International School of Tanganyika

IB Economics

2013 2014
Grade 11/IB(1)

UNIT 4 WORKBOOK
SUGGESTED ANSWERS

Government Intervention (1.4)

Important Information:
This workbook is designed to help you have a record of concepts covered in class i.e. give you base notes on course
content while practicing economics skills.
Complete the Example tasks in the spaces provided. Extra blank sheets have been included to complete the
Exercise tasks. You may wish to write additional notes/answers in your blue write - on economics journal. This
workbook will be checked by your teacher on a regular basis.
This fantastic Workbook belongs to:

Complete the tasks in the spaces provided;

Resources;
- Textbook: Blink & Dorton Textbook, Chapter 5
- Summary Notes - attached (IB Study Guide, Oxford Press, Economics for the IB Diploma, Ziogas, C)- Moodle Unit 4 Government Intervention Folder in G11/12 ECO and G11 Folders
1. Define and give examples of an indirect tax.

A tax imposed on expenditure i.e. it is placed on the selling price of a product so it

raises the firms cost which moves the supply curve to the left e.g. VAT on a restaurant
meal in Dar es Salaam.
2. Find out what these acronyms stand for.
GST Goods and Services Tax
VAT Value Added Tax
Opinion: Which one of the indirect taxes above do you think is most aptly named? Explain your
answer

Probably VAT because it adds to the price of the produce

3. List at least two reasons why governments might impose indirect taxes
- To raise tax revenue

- To reduce the quantity demanded (or Qe)

4. A Specific Tax - On the supply curve below;
(a) Label the supply curve correctly
(b) Draw and label the new supply curve if a per unit tax of $2 is imposed by the government. Label
it Stax

(c) Describe the impact of this specific per unit tax on the supply of cakes - Moves the supply

curve vertically up by the amount of the per unit tax for every output level in this
case by $2.
5. An Ad Valorem (Percentage) Tax - On the supply curve below;
(a) Label the supply curve correctly
(b) On the graph above, draw and label the new supply curve if a 50% sales tax is imposed by the
government on cakes. Label it Stax

(c) Describe the impact of this specific per unit tax on the supply of cakes.

The supply curve moves up at an increasing amount as output increases. It pivots

in an anticlockwise direction from its origin point i.e. where P=0 (no tax imposed
at P=0 because 0 x tax rate = 0)

Now lets introduce the demand curve to see how different groups in the market are affected
6. For each of the graphs below explain in your own words the impact that the per unit tax has had on
(a) the producer, (b) the government, and (c) the consumer

(a) The Producer

Sales down from Qe to Qt
TR from Pe W Qe 0
Have to pay Pt X Y C to government
Price receive from Pe to C
PED important here
If inelastic then tax burden mainly on consumer
If elastic then tax burden mainly on producer
P2 is the price the producer requires for them to
continue to supply old Qe
(b) The Government
Government Tax Revenue by area Pt X Y C
Tax per unit = Pt C

(c) The Consumer

Price pay from Pe to Pt
Amount bought (Qd) from Qe to Qt
In this case they pay about half the tax burden

7. Now it is your turn to practice showing the impact of an indirect tax on the different stakeholders on a
S&D diagram
(a) List the 3 main stakeholders

- Consumer
- Producer
- Government
5

(b) Draw a Stax curve that shows the impact of a 50 cents per
the local government to fund healthy heart education.

slice of pizza tax imposed by

(c) Show/Calculate on your graph with appropriate labelling and shading

(i)
Pre tax Pe = Pe1 = $1.50
(ii)
Post tax Pe = Pe2 = $1.75
(iii)
Pre tax Qe = Qe1 = 600
(iv)
Pre tax Qe = Qe2 = 500
(v)
Producer Revenue before the tax is imposed = $1.50 x 600 = $900
(vi)
Producer Revenue after the tax is imposed = $1.25 x 500 = $600
(vii) Price that the producer receives after the tax is imposed = Pp = $1.75 before tax paid,

$1.25 after tax paid

(viii)
(ix)
(x)
(xi)
(xii)

Pre tax producer surplus = x 600 x $1.50 = $450

Post tax producer surplus = x 500 x $1.25 = $312.5
Pre tax consumer surplus = x600 x $150 = $450
Post tax consumer surplus = x 500 x $1.25 = $312.5
Government Tax Revenue = 500 x $0.50 = $250

(xiii)

Who is worse off after the tax? Why?

Consumers - Pay higher price from $1.50 to $1.75

- Consumer surplus down from $450 to $312.50
Producers - Sell less 600 down to 500 which means total revenue down
from $900 to $600
6

- Producer surplus down from $450 to $312.50

(xiv)

Who is better off after the tax? Why?

Government receive $250 extra tax revenue

(d) Now draw a Stax curve that shows the impact of 50%
government to fund healthy heart education.

ad valorem tax imposed by the local

(e) Show/Calculate on your graph with appropriate labelling and shading

(i)
Pre tax Pe = Pe1 = $1.50
(ii)
Post tax Pe = Pe2 = $1.80
(iii)
Pre tax Qe = Qe1 = 600
(iv)
Pre tax Qe = Qe2 = 480
(v)
Producer Revenue before the tax is imposed = $1.50 x 600 = $900
(vi)
Producer Revenue after the tax is imposed = $1.20 x 480 = $576
(vii) Price that the producer receives after the tax is imposed = Pp = $1.80 before tax paid,

$1.20 after tax paid

(viii)
(ix)
(x)
(xi)
(xii)

Pre tax producer surplus = x 600 x $1.50 = $450

Post tax producer surplus = x 480 x $1.20 = $288
Pre tax consumer surplus = x600 x $150 = $450
Post tax consumer surplus = x 480 x $1.20 = $288
Government Tax Revenue = 480 x ($1.80 - $1.20) = $288

(xiii)

Who is worse off after the tax? Why?

Consumers - Pay higher price from $1.50 to $1.80

7

Producers

(xiv)

- Consumer surplus down from $450 to $288

- Sell less 600 down to 500 which means total revenue down
from $900 to $600
- Producer surplus down from $450 to $288

Who is better off after the tax? Why?

Government receive $288 extra tax revenue

8. Complete the Indirect Taxes summary below by inserting the correct terms in the blank spaces;

Indirect taxes are taxes on goods and services or on expenditure an may be imposed either on a
per unit basis (specific) or as a percentage of the price (ad valorem)
Such taxes are imposed to collect revenue and/or to decrease consumption of a good or service.
Assuming typical demand and supply curves, an indirect tax increases the market price and
decreases output and consumption of the good.
The government collects tax revenue, the size of which depends on the size of the tax but also on
PED and PES.

Subsidies:Impactonmarkets
1.

Define and give examples of subsidies.

An amount of money paid by the government (or controlling authority) to a firm

per unit of output.
e.g. Per student educational subsidy paid by some governments to private schools
2.

List at least three reasons why governments might pay subsidies to a producer (Text g 68)

- Lower prices of essential goods to encourage consumption e.g. milk subsidies,

education subsidies
- To guarantee the supply of essential commodities in the economy e.g. coal production
to fuel power stations
- Protect essential home industries from overseas competitors
3.

Subsidy - On the supply curve below;

(a) Label the supply curve correctly
(b) Draw and label the new supply curve if a per unit subsidy of $1.50 is paid by the government
to the cake supplier. Label it Ssubsidy

(c) Describe the impact of the per unit subsidy on the supply of cakes

Moves the supply curve to the right or vertically down by the amount of the per
unit subsidy a parallel movement

Now lets introduce the demand curve to see how different groups in the market are affected by the
subsidy

4.

For each of the graphs below explain in your own words the impact that the subsidy has on
(a) the producer, (b) the government, and (c) the consumer

(a) The Producer

Sales up from Qe to Q1
TR from Pe X Qe 0 to D W Q1 0
Price receive from Pe to D
DWXPe is gain in Producer Surplus
If PED inelastic then subsidy benefit mainly on
consumer
If elastic then subsidy benefit mainly on producer
P2 is the price the producer requires for them to
continue to supply old Qe
(b) The Consumer
Price pay from Pe to P1
Amount bought (Qd) from Qe to Q1
In this case they gain about half the subsidy benefit
Gain in Consumer Surplus Pe X Z P1

(c) The Government

Government Expenditure by area D W Z P1
Subsidy per unit = D P1
Opportunity Cost of Government Expenditure
No one gains the WZX part of the subsidy it s a
Deadweight Loss

5.

Now it is your turn to practice showing the

impact of a subsidy on the different stakeholders on a S&D diagram
(a) List the 3 main stakeholders
10

- Consumer
- Producer
- Government
(b) The Consumer Draw a Stax curve that shows the impact of a $1.00 per

slice of pizza

subsidy paid by the local government support local non franchise restaurants.

(xv)

Show/Calculate on your graph with appropriate labelling and shading

(i)
Pre subsidy Pe = Pe1 = $1.50
(ii)
Post subsidy Pe = Pe2 = $1.00
(iii)
Pre subsidy Qe = Qe1 = 600 pizza slices
(iv)
Pre subsidy Qe = Qe2 = 800 pizza slices
(v)
Producer Revenue before the subsidy is paid = $1.50 x 600 = $900
(vi)
Producer Revenue after the subsidy is paid = $2.00 x 800 = $1600
(vii) Price that the producer receives after the subsidy is paid = Ps = $2.00
(viii) Pre subsidy producer surplus = x $1.50 x 600 = $450
(ix)
Post subsidy producer surplus = x $2.00 x 800 = $800
(x)
Pre subsidy consumer surplus = x $1.50 x 600 = $450
(xi)
Post subsidy consumer surplus = x $2.00 x 800 = $800
(xii) Government Subsidy expenditure = $1.00 x 800 = $800
(xiii) Who is worse off after the subsidy? Why
Government/Taxpayers subsidy cost $800
(xiv) Who is better off after the subsidy? Why?

Consumers - Lower price paid $1.50 down to $1.00 per pizza slice
- Increased Consumer Surplus by $350
Producers - Receive higher price after subsidy $1.50 up to $2.00
11

- Increased Producer Surplus by $350

- Total Revenue up from $900 to $1600
(6) Now complete the chart below and learn it:
Government
Intervention
& Why

Shifts the
Supply Curve
Left or Right

Moves
equilibrium up
or down the
Demand Curve

Impact on
Consumer

Impact on
Producer

Impact on
Government

Left

Up

P pay
CS
Q

P receive

PS
Q

Tax
Revenue
Admin Costs

Right

Down

P pay
CS
Q

P receive

PS
Q
TR

Government
Spending
Admin Costs

Indirect Tax

Subsidy

6.

Complete the Subsidies summary below by inserting the correct terms in the blank spaces;
Subsidies are granted to; (1) lower the costs of production for firms, (2) lower the market
price of the good or service, (3) increase production and consumption of the good or service, (4)
increase the revenues that firms earn.
Assuming typical demand and supply curves, a subsidy decreases the market price (the price
the consumers pay), increases the price received by producers, increases output and
consumption of the good, and increases total revenue (TR) to firms. It is not clear whether
the total expenditure (TE) that consumers make on the good increases or decreases as this
depends on PED. If demand is price inelastic then the fall in price will lead to a proportionally
smaller increase in quantity demanded and so the TE consumers make will decrease. If demand
is price elastic then the fall in price will lead to a proportionally larger increase in quantity
demanded and so the TE consumers make will increase.
Total spending by the government on the subsidy is the product of the subsidy per unit times the
number of units sold. The size of this expenditure depends not only on the size of the per unit
subsidy granted but also PED and PES.
Both consumers and producers benefit from a subsidy.

PriceControls:
12

Priceceilings(maximumprices)&PriceFloors(minimumprices):rationale,
consequencesandexamples

What do you think the cartoon means??

Price controls are having a negative affect on Zimbabwes economy despite Mugabes
assurances that there will be short-term losses before the long term benefits.

13

PRICE CEILINGS (MAXIMUM PRICES)

(1) On the demand & supply diagram below draw an effective maximum price (price ceiling).

(2) From your graph find

(i)
Pe = $2.50
(ii)

Qe = 35

(iii)

Pmax = e.g. $2

(iv)

Qs at Pmax = 30

(v)

Qd at Pmax = 40

(vi)

Qd Qs = + 10 Is this is a shortage or surplus? Shortage Qd > Qs at Pmax

(vii)

What price would consumers be willing to pay for the Qs at Pmax if there was no
price ceiling?

At price $2 Qs is 30, consumers willing to pay $3 at this Qs

(viii)

What might this situation lead to apart from a shortage? (think illegal and dark??)

A Black Market can sell at the price in vii above

(3) Finish and learn this rule:

An effective maximum price (price ceiling) must be set below equilibrium price
(4) Who generally sets a price ceiling (maximum price)? Governments or a central authority
(e,g local councils)
14

(5) Explain why price ceilings are imposed? Give relevant examples

To protect consumers against high prices usually imposed on necessities such as

housing or basic food to make them affordable to low income households e.g.
maximum rents in New York
(6) Governing bodies/authorities (local, national or international) ensure that the maximum price is
adhered to, by methods such as those listed in the chart below. Complete the following chart
using information from pages 70 -72 of the textbook.
Method to maintain
max price
Rationing (Coupons)

Explain, discuss and use diagrams as appropriate

Example(s)

Government issues coupon on a per need

basis can only purchase the product if
accompanied by coupon non-compliance
is against law

e.g. Food
rationing in
UK during
WW2

Ballots

Luck of the draw. Put in for a lottery on the

allocation of the good or service. Allows
lower income people to have a chance of
consuming. Only a limited number
available (Qs at Pmax)

e.g. Sports
events
rationing
Selected
Rugby
World Cup
final seats

Fines or other
enforceable measures
for non-compliance

Any consumer or pays more than the Pmax

or producer who sells at more than Pmax is
fined or punished by law to discourage.
Usually used in conjunctioning with
rationing coupons

Government
Subsidies

e.g Local
Governmen
t subsidized
housing in
Dar es
Salaam

15

Government
Provision
- State Owned
Businesses
- Government Buffer
Stocks

Government
marketing (D)

Reduce demand for product to lower Pe to

Pmax. Not common given generally Pmax
applied to a merit good (good to consume
more from societies point of view)

e.g. (1) State

provision of
housing in
New
Zealand
(2)
Governmen
t storage of
wheat for
bread
manufactur
ing.
?

(7) Complete Student Workpoint 5.5 (Text pg 72)

(i)

The two common government aims of maximum rents

- provide low cost rented accommodation for people on low

incomes
- provide more rental accommodation for people on low incomes
(ii)

Diagram (label carefully as per normal)

(iii)
16

(iv)

Explain the situation for those people who rent out their properties.

At the lower Pmax, less rental accommodation will be provided

because it is less profitable some suppliers wont be-able to cover
some of the costs (marginal costs) of provision therefore will pull
their accommodation off the market. There will be a shortage.
(v)

Explain the situation for those people who wish to rent properties.

For those that are able to secure rental accommodation it will be

cheaper but demand will outstrip supply
(vi)

Measures that the government might take to ensure that they achieve both of their
stated aims are achieved.

- Subsidise rental housing provision ( S)

- Provide state housing at the Pmax price ( S)
PRICE FLOORS (MINIMUM PRICES)
(1) On the demand & supply diagram below draw an effective minimum price (price floor).

(2) From your graph find

(ix)
Pe = $2.50
(x)

Qe = 35

(xi)

Pmin = e.g. $5

(xii)

Qs at Pmin = 60

(xiii)

Qd at Pmin = 10
17

(xiv)

Qs Qd = 50 Is this is a shortage or surplus? Surplus Qd < Qs at Pmax

(xv)

What price would consumers be willing to pay for the Qs at Pmin if there was no
price floor?

Less than $1
(3) Finish and learn this rule:

An effective minimum price (floor) must be set above equilibrium price

(4) Who generally sets a price floor (minimum price)?

Government or Controlling Authority e.g. Agricultural Cooperative

who is the single buyer of a commodity
(5) Explain why price floors are imposed? Give relevant examples

- Raise producer incomes of goods that the government think are

important e.g. agricultural products Tanzania minimum coffee
prices
- To protect workers by setting minimum wages to ensure a reasonable
income to survive on e.g. New Zealand - The current adult minimum
wage rates (before tax) that apply for employees aged 16 or over are:
$13.75 an hour, which is $110.00 for an 8-hour day or $550.00 for a
40-hour week.
(8) Governing bodies/authorities (local, national or international) ensure that the minimum price is
maintained, by methods such as those listed in the chart below. Complete the following chart
using information from pages 73 -74 of the textbook.
Method to maintain
max price
Government Purchase
of Surplus and store,
sell overseas, destroy

Explain, discuss and use diagrams as appropriate

Example(s)

e.g. SMPs in
NZ in 1980s
Supplementa
ry Minimum
Prices
government
bought up
excess wool
via Wool
Board

18

Government put
Quotas on producers

Government
marketing (D)

e.g. Buy New

Zealand
Lamb
campaigns in
the 1980s

(6) Complete Student Workpoint 5.6(Text pg 74)

(i)

The two common government aims of minimum wages

- ensure higher wages for low-paid workers

- increase the number of workers employed

19

(ii)

Diagram (label carefully as per normal)

(iii)

Explain the consequences of the minimum wage for workers.

Higher than Pe wages for those that can keep or get jobs but creates
a surplus of labour or a shortage of jobs given some firms cant afford
the mimimum wage
(iv)

Explain the situation facing the employers.

Makes labour more expensive can afford to employ (Demand) less

may replace labour with machines/technology given may now be
relatively cheaper than the Pmin wage
(v)

Measures that the government might take to ensure that they achieve both of their
stated aims are achieved.

Create government jobs to increase the Demand (D) for Labour so

new wage Pe at Pmin
Provide training/upskilling for labour so that it is more productive
therefore more in demand (D)
Lower retirement age so that less Labour Supply so Pe increases to
Pmin.

20

(9) Complete the Price Controls summary below by inserting the correct terms in the blank spaces;
An effective maximum price is set below the market (equilibrium) price while an effective
minimum price is set above.
An equilibrium price rations (distributes) the good efficiently, as whoever is willing and
able to pay the price will end up with the good. When a price ceiling is set by the government,
being willing and able to pay the price does not guarantee that one will enjoy the good because
of the resulting shortage. This is why other mechanisms to ration the available amount are
needed such as first come, first served and sellers preferences, randomly (by ballot) or via

coupons.
Resource allocation is inefficient when the price is controlled. Less than the socially optimal
amount is produced in the case of a maximum price whereas more than is socially optimal is
produced in the case of a minimum price.
In the case of a maximum price the costs to the government include costs of enforcing the
policy, while in the case of a minimum price the costs include the necessary expenditure to buy
the surplus at the promised price (which eventually burdens the taxpayers) and the cost of
disposing of the surplus.

21

HL Only - Impact of PES and PED on incidence of Tax Exercise

Some important information to consider;
(1) The more elastic a Demand or a Supply schedule is relative to the other - the more the
tax burden will fall on the other side.
This implies;
- Elastic Supply means consumers have the higher tax incidence
- Elastic Demand means producers have the higher tax incidence
Task (a) Rewrite in your own words;

The more elastic supply is relative to demand, the higher the incidence on the
consumer
(PES>PED higher incidence on consumer)
The more elastic demand is relative to supply, the higher the incidence on the
producer
(PED>PES higher incidence on producer)
(2) It is a common mistake to claim that if demand is price inelastic then the incidence of
tax falls mostly on the consumers. If PES happens to be lower than PED then it is the
producers not the consumers who will pay the bigger proportion.
Task (b) Rewrite in your own words;

(PED>PES higher incidence on producer)

and vice versa (PES>PED higher incidence on consumer)
(3) Tax incidence depends on PES and PED. The following relationship holds
(% of tax incidence on consumers) = PES
(% of tax incidence on producers) PED
NB:
-

the two percentages in the left fraction must equal 100%

e.g. PED = 0.8 (price inelastic) and PES = 0.2, then the incidence on the consumers
will be smaller (consumers pay 20% of the tax and producers pay 80% of the tax in
this case)

Task (c) Learning formula space;

e.g.

(% of tax incidence on consumers) = PES

(% of tax incidence on producers) PED

PES = 0.25 and PED = .80 PES/PED = .25/.80 = 31.75/100

31.75% burden on consumers and (100-31.75) = 68.25% burden on the producers
22

Use the Workbook supplementary notes attached (pg 27) to help you complete & LEARN the
following chart.
If
PES > PED

Tax burden

PES = PED

Tax incidence is evenly

split between
consumers and
producers

PES < PED

Tax incidence on
producers is bigger
than on consumers

Sketch graph to illustrate

Tax incidence on
consumers bigger than
on producers

23

PES = 0

Total tax burden on the

producer

PED = 0

Total tax burden on

the consumer

PES =

Total tax burden on

consumer

PED =

Total tax burden on the

producer

24

HL Only: Linear Equation analysis of Indirect

Taxes

Some helpful hints:

Remember that an INDIRECT TAX shifts the supply curve to the left.
That means you need to adjust the Qs linear equation by subtracting the per
unit tax from the price (the firms get less per unit after paying the tax);
Qs = c + d (P - t)
So if a per unit tax of 50 cents is imposed on the following Supply curve
Qs = 20 + 2P
It would become Qs = 20 + 2(P 0.5) = 19 + 2P
Some Fun Tasks
(1) (a) Assume the market for petrol is represented by the demand and supply equations below
(quantity is in litres, price is in dollars):

Qd = 10 - 0.4P

Qs = -2+2P

On the graph below, illustrate the market for petrol in equilibrium assuming no government
intervention.

Pe = $5
Qe = 8 litres
(b) Assume the government places a $3 tax on each litre of petrol bought and sold. Determine the
new supply equation for petrol.
25

Qs = -2+2(P- 3) therefore Qs = -8 + 2P

(c) On the graph below, show the effect of the $3 tax on petrol.

Supply curve shifts up vertically and parallel by $3 at every quantity

(d) Calculate the new equilibrium price consumers will pay for petrol.

Qd = 10 - 0.4P

Qs* = -8+2P

10 - 0.4P = -8+2P
2.4P = 18
Pe = $7.50
(d) Calculate the new price producers will get to keep after paying the $3 tax to the government.

$7.50 - $5.00 = $2.50 - increase in price to the consumer

$3.00 - $2.50 = $0.50 - amount of the tax paid by the producer
Pe has increased to $7.50 with the tax, from a pre-tax Pe of $5.00 which
means of the $3 per unit tax imposed by the government the producer will
have to bear $0.50.
(f)

Calculate the new equilibrium quantity of petrol sold following the $3 tax.

Qe = 10 0.4 (7.5) = 7 litres

(g)
On the graph you drew for (c), shade the area of consumer tax burden one color
and the area of producer tax burden another color. Explain what these areas represent.

26

(h)
Who appears to bear the greater burden of the petrol tax, producers or consumers? Why
do you think this is the case?

Consumers because the PES >PED therefore using the rule on Pg 12 of this
Workbook the burden must fall on the consumer
(i)

Calculate the following:

(i) The amount of tax paid by petrol consumers:

$2.50 per litre and they are consuming 7 litres after the tax
$2.50 x 7 = $17.50
(ii) The amount of tax paid by petrol producers:

$0.50 per litre and they are selling 7 litres after the tax
$0.50 x 7 = $3.50

(iii) The total tax revenue generated by the petrol tax:

$3.00 per litre and they are selling 7 litres after the tax
$3.00 x 7 = $21.00

(j) Why are petrol taxes so widely used in Europe as an important source of tax revenue for
governments?

The user pays the bulk of the tax hence if tax collected is used to correct
environmental damage or create and maintain roading networks the people
creating the need are paying the bulk of the tax. It is also a very good way to
27

raise government revenue given PES>PED therefore Qe dose not decline as

much in proportion to Pe hence tax revenue is higher

HL Only: Linear Equation analysis of Subsidies

Some helpful hints:
Remember that a SUBSIDY moves the supply curve to the right.
That means you need to adjust the Qs linear equation by adding the per unit
subsidy to the price (the firms get more per unit after receiving the subsidy);
Qs = c + d (P + S)
So if a per unit subsidy of 50 cents is imposed on the following Supply curve
Qs = 20 + 2P
It would become Qs = 20 + 2(P + 0.5) = 21 + 2P
Some More Fun Tasks
Assume the supply and demand for petrol in China is represented by the following equations:

Qs = -200+100P
Qd = 1,000 - 200P
where Qs is the quantity supplied (in millions of litres) by Chinese petrol firms and Qd is
the quantity demanded (in millions of litres) by Chinese petrol consumers. P is the price
per litre for petrol expressed in Chinese yuan.
1.

On the graph below, illustrate the market for petrol in China in equilibrium assuming no
government intervention.
28

2.

Calculate the equilibrium price and quantity of petrol in China, and label them on your graph
above.

Pe = $4

3.

Qs = Qd
-200+100P = 1,000 - 200P
300P = 1200
Qe = 200m litres

Calculate the amount of consumer and producer surplus in the Chinese petrol market. Add these
together to determine the amount of total welfare in the petrol market.

Consumer Surplus = x 200m x 1 = 100m

Producer Surplus = x 200m x 2 = 200m
Community Surplus

= Consumer Surplus + Producer Surplus

= 100m + 200m = 300m

4.

Assume that the government wishes to make petrol more affordable to Chinese consumes, so it
provide a 1 yuan subsidy per litre for petrol producers. Derive the new supply equation for petrol
in China.

Qss = -200+100(P+1)
= -100+ 100P
5.

On the graph below, plot the original supply and demand curves, then show the effect of the 1
yuan subsidy for petrol producers.
29

6.

Calculate the new equilibrium price consumers will pay for petrol and the new equilibrium
quantity of petrol produced. Calculate the price that petrol producers will receive following the 1
yuan subsidy. Indicate these on your graph above.

Qss= Qd
-100+ 100P = 1,000 - 200P
300P = 1100

Pesub = 3.67
7.

Qesub = 266.67m litres

Calculate each of the following:

a. the new area of consumer surplus that will result from the petrol subsidy.

1/2 x (5 3.67) x 266.67m = 354.67m x = 177.36m

b.

the new area of producer surplus following the subsidy.

1/2 x (3.67 - 1) x 266.67m = 356m

c.

8.

The net increase in consumer and producer surplus resulting from the subsidy.

Consumer Surplus = (4 3.67) x (200+266.67)m = 77

Producer Surplus = (1 0.23) x (200+266.67)m = 156

Calculate the cost the subsidy imposes on taxpayers in China.

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266.67m x 1 = 266.67m
9.

Compare the cost you calculated in number 8 to the net increase in consumer and producer
surplus you calculated in 7(c). What does the difference between these two figures represent?

(77 m + 156 m) - 266.67m = -33.67m is a deadweight loss

10.

On the graph you drew in #5, shade and label the area that represents the net effect on total
welfare of the subsidy. Does this represent an increase or a decrease in overall efficiency in the
petrol market? Explain.

The cost of the subsidy is a+b+c+d+e+f outweighs the extra benefit of the
subsidy to the producer, area a+b (increased producer surplus) and the extra
benefit of the subsidy to the consumer, area d+e+f (increased consumer
surplus). Therefore there is a deadweight loss (or loss of total welfare) of area
c.

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HL Only: Linear Equation analysis of PRICE

CONTROLS

Remember all you need to do to find the Qs, or Qd, at a certain price
(e.g. a max or min price) is to put the price into the respective
formula. Then you can see if;
Qs = Qd, or
Qs > Qd (surplus), or
QS < Qd (shortage)
Even More Fun Tasks
Assume the following equations represent the supply and demand for rice (in millions of
kilograms) in India in relation to the price per kilogram (in Indian rupees):

Qd = 80-10P
Qs = -20+10P
1. Calculate the equilibrium price and quantity of rice in India.

Qd = Qs

80-10P = -20+10P
20P = 100
P = 5 rupees
Qe = 80 10x5 = 30 million kgs
2.

On the graph below, illustrate the Indian rice market in equilibrium.

3.

Assume that the government, in order to promote stable food price, places a price ceiling in the
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rice market at 6 rupees per kg and a price floor at 4 rupees per kg. Add dotted lines on the
graph you drew in #2 at these two prices. Explain whether these price controls are effective or
ineffective at the current equilibrium price.

Min price (price floor) of 4 rupees must be set above Pe to be effective. Pe = 5

rupees therefore ineffective i.e. Pmin < Pe therefore ineffective
Max price (price ceiling) of 6 rupees must be set below Pe to be effective. Pe = 5
rupees therefore ineffective i.e. Pmax>Pe therefore ineffective
4.

Assume that due to a particularly fertile growing season, the supply of rice in India increases to
Qs = -10 + 20P. The demand remains at Qd = 80 - 10P. Illustrate the effect of this increase in
supply on the market for rice on your graph above.

Non parallel move to the right given change in values for both quantity
intercept (c) and slope (d) in Qs = c+dP formula
5.

Calculate the new equilibrium price and quantity for rice following the increase in supply.

Qs = Qd
-10 + 20P = 80 - 10P
30P = 90
Pe = 3 rupees therefore Qe = 80-10x3 = 50 million kgs

6. Explain the effect of the governments price controls on the market for rice following the
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increase in supply. Calculate the amount of excess supply created by the 4 rupee price floor.

Price floor is now effective given Pmin > Pe i.e. 4rupees > 3rupees
Creates a surplus at Pmin of 4 rupees:
Qs = -10 +20P = 70 million kgs
Qs > Qd

and

Qd = 80 - 10P = 40 million kgs

Surplus of 70 40 = 30 million kgs

7. Assuming the government takes no action to enforce the minimum price of 4 rupees, how will
the free market likely resolve the disequilibrium that exists in the rice market due to the price
floor?

Advertise to encourage increased rice consumption - D - will reduce or close

surplus gap ceteris parius
Reduce supply in the future (switch to more profitable grains) S to close surplus
gap
8. Next, assume that the Indian government decides to intervene in the rice market to make sure
the price remains at the desired level of 4 rupees. How much would it cost the government (and
therefore taxpayers) to buy the surplus rice at the desired price of 4 rupees per kilogram?

30 million kgs x 4 rupees/kg = 120 million rupees

9. Assume that during the following growing season, severe droughts cause the supply of rice to
fall to Qs = -25 + 5P. Demand remains at Qd = 80 - 10P. Illustrate the effects of this decrease in
supply on the graph below.

10. Calculate the new equilibrium price and quantity of rice following the decrease in supply.
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Qs = Qd
-25 + 5P = 80 - 10P
15P = 105

Pe = 7 rupees therefore Qe = 80-10x7 = 10 million kgs

11. Explain the effect of the governments price controls on the market for rice following the
decrease in supply. Calculate the amount of excess demand created by the 6 rupee price ceiling.

Price ceiling is now effective given Pmax < Pe i.e. 6rupees < 7rupees
Creates a shortage at Pmax of 6 rupees:
Qs = -25 +5P = 5 million kgs
Qd > Qs

and

Qd = 80 - 10P = 20 million kgs

Surplus of 20 5 = 15 million kgs

12. Assuming the government takes no action to enforce the maximum price of 6 rupees, how
will the free market likely resolve the disequilibrium that exists in the rice market due to the
price ceiling?

Increase supply - S by improving productivity

Decrease Demand D by negative advertising (unlikely)
13. Next, assume the Indian government decides to intervene in the rice market to maintain the
desired maximum price of 6 rupees. How much rice would the government have to release into
the market to push the equilibrium price down to within the desired price range.

15 million kgs
i.e. the new Qs formula would be Qs = (-25 + 10) + 5P = -15 + 5P
14. Who benefits from maximum price controls in the markets for goods such as rice? Who
suffers?

Consumers benefit with cheaper prices

(Pmax of 6 rupees compared to Pe of 7 rupees)
Producers suffer with less slaes and revenue and consumers who miss out given the
shortage created

15. Who benefits from minimum price controls? Who suffers?

35

Producers benefit although the government has to buy the surplus

Consumers suffer because they have to pay more than the market price (Pe)

16. What are some short-comings of price controls schemes such as that described in Indias rice
market?

Create a loss of allocative efficiency/community surplus given market not oprating

at its natural equlilibrium. E.g. deadweight loss to administer, inefficient allocation
of resources

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