Question

Question 1: Consider modeling the market for tomatoes in Dubai using the supply and demand diagram.

a) Draw a diagram with the quantity q of tomatoes on the horizontal axis and the price per kg of tomatoes on the vertical axis. Draw supply and demand curves for tomatoes and identify the equilibrium point (q*, p*).

b) Suppose the government imposes a tax of 50 fils per kg of tomatoes on the sellers of tomatoes. In your diagram from part a) analyze the impact of the tax on the equilibrium quantity and prices. Identify the new equilibrium, that is, the equilibrium quantity, the price buyers pay, and the price sellers receive.

c) Identify consumer and producer surplus before and after the imposition of the tax in your diagram.

d) Identify tax revenue in your diagram.

e) Comparing total surplus before and after the imposition of the tax, does

total surplus increase, stay the same, or decrease? (Note, that total surplus includes tax revenue).

Answer 1

(a) In following graph, D0 and S0 are initial demand and supply curves intersecting at point E with price p* and quantity q*.

S. S.

(b) The tax of $50 will reduce the effective price received by the sellers by $50 at every output level, so firms will lower supply and the supply curve will shift leftward by $50 at every output level. In above graph, S0 will shifts leftward to S1, intersecting D0 at point F. Price paid by consumers is p1 and price received by producers is p2 (where p1 - p2 = Unit tax = $50). New quantity is lower at q1.

(c)

Consumer surplus (CS) = Area between demand curve and price paid by consumers

Before tax, CS = Area AEp*

After tax, CS = Area AFp1

Producer surplus (PS) = Area between supply curve and price received by producers

Before tax, PS = Area BEp*

After tax, PS = Area BGP2

(d)

Tax revenue = Area p1FGp2

(e)

Total surplus before tax = CS + PS = AEp* + BEp* = Area AEB

Total surplus after tax = CS + PS + Tax revenue = AFp1 + p1FGp2 + BGp2 = Area AFGB

Since Area(AEB) > Area(AFGB), Total surplus is lower after tax by Area EFG, which is the social inefficiency loss.