Business Economics 2024: Problem Set 2

Posted 28/10/24. Solutions released 11/11/24

1 Equilibrium
In this example we will study the market for coffee. In particular, ‘firms’ in this industry
are the coffee bean farmers — typically very small enterprises. In the short run farmers
can increase their production by working more hours. In the long run they always have
the option of shutting down their farm and working in a job in an urban area; equally,
starting a coffee farm is not difficult and requires only a small investment. Although the
quality and style of coffee beans does vary, let’s assume that within a region they do not,
and let’s further assume that each region contains many farmers.

1. Is it reasonable to apply our perfectly competitive model to this industry? Why or

why not?
Based on the description in the question, applying the perfectly competitive model
seems reasonable. Recall from the lecture slides this model has three assumptions:
(A1) Many small producers; (A2) Homogeneous goods; (A3) Free entry and exit in
the long run. We have been told that these are ‘very small enterprises’ (A1), and
that starting a coffee farm ‘requires only a small investment’ (A3). We are also told
that there are many farmers producing the same quality/style within each region, so
maybe homogeneous goods is not such a bad assumption (A2). A model will never
perfectly fit the real world: the goal is just to judge if it is ‘good enough’ to be useful.

2. Use a graph to show short-run equilibrium in this industry. Be sure to (a) label
the axes, (b) label the supply and demand curves, and (c) indicate the equilibrium
quantity and price.

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 Price p
PS (y)

PD (y)

p∗

y∗ Quantity y

Note that the question should have really asked for inverse supply and demand curves,
rather than just supply and demand curves. In general using either setup — sup-
ply and demand, or inverse supply and demand – is fine, but the usual practice in
economics when drawing a supply and diagram is to use the inverse curves.
3. Suppose a shock lowers the price of tea. Suppose also that most people regard tea
and coffee as close substitutes. What do you think will happen to demand for coffee?
We expect consumers to substitute towards tea, and away from coffee, as the price
of tea falls. The result is a negative demand shock in the market for coffee.
4. What are the short run effects of this shock on price and quantity? Use the graph to
explain your answer.
In the short run, a negative demand shock will lower both the price and the quantity
of coffee. Graphically:

Price p
PS (y)

PD0 (y)

p∗0
PD1 (y)
p∗1

y1∗ y0∗ Quantity y

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 The original inverse demand curve, price, and quantity are all shown with zero sub-
scripts. The new inverse demand curve, price, and quantity are all shown with one
subscripts.

5. What happens to the coffee farmers’ profits in the short run? Do you expect profits
to remain at this level in the long run? Why or why not?
In the short run, the lower price will result in lower (total) profits for coffee farmers.
Indeed, let us suppose that before the shock the market for coffee was in its long run
equilibrium with total profits equal to zero. Then following the shock, in the short
run we expect coffee farmers to earn negative total profits. In the long run, however,
we expect the free entry condition to hold and therefore for total profits to return to
zero.

6. How do you expect equilibrium price and quantity to evolve in the long run? Use
the graph to explain your answer.
In the long run, free entry implies that the inverse supply curve is horizontal at some
fixed price, call it p∗0 . Therefore in the long run the price will return to this level, while
the quantity will fall more than in the short run. The mechanism that ensures this
will be the gradual exit of farmers as long as total profits are negative. Graphically:

Price p

PD0 (y)

PS2 (y)
p∗0 = p∗2
p∗1

PD1 (y)

y2∗ y1∗ y0∗ Quantity y

Long run inverse supply, quantity and price are all shown with two subscripts. Note
that long run inverse supply is horizontal, that the long run price is equal to the
original price, and that in the long run quantity falls more than in the short run as
farmers gradually exit.

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2 Welfare and Taxation
1. Every Thursday – after teaching, perhaps – John goes to his favorite pub. Every time
he goes there he spends £10 on 2 pints. One day, to John’s surprise, the price of pints
there was 10% higher than usual. The higher price induced John to purchase less,
and he purchased only 1.6 pints on this day. (You can assume that John’s favorite
pub is happy to serve pints in non-integer units, and you can also assume that John’s
demand for pints has a constant elasticity form).

(a) Based on this information, what is John’s elasticity of demand for pints?
Recall that one way to calculate the elasticity of demand is to use

% change in demand
ϵD (p) = − .
% change in price

We know that the price has increased by 10% and that demand has fallen by
20%. So the elasticity of demand is 2.0.
(b) What is the consumer surplus that John derives from access to the pub on an
ordinary day, i.e, without the higher price?
Recall that with a constant elasticity demand curve, we can calculate consumer
surplus using the formula
 
1
CS = p∗ y ∗ .
δ−1

p∗ y ∗ is just revenue, which in this case is £10. And from (a) we know that δ,
the elasticity of demand, is just 2.0. So,
   
1 ∗ ∗ 1
CS = p y = × 10 = 10.
δ−1 2.0 − 1

So John’s consumer surplus is £10.

(c) What is the consumer surplus John derives from the pub after prices have in-
creased by 10%?
We can continue to use the formula from (b), and we only need to adjust the
revenue term. We know that after the price increase, John buys 1.6 pints, and
at the new price each pint must cost £5.50 (recall John was initially spending
£10 on two pints, so the price of one pint must have been £5). That implies
revenue is now 1.6 × 5.50 = £8.80. Plugging this into the consumer surplus
formula implies his new consumer surplus is just £8.80.

Suppose that the price of pints returns to its original level. Unfortunately, however,
the pub decides to impose a cover charge for entry.

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 (d) What is the highest such charge the pub could impose on John? Explain your
reasoning.
The highest price the pub can impose on John is £10, exactly his consumer
surplus at the original price. This is because consumer surplus measures John’s
willingness to pay to access the market: in this case, he is willing to pay £10 to
enter the pub.

2. Suppose a market is perfectly competitive and that the inverse supply curve is hori-
zontal, or in other words, that the elasticity of supply is infinite. What is producer
surplus in this market? Explain the intuition behind your answer.
Producer surplus is exactly zero. One way to see this is to note that producer surplus
can be calculated using the formula
 
1
PS = p∗ y ∗ ,
1+σ

where σ is the supply elasticity. As σ goes to infinity, the bottom line of this fraction
becomes very large and producer surplus shrinks to zero. What is happening here
intuitively? A horizontal supply curve corresponds to constant marginal cost: the
firm is willing to supply any amount as long as price is at least covers this marginal
cost. In equilibrium we know that the firm will choose a level of output such that
price is equal to marginal cost. In other words, the price the firm receives for each
unit it produces is just the (variable) cost that it incurs in producing that unit. The
result is that (variable) profits, and therefore producer surplus, are zero.

3. You friend complains that taxes – on goods, let’s say – are terrible because they
lower the prices facing firms and raise the prices facing consumers, so that everyone
is worse off. Do you agree with your friend’s reasoning? Explain briefly.
Your friends may be right that taxes are terrible, or at least, tend to reduce welfare
(in the absence of any externalities), but their reasoning about why is not correct.
The welfare loss due to taxation does not come from the higher or lower prices some
agents face, because what they lose from those higher or lower prices becomes tax
revenue for the government, which we also count in our measure of welfare. Instead,
the destructive effect of taxes comes from the fact producers respond to lower prices
by producing less, and consumers respond by buying less. Thus both consumers
and producers miss out on potentially profitable or welfare-improving transactions,
because the tax has distorted their incentives.

4. In the lecture slides, we analysed taxes. The same framework can be used to analyse
the costs and benefits of subsidies. To see this, consider the market for electric
vehicles. Let’s suppose that it is composed of many small producers who produce
cars which are very similar. The government is considering subsidising these vehicles

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by rebating consumers for their purchases. Specifically, for every £100 a consumer
spends on electric vehicles the government will rebate them £30.
Note: approach this question by following the lecture slides on taxes and think of the
subsidy as a negative tax rate. You may find it helpful to look at section 9.6 in the
textbook.

(a) What is the subsidy rate? What is the relationship between the price facing
producers and the price facing consumers?
From the description above, if the producer receives 100 the consumer ultimately
pays 70. So the tax rate τ – which we can regard as the negative of the subsidy
rate – must satisfy,
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q = (1 − τ )p =⇒ 100 = (1 − τ )70 =⇒ τ = − ≃ −43%.
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(b) Graphically analyse the effects of this subsidy on the equilibrium quantity and
producer and consumer prices.
In the graph below, the pre-subsidy equilibrium is shown with zero subscripts
and the post-subsidy equilibrium is shown with one subscripts. At the new
equilibrium the price facing producers is higher than in the old equilibrium
(note that pre-subsidy, the price facing producers was just p∗0 ), while the price
facing consumers has fallen. As a result the equilibrium quantity is higher with
the subsidy.
Price p
PS (y)

PD (y)
q1∗ = 1.43p∗1

p∗0
p∗1

y0∗ y1∗ Quantity y

(c) How do consumer and producer surplus change as a result of the subsidy?
Both consumer and producer surplus rise as a result of the subsidy. Consumers
enjoy a lower price, while producers enjoy a higher price.

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(d) Does this subsidy create any deadweight loss? Explain intuitively, and if there
is deadweight loss, mark it on your graph.
The subsidy creates deadweight loss in much the same way as a tax. To see
this, let’s shade in the changes in the producer and consumer surplus in the
graph. The blue area shows the consumer surplus created by the subsidy, which
is just the change in the area between demand curve and price. The red area
does the same for producer surplus. The sum of these two areas is the change in
consumer and producer surplus. But we must also account for the expenditure
of the government, which is the entire area between the producer and consumer
prices, from zero output to y1∗ . This rectangle is clearly larger than the increase
in consumer and producer surplus, so the subsidy reduces welfare. The reduction
in welfare — the deadweight loss of the subsidy — is shaded in grey. Intuitively,
the subsidy creates deadweight loss because it distorts agents incentives so that
cost of some of the units produced exceeds the highest price the consumer would
be willing to pay for them. Optimally these units would not be produced.
Price p
PS (y)

PD (y)
q1∗ = 1.43p∗1

p∗0
p∗1

y0∗ y1∗ Quantity y

Suppose that, before the subsidy, this market has total revenues equal to £3 billion,
and further suppose that the elasticity of demand is 5 and the short run elasticity of
supply is 1.

(e) How do producer and consumer prices change as a result of the subsidy? Provide
a quantitative answer.
From the lecture slides, we know the change in consumer prices due to a tax is
approximately
 
σ
% change in consumer price = τ,
σ+δ

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 where σ is the supply elasticity, δ is the demand elasticity and τ is the tax rate.
In our case δ = 5, σ = 1, and τ = −0.43, so
 
1
% change in consumer price = × (−0.43) = −0.07,
1+5

so the price facing consumers falls by 7%. A similar formula applies to the
producer price,
   
δ 5
% change in producer price = − τ= × (0.43) = 0.36,
σ+δ 1+5

so the price facing producers rises by 36%.

(f) What is the size of deadweight loss created by this subsidy?
The lecture slides introduced the following formula for deadweight loss (DWL)
 
DW L 1 σδ
= τ 2.
p∗ y ∗ 2 σ+δ
Plugging our numbers in,
 
DW L 1 5×1
∗ ∗
= 0.432 = 0.077.
p y 2 5+1

So deadweight loss is 7.7% of revenue, or £231 million.

(g) Suppose that in the long run entry and exit mean that the elasticity of supply
is infinite. How do your answers to (e) and (f) change?
Let’s start with producer prices, given by
 
δ
% change in producer price = − τ,
σ+δ
As σ becomes infinitely large, the bottom line of the fraction here also goes to
infinity and so the fraction shrinks to zero. The result is that producer prices
do not change at all in the long run. Since we know that consumer prices must
be 43% below producer prices, we can immediately infer that consumer prices
falls by 43% in the long run relative to the pre-subsidy equilibrium. This is in
line the claim that the inelastic side of the market bears the burden of taxation;
supply is infinitely elastic and so producers bear none of the burden, or in this
case, receive none of the benefit of the subsidy. To see how deadweight loss
changes, it is useful to write it as
!
DW L 1 1
= δ τ 2,
p∗ y ∗ 2 1 + σδ

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which is mathematically identical to our original expression. As σ becomes very
large, the fraction here goes to one, and so deadweight loss with infinitely elastic
supply is just
DW L 1
∗ ∗
= δτ 2 .
p y 2
Plugging in our numbers, we find that deadweight loss is 46% of revenue, or
£1.38 billion. Deadweight loss is much larger in the long run because producers
are much more responsive to the distorted incentives created by the subsidy.