Assignment 2

Due date: Nov 26

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1. Government actions and Welfare economics. (30 points)

Consider the market for sugar in China. The domestic demand function is given by
𝑄 𝐷 = 10 − 2 × 𝑃.
The domestic supply function is
𝑄 𝑆 = 2 × 𝑃 − 2.
Please draw graphs to help illustrate your answers to the following questions.
(a) Suppose there is a price ceiling of 2 (RMB),
(i) Is there any excess demand or excess supply? If any, how much? (2 points)
Excess demand.
When there is a price ceiling of 2(<3), which is a binding price ceiling, the
market price should be P=2.
At P=2, quantity demanded is 10 − 2 × 2 = 6, quantity supplied is 2 × 2 −
2 = 2. Thus, the excess demand is 6-2=4 units.
(ii) What is the deadweight loss? (3 points)
 With the price ceiling of 2, the market quantity is 2. Then the deadweight loss
4−2
is (4 − 2) × 2 = 2.

(b) Suppose there is a price floor of 4 (RMB),

(i) Is there any excess demand or excess supply? If any, how much? (2 points)
Excess demand.
When there is a price floor of 4(>3), which is a binding price floor, the
market price should be P=4.
At P=4, quantity demanded is 10 − 2 × 4 = 2, quantity supplied is 2 × 4 −
2 = 6. Thus, the excess supply is 6-2=4 units.

(ii) What is the deadweight loss? (3 points)

With the price floor of 2, the market quantity is 4. Then the deadweight loss
4−2
is (4 − 2) × = 2.
2

(c) Suppose the government is going to charge 1 (RMB) per unit of butter on the
suppliers.
(i) What is the tax incidence? Does the tax incidence change if the tax is levied
on the buyers? (8 points)
When a tax=1 is levied on the supplier, the new supply curve should be
𝑄 𝑆 = 2 × (𝑃 − 1) − 2 .
The new market equilibrium price satisfies 2 × (𝑃 − 1) − 2 = 10 − 2 × 𝑃,
i.e., P=3.5. Thus, the tax incidence is that the buyer bears a tax of 3.5-3=0.5,
and the supplier bears 3-2.5=0.5.
(Note that after the tax is levied, the price paid by a buyer is 3.5 . The
quantity traded in the market is 10 − 2 × 3.5 = 3 . The price that the
supplier actually receives satisfies 3 = 2 × 𝑃 − 2, which implies that the
price received is 2.5 .
Compared to the case before tax, the buyer pays 3.5-3=0.5 RMB more. The
seller receives 3-2.5=0.5 RMB less. )
(ii) What is the consumer surplus? (3 points)
 The consumer surplus is (5 − 3.5) × 3 ÷ 2 = 2.25.
(iii) What is the producer surplus? (3 points)
The producer surplus is (2.5 − 1) × 3 ÷ 2 = 2.25.
(iv) What is the government revenue? (3 points)
The government revenue is 3 × 1 = 3.
(v) What is the deadweight loss? (3 points)
The deadweight loss is (4 − 3) × 1 ÷ 2 = 0.5.
2. Consumer Theory. (25 points)
Xiao Ming has 8 RMB to spend. The price of tea is 1 RMB each, and burgers cost 2 RMB
each.
(a) Denote 𝑄𝑇 , and 𝑄𝐵 as the quantities of tea and burgers, respectively. What is the
budget constraint? Draw a graph to illustrate it. (3 points)
The budget constraint is 𝑄𝑇 + 2𝑄𝐵 ≤ 8.

𝑄𝐵

8 𝑄𝑇
 (b) Xiao Ming’s total utility schedule is as below. Fill the table below and answer the
following three questions. (12 points)
Number UT MUT MUT⁄PT Number of UB MUB MUB⁄PB
of tea Burgers
0 0 6 6 0 0 10 5
1 6 4 4 1 10 4 2
2 10 3 3 2 14 1 0.5
3 13 2 2 3 15 0 0
4 15 1 1 4 15 -8 -4
5 16 - - 5 7 - -
(c) Which of the two goods demonstrates the law of diminishing marginal utility? (1 points)
Both.
(d) What is the optimal consumption bundle with the highest obtainable utility level of
Xiao Ming? What is the highest utility level? (5 points)
𝑄𝑇 = 4 and 𝑄𝐵 = 2. Highest utility level is 15+14=29.
(e) Suppose after attending some health course, Xiao Ming now prefers a healthier life.
How does it affect his choices? (4 points)
MUT⁄PT would increase/decrease/not affected .
MUB⁄PB would increase/decrease/not affected .
Lisa would spend more on Tea and less on Burger .

3. Consumer Theory. (15 points)

Anna’s utility function for goods X and Y is represented as
U(X, Y) = ln(X) + 4ln(Y)
The prices of X and Y are 2 RMB and 4 RMB, respectively. Anna’s income is 20 RMB. What
is Anna’s optimal consumption bundle (X*, Y*).
(Notice that here X and Y also refers to the quantity consumed by Anna.)
Anna’s problem is
max U(X, Y) = ln(X) + ln(Y)
X,Y

Subject to 2X + 4Y = 20.
 At optimal, we should have 𝑀𝑈𝑋 ⁄𝑃𝑋 = 𝑀𝑈𝑌 ⁄𝑃𝑌 . Since 𝑀𝑈𝑋 = 1/𝑋 and 𝑀𝑈𝑌 = 4/𝑌, we
have
1/𝑋 4/𝑌
=
2 4
which gives X = 0.5Y. Combining the budget constraint, we have 𝑋 ∗ = 2 and 𝑌 ∗ = 4.
4. Income Effect and Substitution Effect. (30 points)
Bob has $12 to spend on tea and burgers. The price of tea is $1 each. The price of burgers is $2
each. Tea is a normal good, but burger is an inferior good. Now, the price of burger has increased
to $3 each. Draw a two-dimensional graph and indicate the income effect and the substitution
effect.

Note that 𝑄𝐵 at point C can be either greater or smaller than that at point A, but it must be
greater than that at point B because of the income effect for an inferior good.