Chapter 4 the mayor of Gotham City decides to lower the price

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S-61

1. In order to ingratiate himself with voters, the mayor of Gotham City decides to lower

the price of taxi rides. Assume, for simplicity, that all taxi rides are the same distance

and therefore cost the same. The accompanying table shows the demand and supply

schedules for taxi rides.

a. Assume that there are no restrictions on the number of taxi rides that can be sup-

plied (there is no medallion system). Find the equilibrium price and quantity.

b. Suppose that the mayor sets a price ceiling at $5.50. How large is the shortage of

rides? Illustrate with a diagram. Who loses and who benefits from this policy?

c. Suppose that the stock market crashes and, as a result, people in Gotham City

are poorer. This reduces the quantity of taxi rides demanded by 6 million rides

per year at any given price. What effect will the mayor’s new policy have now?

CHAPTER

Price Controls and Quotas:

Meddling with Markets

$7.00 10 12

6.50 11 11

Quantity of rides

(millions per year)

Fare

(per ride) Quantity demanded Quantity supplied

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Solution

1. a. The equilibrium in the market for taxi rides is shown by E1 in the accompany-

ing diagram. The equilibrium price is $6.50; at that price, the quantity demanded

equals the quantity supplied—11 million taxi rides per year. The demand and sup-

ply curves (D1 and S) illustrate this initial situation.

$7.00

6.50

6.00

Fare

(per ride)

= 4 million. Taxi drivers clearly lose out: there are fewer taxi rides supplied than

before, and at a lower price. The impact on consumers is unclear: fewer people

now manage to get rides, but those who do, get them at a lower price.

$7.00

Fare

(per ride)

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c. The new demand curve is D2. Now the price ceiling has no effect: the equilibrium

is point E2 and the market price settles at $5, which is below the mandated price

ceiling of $5.50. There will be 8 million taxi rides demanded and supplied, at a

price of $5 each.

$7.00

6.50

Fare

(per ride)

d. The accompanying diagram illustrates the effect of the quota of 10 million taxi

rides. The quantity of taxi rides is now 10 million, at a price of $7. The quota rent

per ride is $1.

$7.00

6.50

Fare

(per ride)

Quota

rent

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Solution

2. In the late eighteenth century, the price of bread in New York City was controlled,

set at a predetermined price above the market price.

a. Draw a diagram showing the effect of the policy. Did the policy act as a price ceil-

ing or a price floor?

2. a. Panel (a) of the accompanying diagram illustrates the effect of this policy. Since

the price is set above the market equilibrium price, this policy acts as a price floor:

it raises the price artificially above the equilibrium. As a result, too much bread is

produced: there is a surplus.

Price

of bread

Price

of bread

Surplus

Price

ceiling

Panel (a) Panel (b)

b. As with all price floors above the equilibrium price, there are several associated

inefficiencies. First, some transactions that would have occurred at the unregu-

lated market price no longer occur. Second, there is inefficient allocation of

sales among bakers. Some bakers who are willing to sell at a lower price don’t get

d. As with all price ceilings below the equilibrium price, there are several associated

inefficiencies. First, there is inefficiently low quantity transacted. There is a

persistent shortage of bread, and some transactions that would have occurred

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Solution

3. The U.S. Department of Agriculture (USDA) administers the price floor for butter,

which the 2008 Farm Bill set at $1.05 per pound. At that price, according to data

from the USDA, the quantity of butter supplied in 2010 was 1.7 billion pounds,

Price of butter

(per pound)

$1.20

1.15

1.10

1.05

a. In the absence of a price floor, how much consumer surplus is created? How

much producer surplus? What is the total surplus?

b. With the price floor at $1.05 per pound of butter, consumers buy 1.6 billion

pounds of butter. How much consumer surplus is created now?

3. a. In the absence of a price floor, consumer surplus is the area below the demand

curve but above the equilibrium price of $1.00: it is (($1.15 − $1.00) × 1.65 bil-

lion)/2 = $123.75 million. Producer surplus is the area above the supply curve

but below the equilibrium price of $1.00: it is (($1.00 − $0.85) × 1.65 billion)/2

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Solution

S-66 CHAPTER 4 PRICE CONTROLS AND QUOTAS: MEDDLING WITH MARKETS

d. The USDA buys 100 million pounds of butter at a price of $1.05 per pound, for a

4. The accompanying table shows hypothetical demand and supply schedules for milk

per year. The U.S. government decides that the incomes of dairy farmers should be

maintained at a level that allows the traditional family dairy farm to survive. So it

implements a price floor of $1 per pint by buying surplus milk until the market price

is $1 per pint.

$1.20 550 850

Quantity of milk

(millions of pints per year)

Price of milk

(per pint) Quantity demanded Quantity supplied

a. How much surplus milk will be produced as a result of this policy?

b. What will be the cost to the government of this policy?

c. Since milk is an important source of protein and calcium, the government decides

4. a. With demand of D1 and supply of S, the equilibrium would be at point E1 in the

accompanying diagram. However, with a price floor at $1, the quantity supplied is

750 million pints and the quantity demanded is 650 million pints. So the policy

causes a surplus of milk of 100 million pints per year.

$1.20

Price of milk

(per pint)

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b. In order to sustain this price floor (to prevent black market sales of surplus milk

below the price floor), the government has to buy up the surplus of milk. Buying

100 million pints of milk at a price of $1 each costs the government $100 million.

c. As a result of sales of cheap milk to schools, the quantity demanded falls by 50

million pints per year at any price: the demand curve shifts leftward to the new

demand curve D2. Without the price floor, the equilibrium would now be at point

$1.20

1.10

1.00

Price of milk

(per pint)

Surplus of

150 million pints

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5. European governments tend to make greater use of price controls than does the U.S.

government. For example, the French government sets minimum starting yearly

€45,000 200,000 325,000

€40,000 220,000 320,000

Wage

(per year)

Quantity supplied

(new job seekers

per year)

Quantity demanded

(new job offers

per year)

a. In the absence of government interference, what are the equilibrium wage and

number of graduates hired per year? Illustrate with a diagram. Will there be any-

one seeking a job at the equilibrium wage who is unable to find one—that is, will

there be anyone who is involuntarily unemployed?

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Solution

5. a. The equilibrium wage is €30,000, and 290,000 workers are hired. There is full

employment: nobody is involuntarily unemployed. The equilibrium is at point E.

€45

Wage

(thousands

per year)

Minimum wage

€40,000

Surplus

b. With a minimum wage of €35,000, there is a surplus of workers of 60,000 (the

quantity supplied is 310,000 and the quantity demanded is 250,000). That is,

there are 60,000 workers who are involuntarily unemployed. At a minimum wage

of €40,000, there is a surplus of workers of 100,000: this is the number of invol-

untarily unemployed workers.

c. The higher the minimum wage, the larger the amount of involuntary unemploy-

ment. The people who benefit from this policy are those workers who succeed in

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Solution

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6. For the last 80 years the U.S. government has used price supports to provide income

assistance to American farmers. To implement these price supports, at times the

government has used price floors, which it maintains by buying up the surplus farm

products. At other times, it has used target prices, a policy by which the government

gives the farmer an amount equal to the difference between the market price and the

target price for each unit sold. Consider the market for corn depicted in the accom-

panying diagram.

Price of corn

(per bushel)

a. If the government sets a price floor of $5 per bushel, how many bushels of corn

are produced? How many are purchased by consumers? By the government? How

much does the program cost the government? How much revenue do corn farm-

ers receive?

6. a. With a price floor of $5, the quantity of corn supplied is 1,200 bushels. The quan-

tity demanded is only 800 bushels: there is a surplus of 400 bushels. The govern-

ment therefore has to buy up the surplus of 400 bushels, at a price of $5 each:

the program costs the government 400 × $5 = $2,000. Corn farmers sell 1,200

bushels (800 to consumers and 400 to the government) and therefore make 1,200

Solution

7. The waters off the North Atlantic coast were once teeming with fish. But due to

over fishing by the commercial fishing industry, the stocks of fish became seriously

depleted. In 1991, the National Marine Fishery Service of the U.S. government imple-

$20 6 15

18 7 13

16 8 11

Quantity of swordfish

(millions of pounds per year)

Price of swordfish

(per pound) Quantity demanded Quantity supplied

7. a. The quantity sold is 7 million pounds, at a price of $18 per pound. On each

pound of fish caught, each fisherman earns quota rent of $6, as shown in the

accompanying diagram.

$20

Price of swordfish

(per pound)

Quota

rent

Quota

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Solution

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8. In Maine, you must have a license to harvest lobster commercially; these licenses are

issued yearly. The state of Maine is concerned about the dwindling supplies of lob-

sters found off its coast. The state fishery department has decided to place a yearly

quota of 80,000 pounds of lobsters harvested in all Maine waters. It has also decided

to give licenses this year only to those fishermen who had licenses last year. The

accompanying diagram shows the demand and supply curves for Maine lobsters.

$22

Price of

lobster

(per pound)

8. a. Without government restrictions, the equilibrium in the market for lobsters is

at point E. The equilibrium price for lobsters is $10 per pound. At that price, the

quantity demanded and the quantity supplied are 120,000 pounds of lobsters.

$22

Price of lobster

(per pound)

Quota

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b. The demand price of 80,000 pounds of lobsters is $14.

9. The accompanying diagram shows data from the U.S. Bureau of Labor Statistics on

the average price of an airline ticket in the United States from 1975 until 1985,

adjusted to eliminate the effect of inflation (the general increase in the prices of all

goods over time). In 1978, the United States Airline Deregulation Act removed the

price floor on airline fares, and it also allowed the airlines greater flexibility to offer

new routes.

Price of airline

ticket (index:

1975 = 100)

160

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Solution

9. a. When a binding price floor—one that is set above the equilibrium price—is

removed, you should expect the price of the good to fall. From looking at the data

in the figure, you should think that the pre – 1978 price floor was ineffective, since

the price of an airline ticket actually rose after 1978. In the accompanying dia-

gram, the price floor, PF, is non binding: it is set below the equilibrium price, PE. In

that case, removing the price floor would not lead to a decrease in price.

Price of

airline ticket

10. Many college students attempt to land internships before graduation to burnish

their resumes, gain experience in a chosen field, or try out possible careers. The hope

shared by all of these prospective interns is that they will find internships that pay

more than typical summer jobs, such as waiting tables or flipping burgers.

a. With wage measured on the vertical axis and number of hours of work on the

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Solution

10. a. Here the market-clearing wage, W1, is non-binding because it is above the mini-

mum wage. In this case the minimum wage has no effect on the market for

interns: the number of hours transacted in the market equilibrium, X1, is the

same as if there had been no minimum wage.

Wage

b. The economic downturn will result in an increase in the supply of interns. The

supply curve will shift outward to its new position at S2 and result in a new equi-

librium wage of zero. The minimum wage is now binding.

Wage

Minimum

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Solution

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

market rents will now prevail. Assume that all rental units are identical and so are

offered at the same rent. To address the plight of residents who may be unable to pay

the market rent, an income supplement will be paid to all low – income households

equal to the difference between the old controlled rent and the new market rent.

a. Use a diagram to show the effect on the rental market of the elimination of rent

11. a. With a price ceiling at PC, the quantity bought and sold is QC, indicated by

point A. The ceiling at PC is eliminated and the rent returns to the market equilib-

rium E1, with an equilibrium rent of P1. The quantity supplied increases from QC

to the equilibrium quantity Q1. At the same time, you should expect the quality of

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b. The income – supplement policy causes a rightward shift of the demand curve from

D1 to D2. This results in an increase in the equilibrium rent, from P1 to P2, and an

increase in the equilibrium quantity, from Q1 to Q2, as the equilibrium changes

from E1 to E2.

Monthly

rent

c. Landlords are clearly better off as a result of these two policies: more landlords

rent out apartments, and at a higher monthly rent. It is not clear whether

tenants are better or worse off. Some tenants who previously could not get

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