UNIVERSITY OF MELBOURNE

DEPARTMENT OF ECONOMICS

ECON90015 Managerial Economics

Semester 1, 2018

Solution Sheet

Tutorial Exercise 4: Economic surplus and applications

Task 1

Cath
16

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The market price is $7 and the quantity traded will be 4 massages – trade will
occur up until the point where MB = MC [where Chris’ WTP = Stewart’s
C
opportunity cost].
CS = [16-7] + [13-7] + [10-7] + [7-7] = $18
PS = [7-1] + [7-3] + [7-5] + [7-7] = $12
Total economic surplus = CS + PS = $30

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1
A massage will be bought by Cath, Colin, Chloe and Chris. A massage will be
supplied by Sally, Simon, Sonia and Stewart. Cassie and Sam will not trade as
MC>MB.

Task 2

(a) The effect of falling production costs in the market for computers results in a
shift to the right in the supply curve, as shown in the figure. As a result, the
equilibrium price of computers declines and the equilibrium quantity increases. If
demand is relatively price elastic there will be a larger proportionate increase in
quantity than in price [see figure 1].

(b) The decline in the price of computers creates additional economic surplus of
(C + D + F+ G). The consumers capture additional surplus of (B + C +D). The
effect on producer surplus is ambiguous, as they capture additional surplus of (F
+ G), but lose B. The extent to which they gain or lose will depend on the relative
sizes of the surpluses. The increase in sales increases producer surplus, but the
fall in prices reduces producer surplus. [see figure 2]

2
 P

Surplus Before reduction After reduction in Change in surplus

in costs costs
Consumer surplus A A+B+C+D B+C+D
Producer surplus B+E E+F+G [F+G] - B
Total surplus A+B+E A+B+C+D+E+F+G C+D+F+G

(c) If the supply of computers is very elastic, then the shift of the supply curve
benefits consumers most. To take the most dramatic case, suppose the supply
curve was perfectly elastic. Then consumers capture all of the value from falling
production costs – Consumer surplus increases from A to A+B+C. There is no

P1
increase in producer surplus.
[see figure 3].

B
 P

Task 3

a) Derive equilibrium price and quantity traded by finding price at which Quantity
demanded = Quantity supplied. Hence equilibrium price is $2 per kg, and
equilibrium quantity is 500.

4
 P
b) (i) With a binding price floor of $3 per kg the quantity demanded is 400, and
quantity supplied is 620. Hence price increases to $3 per kg, and quantity traded
decreases to 400 – determined by quantity demanded the “short side” of the
market.
[See figure 2].

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 P
Surplus No regulation Price floor Change in surplus
Consumer surplus A+B+C A -B - C
Producer surplus D+E B+D B-E
Total surplus A+B+C+D+E A+B+D -[C+E]

(ii) The effect of the price floor on producers is ambiguous, as producers capture
the additional surplus of B, but lose E. The extent to which they gain or lose will
depend on the relative sizes of these surpluses. The consumers definitely lose,
as they lose the consumer surpluses of B and C. Society also loses, as a
deadweight loss of C and E is created.
A
c) (i) Where the government sets a binding production quota of 450 kg per week,

3
producers will receive a price of $2.50. At the quota level, the effective supply
curve is S*. This is the price at which quantity demanded equals 450 kg [but the
producers will want to supply 550 kg at that price – so there is a surplus of 100].
[See figure 5]

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 P
Surplus No regulation Production quota Change in surplus
Consumer surplus A+B+C A -B - C
Producer surplus D+E B+D B-E
Total surplus A+B+C+D+E A+B+D -[C+E]

(ii) The effect of the production quota on producers is ambiguous, as producers

capture the additional surplus of B, but lose E. The extent to which they gain or

A
lose will depend on the relative sizes of these surpluses. The consumers lose, as
they lose the consumer surpluses of B and C. Society also loses, as a
deadweight loss of C and E is created.

d) i) New supply schedule

Pc Qd ( kg) Ps Qs (kg)
2.5
B
4 300
3.50 350
3 400 4 800
2.50 450 3.50 680
2 500 3 620
1.50 550 2.50 550
1 600 2
7
500
2
ii) The subsidy is paid to producers so the supply curve shifts down or to the right
(not shown). Derive quantity traded by finding price at which Quantity demanded
= Quantity supplied. The equilibrium quantity is 550 kg. The equilibrium market
price and the price paid by the consumer and received by the producer is lower
at $1.50 per kg. However, while the seller receives this lower price in the market,
the government then pays the producer a $1 per unit subsidy, so the effective
price they receive increases to $2.50 per kg.

iii) The cost of the subsidy to the government is $550. (Equal to quantity traded
multiplied by the unit subsidy = 550 multiplied by $1.) [See figure 3].

P
Surplus No regulation Subsidy Change in surplus
Consumer surplus A+B A+B+D+E+G D+E+G
Producer surplus D+F B+C+D+F B+C
Government nil - [B+C+D+E+G+H] - [B+C+D+E+G+H]
expenditure
Total surplus A+B+D+F A+B+D+F-H -H

(iv) The producers win from the subsidy as they capture the additional producer

A
surpluses of B and C. The consumers also win as they capture the additional

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consumer surpluses of D, E and G. The government loses from its expenditure,
as they lose the surpluses of B, C, D, E, G and H. Society also loses, as a
deadweight loss of H is created.