Chapter 3

Why does a subsidy create a deadweight loss?

In a market with a subsidy, more people purchase the good or service than would have in the competitive market. The resulting deadweight loss derives from these people who would not have purchased the good in the competitive market.

When is a price ceiling nonbinding? When is a price floor nonbinding?

A nonbinding price ceiling is set at a level above equilibrium price, and a nonbinding price floor is set at a level below equilibrium price.

What is a price ceiling? Why does a price ceiling create excess demand for (shortage of) a good?

A price ceiling sets the highest price that can be paid legally for a good. If this price is set below the equilibrium price, consumers will demand more of the good than producers are willing to supply, resulting in excess demand for the good.

What is a price floor? Why does a price floor create an excess supply of (surplus of) a good?

A price floor sets the lowest price that can be paid legally for a good. If this price is set above the equilibrium price, producers will supply more of the good than consumers are willing to buy, resulting in excess supply for the good.

What is a quota? How does it differ from a price ceiling or a price floor?

A quota directly regulates the quantity of a good or service that can be provided, unlike a price floor or price ceiling that directly regulates the price of a good or service.

How does a subsidy affect consumer and producer surplus?

A subsidy increases both producer and consumer surplus.

What is a subsidy?

A subsidy is the opposite of a tax—it is a payment by the government to a buyer or seller of a good or service.

What happens to the equilibrium price and quantity of a good when a tax is imposed on the good? Why does a tax create a wedge between the price the consumer pays and the price the producer receives?

A tax causes quantity to decrease and the price that consumers pay to increase. A tax wedge occurs because the price suppliers receive for the good is lower than the price consumers pay by the amount of the tax.

How does a demand shift affect consumer and producer surplus in a given market? Consider both inward and outward shifts of the demand curve.

An inward shift of the demand curve reduces producer surplus and has an ambiguous effect on consumer surplus. An outward shift of the demand curve increases producer surplus, while also having an ambiguous effect on consumer surplus.

How does a supply shift affect consumer and producer surplus in a given market? Consider both inward and outward shifts of the supply curve.

An inward shift of the supply curve reduces consumer surplus and has an ambiguous effect on producer surplus. An outward shift of the supply curve increases consumer surplus, while also having an ambiguous effect on producer surplus.

Define consumer and producer surplus.

Consumer surplus is the difference between the price consumers would be willing to pay for a good and the price they actually have to pay. Producer surplus is the difference between the price at which producers would be willing to sell their good or service and the price they actually receive.

What is a deadweight loss? If the price elasticity of a good is large, would you expect the deadweight loss to be large or small?

Deadweight loss is the reduction in total surplus that results from a market inefficiency. A large price elasticity indicates that supply or demand is sensitive to price. As a result, the resulting deadweight loss in a market with a large price elasticity will be relatively large

What is the demand choke price? How does this price relate to consumer surplus?

The demand choke price is the price at which quantity demanded is reduced to zero. Consumer surplus is equal to the area of the triangle with its base equal to the quantity sold and its height the difference between the market price and the demand choke price.

What is the supply choke price? How does this price relate to producer surplus?

The supply choke price is the price at which quantity supplied is reduced to zero. Producer surplus is equal to the area of the triangle with its base equal to the quantity sold and its height the difference between the marke

What is the tax incidence? What factors determine the tax incidence?

The tax incidence is who—the producers or consumers—actually bears the burden of a tax. The tax incidence is determined by the elasticity of supply and demand.

How does a tax affect consumer and producer surplus? Why does a tax create a deadweight loss?

The tax wedge reduces both consumer and producer surplus in the market, creating the deadweight loss of a tax.