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5 micro - Solution to Exercise 5 1 a The top diagram shows...

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Solution to Exercise 5 1 a. The top diagram shows that at price P 0 there is excess supply of M-O. The bottom diagram shows that to raise the price that the producers get from A to P 0 the government has to pay a subsidy of P 0 -A. This has the effect of raising the demand curve that the producers perceive. The vertical distance between these two parallel demand curves is the subsidy. The subsidy increases the quantity demanded by consumers by M-0, thus eliminating the excess supply. The total amount of money that the government spends on the subsidy is the product of the subsidy (P 0 -A) and the quantity supplied and demanded (O). b . In both cases the price to the producers is the same and is equal to P 0 . The producers sell the same quantity and earn the same profits in both alternative, and any difference between them is only technical from their point of view. c . Under the first method the consumers buy a quantity of M at a price of P 0 . Under the second method the consumers buy a quantity of O at the price of A. Thus the consumers are better off with a subsidy. d . It depends on the elasticity of the demand curve. In the first case the cost for the government equals (O-M)*P 0 . In the second case the cost to the government is equal to O*(P 0 -A). The greater the elasticity of supply the more costly is the first alternative to the government compared with the second alternative. The reason is that with elastic demand the excess supply (O-M) in the first method is large. 2. (1) As the diagram below shows the project increases the public sector’s demand for engineers.

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