KEY for Exercise #10 ECON 460 Fall 1996 Prof. Kilkenny

re: Deficiency Payment Experiment

1. a. free market price is determined when supply equals demand:

QS = -5 + 10*P = 15 ­ (10/3)*P = QD

(10 + 10/3)P = 20

P = 60/40 = $1.50 (just like what happenned in the experimental market)

b. quantity: at P = $1.50, QS = -5 + 10*1.50 = 10

QD = 15 ­ (10/3)*1.50 = 10

3. At (P^e, Q^e),

a. g_S = %ªQS/%ªP = MQS/MP * P^e/Q^e

MQS/MP = 10, so g_S = 10 * 1.50/10 = 1.5 since 1.5 is greater than 1, supply is elastic.

b. g_D = %ªQD/%ªP = MQD/MP * P^e/Q^e

MQD/MP = 10/3 (use absolute values), so g_D = 10/3 * 1.50/10 = 0.5 inelastic since g_D is < 1.

c. CS = willing to pay over actually pay = area under D above P^e = 2(base*height)

base = Q^e = 10

height = (4.50-1.50) = $3.00 (your graph makes this very clear)

CS = 0.5*10*$3 = $15.00

d. PS (same formula, under the market price, above S curve)

PS = 0.5*($1.5-$0.50)*10 = $5.00

total welfare = $15.00 + $5.00 = $20.00; notice that consumer side gets 3/4 of it!

4. When target price is $1.75, Q^policy= QS = -5 + 10*(1.75) = 12.5 (policy induces more supply)

b. P^policy = PD, found by 12.5 = 15 - (10/3)*PD => P = $0.75

c. graph it yourself on the same graph as for #2.

d. taxpayer costs = subsidy rate per unit times level supplied = ($1.75-.75)*12.5 = $12.50

e. Tabulate and calculate the welfare effects

new CS = 2(4.50-0.75)*12.5 = $23.44

ªCS = (A+B)+C = (1.50-0.75)*10 + 2(1.50-0.75)*2.5 = $8.44 gain (also: $23.44-$15.00=$8.44)

new PS = 2(1.75-0.50)*12.5 = $7.81

ªPS = D + E = (1.75-1.50)*10 + 2(0.25)*(2.50) = $2.81 gain (also: $7.81-$5.00 = $2.81)

ªG = taxpayer costs = -$12.50 loss!

overall : $8.44 + 2.81 - 12.50 = -$1.25 OVERALL LOSS

f. the tax rate that balances the budget = $12.50/31.25 IS ABOUT 40%.

5. CS is 75% of total welfare while PS is only 25%. This means consumer benefits are three times the producer benefits. Notice that demand is one third as elastic as supply! When subsidies are provided, consumers gain much more than producers. In the classroom experiment, people on the "demand side" got a lot more money than people on the "supply" side, both before and after the "deficiency payment policy" was in effect.

6. Also in the experiments we showed that:

(1) economic models that predict market prices and quantities WORK in that they correctly predict what happens even in auction markets with inexperienced participants

(2) even perfect markets cannot help someone with no income ("values to consumer" too low to be able to buy) or with poor endowments ("costs of production" too high to sell): the market mechanism cannot "correct" an unequal distribution of resources. There is a redistributive role for government.

(3) the only "information" needed for markets to function "perfectly" are knowledge of one's own costs and values, and what other bids and offers end in successful transactions. Notice also that the last transaction converged to the predictable market-clearing price and quantity, even if the other transactions were systematically above (or below) it.

(4) It is difficult to estimate a tax rate that would be both fair (ie, consumers pay more than producers, since they benefit more) and would exactly balance the budget ex ante (before the effect of taxes on market prices and quantities is revealed). When government subsidies came from "heaven," 12.5 were transacted at a total cost of $12.50. Taxing consumers $0.65 per transaction and producers $0.25, reduced transactions to 10, so market prices rose (10 = 15 - (10/3)*PD => PD = $0.85.) Thus, the ultimate actual cost of the program depends on how it is financed. And the estimated tax liabilities were not exact. Revenue collected = 10*$0.85 = $8.50; the subsidy cost = (1.75-0.85)* 10 = $9.00. So we had a government budget deficit of $0.50.)

(5) The dollar value of being able to use economics is the difference between what you could have made (if you had already "done your homework" and calculated the equilibrium prices) and what you actually made. Some demanders paid much higher prices than necessary. Some suppliers received lower prices than they could have gotten.

Extra:

The kind of information available "in the real world" includes actual market prices and quantities (P^e and Q^e) and elasticities of supply and demand (estimated by economists). You can 'reconstruct' supply and demand curves from that kind of data. Try it.