Section 3: Market Efficiency and Price Controls
Question 1
1. Determine the amount of consumer surplus generated in each of the following situations.
a. Leon goes to the clothing store to buy a new T-shirt, for which he is willing to pay up to
$10. He picks out one he likes with a price tag of exactly $10. When he is paying for it, he
learns that the T-shirt has been discounted by 50%.
b. Alberto goes to the music store hoping to find a used copy of Nirvana’s Nevermind for up
to $30. The store has one copy of the record selling for $30, which he purchases.
c. After soccer practice, Stacey is willing to pay $2 for a bottle of mineral water. The 7-Eleven
sells mineral water for $2.25 per bottle, so she declines to purchase it.
Solution 1
Question 2
2. Determine the amount of producer surplus generated in each of the following situations.
a. Gordon lists his old Lionel electric trains on eBay. He sets a minimum acceptable price,
known as his reserve price, of $75. After five days of bidding, the final high bid is exactly
$75. He accepts the bid.
b. So-Hee advertises her car for sale in the used-car section of the student newspaper for
$2,000, but she is willing to sell the car for any price higher than $1,500. The best offer she
gets is $1,200, which she declines.
c. Sanjay likes his job so much that he would be willing to do it for free. However, his annual
salary is $80,000.
Solution 2
Question 3
3. There are six potential consumers of computer games, each willing to buy only one game.
Consumer 1 is willing to pay $40 for a computer game, consumer 2 is willing to pay $35,
consumer 3 is willing to pay $30, consumer 4 is willing to pay $25, consumer 5 is willing to
pay $20, and consumer 6 is willing to pay $15.
a. Suppose the market price is $29. What is the total consumer surplus?
b. The market price decreases to $19. What is the total consumer surplus now?
c. When the price fell from $29 to $19, how much did each consumer’s individual consumer
surplus change? How does total consumer surplus change?
Solution 3
Question 4
4. a. In an auction, potential buyers compete for a good by submitting bids. Adam Galinsky, a
social psychologist at Northwestern University, compared eBay auctions in which the same
good was sold. He found that, on average, the higher the number of bidders, the higher the
sales price. For example, in two auctions of identical iPads, the one with the higher number
of bidders brought a higher selling price. According to Galinsky, this explains why smart
sellers on eBay set absurdly low opening prices (the lowest price that the seller will
accept), such as 1 cent for a new iPad. Use the concepts of consumer and producer surplus
to explain Galinsky’s reasoning.
b. You are considering selling your first car. If the car is in good condition, it is worth a lot; if
it is in poor condition, it is useful only as scrap. Assume that your car is in excellent
condition but that it costs a potential buyer $40 for a CARFAX report to determine the
car’s condition. Use what you learned in part a to explain whether or not you should pay
for the CARFAX report and share the results with all interested buyers.
Solution 4
Question 5
5. The accompanying table shows the supply and demand schedules for used copies of the fourth
edition of this textbook. The supply schedule is derived from offers at Amazon.com. The
demand schedule is hypothetical.
Price of book
Quantity of books
demanded
Quantity of books
supplied
$55
50
0
60
35
1
65
25
3
70
17
3
75
14
6
80
12
9
85
10
10
90
8
18
95
6
22
100
4
31
105
2
37
110
0
42
a. Calculate consumer and producer surplus at the equilibrium in this market.
b. Now the fifth edition of this textbook becomes available. As a result, the willingness to pay
of each potential buyer for a second-hand copy of the fourth edition falls by $20. In a table,
show the new demand schedule and again calculate consumer and producer surplus at the
new equilibrium.
Solution 5
Question 6
6. On Thursday nights, a local restaurant has a pasta special. Ari likes the restaurant’s pasta, and
his willingness to pay for each serving is shown in the accompanying table.
Willingness to pay
for pasta (per
serving)
$10
8
6
4
2
0
a. If the price of a serving of pasta is $4, how many servings will Ari buy? How much
consumer surplus does he receive?
b. The following week, Ari is back at the restaurant again, but now the price of a serving of
pasta is $6. By how much does his consumer surplus decrease compared to the previous
week?
c. One week later, he goes to the restaurant again. He discovers that the restaurant is offering
an “all-you-can–eat” special for $25. How much pasta will Ari eat, and how much
consumer surplus does he receive now?
d. Suppose you own the restaurant and Ari is a typical customer. What is the highest price you
can charge for the “all-you-can–eat” special and still attract customers?
Solution 6
Question 7
7. The accompanying diagram illustrates a taxi driver’s individual supply curve (assume that
each taxi ride is the same distance).
a. Suppose the city sets the price of taxi rides at $4 per ride, and at $4 the taxi driver is able to
sell as many taxi rides as he desires. What is this taxi driver’s producer surplus? (Recall
that the area of a right triangle is ½ × the height of the triangle × the base of the triangle.)
b. Suppose that the city keeps the price of a taxi ride set at $4, but it decides to charge taxi
drivers a “licensing fee.” What is the maximum licensing fee the city could extract from
this taxi driver?
c. Suppose that the city allowed the price of taxi rides to increase to $8 per ride. Again assume
that, at this price, the taxi driver sells as many rides as he is willing to offer. How much
producer surplus does an individual taxi driver now get? What is the maximum licensing
fee the city could charge this taxi driver?
Solution 7
Question 8
8. Streaming music services have changed the way we listen to music. Spotify, Pandora, Tidal,
and Google Play are some of the more popular services. These companies offer free access to
music. For a small monthly fee users can purchase premium access and listen to millions of
songs on demand and ad free. But not all artists are fans of free streaming music. In 2016,
Taylor Swift’s move to prevent Spotify from playing her new release, 1989, for free, made
national headlines. When Spotify refused to restrict access to only paying customers, Swift
would not allow the company to play her music for free. She is not alone. Adele, Dr. Dre,
Garth Brooks, and Coldplay have all had run-ins with free streaming services.
a. If music lovers obtain music and video content via free music streaming services, instead of
buying it directly or paying for premium access, what would the record companies’
producer surplus be from music sales? What are the implications for record companies’
incentive to produce music content in the future?
b. If Taylor Swift and other artists were not allowed to pull their music from the free
streaming services, what would happen to mutually beneficial transactions (the producing
and buying of music) in the future?
Solution 8
Question 9
9. 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.
Fare (per ride)
Quantity of rides
(millions per
year)
Quantity
demanded
Quantity supplied
$7.00
10
12
6.50
11
11
6.00
12
10
5.50
13
9
5.00
14
8
4.50
15
7
a. Assume that there are no restrictions on the number of taxi rides that can be supplied (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? Illustrate with a diagram.
d. Suppose that the stock market rises and the demand for taxi rides returns to normal (that is,
returns to the demand schedule given in the table). The mayor now decides to ingratiate
himself with taxi drivers. He announces a policy in which operating licenses are given to
existing taxi drivers; the number of licenses is restricted such that only 10 million rides per
year can be given. Illustrate the effect of this policy on the market, and indicate the
resulting price and quantity transacted. What is the quota rent per ride?
Solution 9
Question 10
10. 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 ceiling or a
price floor?
b. What kinds of inefficiencies were likely to have arisen when the controlled price of bread
was above the market price? Explain in detail.
One year during this period, a poor wheat harvest caused a leftward shift in the supply of
bread and therefore an increase in its market price. New York bakers found that the controlled
price of bread in New York was below the market price.
c. Draw a diagram showing the effect of the price control on the market for bread during this
one-year period. Did the policy act as a price ceiling or a price floor?
d. What kinds of inefficiencies do you think occurred during this period? Explain in detail.
Solution 10
Question 11
11. In 2014, the U.S. House of Representatives approved a new farm bill establishing the Margin
Protection Program (MPP) for dairy producers. The MPP supports dairy farmers when the
margin between feed costs and milk prices falls below $0.08 per pound. Assume that current
feed costs are $0.10 per pound, which means the program creates a price floor for milk at
$0.18 per pound. At that price, the quantity of milk supplied is 240 billion pounds, and the
quantity demanded is 140 billion pounds. To support the price of milk at the price floor, the
U.S. Department of Agriculture (USDA) has to buy up 100 billion pounds of surplus milk.
The supply and demand curves in the following diagram illustrate the market for milk.
a. In the absence of a price floor, how much consumer surplus is created? How much
producer surplus? What is the total surplus (producer surplus plus consumer surplus)?
b. With the price floor at $0.18 per pound of milk, consumers buy 140 billion pounds of milk.
How much consumer surplus is created now?
c. With the price floor at $0.18 per pound of milk, producers sell 240 billion pounds of milk
(some to consumers and some to the USDA). How much producer surplus is created now?
d. How much money does the USDA spend to buy surplus milk?
e. Taxes must be collected to pay for the purchases of surplus milk by the USDA. As a result,
total surplus is reduced by the amount the USDA spent buying surplus milk. Using your
answers from parts b, c, and d, what is the total surplus when there is a price floor? How
does this total surplus compare to the total surplus without a price floor from part a?
Solution 11