Homework 9

1.	Consider a theater customer with the following demand for popcorn: Q = 3 - 2^.P, where P=price per carton and Q=cartons of popcorn. The marginal cost of popcorn to the theater owner is constant at $.50 per carton, and the owner presently charges a price of $1.00 per carton.
	a.	Depict the above information in a supply and demand diagram for popcorn. Indicate the present consumer surplus of the theater customer and the present popcorn profits of the theater owner.
	b.	Assume that all of the theater's customers have the same demand for popcorn that is illustrated here. Keeping in mind that theater owners can change both their ticket price and their popcorn price, use the concept of consumer surplus to calculate how much this owner can increase overall profits by reducing the price of popcorn to its marginal cost of $.50 per carton.

2.	Suppose that the price of health care rises.
	a.	Placing income spent on other goods (IO) on the vertical axis and the quantity of health care (H) on the horizontal axis, use indifference curves to illustrate the effects of the price increase on a typical health care consumer.
	b.	Now suppose that you have actually shown the situation of a typical low-income consumer. Suppose the government decides to subsidize the price of health care for this consumer so that she continues to pay the old price. Indicate the cost of this program to the government and label it "1".
	c.	Suppose instead that the government makes a cash payment to the consumer which is just sufficient to keep her at the level of utility she achieved before the price increase. In your diagram, indicate the cost of the cash payment to the government and label it "2". Which policy option costs less? How can you tell from the diagram?

3.	a.	The residents of Owens Valley on the eastern side of California's Sierra Nevada Mountains consume water (W) and spend the rest of their income on other goods (Io). In the diagram to the right, draw an initial budget line, putting water on the horizontal axis, and use a (nice smooth) indifference curve to illustrate an initial optimum for a typical Owens Valley consumer. Label your initial consumption point as point "a."
	b.	Several years ago, Los Angeles began shipping water from the Owens Valley to L.A. Illustrate in your diagram the impact of the resulting increase in the price of water for your Owens Valley consumer. Label your new consumption point as point "b." Clearly separate your change in water consumption into a substitution effect and an income effect.
	c.	Now suppose that the Owens Valley residents reach an agreement with L.A. to be compensated with enough income to restore the typical Owens Valley consumers to their original level of utility. Indicate in your diagram the size of the payment received.
	d.	Is the amount you have shown larger than, smaller than, or equal to the consumer's compensating variation for the increase in the price of water? Explain.

Now consider the situation of a typical L.A. water consumer receiving Owens Valley water. In the diagram to the right, draw an initial budget line, putting water on the horizontal axis, Io on the vertical axis, and use a (nice smooth) indifference curve to illustrate an initial optimum. Label your initial consumption point as point "a."

Suppose L.A. finances the payments it makes to the Owens Valley by imposing a tax on water consumed by L.A. residents. Illustrate the new optimum in your diagram (label it as point "b"), and clearly label the amount of tax revenue collected from the consumer.

Would your consumer have been better off if L.A. had financed the same-sized payment to the Owens Valley with an income tax instead of a tax on water? Explain briefly, and use your diagram for support.