Question

Suppose the aggregate demand for honey in a small country is given by Q^D = 100 − P and the aggregate supply is Q^S = P. The international price of honey is P^I = 60, and the world market is willing to buy or sell any amount at that price. Let all quantities be given in gallons and all prices in dollars per gallon. Suppose the country initially starts out with closed borders, and cannot import or export at all.

Suppose, instead of a subsidy, the government sets a price ceiling to keep the price of honey low for consumers. Let the government set a maximum price P¯ = 40 for honey. If there is any excess demand, the government agrees to make up the shortfall by importing honey from the world market and selling it to consumers at the domestic price.

(g) What is the new domestic equilibrium price? What is the quantity demanded domestically and quantity supplied by domestic suppliers? How much must the government import to clear the market?

(h) Compute producer surplus, consumer surplus, government transfers, and social welfare with the price ceiling. Depict it graphically.

(i) Which parties benefit from the government’s price ceiling? Which are worse off? What is the deadweight loss of the policy?

Answer 1