what would her consumer surplus
have been?
c. If the price of an iPod were $250, what would her consumer surplus have
been?
Answer: a) Consumer surplus is equal to willingness to pay minus the price paid.
Therefore, Melissa's
Willingness to pay must be $200 ($120 + $80).
b) Her consumer surplus at a price of $90 would be $200 - $90 = $110.
c) If the price of an iPod was $250, Melissa would not have purchased one because the price is
greater than her willingness to pay. Therefore, she would receive no En consumer surplus.
2. An early freeze in California sours the lemon crop. Explain what happens to
consumer surplus in the market for lemons. Explain what happens to consumer
surplus in the market for lemonade. Illustrate your answers with diagrams.
Answer: If an early freeze in California sours the lemon crop, the supply curve for lemons shifts
to the left, as shown in Figure 01. The result is a rise in the price of lemons and a decline in
consumer surplus from A + B + C to just A. So consumer surplus declines by the amount B + C.

Price of
lemons S2

A
S1
P2
B C
P1

Demand

Figure: 01
Quantity of lemons

In the market for lemonade, the higher cost of lemons reduces the supply of lemonade, as shown
in Figure 02. The result is a rise in the price of lemonade and a decline in consumer surplus from
D + f + i to just D, a loss of E + F. Note that an event that affects consumer surplus in one market
often has effects on consumer surplus in other markets.
 Price of
lemonad S2

D S1
P2
E
i
P1

Demand

Quantity of lemonade

Figure: 02
3. Suppose the demand for French bread rises. Explain what happens to producer
surplus in the market for French bread. Explain what happens to producer
surplus in the market for flour. Illustrate your answers with diagrams.
Answer: A rise in the demand for French bread leads to an increase in producer surplus in the
market for French bread, as shown in Figure 03. The shift of the demand curve leads to an
increased price, which increases producer surplus from area A to area A + B + C.

Price of French
bread
Supply
B
C

P2

P1 A

D2
D1

Q1 Q2 Quantity of French
bread

Figure: 03
The increased quantity of French bread being sold increases the demand for flour, as shown in
Figure 04. As a result, the price of flour rises, increasing producer surplus from area D to D + E
+ F. Note that an event that affects producer surplus in one market leads to effects on producer
surplus in related markets.

Price of
flour E Supply

P2

P1 D

D1 D2

Quantity of flour

Figure: 04

4. It is a hot day, and Bert is thirsty. Here is the value he places on a bottle of water:
i. Value of first bottle $7
ii. Value of second bottle 5
iii. Value of third bottle 3
iv. Value of fourth bottle 1
a. From this information, derive Bert’s demand schedule. Graph his demand
curve for bottled water.
b. If the price of a bottle of water is $4, how many bottles does Bert buy? How
much consumer surplus does Bert get from his purchases? Show Bert’s
consumer surplus in your graph.
c. If the price falls to $2, how does quantity demand change? How does
Bert’s consumer surplus change? Show these changes in your graph.
Answer: A) Bert’s demand schedule is:

Price Quantity Demanded

More than $7 0
$5 to $7 1
$3 to $5 2
$1 to $3 3
$1 or less 4
 Bert’s demand curve is shown in Figure 48.

Price
of
water
$7

6
A
5
4

3 B
2

1 2 3 4 Quantity of water

B) When the price of a bottle of water is $4, Bert buys two bottles of water. His consumer
surplus is shown as area A in the figure. He values his first bottle of water at $7, but pays only $4
for it, so has consumer surplus of $3. He values his second bottle of water at $5, but pays only $4
for it, so has consumer surplus of $1. Thus Bert’s total consumer surplus is $3 + $1 = $4, which
is the area of A in the figure.
C) When the price of a bottle of water falls from $4 to $2, Bert buys three bottles of water, an
increase of one. His consumer surplus consists of both areas A and B in the figure, an increase in
the amount of area B. He gets consumer surplus of $5 from the first bottle ($7 value minus $2
price), $3 from the second bottle ($5 value minus $2 price), and $1 from the third bottle ($3
value minus $2 price), for a total consumer surplus of $9. Thus consumer surplus rises by $5
(which is the size of area B) when the price of a bottle of water falls from $4 to $2.

5. Ernie owns a water pump. Because pumping large amounts of water is harder
than pumping small amounts, the cost of producing a bottle of water rises as he
pumps more. Here is the cost he incurs to produce each bottle of water:
i. Cost of first bottle $1
ii. Cost of second bottle 3
iii. Cost of third bottle 5
iv. Cost of fourth bottle 7
a. From this information, derive Ernie’s supply schedule. Graph his
supply curve for bottled water.
b. If the price of a bottle of water is $4, how many bottles does Ernie produce
and sell? How much producer surplus does Ernie get from these sales? Show
Ernie’s producer surplus in your graph.
 c. If the price rises to $6, how does quantity supply change? How does
Ernie’s producer surplus change? Show these changes in your graph.
Answer: A) Ernie’s supply schedule for water is:

Price Quantity Supplied

More than $7 4
$5 to $7 3
$3 to $5 2
$1 to $3 1
Less than $1 0

Ernie’s supply curve is shown in Figure 06.

Price of
water

$7
6

5 B
4
3 A

1 2 3 4 Quantity of water

Figure: 06

B) When the price of a bottle of water is $4, Ernie sells two bottles of water. His producer
surplus is shown as area A in the figure. He receives $4 for his first bottle of water, but it costs
only $1 to produce, so Ernie has producer surplus of $3. He also receives $4 for his second bottle
of water, which costs $3 to produce, so he has producer surplus of $1. Thus Ernie’s total
producer surplus is $3 + $1 = $4, which is the area of A in the figure.
C) When the price of a bottle of water rises from $4 to $6, Ernie sells three bottles of water, an
increase of one. His producer surplus consists of both areas A and B in the figure, an increase by
the amount of area B. He gets producer surplus of $5 from the first bottle ($6 price minus $1
cost), $3 from the second bottle ($6 price minus $3 cost), and $1 from the third bottle ($6 price
minus $5 price), for a total producer surplus of $9. Thus producer surplus rises by $5 (which is
the size of area B) when the price of a bottle of water rises from $4 to $6

6. Consider a market in which Bert from Problem 4 is the buyer and Ernie
from Problem 5 is the seller.
a. Use Ernie’s supply schedule and Bert’s demand schedule to find the
quantity supplied and quantity demanded at prices of $2, $4, and $6. Which
of these prices brings supply and demand into equilibrium?
b. What is consumer surplus, producer surplus, and total surplus in
this equilibrium?
c. If Ernie produced and Bert consumed one fewer bottle of water, what
would happen to total surplus?
d. If Ernie produced and Bert consumed one additional bottle of water,
what would happen to total surplus?
Answer: A) From Ernie’s supply schedule and Bert’s demand schedule, the quantity demanded
and supplied are:
Price Quantity Supplied Quantity
Demanded
$2 1 3
$4 2 2
$6 3 1
Only a price of $4 brings supply and demand into equilibrium, with an equilibrium quantity of
two.
b) At a price of $4, consumer surplus is $4 and producer surplus is $4, as shown in Problems 3
and 4 above. Total surplus is $4 + $4 = $8.
c) If Ernie produced one less bottle, his producer surplus would decline to $3, as shown in
Problem 5 above. If Bert consumed one less bottle, his consumer surplus would decline to $3, as
shown in Problem 4 above. So total surplus would decline to $3 + $3 = $6
d) If Ernie produced one additional bottle of water, his cost would be $5, but the price is only
$4, so his producer surplus would decline by $1. If Bert consumed one additional bottle of water,
his value would be $3, but the price is $4, so his consumer surplus would decline by $1. So total
surplus declines by $1 + $1 = $2.

7. The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider
some implications of this fact. A
a. Draw a supply-and-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 these TVs?

Answer: a) Supply curve shift to the right as production cost decrease. Quantity of goods
sold increase.

P S1

S2
Pe1

Pe2

Demand

0 Qe1 Qe2 Q

b) Consumer supply increase from area of AO’Pe1 to area of AOPe2. Producer supply
increase from area of Pe1OC to area of Pe2O’C’.

P A
S1

0
S2
Pe1 0

Pe2

C
D
C

Qe1 Qe2 Q

c) A very elastic demand leads to more consumer benefits most from falling production costs.
 8. There are four consumers willing to pay the following amounts for
haircuts: Jerry: $7 Oprah: $2 Ellen: $8 Phil: $5
There are four haircutting businesses with the following costs:
Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2
Each firm has the capacity to produce only one haircut. For efficiency, how many
haircuts should be given? Which businesses should cut hair and which consumers
should have their hair cut? How large is the maximum possible total surplus?
Answer: For efficiency, 3 haircuts should be given. The firms with It cost should provide
haircut and consumers with most willingness to pay should get the haircut. Da reach
efficient level of haircut, haircutting should continue till willingness to pay is higher than
the cost of haircut.
As a result, Firm A, C and D should give haircut; Gloria, Claire and Phil should get
haircut.
The maximum possible total surplus A corresponding to most efficient hair cutting
mentioned above. As a result,
Maximum possible total surplus = 7+ 8 + 5 — 3 — 4 — 2
=$11.
9. Suppose a technological advance reduces the cost of making computers.
a. Draw a supply-and-demand diagram to show what happens to price,
quantity, consumer surplus, and producer surplus in the market for
computers.
b. Computers and typewriters are substitutes. Use a supply-and-demand
diagram to show what happens to price, quantity, consumer surplus, and
producer surplus in the market for typewriters. Should typewriter producers
be happy or sad about the technological advance in computers?
c. Computers and software are complements. Draw a supply-and-demand
diagram to show what happens to price, quantity, consumer surplus, and
producer surplus in the market for software. Should software producers be
happy or sad about the technological advance in computers?
d. Does this analysis help explain why software producer Bill Gates is one of the
world’s richest men?
Answer: a) The effect of falling production costs in the market for computers results in a shift to
the right in the supply curve, as shown in Figure 09. As a result, the equilibrium price of computers declines and the
equilibrium quantity increases. The decline in the price of computers increases consumer surplus from area A to A
+ B + C + D, an increase in the amount B + C + D.
 Price of S1
computers
B
A S2
P1 C

P2 D
F

G
E
Demand

Q1 Q2 Quantity of computers

Figure: 09
Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve
and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer
surplus changes by the amount F + G – B, which may be positive or negative. The increase in
quantity increases producer surplus, while the decline in the price reduces producer surplus.
Because consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total
surplus rises by C + D + F + G.
9. B) Because adding machines are substitutes for computers, the decline in the price of
computers means that people substitute computers for adding machines, shifting the demand for
adding machines to the left, as shown in Figure 10. The result is a decline in both the equilibrium
price and equilibrium quantity of adding machines. Consumer surplus in the adding-machine
market changes from area A + B to A + C, a net change of C – B. Producer surplus changes from
area C + D + E to area E, a net loss of C + D. Adding-machine producers are sad about
technological advances in computers because their producer surplus declines.

Price of
B S
Adding
D
Machine
A
P1

P2 E

C D1
D2

Quantity of Adding
Q2 Q1 Machines

9. C) Because software and computers are complements, the decline in the price and increase in
the quantity of computers means that the demand for software increases, shifting the demand for
software to the right, as shown in Figure 11. The result is an increase in both the price and
quantity of software. Consumer surplus in the software market changes from B + C to A + B, a
net change of A – C. Producer surplus changes from E to C + D + E, an increase of C + D, so
software producers should be happy about the technological progress in computers.

Price of
B
software

A Supply

P2
C D

P1
E

D2
D1

Q1 Q2 Quantity of software
Figure: 11

D) Yes, this analysis helps explain why Bill Gates is one the world’s richest people, because his
company produces a lot of software that is a complement with computers and there has been
tremendous technological advance in computers.

A friend of yours is considering two cell phone service providers. Provider A charges $120
per month for the service regardless of the number of phone calls made. Provider B does
not have a fixed service fee but instead charges $1 per minute for calls. Your friend’s
monthly demand for minutes of calling is given by the equation QD 5 150 2 50P, where P is
the price of a minute.
With each provider, what is the cost to your friend of an extra minute on the phone?
In light of your answer to (a), how many minutes would your friend talk on the phone with
each provider?
How much would he end up paying each provider every month?
How much consumer surplus would he obtain with each provider? (Hint: Graph the
demand curve and recall the formula for the area of a triangle.)
Which provider would you recommend that your friend choose? Why?
Answer: a) For plan A each additional minute on the phone will cost your friend no extra money
because she is paying a, lump sum regardless of the amount she talks on the phone. For plan B
each additional minute costs your friend $1.
b) To find the amount of minutes your friend will talk on the phone given either plan we apply
the price per additional minute for each plan into the equation provided. With plan A your friend
will talk on the phone 150 minutes. With plan B your friend will talk 100 minutes.
c) With provider a she will pay $120. Plan B she will pay $100.
d) To answer this question first we will graph demand curve for each plan and then find the area
of the triangle created by drawing a straight-line out from the price per minute of each plan. With
plan A your friend will talk for 150 minutes at a cost of 120 dollars, therefore to find her price
per minute with this plan we will divide the price per minute by the amount of minutes (120/150)
which is $.8 per minute The consumer surplus for plan a is represented by triangle adc, and the
consumer surplus for plan b is represented by triangle aeb. We can determine the area of each by
multiplying the height, by the width then dividing by 2.
Plan a
2.2 x 120 /2 =132
Plan b
2 x 100/2=100
The area highlighted in yellow represents the additional consumer surplus offered by that plan.
I would recommend plan A for my friend because the consumer surplus is greater therefore
she is receiving more utility for the cost.
11. Consider how health insurance affects the quantity of healthcare services performed.
Suppose that the typical medical procedure has a cost of $100, yet a person with health
insurance pays only $20 out of pocket. Her insurance company pays the remaining $80. (The
insurance company recoups the $80 through premiums, but the premium a person pays does
not depend on how many procedures that person chooses to undertake.)

a) Draw the demand curve in the market for medical care. (In your diagram, the
horizontal axis should represent the number of medical procedures.) Show the quantity
of procedures demanded if each procedure has a price of $100.
b) On your diagram, show the quantity of procedures demanded if consumers pay only
$20 per procedure. If the cost of each procedure to society is truly $100, and if individuals
have health insurance as just described, will the number of procedures performed
maximize total surplus? Explain
c) Economists often blame the health insurance system for excessive use of medical care.
Given your analysis, why might the use of care be viewed as ―excessive‖?
d) What sort of policies might prevent this excessive use?
Answer: A) Figure 12 illustrates the demand for medical care. If each procedure has a price of
$100, quantity demanded will be Q1 procedures.
 Price of
medical
procedure

$100 Supply

$20 Demand

Q1 Figure:Q2 12 Quantity of medical

procedure
Figure: 12

B) If consumers pay only $20 per procedure, the quantity demanded will be Q2 procedures.
Because the cost to society is $100, the number of procedures performed is too large to maximize
total surplus. The quantity that maximizes total surplus is Q1 procedures, which is less than Q2.

C) The use of medical care is excessive in the sense that consumers get procedures whose value
is less than the cost of producing them. As a result, the economy’s total surplus is reduced.

D) To prevent this excessive use, the consumer must bear the marginal cost of the procedure. But
this would require eliminating insurance. Another possibility would be that the insurance
company, which pays most of the marginal cost of the procedure ($80, in this case) could decide
whether the procedure should be performed. But the insurance company does not get the benefits
of the procedure, so its decisions may not reflect the value to the consumer.