I understand the first half but get stuck with the budget nuetral subsidy (6-10)
ID: 1205045 • Letter: I
Question
I understand the first half but get stuck with the budget nuetral subsidy (6-10)
Consider a market where demand is: P = 70 – Q and supply is S: P = Q.
1. Equilibrium quantity Qe is a. 35 b. 36 c. 45 d. 56
2. Equilibrium price Pe is a. $34 b. $35 c. $36 d. $37
3. Consumer surplus CS is a. $610 b. $612.5 c. $615 d. $648
4. Producer surplus PS is a. $610 b. $612.5 c. $615 d. $648
5. Total surplus TS is a. $1,222 b. $1,223 c. $1,224 d. $1,225
Construct a budget neutral subsidy in the above market.
6. Post-subsidy quantity Q’ is a. 35 b. 36 c. 45 d. 56
7. Post-subsidy price P’ is a. $34 b. $35 c. $36 d. $37
8. Consumer surplus CS’ is a. $610 b. $612.5 c. $615 d. $648
9. Producer surplus PS’ is a. $610 b. $612.5 c. $615 d. $648
10. Total surplus TS is (do not forget to account for the subsidy expenditure SE) a. $1,222 b. $1,223 c. $1,224 d. $1,225
Explanation / Answer
1. Equilibrium qty = 35. i.e. demand = supply i.e. P = Q = 70 -Q, P = 35, Q = 35
2. Equilibrium price = $ 35, as arrived at above
3. Consumer surplus = difference in the total amount consumers are willing to pay and what they actually pay
i.e. area of the triangle (Max P - Pe) * Qe * 1/2 = (70-35)*35*0.5 = 612.5
4. Producer surplus = difference in the total amount at which the producer is willing to supply goods and the amount he actually sells at
i.e. area of the triangle (Pe*Qe*1/2) = 35*35*0.5 = 612.5
5. Total surplus = consumer surplus + producer surplus = 612.5 + 612.5 = 1225
Budget neutral refers to an approach which has no impact on the total budget, subsidy will involve reduction in consumer price (if any). If we try reducing the price the demand qty will increase but the net output will start to reduce, hence the price will remain at $ 35, hence all the other elements i.e qty, surplus etc will remain the same as derived above.