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Competitive market with inelastic demand

QUIZ 2

Answer each of the following questions and return your completed papers by the beginning of the next class meeting.  You will find the Appendix to Chapter 4 helpful in answering these questions.

Competitive market with inelastic demand

1.         Assume that a competitive market with a highly inelastic demand is in equilibrium.  Now suppose the government imposes a per-unit tax on the sale of the good (that is, $t is collected from the seller for each unit sold).  Using a graph, illustrate the effect that such a tax has on the price paid by consumers, the price received by sellers, the quantity sold in the market and the amount of tax revenue collected by the state.

SAMPLE ANSWER: In a competitive market there are many buyers and sellers of a product and as given that highly inelastic demand is in equilibrium. Highly inelastic demand or perfectly inelastic demand is that when price changes do not affect its demand. Now, as per assumption if the government imposes a per-unit tax or marginal tax on the sale of the good, it means that selling price or the market price will increase, finally this will increase the price of the good because of increased tax.

2.         Using the information you obtained from doing problem 1, explain why a per-unit tax in a market with a highly elastic demand curve would result in less tax revenue paid to the state.  You will find it helpful to graph an elastic demand curve on the graph you used in problem 1, going through the same initial equilibrium point, to answer this question.

3.         Assume that the government imposes a price ceiling below the equilibrium price in a market for widgets.  Using a graph, illustrate the amount that will be sold and the price that will be charged in such a situation.  What are some of the ways the sellers will choose who gets to buy the good and how much each may buy?

SAMPLE ANSWER: Price ceiling is done below the natural equilibrium.

When a price ceiling is done, a shortage occurs. At the price for the ceiling is done, the demand increases more than there is at the equilibrium price. But, there is less supply than the equilibrium price, thus there is more quantity demanded than quantity supplied. Inefficiency takes place since at the price ceiling quantity supplied the marginal benefit is more than the marginal cost. This inefficiency results into the deadweight welfare loss.

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