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solution2 - September 27 2006 Solution to Problem Set 2...

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September 27 2006 Solution to Problem Set 2 Come see me if you have trouble with question 1. This is the answer to question 2 a) In the absence of the target price policy, consumers and producers both facethesamepr ice . There fore ,thereisnoamb igu ityaboutthemean ingo f "price". I can graph both supply and demand as a function of the price — because there is only one price. However, as soon as we introduce the target price policy, there are two relevant prices — the price that consumers pay and the price that producers receive. These prices are not the same; they di f er by the amount of the de f ciency payment. It is convenient to continue to let the vertical axis represent the consumer price. With this convention, the demand curve is unchanged by the policy. However, whenever the market price (i.e. the price that consumers pay) is below p , the relevant price for producers is p (because that is the price that they receive). Therefore, since I have the consumer (i.e. "market") price on the vertical axis, and since the producer supply is determined by p whenever the market price is less than p , the "policy distorted supply curve" is vertical at p ,asshownin f gure 1a. The autarkic price is given by the intersection of this vertical line and the demand curve. In the presence of the policy, the excess supply curve is the di f erence between the (policy distorted) supply curve and the demand curve. Figure 1a shows the supply and demand curves. With the target price policy, the market-clearing price (i.e. the price that consumers pay) is shown as ˆ p a . The target price policy increases consumer surplus by the area abc ˆ p a and it increases producer surplus by the area abep . The cost of the program is shown by the area p ec ˆ p a , so the deadweight cost is the area bce . The excess supply curve (with the policy) is the same as the no-policy excess supply curve for prices above p* (since for that region the original and the policy distorted domestic supply curves are the same); it has a kink at p*andissteeperforpr icesbe lowp* .(SeeF igure1b) I have drawn an arbitrary world price p 0 above ˆ
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to taxpayers) decreases by the amount of supply times the price change. The gain to the treasury minus the loss to domestic consumers equals the
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This note was uploaded on 08/01/2008 for the course ARE 201 taught by Professor Karp during the Fall '07 term at Berkeley.

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solution2 - September 27 2006 Solution to Problem Set 2...

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