EC1000 – Question Sheet 4 – Week 10

1.The New York Times (July 1, 1994) reported on a Clinton administration proposal to lift the ban on exporting from the North Slope of Alaska. According to the article, the administration said that “the chief effect of the ban has been to provide California refiners with crude oil cheaper than oil on the world market… The ban created a subsidy for California refiners that had not been passed on to consumers.” Let’s use our analysis of firm behaviour to analyze these claims.

  1. Draw the cost curves for a California refiner and for a refiner in another part of the world. Assume that the California refiners have access to inexpensive Alaskan crude oil and that other refiners must buy more expensive crude oil from the Middle East.
  1. All of the refiners produce gasoline for the world gasoline market, which has a single price. In the long-run equilibrium, will this price depend on the costs faced by California producers or the costs faced by other producers? Explain. (Hint: California cannot itself supply the entire world market.) Draw new graphs that illustrate the profits earned by a California refiner and another refiner.
  1. In this model, is there a subsidy to California refiners? Is it passed on to consumers?

2. Leicester City Council believes that the social value of a public good (i.e. the total willingness to pay obtained by summing over all consumers) far exceeds its cost, which is estimated at £100,000. Therefore, the City Council wants to provide the public good. However, it is concerned with the problem of dividing the cost among Leicester residents in a fair way. To this end, it asks ask each Leicester resident to state how much he or she values the good, specifying that (i) the good will be provided only if the sum of the stated values exceeds the cost and that (ii) each resident will have to pay proportionally to his or her stated valuation. In your opinion, will this mechanism work? Which problems may likely arise?

3. Consider three consumers, A, B and C. All buy two goods, 1 and 2. Consumer A has an income of 100 and faces prices p1= 10 and p2= 5. Consumer B has an income of 80 and faces prices p1= 8 and p2= 5. Consumer C has an income of 60 and faces prices p1= 5 and p2= 2. Which consumer has the largest real income (i.e. the highest purchasing power)?

4. In the last 150 years or so, the wage rate has increased more than ten times whereas working hours have decreased. In your opinion, why people have not responded to the huge increase in the price of labour by supplying more labour?

5. “When two goods are perfect complements, the substitution effect vanishes.” Comment.

6. An alcoholist consumes only two goods, wine and beer. His preferences are as follows: between any two bundles of wine and beer, he prefers the one that contains more alcohol. When two bundles contain the same amount of alcohol, he prefers the one that contains more wine. Can you draw the indifference curves of this consumer?

EC1000 – Question Sheet 4 – Week 10

7. Consider a proportional tax on labour income. Assuming that the gross wage rate is constant, how does such a tax affect the household’s budget constraint? What are the possible effects on labour supply?

8. Many airline companies offer lower prices for tickets that require passengers to spend the weekend (or at least Saturday night) away from home. What is the possible rationale behind this price discrimination strategy?

9.Describe the problem of adverse selection in the market for health insurance. Explain why making health insurance compulsory might alleviate the problem.

10. Suppose that the price of Leicester Tigers tickets is determined by market forces. Currently, the demand and supply schedules are as follows:

Price / Quantity Demanded / Quantity Supplied
£15 / 20,000 / 16,000
£20 / 16,000 / 16,000
£25 / 12,000 / 16,000
£30 / 8,000 / 16,000

a. Draw the demand and supply curves. What is unusual about this supply curve? Why mightthis be true?

b. What are the equilibrium price and quantity of tickets?

c. Suppose that demand increases by 8,000 units at any price. What are the new equilibrium price and quantity?