B. What Is the Combined Effect of These Two Programs on the Price of Cigarettes?

EC1000 – Question Sheet 3 – Week 8

1. In the U.S., the government administers two programs that affect the market for cigarettes. Just like in Europe, media campaigns and labelling requirements are aimed at making the public aware of the dangers of cigarette smoking. At the same time, the US Department of Agriculture maintains a price-support program for tobacco farmers, which raises the price of tobacco above the equilibrium price.

a. How do these two programs affect cigarette consumption? Use a graph of the cigarette market in your answer.

b. What is the combined effect of these two programs on the price of cigarettes?

c. Cigarettes are also heavily taxed (in the US and in Europe). What effect does this tax have on cigarette consumption?

2. Many parts of California experienced a severe drought in the late 1980s and early 1990s.

1. Use a diagram of the water market to show the effects of the drought on the equilibrium price and quantity of water.

1. Many communities did not allow the price of water to change, however. What is the effect of this policy on the water market? Show on your diagram any surplus or shortage that arises.

1. A 1991 op-ed piece in The Wall Street Journal stated that “all Los Angeles residents are required to cut their water usage by 10 percent as of March 1 and another 5 percent starting May 1, based on their 1986 consumption levels.” The author criticized this policy on both efficiency and equity grounds, saying “not only does such a policy reward families who 'wasted' more water back in 1986, it does little to encourage consumers who could make more drastic reductions, [and] ... punishes consumers who cannot so readily reduce their water use.” In what way is the Los Angeles system for allocating water inefficient? In what way does the system seem unfair?

1. Suppose instead that Los Angeles allowed the price of water to increase until the quantity demanded equalled the quantity supplied. Would the resulting allocation of water be more efficient? In your view, would be more or less fair than the proportionate reductions in water use mentioned in the newspaper article? What could be done to make the market solution fairer?

3. Evaluate the following two statements. Do you agree? Why or why not?

a. A tax that has no deadweight loss cannot raise any revenue for the government.

b. A tax that raises no revenue for the government cannot have any deadweight loss.

4. Suppose that the government imposes a tax on heating oil.

a. Would the deadweight loss from this tax likely be greater in the first year after it is imposed or in the fifth year? Explain

b. Would the revenue collected from this tax likely be greater in the first year after it is imposed or in the fifth year? Explain.

EC1000 – Question Sheet 3 – Week 8

5. 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 taxing food is a "good" way to raise revenue? In what sense it is not a "good" way to raise revenue?

6. The government places a tax on the purchase of socks.

a. Illustrate the effect of this tax on equilibrium price and quantity in the sock market.

Identify the following areas both before and after the imposition of the tax: total spending by consumers, total revenue for producers, and government tax revenue.

b. Does the price received by producers rise or fall? Can you tell whether total receipts for producers rise or fall? Explain.

c. Does the price paid by consumers rise or fall? Can you tell whether total spending by consumers rises or falls? Explain carefully. (Hint: Think about elasticity.) If total consumer spending falls, does consumer surplus rise? Explain.

7. Contributions to charitable organisations are deductible under the federal income tax. In what way does this government policy encourage private solutions to externalities?

8. The Swiss government subsidizes cattle farming, and it is rumoured that the subsidy is larger in areas with more tourist attractions. Can you think of a reason why this policy might be efficient?

9. Suppose that the government decides to issue tradable permits for a certain form of pollution.

1. Does it matter for economic efficiency whether the government distributes or auctions the permits? Does it matter in any other ways?
2. If the government chooses to distribute the permits, does the allocation of permits among firms matter for efficiency? Does it matter in any other ways?

10. It has been claimed that private firms will not undertake the efficient amount of basic scientific research.

1. Explain why this is so. In your answer classify basic research according to the criteria of excludability and rivalness.

1. What sort of policy have governments adopted in response to this problem?

1. It is often argued that current policy increases the technological capability of producers located in developed countries relative to that of firms in developing countries. Is this argument consistent with your classification of basic research in part (a)? (Hint: Can excludability apply to some potential beneficiaries of a public good and not others?)

EC1000 – Question Sheet 3 – Week 8

11. The Washington, D.C., metro system (subway) charges higher fares during rush hours than during the rest of the day. Why might it do this?

12. How can intellectual property rights help solve the problem of under-provision of innovative knowledge? What trade-off does society face when designing the system of intellectual property rights?

13. In a market economy, information about the quality or function of goods and services is a valuable good in its own right. How does the private market provide this information? Can you think of any way in which the government plays a role in providing this information?