EXERCISES FOR REVIEW

§ It is a hot day, and Bert is thirsty. Here is the value he places on each bottle of water:

§ Value of first bottle $7 Value of second bottle $5 Value of third bottle $3 Value of
fourth bottle $1
§ From this information, derive Bert’s demand schedule. Graph his demand curve for
bottled water.
§ If the price of a bottle of water is $4,how many bottles does Bert buy? How much
consumer surplus does Bert get from his purchases? Show Bert’s consumer surplus in
your graph.
§ If the price falls to $2, how does quantity demanded change? How does Bert’s consumer
surplus change? Show these changes in your graph
Price Quantity Demanded
More than $7 0
$5 to $7 1
$3 to $5 2
$1 to $3 3
$1 or less 4
b. When the price of a bottle of water is $4, Bert buys two bottles of water. His
consumer surplus is shown as area A in the figure. He values his first bottle of water
at $7, but pays only $4 for it, so has consumer surplus of $3. He values his second
bottle of water at $5, but pays only $4 for it, so has consumer surplus of $1. Thus
Bert’s total consumer surplus is $3 + $1 = $4, which is the area of A in the figure.
c. When the price of a bottle of water falls from $4 to $2, Bert buys three bottles of
water, an increase of one. His consumer surplus consists of both areas A and B in the
figure, an increase in the amount of area B. He gets consumer surplus of $5 from the
first bottle ($7 value minus $2 price), $3 from the second bottle ($5 value minus $2
price), and $1 from the third bottle ($3 value minus $2 price), for a total consumer
surplus of $9. Thus consumer surplus rises by $5 (which is the size of area B) when
the price of a bottle of water falls from $4 to $2.
§ Ernie owns a water pump. Because pumping large amounts of water is harder than
pumping small amounts, the cost of producing a bottle of water rises as he pumps
more. Here is the cost he incurs to produce each bottle of water:
§ Cost of first bottle $1 Cost of second bottle $3 Cost of third bottle $5 Cost of fourth
bottle $7
§ From this information, derive Ernie’s supply schedule. Graph his supply curve for
bottled water.
§ If the price of a bottle of water is $4, how many bottles does Ernie produce and
sell? How much producer surplus does Ernie get from these sales? Show Ernie’s
producer surplus in your graph.
§ If the price rises to $6, how does quantity supplied change? How does Ernie’s
producer surplus change? Show these changes in your graph.
 Price Quantity Supplied Quantity Demanded

$2 1 3
$4 2 2
$6 3 1

Only a price of $4 brings supply and demand into equilibrium, with an

§ When the price of a bottle of water rises from $4 to $6, Ernie sells three bottles of
water, an increase of one. His producer surplus consists of both areas A and B in the
figure, an increase by the amount of area B. He gets producer surplus of $5 from the
first bottle ($6 price minus $1 cost), $3 from the second bottle ($6 price minus $3
cost), and $1 from the third bottle ($6 price minus $5 price), for a total producer
surplus of $9. Thus producer surplus rises by $5 (which is the size of area B) when
the price of a bottle of water rises from $4 to $6.
§ One of the largest changes in the economy over the past several decades is that
technological advances have reduced the cost of making computers.
§ Draw a supply-and-demand diagram to show what happened to price, quantity, consumer
surplus, and producer surplus in the market for computers.
§ Forty years ago, students used typewriters to prepare papers for their classes; today they use
computers. Does that make computers and typewriters complements or substitutes? Use a
supply-and- demand diagram to show what happened to price, quantity, consumer surplus,
and producer surplus in the market for typewriters. Should typewriter producers have been
happy or sad about the technological advance in computers?
§ Are computers and software complements or substitutes? Draw a supply-and-demand
diagram to show what happened to price, quantity, consumer surplus, and producer surplus
in the market for software. Should software producers have been happy or sad about the
technological advance in computers?
§ Does this analysis help explain why software producer Bill Gates is one of the world’s richest
men?
§ 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 Figure 14. As a result, the equilibrium
price of computers declines and the equilibrium quantity increases. The decline in
the price of computers increases consumer surplus from area A to A + B + C + D,
an increase in the amount B + C + D.
§ Prior to the shift in supply, producer surplus was areas B + E (the area above the
supply curve and below the price). After the shift in supply, producer surplus is
areas E + F + G. So producer surplus changes by the amount F + G – B, which may
be positive or negative. The increase in quantity increases producer surplus, while
the decline in the price reduces producer surplus. Because consumer surplus rises
by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D +
F + G.
§ Because adding machines are substitutes for computers, the decline in the price of
computers means that people substitute computers for adding machines, shifting
the demand for adding machines to the left, as shown in Figure 15. The result is a
decline in both the equilibrium price and equilibrium quantity of adding machines.
Consumer surplus in the adding-machine market changes from area A + B to A + C,
a net change of C – B. Producer surplus changes from area C + D + E to area E, a
net loss of C + D. Adding-machine producers are sad about technological
advances in computers because their producer surplus declines.
§ Because software and computers are complements, the decline in the price and
increase in the quantity of computers means that the demand for software
increases, shifting the demand for software to the right, as shown in Figure 16. The
result is an increase in both the price and quantity of software. Consumer surplus in
the software market changes from B + C to A + B, a net change of A – C. Producer
surplus changes from E to C + D + E, an increase of C + D, so software producers
should be happy about the technological progress in computers.
§ Yes, this analysis helps explain why Bill Gates is one the world’s richest people,
because his company produces a lot of software that is a complement with
computers and there has been tremendous technological advance in computers.
§ The market for pizza is characterized by a downward- sloping demand curve and
an upward-sloping supply curve.
§ Draw the competitive market equilibrium. Label the price, quantity,consumer
surplus, and producer surplus. Is there any deadweight loss? Explain.
§ Suppose that the government forces each pizzeria to pay a $1 tax on each pizza
sold. Illustrate the effect of this tax on the pizza market, being sure to label the
consumer surplus, producer surplus, government revenue, and deadweight loss.
How does each area compare to the pre-tax case?
§ If the tax were removed, pizza eaters and sellers would be better off, but the
government would lose tax revenue. Suppose that consumers and producers
voluntarily transferred some of their gains to the government. Could all parties
(including the government) be better off than they were with a tax? Explain using
the labeled areas in your graph.
§ With a $1 tax on each pizza sold, the price paid by buyers, PB, is now higher than
the price received by sellers, PS, where PB = PS + $1. The quantity declines to Q2,
consumer surplus is area A, producer surplus is area F, government revenue is area
B + D, and deadweight loss is area C + E. Consumer surplus declines by B + C,
producer surplus declines by D + E, government revenue increases by B + D, and
deadweight loss increases by C + E.
§ If the tax were removed and consumers and producers voluntarily transferred B +
D to the government to make up for the lost tax revenue, then everyone would be
better off than without the tax. The equilibrium quantity would be Q1, as in the case
without the tax, and the equilibrium price would be P1 . Consumer surplus would be
A + C, because consumers get surplus of A + B + C, then voluntarily transfer B to
the government. Producer surplus would be E + F, because producers get surplus
of D + E + F, then voluntarily transfer D to the government. Both consumers and
producers are better off than the case when the tax was imposed. If consumers and
producers gave a little bit more than B + D to the government, then all three
parties, including the government, would be better off. This illustrates the
inefficiency of taxation.
§ After economics class one day, your friend suggests that taxing food would be a
good way to raise revenue because the demand for food is quite inelastic. In what
sense is taxing food a “good” way to raise revenue? In what sense is it not a “good”
way to raise revenue?
§ Because the demand for food is inelastic, a tax on food is a good way to raise
revenue because it does not lead to much of a deadweight loss; thus taxing food is
less inefficient than taxing other things. But it is not a good way to raise revenue
from an equity point of view, because poorer people spend a higher proportion of
their income on food. The tax would hit them harder than it would hit wealthier
people.