Econ 211
Problem Set 3 Answers

1. The answer is in your notes and in the text book.

2.  Elasticity.
a) Elastic, since they expected a revenue increase stemming from the lower fares.
b) E = [(1/3)(.75)]/400 = 0.06; caffeine can be addicting
c) Yes, the claim is consistent since elasticity is E = .4 (inelastic).
d) E = 1.4 for teens. Elasticity is likely to be smaller for older smokers due to addiction (few available substitutes for delivering nicotine) and the fact that older smokers are likely to have more income than teens.
e) Elastic.
f) Since E = .60 and we know the percent change in price to be 16.7% (using the midpoint formula), it must be the case that the percent change in quantity demanded is 10.0%. The midpoint percentage change in quantity is = [100,000-x)/(100,000+x)/2]. Where x is the number of apartments rented at the higher rent. This implies that x = 90,476 (give or take due to rounding).

3.   Bus rides in Marietta.
a) Demand for bus rides is price inelastic since E = .5 < 1.
b) An increase in bus fares would raise revenues since demand is inelastic: for a given change increase in price, bus rides would fall by a relatively small amount.
c) Bus rides and gasoline are substitutes since the cross-price elasticity is positive.
d) An increase in the price gasoline by 10% will increase the number of bus rides by 2%.
e) An increase in incomes of 5% will cause bus rides to fall by 0.5%.
f) Bus rides must be an inferior good since the income elasticity is negative.

4.  The key to this question is to recognize that the amount of crime committed by users depends on the total funds necessary to support one's habit. The total funds necessary is equivalent to the total expenditures made by users in the heroin market; in other words, total funds = PQ (price times quantity). Consequently, if the government increases penalties on heroin suppliers, the supply curve will shift to the left, the price of heroin will increase and the equilibrium quantity of heroin will fall. Since demand for heroin is assumed to be inelastic, the total expenditures made on the part of heroin users will rise as price goes up. Since total expenditures rise, the amount of crime will also rise.

5.  This is for you to ponder.

6.  Your answers to part (a) and (b) should focus on differences in the price elasticity of demand for the products.  We know that given a downward sloping demand curve, a tax will raise the price and reduce the quantity demanded.  How much price will rise, and how much quantity demanded falls, depends on the elasticity of demand.  Draw a very steep demand curve (to represent a relatively inelastic demand) and show what happens to price and quantity when a tax is put on the sellers.  Do the same thing for a very flat demand curve.  What are the differences?

7. Four tax policies.
a)  Benefits principle  
b)  Ability to pay. 
c)  Benefits principle 
d)  Ability to pay 

8.  National defense.
a)  Regressive; Progressive 
b)  Benefits principle; Ability to pay 
c)  Lump sum is more efficient since the marginal tax rate is zero once the tax is paid.  If there is no marginal tax rate, there will be no distortion of market behavior.

9.  Airline travel.
a)  $3,804,800,000 (=$5.80*656m)
b)  655m trips; price = $389.17; revenue = $3,864,500,000
c)  tax revenue increases

10.  Luxury cars.
a)  Consumers pay $54,000; Producers receive $48,000; tax revenue = $240,000,000
b)  Consumers pay $53,000; Producers receive $48,500; tax revenue = $270,000,000
c)  Tax revenue rises with the lower excise tax.  This suggests that the demand for luxury cars is relatively elastic.

11.  More tax proposals.
a)  MTR = 20%; $5000 income person pays $1000 in taxes; $40,000 income person pays $8000; Proportional tax
b)  MTR = 0 up to $10,000; MTR = 20% on income over $10,000; $5000 income person pays $0; $40,000 income person pays $6000; Progressive 
c)    MTR = 10% on first $10,000, 20% on next $10,000; 30% on all income above $20,000; $5000 income person pays $500; $40,000 income person pays $9000; Progressive.
d)  MTR = 100% for incomes less than $10,000; MTR = 0 for incomes greater than $10,000.  $5000 income person pays $5000; $40,000 person pays $10,000; Regressive. 
e)  Tax in (d) has worst incentive problems. 

12.  This is similar to the lab experiment.

13.  US and Saudi Arabia.
a)    In SA, the opp. cost of 1 car is 200 barrels of oil.  In US, the opp cost of 1 car is 40 barrels of oil.  In SA, the opp cost of 1 barrel of oil is 0.005 of a car.  In US, the opp cost of 1 barrel of oil is 0.025 car.
b)  SA has comparative advantage in oil production.  US has comparative advantage in car production. 
c)  In autarky SA cannot produce both more oil and more cars.  If SA produces 200 million barrels of oil and 3m cars, it is on its PPF.  This means that it can produce more oil only if it produces fewer cars.  The same is true for the US. 

14.  US and Saudi Arabia
a)  If each country specializes, SA will produce 800m barrels of oil and the US will produce 10m cars.
b)  It is possible fo SA to consume 400m barrels of oil  and for the US to consume 400m barrels of oil.  And it is possible for SA to consume 5m cars and for the US to consume 5m cars.
c)  US imports 500m barrels of oil and exports 4m cars.  That is, each car trades for 125 barrels of oil.  If a car costs $10,000 on the world market, then a barrel of oil costs $10,000/125 = $80.

15.  The Hecksher-Ohlin model predicts that a country will have a comparative advantage in the good whose production is intensive in the factor the country has abundantly available:  the US has the comparative advantage in satellite production, and China has the comparative advantage in shoe production.  US will export satellites and China will export shoes.  In the US, demand for capital increases, raising the price of capital, but he demand for labor decreases, lowering the wage.

16.  I would expect each of you to be able to explain to your grandfather the benefits of free trade.

17.  NAFTA
a)  CS in Mexico decreases; CS in US increases.
b)  PS in US decreases; PS in Mexico increases.
c)  Wages of US tomato workers will fall; wages of Mexican tomato workers will rise. 
d)  CS in Mexico increases; CS in US decreases.
e)  PS in Mexico decreases; PS in US increases.
f)  Wages of US poultry workers will rise; wages of Mexican poultry workers will fall. 

18.  Jet airplanes.  You'll have to fly solo on this one.

19.  Orange market.
a)  Draw your own diagram.
b)  US will import 12,000 oranges. 
c)  US will import 6,000 oranges
d)  I'll leave it to you to think through the welfare loss.

20.  Orange market again.   
a)   See diagram above.
b)  Price = $0.60 
c)  quota rents =   $900 (=$0.30*3000)