Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Course 2020-2021 - Problem Set 6

Conceptual Questions
Write down a short and concise answer. When you are asked to solve the question in class, explain
the concept clearly and give examples or pieces of evidence.
1. Consider three possible methods to sell a car that you own: a) Advertise it in the local
newspaper. b) Take it to a car auction. c) Offer it to a second-hand car dealer. Would your
reservation price be the same in each case? Why?
The seller's reservation price is the minimum price he or she is willing to accept. One would
expect that the absolute minimum would not change with the method used to sell it. Because
each method may require a different amount of effort on the part of the seller, the reservation
prices may be different for each channel. For example, offering the car to a second hand-car
dealer requires minimal effort, so the seller may be willing to settle for a lower price.
Advertising it in a local newspaper requires more effort on the part of the seller, who might
then have a higher reservation price due to compensation for their time. In addition, the
likelihood of sale may affect the price that one is willing to accept.
2. Which of the methods described in the previous question do you think would result in the
highest sale price? If you used the first method, would you advertise it at your reservation
price?
It is likely that an auction may receive the highest price, because it creates competition between
the buyers, who may try to outbid each other by raising the purchase price. It is likely that most
sellers will advertise a higher price in the hope that buyers will value the car higher than the
seller’s reservation price.
3. We have used chocolate bars as a hypothetical example of an approximately competitive
market. But in recent years, producers of best-selling chocolate bars worldwide have been
accused of colluding with each other to keep prices high. In what ways does the market for
chocolate bars fail to satisfy the conditions for perfect competition?
Use the definition of perfect competition:
a) homogeneous product
b) large numbers of potential buyers and sellers
c) who act independently
d) buyers and sellers can readily know the prices at which
goods are exchanged.
The focus in the answer is on (a), (b) and (c). Markets are not perfectly competitive when
products are differentiated. In the case of chocolate bars, each company uses a slightly different
recipe for making chocolate, including non-cocoa ingredients such as nuts or raisins and
different shapes (such as ‘mountain shaped’ for Toblerone) to differentiate their chocolate from
another company’s. Companies also use marketing (including product packaging) to
differentiate their products. This allows firms to acquire market power.
4. Each brand of chocolate bar faces competition from many other similar brands. Why, despite
this, do some producers have considerable market power?
As mentioned in the previous question, despite the chocolates tasting similar, companies use
marketing to build a distinct brand identity, so that consumers still consider the brands as
sufficiently different from each other. Building brand loyalty is one way to gain market power,
because consumers will be less responsive to price changes and less likely to switch to similar
brands if the price of their favourite brand increases.

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 Problems
1. In a perfectly competitive market the demand is Q = 27 – 2P and the supply is Q =
P – 3. Please answer this question graphically and also analytically whenever
possible.
a. What is the equilibrium price, quantity, producer and consumer surplus in
equilibrium?
b. Suppose the government announces a tax of 3 per unit of the good on the
producers. What is the new equilibrium price, quantity, producer and
consumer surplus, government revenue and deadweight loss?
c. Suppose the income of the consumers in this economy increases, and that
the good is a normal good. What will happen with the equilibrium price,
quantity and producer and consumer surplus? Who will benefit or lose more
from the changes, and what does this depend on?
a. In equilibrium, 27 – 2P = P – 3, so P = 10, and Q = 7. Consumer surplus is
(13.5-10)*7/2=12.25 and producer surplus is (10-3)*7/2 = 24.5.
b. New supply is P - 6, so 27 – 2P = P – 6, so P = 11, and Q = 5. Consumer
surplus is (13.5-11)*5/2=6.25 and producer surplus is (11-6)*5/2 = 12.5.
Government revenue is 3*5 =15. Sum of CS, PS and government revenue is
then 33.75, lower than the sum of 36.75 without tax in 3 units, which can
also be calculated as (7-5)*3/2 = 3.
c. As income increases, since the good is normal, demand increases. Clearly
price and quantity will increase, and both consumer and producer surplus.
Who wins more depends on the relative (new) elasticities of demand and
supply.
2. Answer the following questions.
a. Sketch a diagram to illustrate the competitive market for bread, showing the
equilibrium where 5,000 loaves are sold at a price of €2.00.
b. Suppose that the bakeries get together to form a cartel. They agree to raise
the price to €2.70, and jointly cut production to supply the number of loaves
that consumers demand at that price. Shade the areas on your diagram to
show the consumer surplus, producer surplus, and deadweight loss caused
by the cartel.
c. For what kinds of goods would you expect the supply curve to be highly
elastic?
d. Draw diagrams to illustrate how the share of the gains from trade obtained
by producers depends on the elasticity of the supply curve.

a. The following graph answers the question

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 b. At €2.70, the bakeries sell 3,000 loaves in total (point B).

c. Goods with a highly elastic supply curve are likely to have a number of
characteristics. These are:
- Supplier has the spare capacity to increase output
- Short time frame needed to get products to market
- Factors of production can be reallocated easily.
d.

We can observe the impact of the elasticity of supply by comparing two supply and
demand graphs. In the market on the right, supply is less elastic than on the left. As a
result, more of the gains from trade go to the producer compared to the case on the left.

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 Other Questions

1. The following diagram depicts the demand and supply curves in the salt market. It
also depicts the shift in the supply curve due to a 30% tax on the price of salt. Now
suppose that the market demand curve for salt is less elastic than in the diagram.
The equilibrium before tax is still at (Q*, P*). Let the post-tax equilibrium be
denoted by (Q2 , P2) (not shown on the diagram). Based on this information, which
of the following statements is correct?
a. For the prices, P* < P2 < P1.
b. For the outputs, Q1 < Q2 < Q*.
c. The tax revenue raised would be lower if the demand curve were less elastic.
d. Proportionally, more of the burden of the tax would be on the producer if the
demand curve were less elastic.

a. Less elasticity implies a steeper demand curve. Therefore, P2 will be higher than P1.
b. The demand curve would be steeper, so the equilibrium quantity demanded would
be in between Q1 and Q*.
c. The government’s tax revenue would be greater if the demand curve were steeper.
Alternatively, the tax revenue is given by (P2 – P0) x Q2. Given that P2 > P1 and Q2
> Q1, this is unambiguously bigger than the original tax revenue (P1 – P0) x Q1.
d. Proportionally, more of the burden of the tax would be on the consumer if the
demand curve were steeper.

2. The market demand curve of a particular good is downward-sloping. Based on this

information, which of the following statements is correct regarding a price-taking
firm producing that good?
a. The demand curve faced by the firm is downward-sloping.
b. The firm chooses the price that equals its marginal cost.
c. The firm chooses its output such that the marginal cost equals the price.
d. A price-taking firm cannot be profit-maximising.
a. The firm does not face the market demand curve, but instead faces a curve
determined by the price charged by all other firms. Therefore the firm’s
demand curve is horizontal.
b. The firm cannot choose the price; it is a price-taker.
c. The firm can only choose output, taking the price as given. To maximise
profits, the firm chooses the output such that marginal cost equals price.

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d. By profit-maximising, a price taking firm chooses the output that equates its
marginal cost with the market price.