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Problem Set #3 Answer Key Econ326 Fall 2011 Instructor: Ginger Jin 1. The United States currently imports all of its coffee. The annual demand for coffee by U.S. consumers is given by the demand curve Q = 250 – 10P, where Q is quantity (in millions of pounds) and P is the market price per pound of coffee. World producers can harvest and ship coffee to U.S. distributors at a constant marginal (= average) cost of \$8 per pound. U.S. distributors can in turn distribute coffee for a constant \$2 per pound. The U.S. coffee market is competitive. Congress is considering a tariff on coffee imports of \$2 per pound. a. If there is no tariff, how much do consumers pay for a pound of coffee? What is the quantity demanded? (Hint: market supply is determined by the overall marginal cost which includes both the marginal cost of world producers and the marginal cost of US distributors). If there is no tariff then consumers will pay \$10 per pound of coffee, which is found by adding the \$8 that it costs to import the coffee plus the \$2 that it costs to distribute the coffee in the U.S. In a competitive market , price is equal to marginal cost. At a price of \$10, the quantity demanded is 150 million pounds. b. If the tariff is imposed, how much will consumers pay for a pound of coffee? What is the quantity demanded? (Hint: tariff will be imposed on every pound imported, so it increases the marginal cost of production before US distributors get the coffee.) Now add \$2 per pound tariff to marginal cost, so price will be \$12 per pound, and quantity demanded is Q = 250 – 10(12) = 130 million pounds. c. Calculate the lost consumer surplus. Lost consumer surplus is (12–10)(130) + 0.5(12–10)(150–130) = \$280 million. d. Calculate the tax revenue collected by the government. The tax revenue is equal to the tariff of \$2 per pound times the 130 million pounds imported. Tax revenue is therefore \$260 million. e. Does the tariff result in a net gain or a net loss to society as a whole? (Hint: the society as a whole will consider consumer surplus, producer surplus and government revenue.) 1

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Problem Set #3 Answer Key Econ326 Fall 2011 Instructor: Ginger Jin There is a net loss to society because the gain (\$260 million) is less than the loss (\$280 million). Notice that since the producer is earning zero profit before and after tariff, there is no change in the producer surplus. 2. Morris Zapp and Philp Swallow consume wine and books. Morris has an initial endowment of 60 books and 10 bottles of wine. Philip has an initial endowment of 20 books and 30 bottles of wine. They have no other assets and make no trades with anyone other than each other. For Morris, a book and a bottle of wine are perfect substitutes. His utility function is U(b,w)=b+w, where b is the number of books he consumers and w is the number of bottles of wine he consumes. Philip’s preferences are more subtle and convex. He has a Cobb-Douglas utility function, U(b,w)=b*w. in the Edgeworth box below, Morris’s consumption is measured from the lower left, and Philip’s is measured
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