Question

. Suppose that, in the market for cars, demand is given by P= 10 – Q and supply is given by P= Q.

A. What is the market price that maximises total economic surplus?

B. Illustrate on a graph and calculate consumer and producer surplus at this price.

(Remember to clearly label any relevant prices and quantities.)

C. Explain why no other market price leads to a Pareto efficient outcome. (You can draw the graph, take a picture and attach it here. Please do *not* take a picture of your hand-written answer, it is much easier for your marker to read typed text)

Answer 1

P = 10 - Q

P = Q

A) At equilibrium, demand = supply where market maximized total economic surplus

10 - Q = Q

Q = 5

At this Q, P = 5

B) Consumer surplus at this market is area of portion C + D + A whose sum is (1/2) * (10 - 5) * (5 - 0) = 12.5

Producer surplus is area of portion E + B + F + G whose sum is (1/2) * (5 - 0) * (5 - 0) = 12.5

C) Pareto efficient outcome occurs when it is impossible to make one party better off without making other worse off. If price is higher than equilibrium price, supply would be greater than demand. At this price, producers would be better off by making consumers worse off. On the other hand, lower price than equilibrium price make consumer better off and make producer worse off. Thus, we can say that pareto efficient outcome occurs when demand = supply.