ECO 101H1: Principles of Microeconomics Prof.

Freitas, University of Toronto

Problem set: Price Controls and Taxes

Questions and Solutions

NOTE: In this problem set, PS = Producer Surplus, CS = Consumer Surplus, TS = Total Surplus, DWL =
Deadweight Loss.
1) Consider a perfectly competitive market without externalities. Market demand is given by P = M W T P =
24 − 31 Q and market supply is given by P = M C = 21 Q + 6.
1a) What is the highest total surplus possible?

Solution: Since we have no externalities, marginal social benefit is the marginal private benefit, i.e. M W T P.
The marginal social cost is the marginal private cost which is the M C(Q) function. To maximize surplus,
we line up all individuals in order of decreasing M W T P and increasing M C and find the highest output for
which M W T P ≥ M C. The point at which M W T P = M C is the point we go from an extra unit of output
increasing surplus to it decreasing surplus. This quantity is where

24 − 31 Q = 1
2Q +6
5
6Q = 18
Q = 21.6

The surplus at this quantity is the area below the MWTP curve and above the MC curve. (NOTE: We are
not calculating market outcomes here and there is no price so we can’t find and do not want to find consumer
and producer surplus.)
The area below the MWTP curve is calculated by (draw a diagram and see how you would calculate it if you
can’t figure out where we got these numbers from)

0.5 ∗ (24 − 16.8) ∗ 21.6 + 21.6 ∗ 16.8

= 440.64

(Note: there is no price, we are just using the number to break up the shape into a triangle and a rectangle)
The area below the MC curve is calculated by.

0.5 ∗ (21.6) ∗ (16.8 − 6) + 21.6 ∗ 6

= 246.24

The difference gives us total surplus.

T S = 440.64 − 246.24 = 194.4

1b) Calculate TS, CS, PS at the market outcome without any interventions.
Solution: In this case we are looking for the market outcomes so can calculate market prices and quantities using
the market demand (M W T P (Q) = P (QD )) and supply (M C(Q) = P (QS ) curves. Below I’ve rewritten them
in terms of quantity and set QS = QD

72 − 3P = 2P − 12
5P = 84
P = 16.8
⇒Q = 21.6

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

Given market price, CS is the area below M W T P and above P which is

CS = 0.5 ∗ 21.6 ∗ (24 − 16.8) = 77.76

PS is the area above M C and below P which is

P S = 0.5 ∗ 21.6 ∗ (16.8 − 6) = 116.64

Total surplus is
T S = P S + CS = 194.4
Notice it is the same as the number we solved for in part (a). A perfectly competitive market with no
externalities results in the efficient quantity being produced.
1c) Calculate TS, CS, PS, government revenue at the market outcome with a $2 tax imposed on the market.
Solution: Notice I haven’t told you who pays the tax because I want you to develop the habit of thinking about
taxes as wedges and solving for a tax equilibrium using that method. Even when you are given who pays the
tax, I strongly recommend you do it this way as it minimizes errors and it is an easier way to find CS, PS.
Who pays the tax determines what sticker price is in the economy and the parts below will cover that.
We have three unknowns PS , PD , Qtax to solve for. We will need three equations. The first is the relationship
between PS and PD which for a per-unit tax (t) is

PD = PS + t

The other two equations are demand and supply which we get equal to each other

QD (PD ) = QS (PS )
72 − 3PD = 2PS − 12
72 − 3(PS + t) = 2PS − 12
5PS = 84 − 3t
5PS = 84 − 6
PS = 15.6
⇒ PD = 17.6
⇒Q tax
= 19.2

Now that we have this we can calculate the other objects. CS is the area below M W T P and above PD which
is
CS = 0.5 ∗ 19.2 ∗ (24 − 17.6) = 61.44
PS is the area above M C and below P which is

P S = 0.5 ∗ 19.2 ∗ (15.6 − 6) = 92.16

Government revenue is
Tax Revenue = 2 ∗ 19.2 = 38.4
Total surplus is
T S = P S + CS + Tax Revenue = 192

1d) What is the deadweight loss due to the tax? Calculate this using two methods.
Solution: Method 1: This method calculates the area of the DWL triangle. In this example is is

= 0.5 ∗ (17.6 − 15.6) ∗ (21.6 − 19.2)

⇒ DW L = −2.4

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

Method 2 uses the difference between the TS in the efficient outcome and that of the tax equilibrium. (I
strongly recommend you use this method and use the method above to check your answers, if the DWL is a
triangle. ) Doing so gives you the same answer.
DW L = T S tax − T S ef f icient = 194.4 − 192 = −2.4
Note: whether you get a negative or positive sign will just depend on how you calculate the DWL. Don’t
focus too much on the sign, solve for the absolute and then notice that a loss implies that surplus decreases
so total surplus in the economy decreases by 2.4 or the DW L = −2.4
1e) What is the economic incidence of the tax on the buyer? on the seller?
Solution: The economic incidence on the buyer is the amount the price for the consumer rises with the tax
compared to the no tax situation.
= 17.6 − 16.8 = 0.8
The economic incidence on the seller is the amount the price for the producer falls with the tax compared to
the no tax situation.
= 16.8 − 15.6 = 1.2
1f) If the producer pays the tax, what is market price? If the consumer pays the tax, what is market price?
Solution: If at checkout tax of t per unit is added to buyer’s bill. ⇒ Buyer pays P + t, Seller gets P . More
generally, buyer’s out of pocket price is PD = P + t, Seller PS = P . The market price in this case will be 15.6
If at checkout tax of t per unit is taken from what buyer pays and gets sent to govt. by the seller then ⇒
Seller gets P − t, Buyer pays P . The seller’s in-pocket price is PS = P − t, Buyer PD = P . The market price
in this case will be 17.6
2) Consider a perfectly competitive market without externalities. Market demand is given by M W T P (Q) = 20− 51 Q
and market supply is given by M C(Q) = 21 Q + 6.
2a) What is the highest total surplus possible?
Solution: Since we have no externalities, marginal social benefit is the marginal private benefit, i.e. M W T P.The
marginal social cost is the marginal private cost which is the M C(Q) function. To maximize surplus, we
line up all individuals in order of decreasing M W T P and increasing M C and find the highest output for
which M W T P ≥ M C. The point at which M W T P = M C is the point we go from an extra unit of output
increasing surplus to it decreasing surplus. This quantity is where

20 − 51 Q 1
2Q +6
7
10 Q = 14
Q = 20

The surplus at this quantity is the area below the MWTP curve and above the MC curve. (NOTE: We are
not calculating market outcomes here and there is no price so we can’t find and do not want to find consumer
and producer surplus.)
The area below the MWTP curve is calculated by (draw a diagram and see how you would calculate it if you
can’t figure out where we got these numbers from)

0.5 ∗ (20 − 16) ∗ 20 + 20 ∗ 16

= 360

(Note: there is no price, we are just using the number to break up the shape into a triangle and a rectangle)
The area below the MC curve is calculated by.

0.5 ∗ (20) ∗ (16 − 6) + 20 ∗ 6

= 220

The difference gives us total surplus.

T S = 360 − 220 = 140

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

2b) Calculate TS, CS, PS at the market outcome without any interventions.
Solution: In this case we are looking for the market outcomes so can calculate market prices and quantities using
the market demand (M W T P (Q) = P (QD )) and supply (M C(Q) = P (QS ) curves. Below I’ve rewritten them
in terms of quantity and set QS = QD

100 − 5P = 2P − 12
7P = 112
P = 16
⇒Q = 20

Given market price, CS is the area below M W T P and above P which is

CS = 0.5 ∗ (20 − 16) ∗ 20 = 40

PS is the area above M C and below P which is

P S = 0.5 ∗ (20) ∗ (16 − 6) = 100

Total surplus is
T S = P S + CS = 140
Notice it is the same as the number we solved for in part (a). A perfectly competitive market with no
externalities results in the efficient quantity being produced.
2c) Calculate TS, CS and PS at the market outcome with a P = 10 price ceiling imposed on the market.
Solution: A price ceiling of P = 10 is binding as without it market price would be 16. When P = 10,demand is 50
and supply is 8. We have excess demand. The quantity traded is determined by the lower of the two which
makes market quantity in this case QC = 8. To calculate surplus we find

CS = 0.5 ∗ (20 − 18.4) ∗ 8 + (18.4 − 10) ∗ 8 = 73.6

P S = 0.5 ∗ 8 ∗ (10 − 6) = 16

T S = P S + CS = 89.6

2d) What is the minimum deadweight loss due to the price ceiling? Calculate this using two methods.
Solution: Method 1: This method calculates the area of the DWL triangle. In this example is is

= 0.5 ∗ (18.4 − 10) ∗ (20 − 8)

⇒ DW L = −50.4
Method 2 uses the difference between the TS in the efficient outcome and that of the price ceiling equilibrium.
Doing so gives you the same answer.

DW L = T S C − T S ef f icient = 140 − 89.6 = −50.4

Note: whether you get a negative or positive sign will just depend on how you calculate the DWL. Don’t
focus too much on the sign, solve for the absolute and then notice that a loss implies that surplus decreases
so total surplus in the economy decreases by 50.4 or the DW L = −50.4.
This is the minimum DWL because there could be additional sources of DWL (see videos/textbook for more
details).
2e) Calculate TS, CS and PS at the market outcome with a P = 18.4 price floor imposed on the market.

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

Solution: A price floor of P = 18.4 is binding as without it market price would be 16. When P = 18.4,demand
is 8 and supply is 24.8. We have excess supply. The quantity traded is determined by the lower of the two
which makes market quantity in this case QC = 8. To calculate surplus we find

CS = 0.5 ∗ (20 − 18.4) ∗ 8 = 6.4

P S = 0.5 ∗ 8 ∗ (10 − 6) + (18.4 − 10) ∗ 8 = 83.2

T S = P S + CS = 89.6
Notice that the quantity is the same as the part above but the price is different which results in the same
surplus being split in different ways depending on the price.
2f) What is the minimum deadweight loss due to the price floor? Calculate this using two methods.
Solution: Method 1: This method calculates the area of the DWL triangle. In this example is is

= 0.5 ∗ (18.4 − 10) ∗ (20 − 8)

⇒ DW L = −50.4
Method 2 uses the difference between the TS in the efficient outcome and that of the price ceiling equilibrium.
Doing so gives you the same answer.

DW L = T S C − T S ef f icient = 140 − 89.6 = −50.4

This is the minimum DWL because there could be additional sources of DWL (see videos/textbook for more
details).
3) Consider a perfectly competitive market where Market demand is given by P = 50− 12 Q, market price is P ∗ = 23
and supply elasticity is 1.28. A $5 tax is imposed on buyers currently buying positive quantities of a good.
Claim: market price will decrease by more than $2.5. Agree/Disagree/It depends? Explain.
Solution: Suppose sticker price on good is P
• If at checkout tax of t per unit is added to buyer’s bill. ⇒ Buyer pays P +t, Seller gets P . More generally,
buyer’s out of pocket price is PD = P + t, Seller PS = P
• If at checkout tax of t per unit is taken from what buyer pays and gets sent to govt. by the seller then
⇒ Seller gets P − t, Buyer pays P . The seller’s in-pocket price is PS = P − t, Buyer PD = P
Notice that it doesn’t matter who pays the tax, in either case the tax is a wedge between the effective price
for buyers and seller.
• Seller pays: PS = P − t, PD = P
• Buyer pays: PD = P + t, PS = P
The economic incidence of the tax depends on relative elasticities. Denote the market price without any taxes
as P . We know that PD = PS + t and they will be centered around P .
Since we are looking for an decrease in market price it means that we are looking at PS = P , i.e. seller pays
the price.
If the elasticities as the same, i.e. the absolute value of the demand elasticities is 5 then the tax will be split
equally and the market price fall by $2.5. To get a market price that decreases by more than $5 we will need
the demand to be less elastic than the supply. Demand elasticity is
23
|εD | = | − 2 ∗ | = 0.85
54
Since supply elasticity is 1.28, supply is more elastic which means the buyer bears the larger burden of the
tax. As the supplier bears the smaller burden, prices for the supplier (i.e. market price) will fall by less than
half so less than 2.5. The claim is False.

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

4) Currently the market is in equilibrium with a per-unit tax. If the government reduces this tax by $0.1, will
government revenue (or surplus) from the tax increase? Explain your reasoning.
Solution: Denote the old quantity sold under the old tax of t by Qold . A reduction in the tax rate will increase
quantity sold in the market to Qnew .
This will have two effect on government revenue.

1. For every unit sold both before and with the new lower tax (i.e. for quantity Qold ) the tax revenue will
decrease by $0.1
4Rev = −0.1 ∗ Qold
2. More units will be sold and for every extra unit sold the government will get t − 0.1 dollars which makes

4Rev = (t − 0.1) ∗ (Qnew − Qold )

Combining both we get

4Rev = −0.1 ∗ Qold + (t − 0.1) ∗ (Qnew − Qold ) = −0.1 ∗ Qnew + t ∗ (Qnew − Qold )

The equations are capturing the idea that we get new tax revenue from the new units but lose tax revenue
from the old units. To know the final effect on both we will need to plug in the numbers as it could increase
or decrease.
See the discussion on Laffer curve in the textbook.
5) Suppose we have a perfectly competitive market with the usual assumptions. Suppose we have a (binding)
intervention that are either price ceiling, price floor and a per-unit tax. Claim: in equilibrium, market
demand is always equal to market supply. Agree/Disagree/It depends? Explain.

Solution: Disagree. The difference between a tax and a price control is in what happens to quantities produced.
With a tax, producers and consumers face two effective prices. The market quantity is a result of them both
reacting to their own effective prices to get a single market quantity where QD (PD ) = QS (PS ). In this case,
yes, market demand is always equal to market supply.
However with the price controls, this is not the case. Both sides face the same price. But, because in the
binding case, prices are not allowed to rise/fall to their equilibrium prices where demand=supply, we are
necessarily in a situation where we have excess demand or excess supply.
We can still solve for market quantity because that is the units that are exchanged. The number exchanged
will be the minimum of demand and supply at the price since we can’t force anyone to produce or buy.
6) Assume the city of Toronto can impose taxes on good. Suppose Toronto has a per-unit tax on sugary sodas in
Toronto. It is considering raising it. The goal is to reduce consumption of sugary drinks and raise revenue for
the city.
Real world inspiration: The Op-ed “Let’s tax sugary drinks to discourage consumption” by Christopher Labos
in the Montreal Gazette. July 23, 2019.
6a) Someone claims that the tax will decrease revenues instead of increasing them. Can you explain the reasoning
behind such a claim?

Solution: See solution to Q4. If the particular can has a large decrease in quantity sold of sugary soda because
people are escaping the tax, then government revenues will decrease. This could be because they get their
sugary drinks from sweetened fruit juice (a close substitute).
6b) Another person says that the tax will not change people’s consumption of sugar very much. Can you explain
the reasoning behind such a claim?
Solution: Usually one reason we have a tax is to change people’s decisions. A tax increases M C so when people
are making a M C vs M B decision, they will stop at a lower quantity. However, if this is not sufficient to
induce a big people’s behavior it means that the M B are high enough so that even even with the higher
prices, people buy large quantities. This show up as inelastic demand. It could be because there are no close
substitutes for example.

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

7) Assume a perfectly competitive market with no externalities. Consider a market with a binding price floor. If
the government buys any excess supply will the DWL be higher or lower compared to the situation with the
price floor but the government does not buy the excess supply. Explain.
Solution: See the diagram below. We can see that when the govt buys the surplus DWL is bigger. This is because
the economy is producing units for which the marginal social benefit is less than the marginal social cost. If the
govt. does not buy it, there units are not produced. Producers will want to produce them but in equilibrium
only the ones traded are produced. Remember DWL is calculated by comparing TS to the efficient TS. Since
we have no externalities and a perfectly competitive market, this is the market TS.
P
S
D

P1
B G
E
P∗ J
F
C

H I

Q
Q1 Q∗

Surplus at Q∗ , P ∗
CS: A+B+E
PS: C+F
T S mkt : A+B+C+E+F
Surplus at Q1 , P1
Govt. does not buy excess
CS: A
PS: B+C
T S ceiling : A+B+C
|DWL|:T S mkt − T S ceiling = E+F

Surplus at Q1 , P1
Govt buys excess supply
CS: A
PS: B+C+E+F+G
Govt: -(E+F+G+J+H+I)
T S ceiling : A+B+C+E+F+G-(E+F+G+J+H+I)=A+B+C-J-H-I
|DWL|: T S mkt − T S ceiling =A+B+C+E+F-A-B-C+J+H+I=E+F+J+H+I

8) With COVID-19 prices of certain products increased dramatically. There were calls for the government to step
in to impose price controls. Ontario imposed fines for anyone found guilty of price gouging (see: Ontario
corporations, individuals could face ’staggering’ fines for price gouging by Katherine DeClerq. CTV News.
March 28, 2020.)
Do you agree that the province should punish price gouging? Explain your reasoning.

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ECO 101H1: Principles of Microeconomics Prof. Freitas, University of Toronto

Solution: If you stick within the traditional framework, then a price control will cause a Deadweight Loss (DWL).
The DWL could be even higher than the triangle due to lost sales (i.e. (E+F) in the question above) because
of issues like misallocation. Someone with a lower Marginal Willingness to Pay (MWTP) get the good instead
of someone with a higher MWTP.
Those would be argument against imposing price controls. What about arguments for price controls? Here
are some things to think about.

• MWTP incorporates both value and ability to pay. What if someone has a higher MWTP because they
are richer and are able to pay more? How should we think about this. Note: This is a general criticism
against the efficiency argument (see the videos in the Surplus module).
• What if the good is face masks and some people should get the face masks because they are in contact
with more people than others? There are two aspects to this (1) MWTP may not be high for the person
who actually has a higher risk of infecting everyone else. (2) What about the impact of a wearing a face
mask on other people? Where would we see this in the current framework? Short answer, we can’t–yet.
This is an example of an externality that will be introduced later. But thinking about it reminds you
about the strong assumptions behind the conclusions made on the basis of perfect competition. See
Price controls don’t work-but mask rationing is the exception that proves the rule by Amihai Glazer.
The Conversation. April 24, 2020

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