AIU Exam – Price Controls & Elasticity

School: Business & Economics

Course title: Price Controls & Elasticity

Book & chapter: Economics by Paul Krugman, Chapters 5 and 6

http://aiustudev.aiu.edu/submissions/profiles/resources/onlineBook/a7C6g6_krugman
%20economics.pdf
Bibliography of book:

Krugman, Paul. Robin Wells. "Economics." Worth Publishers, 4th Edition (2015).
.

Format of the assignment: Assignment must have an AIU cover page, introduction to
the topics of the chapter, answers to the questions below, conclusion about the exam
and the bibliography of book at end of assignment.
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Questions…
Chapter 5
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
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?

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
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.

3. 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.

a. In a diagram, show the deadweight loss from the inefficiently low quantity bought
and sold.
b. How much surplus milk will be produced as a result of this policy?
c. What will be the cost to the government of this policy?
d. Since milk is an important source of protein and calcium, the government
decides to provide the surplus milk it purchases to elementary schools at a
price of only $0.60 per pint. Assume that schools will buy any amount of milk
available at this low price. But parents now reduce their purchases of milk at
any price by 50 million pints per year because they know their children are
getting milk at school. How much will the dairy program now cost the
government?
e. Explain how inefficiencies in the form of inefficient allocation to sellers and
wasted resources arise from this policy.

4. 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
wages for new hires who have completed le bac, certification roughly equivalent to
a high school diploma. The demand schedule for new hires with le bac and the
supply schedule for similarly credentialed new job seekers are given in the
accompanying table. The price here—given in euros, the currency used in France
—is the same as the yearly wage.
 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
anyone seeking a job at the equilibrium wage who is unable to find one—that
is, will there be anyone who is involuntarily unemployed?
b. Suppose the French government sets a minimum yearly wage of €35,000. Is
there any involuntary unemployment at this wage? If so, how much? Illustrate
with a diagram. What if the minimum wage is set at €40,000? Also illustrate
with a diagram. c. Given your answer to part b and the information in the
table, what do you think is the relationship between the level of involuntary
unemployment and the level of the minimum wage? Who benefits from such a
policy? Who loses? What is the missed opportunity here?

5. In many European countries high minimum wages have led to high levels of
unemployment and underemployment, and a two-tier labor system. In the formal
labor market, workers have good jobs that pay at least the minimum wage. In the
informal, or black market for labor, workers have poor jobs and receive less than
the minimum wage.
a. Draw a demand and supply diagram showing the effect of the imposition of a
minimum wage on the overall market for labor, with wage on the vertical axis
and hours of labor on the horizontal axis. Your supply curve should represent
the hours of labor offered by workers according to the wage, and the demand
curve represents the hours of labor demanded by employers according to the
wage. On your diagram show the deadweight loss from the imposition of a
minimum wage. What type of shortage is created? Illustrate on your diagram
the size of the shortage. (Solution…The shortage created is a shortage of
jobs: at the minimum wage there are more job-seekers than there are jobs
available.)
b. Assume that the imposition of the high minimum wage causes a contraction in
the economy so that employers in the formal sector cut their production and
their demand for workers. Illustrate the effect of this on the overall market for
labor. What happens to the size of the deadweight loss? The shortage?
Illustrate with a diagram. (Solution… The contraction in the economy causes
the demand for labor to fall, shifting the demand curve leftwards from D to its
new position at D’. Both the deadweight loss and the shortage of jobs caused
by the minimum wage increase as a result of the fall in the demand for labor)
c. Assume that the workers who cannot get a job paying at least the minimum
wage move into the informal labor market where there is no minimum wage.
 What happens to the size of the informal market for labor as a result of the
economic contraction? What happens to the equilibrium wage in the informal
labor market? Illustrate with a supply and demand diagram for the informal
market. (Solution… As a result of the economic contraction which reduces
the demand for workers in the overall market, workers move to the informal
labor market. This increases the supply of labor in the informal labor market.
The supply curve for labor shifts rightwards from S to its new position at S’.
The equilibrium wage in the informal labor market falls from w* to w** and the
quantity of hours transacted increases from Q* to Q**, as the informal labor
market expands.)

Chapter 6
6. Do you think the price elasticity of demand for Ford sport-utility vehicles (SUVs) will
increase, decrease, or remain the same when each of the following events occurs?
Explain your answer.
a. Other car manufacturers, such as General Motors, decide to make and sell
SUVs.
b. SUVs produced in foreign countries are banned from the American market.
c. Due to ad campaigns, Americans believe that SUVs are much safer than
ordinary passenger cars.
d. The time period over which you measure the elasticity lengthens. During that
longer time, new models such as four- wheel-drive cargo vans appear.

7. In the United States, 2013 was a bad year for growing wheat. And as wheat supply
decreased, the price of wheat rose dramatically, leading to a lower quantity
demanded (a movement along the demand curve). The accompanying table
describes what happened to prices and the quantity of wheat demanded.

a. Using the midpoint method, calculate the price elasticity of demand for winter
wheat.
b. What is the total revenue for U.S. wheat farmers in 2012 and 2013?
c. Did the bad harvest increase or decrease the total revenue of U.S. wheat
farmers? How could you have predicted this from your answer to part a?

8. The accompanying table lists the cross-price elasticities of demand for several goods,
where the percent quantity change is measured for the first good of the pair, and
the percent price change is measured for the second good.
 a. Explain the sign of each of the cross-price elasticities. What does it imply about
the relationship between the two goods in question?
b. Compare the absolute values of the cross-price elasticities and explain their
magnitudes. For example, why is the cross-price elasticity of McDonald’s
burgers and Burger King burgers less than the cross-price elasticity of butter
and margarine?
c. Use the information in the table to calculate how a 5% increase in the price of
Pepsi affects the quantity of Coke demanded.
d. Use the information in the table to calculate how a 10% decrease in the price of
gasoline affects the quantity of SUVs demanded.

9. What can you conclude about the price elasticity of demand in each of the following
statements?
a. “The pizza delivery business in this town is very competitive. I’d lose half my
customers if I raised the price by as little as 10%.”
b. “I owned both of the two Jerry Garcia autographed lithographs in existence. I
sold one on eBay for a high price. But when I sold the second one, the price
dropped by 80%.”
c. “My economics professor has chosen to use the Krugman/Wells textbook for this
class. I have no choice but to buy this book.”
d. “I always spend a total of exactly $10 per week on coffee.”

10. Worldwide, the average coffee grower has increased the amount of acreage under
cultivation over the past few years. The result has been that the average coffee
plantation produces significantly more coffee than it did 10 to 20 years ago.
Unfortunately for the growers, however, this has also been a period in which their
total revenues have plunged. In terms of an elasticity, what must be true for these
events to have occurred? Illustrate these events with a diagram, indicating the
quantity effect and the price effect that gave rise to these events.