Modern Principles of Economics 3rd Edition Cowen

Solutions Manual
Full download at link:

Solution Manual: https://testbankpack.com/p/solution-manual-for-modern-principles-of-

economics-3rd-edition-cowen-tabarrok-1429278390-9781429278393/

Test Bank: https://testbankpack.com/p/test-bank-for-modern-principles-of-economics-3rd-edition-

cowen-tabarrok-1429278390-9781429278393/

modern principles modern principles:

Cowen3e_CH06_Solutions.indd 1 29/06/15 9:54 AM
S-2 • C H A P T E R 6 • Taxes and Subsidies

c. Elastic supply is better from the government’s point of view, just as elastic
demand is better.As long as the goal is getting the quantity to move a lot, you
want elasticity.
d. II: Both should be elastic.
3. As we saw in the chapter, a lot turns on elasticity. Decades ago,Washington, D.C., a
fairly small city, wanted to raise more revenue by increasing the gas tax.Washington,
D.C., shares borders with Maryland andVirginia, and it’s very easy to cross the borders
between these states without even really noticing:The suburbs just blend together.
a. How elastic is the demand for gasoline sold at stations within Washington, D.C.? In
other words, if the price of gas in D.C., rises, but the price in Maryland and
Virginia stays the same, will gasoline sales at D.C., stations fall a little, or will
they fall a lot?
b. Take your answer in part a into account when answering this question. So, when
Washington, D.C., increased its gasoline tax, how much revenue did it raise: Did
it raise a little bit of revenue, or did it raise a lot of revenue?
c. How would your answer to part b change if D.C., Maryland, andVirginia all
agreed to raise their gas tax simultaneously? These states have heavily populated
borders with each other, but they don’t have any heavily populated borders with
other states.
Solution 3. a. Washington, D.C., gas sales are very elastic: It’s easy to drive across the border

to buy gas where it’s cheapest. Hence, we can say that the gasoline sales at D.C.
stations will fall a lot.
b. Gasoline sales in Washington, D.C., plummeted and the tax raised very little revenue.
c. If they all raised the gas tax simultaneously, they could raise a lot of revenue.The
demand within these three states is more inelastic, since drivers don’t have many
good alternatives to filling up within the tri-state area.
4. In Figure 6.5, what is the total revenue raised by the tax, in dollars? What is the
deadweight loss from the tax, in dollars? (Note:You’ve seen the formula for the
latter before.We’ll let you look around a little for this one.)
Solution 4. Tax revenue: 500 3 $1 5 $500. Deadweight loss 5 $1 tax 3 200 apples 3 ½
(because it’s a triangle) 5 $100.
5. a. Once again:Why does the chapter say that elasticity 5 escape? (This is worth

remembering: Elasticity is one of the toughest ideas for most economics

students.)
b. Which two groups of workers did we say have a relatively high elasticity of labor
supply? Keep this in mind as politicians debate raising or lowering taxes on dif-
ferent types of workers:These two groups are the ones most likely to make big
changes in their behavior.
Solution 5. a. Elasticity 5 escape because someone with high elasticity is someone who can
easily escape to another market, either as a supplier or as a demander.
b. Men nearing retirement and married women have the highest labor supply
elasticity.They respond to labor-market incentives the most, while middle-aged
men tend to work the same hours even when the wage changes.
6. Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is willing
to accept as little as $25 for a haircut.
a. What possible prices for the haircut would be beneficial to both Maria and Juan?
How much total surplus (i.e., the sum of consumer and producer surplus) would
be generated by this haircut?
Cowen3e_CH06_Solutions.indd 2 29/06/15 9:54 AM
 Taxes and Subsidies • C H A P T E R 6 • S-3

b. If the state where Maria and Juan live instituted a tax on services that included
a $5 per haircut tax on stylists and barbers, what happens to the range of haircut
prices that benefit both Maria and Juan? Will the haircut still happen? Will this
tax alter the total economic benefit of this haircut?
c. What if instead the tax was $20?
Solution 6. a. Any price greater than $25 will make Juan better off; any price lower than $40
will make Maria better off. No matter what the price is, the sum of consumer
and producer surplus (the total gains from trade) will be $15.
b. If Juan has to pay a $5 tax for every haircut he gives, then his willingness-to-
accept price will rise to $30.At a price of $30, he will give $5 to the govern-
ment and have $25 leftover for himself, which was originally the minimum he
was willing to accept. Now Juan and Maria must find a price greater than $30
but less than $40.There are a lot of prices in between these numbers, so it is still
likely that the haircut would take place.The tax will not necessariy alter the total
economic benefit of the haircut.While the benefit to Maria and Juan will sum
only to $10, the government also receives $5 in tax revenue, so the total eco-
nomic benefit generated by the haircut is still $15.
c. If the tax was $20, Juan’s minimum willingness to accept rises to $25 1 $20 5
$45. Now, there are no prices high enough to satisfy Juan (higher than $45) but
low enough to satisfy Maria (lower than $40).Therefore, the haircut will not
take place. It will, therefore, not generate any tax revenue.The total economic
benefit will be reduced to $0.

Thinking and Problem Solving

1. Some people with diabetes absolutely need to take insulin on a regular basis to
survive. Pharmaceutical companies that make insulin could find a lot of other ways
to make some money.
a. If the U.S. government imposes a tax on insulin producers of $10 per cubic cen-
timeter of insulin, payable every month to the U.S.Treasury, who will bear most of
the burden of the tax: insulin producers or people with diabetes? Or can’t you tell
with the information given?
b. Suppose instead that because of government corruption, the insulin manufacturers
convince the U.S. government to pay the insulin makers $10 per cubic centimeter
of insulin, payable every month from the U.S.Treasury.Who will get most of the
benefit of this subsidy: Insulin producers, people with diabetes, or can’t you tell
with the information given?
Solution 1a and b. In both cases, it’s the diabetes patients who are affected: Inelastic buyers
face a steep price hike under a tax and so bear the burden of the tax, and inelastic
buyers reap the benefits of the insulin subsidy.
2. Let’s see if we can formulate any real laws about the economics of taxation.Which
of the following must be true, as long as supply and demand curves have their
normal shape (i.e., they aren’t perfectly vertical or horizontal, and demand curves
have a negative slope while supply curves have a positive slope)? More than one
may be true.
If there is a tax:
a. The equilibrium quantity must fall, and the price that buyers pay must rise.
b. The equilibrium quantity must rise, and the price that sellers pay must rise.

Cowen3e_CH06_Solutions.indd 3 29/06/15 9:54 AM

 S-4 • C H A P T E R 6 • Taxes and Subsidies

c. The equilibrium quantity must fall, and the price that sellers receive must fall.
d. The equilibrium quantity must rise, and the price that buyers receive must fall.
(Note:The correct answer[s] to this question was [were] actually controversial until
Nobel Laureate Paul Samuelson created a simple mathematical proof in his legend-
ary graduate textbook, Foundations of Economic Analysis.)
Solution 2. Both a and c are correct: Quantity falls, the price received by suppliers falls, and the
price paid by the buyer rises.
3. Using the following diagram, use the wedge shortcut to answer these questions:
a. If a tax of $2 were imposed, what price would buyers pay and what price would
suppliers receive? How much revenue would be raised by the tax? How much
deadweight loss would be created by the tax?
b. If a subsidy of $5 were imposed, what price would buyers pay and what price
would suppliers receive? How much would the subsidy cost the government?
How much deadweight loss would be created by the subsidy?
Price

$11
10
9
8 Supply
7
6
5
4
3
2 Demand
1

1 2 3 4 5 6 7 8 9 10
Quantity

Solution 3. a. The answers can be found in this diagram.

Price
$11
10
Deadweight loss
9
= 2 * 1.5/2 = 1.5
8 Supply
Price paid by 7
buyers Revenues
tax

6
= $2 * 4 = $8
Price received 5
by sellers 4
3
2 Demand
1

1 2 3 4 5 6 7 8 9 10
Quantity

Cowen3e_CH06_Solutions.indd 4 29/06/15 9:54 AM

 Taxes and Subsidies • C H A P T E R 6 • S-5

b. The answers can be found in this diagram.

Price
$11
10
Deadweight loss
9
= 5 * 3.5/2 = 8.75
8
Price received 7 Supply
by sellers
6

Subsidy
5
4
Subsidy
3
cost = 5 * 9 = $45
Price paid by 2 Demand
buyers 1

1 2 3 4 5 6 7 8 9 10
Quantity

4. When government is trying to raise tax revenue, it sometimes attempts to target

higher-income people, because they are in a better position to bear the burden of a
tax. However, it can be very difficult to earn tax revenue from wealthy people.
a. Consider the progressive nature of the U.S. federal income tax system: It’s
designed so that higher incomes are taxed at higher tax rates.Thinking about the
elasticity of labor supply, why might it be more difficult to collect tax revenue
from a wealthy individual than from a poor person, all else equal?
b. Another way governments have tried to collect taxes from the wealthy is
through the use of luxury taxes, which are exactly what they sound like: taxes on
goods that are considered luxuries, like jewelry or expensive cars and real estate.
What is true about the demand for luxuries? Consider jewelry. Is a luxury tax
more likely to hurt the buyers of jewelry or the sellers of jewelry?
c. The chapter began by discussing another tax that targets wealthy individuals:
the estate tax. Comment on the effectiveness of this tax (in terms of government
revenue), considering the demand of wealthy individuals for leaving an
inheritance.
Solution 4. a. We might expect the wealthy to have more elastic labor supply. One reason
might be related to mobility:A wealthy person may have the resources necessary
to move in order to find a better job, while a poorer person may not. Likewise,
a poorer person cannot take time out of the labor market to wait for a bet-
ter opportunity, but a wealthy person can. If a wealthy person has greater labor
supply elasticity, then this means he or she is in a better position to escape the
impact of an income tax. Likewise, the total compensation of higher-paying
jobs generally involves more components than just a wage or salary, like benefits,
vacation days, comfortable and clean working environments, etc. So if a person
at a higher-paying job faces an increase in income taxes, he or she can simply
substitute lower income with more fringe benefits and other job amenities, and
avoid paying the income tax by switching their “compensation” from income to
some other thing. Low-skilled workers in low-paid work do not have these op-
tions, and cannot avoid income taxes simply by changing the nature of their total
compensation.
b. The demand for luxuries is necessarily elastic. If the supply of these goods is not
likewise elastic, then the buyers of luxuries will escape the luxury tax and it will
be borne primarily by the sellers of luxuries, like jewelry.

Cowen3e_CH06_Solutions.indd 5 29/06/15 9:54 AM

 S-6 • C H A P T E R 6 • Taxes and Subsidies

c. Although the text points out that in some cases people are able to time
deaths to accommodate estate tax changes, in reality no one can avoid dy-
ing forever. Further, when considering whether to leave an inheritance, a
wealthy person is choosing between using all of their wealth while alive
or passing some of it on.There is good reason to believe that the estate tax
would have to be quite high for a person (especially a wealthy person) to
feel that it is better to spend all of their wealth while alive. For a poor per-
son, the wealth may be needed to purchase necessities, but this is not
the case for a wealthy person. In this sense, the estate tax represents a method
of taxing wealthy people that could be more effective than the other two
mentioned above.
5. As we learned in Chapter 4, the competitive market equilibrium maximizes gains
from trade.Taxes and subsidies, by altering the market outcome, reduce the gains
from trade. Does this happen primarily because of the impact of taxes and subsidies
on prices or the impact of taxes and subsidies on quantities?
Solution 5. The gains from trade are reduced primarily through the impact of taxes and
subsidies on the market quantity. In the case of taxes, too few transactions take place,
which means that there are some unexploited opportunities to exchange goods
with value higher than their costs. In the case of subsidies, too many transactions
take place, so that some goods are exchanged that have costs higher than their value.
So quantity is the key, and economic welfare can be reduced if too many or too few
transactions take place.
6. Consider the following diagram of a tax.The triangular area representing dead-
weight loss is highlighted, and its dimensions are labeled “Base” and “Height” (recall
that the formula for the area of a triangle is 12 × Base × Height).
Price

Supply

Base Height

Demand

Quantity

a. In order to calculate the deadweight loss of a tax, you don’t need the entire
demand and supply diagram; you just need to know two numbers, the base and
height of the deadweight loss triangle.What is the real-life meaning of the base?
What about the height?
b. Can you turn your answers to part a into general rules about the deadweight loss
associated with taxes? Try phrasing it like this but replacing the part in brackets:
“The larger the [base or height], the more deadweight loss is generated by a
given tax.”
c. Holding the base constant, the height and thus the deadweight loss would get
larger if the demand curve or the supply curve were more ?

Cowen3e_CH06_Solutions.indd 6 29/06/15 9:54 AM

 Taxes and Subsidies • C H A P T E R 6 • S-7

d. Without having a diagram as a reference, can you answer the preceding ques-
tions for a subsidy?
Solution 6. a. The base represents the per-unit size of the tax, and the height represents the
decrease in quantity caused by the tax.
b. The larger the per-unit size of the tax, the more deadweight loss is generated
by a given tax.The larger the decrease in quantity caused by a tax, the more
deadweight loss is generated by a given tax.
c. Holding the base (per-unit tax) constant, the height and thus the deadweight
loss would get larger if the demand curve or the supply curve were more elastic.
d. For a subsidy, the base would be the per-unit size of the subsidy, and the height
would be the increase in quantity caused by the subsidy.The general rules would
be:The larger the per-unit size of the subsidy (or the larger the increase in
quantity caused by a subsidy), the more deadweight loss is generated by a given
subsidy.
7. Suppose your state government has decided to tax donuts. Currently, in your state,
300,000 donuts are sold every day.Three possible taxes are being considered by law-
makers: a 20-cent per donut tax, which would decrease donut sales by 50,000 per
day; a 25-cent per donut tax, which would decrease donut sales by 100,000 per day;
and a 50-cent per donut tax, which would decrease donut sales by 150,000 donuts
per day.
a. Calculate the amount of tax revenue generated by each tax and the deadweight
loss caused by each tax.
b. If the goal of your state government is simply to raise the most tax revenue,
which tax is preferable?
c. If the goal of your state government is to raise tax revenue in the most efficient
manner (with the least deadweight loss per dollar of revenue), which tax is pref-
erable?
d. What other goal might your state government have when creating this kind of
tax besides raising tax revenue?
Solution 7. a. The tax revenues generated by the three taxes are $50,000, $50,000, and $75,000
per day, respectively.The deadweight losses caused by the three taxes are $5,000,
$12,500, and $37,500 respectively.
b. The $0.50 tax raises the most tax revenue
c. This question can be answered by calculating the deadweight loss per dollar
of revenue for each tax, using the numbers calculated in part a.The values are
$0.10, $0.25, and $0.50 for the three taxes, respectively (in other words, the
$0.50 tax increases government revenues by $75,000, but it decreases consumer
and producer surplus by a total of $112,500).Therefore, the most efficient tax is
the $0.20 tax, which raises $50,000 in revenue with only $5,000 in deadweight
loss.
d. Another goal might simply be to reduce donut consumption. In that case, the
biggest tax would be the most preferred because it reduces quantity the most.
8. How is it that a tax creates a deadweight loss by decreasing quantity, but a subsidy
creates a deadweight loss by increasing quantity?
Solution 8. One way to answer this is that the free market equilibrium quantity maximizes total
gains from trade, so that any other quantity (whether higher or lower) necessarily
causes a reduction in the gains from trade (causes a deadweight loss). Going a step
further, a tax reduces the quantity below the free market equilibrium quantity and
therefore causes some transactions not to take place that would have generated gains

Cowen3e_CH06_Solutions.indd 7 29/06/15 9:54 AM

 S-8 • C H A P T E R 6 • Taxes and Subsidies

for trade. So the deadweight loss associated with a tax is from unrealized potential
gains from trade.A subsidy, on the other hand, leads to a greater quantity than the
free market equilibrium quantity, causing some transactions to take place which
should not because the cost of the unit(s) in question exceeds the value of the
unit(s). So the deadweight loss associated with a subsidy is from wasted resources—
resources used to produce goods that are not valued enough by consumers to justify
their production.

Challenges
1. Let’s apply the economics of taxation to romantic relationships.
a. What does it mean to have an inelastic demand for your boyfriend or girlfriend?
How about an elastic demand?
b. Sometimes relationships have taxes. Suppose that you and your boyfriend or
girlfriend live one hour apart. Using the tools developed in the chapter, how can
you predict which one of you will do most of the driving? That is, which one of
you will bear the majority of the relationship tax?
Solution 1. a. An inelastic demand means you can’t live without him or her.An elastic demand
means that there are good substitutes for the current boyfriend or girlfriend.
b. All other things being equal, the more inelastic party will do most of the
driving—the other party has good substitutes.
2. a. In the opening scene of the classic Eddie Murphy comedy Beverly Hills Cop,
Axel Foley, a Detroit police officer, is stopping a cigarette smuggling ring.
Of course, smugglers don’t pay the tax when the cigarettes cross state lines.
Which way do you suspect the smugglers were moving the cigarettes, based
on economic theory? From the high-tax North to the low-cost South, or
vice versa?
b. In our discussion of taxation, we’ve acted as if it were effortless to pass and enforce
tax laws. But, of course, law enforcement officials including the Internal Revenue
Service put a lot of effort into enforcing tax laws. Let’s think for a moment about
what kind of taxes are easiest to collect, just based on the basic ideas we’ve covered.
Who will make the most effort to escape a tax: the party who is elastic or the
party who is inelastic? (Hint: It doesn’t matter whether we’re talking about suppli-
ers or demanders.) (Note: Public administration researchers know the most about
this topic: Carolyn Webber and Aaron Wildavsky’s surprisingly enjoyable classic,
The History of Taxation and Expenditure in the Western World, sets out just how dif-
ficult it’s been for most Western governments to collect taxes.)
Solution 2. a. The smugglers were quite likely moving cigarettes from the low-tax South to
the high-tax North.There was money to be made in avoiding taxes.
b. The party who is inelastic will make the most effort, because he or she bears
most of the tax burden. So if the supplier is inelastic, she will go to great efforts
to find a way around the tax. People want to “escape” the tax but if they can’t
escape by choosing a substitute, they’re more likely to try to “escape” through
tax avoidance.
3. Let’s get some practice with the “wedge trick,” and use it to learn about the
relationship between subsidies and lobbying.The U.S. government has many
subsidies for alternative energy development: Some are just called subsidies, some

Cowen3e_CH06_Solutions.indd 8 29/06/15 9:54 AM

 Taxes and Subsidies • C H A P T E R 6 • S-9

are called tax breaks instead. Either way, they work just like the subsidies we studied
in this chapter.We’ll look at the market for windmills.
a. In the two figures, one is a case where the sellers of windmills have an elastic
supply and the buyers of windmills (local power companies) have inelastic
demand. In the other case, the reverse is true.Which is which?
Price per Price per Supply
windmill windmill

Supply

Demand

Demand

Quantity of Quantity of
windmills windmills

b. In which case will a subsidy cut the price paid by the buyers the most: When
demand is elastic or when it is inelastic? (It’ll be easiest if you use the wedge
trick.) Is this the first or second graph?
c. In which case will a subsidy increase the price paid to the sellers more: When
supply is elastic or when it is inelastic? Again, which graph is this?
d. Now look at how producer surplus and consumer surplus change in these two
cases.To see this, remember that producer surplus is the area above the supply
curve and below the price, and consumer surplus is the area below the demand
curve and above the price. So in the first graph, who gets the lion’s share of
any subsidy-driven extra surplus: suppliers or demanders? Is that the inelastic
group or the elastic group? In other words, whose surplus triangle gets bigger
faster as the quantity increases? (You might try shading in these triangles just
to be sure.)
e. Now it’s time for the second graph.Again, who gets the lion’s share of any
subsidy-driven extra surplus: suppliers or demanders? Is that the inelastic group
or the elastic group?
f. There’s going to be a pattern here in parts d and e: The more [elastic or
inelastic?] side of the market gets more of the extra surplus from the subsidy.
g. When Congress gives subsidies for the alternative energy market, it is hoping
that a small subsidy can get a big increase in output: In other words, they are
hoping that the equilibrium quantity will be elastic. At the same time, the
groups most likely to lobby Congress for a big alternative energy subsidy are
going to be the groups that get the most extra surplus from any subsidy. After
all, if the subsidy doesn’t give them much surplus they’re not likely to ask Con-
gress for it.
So here’s the big question:Will the groups that are most likely to lobby for a
subsidy be the same groups that are mostly likely to respond to the subsidy?
(Note:This is a general lesson about the incentives for lobbying: It’s not just a
story about the alternative energy industry.)
Solution 3. a. In the first graph, supply is relatively elastic and demand relatively inelastic.
In the second graph, supply is relatively inelastic and demand is relatively elastic.
b. The price paid by the buyers will fall the most if demand is inelastic (first graph).
c. The price received by the sellers will rise the most if supply is inelastic
(second graph).
Cowen3e_CH06_Solutions.indd 9 29/06/15 9:54 AM
 S-10 • C H A P T E R 6 • Taxes and Subsidies

d. The party who is more inelastic gets the biggest boost to surplus as the subsidy
grows. In the first group, that’s the demanders, with a steep demand curve and
hence an inelastic demand for windmills.
e. This time, it’s the suppliers, who again have an inelastic supply.
f. The more inelastic side of the market gets most of the benefit from the extra
surplus.
g. No, the reverse is true. Groups that lobby for the subsidy are those who are least
likely to respond to the subsidy.Therefore, if a group is lobbying heavily for a
subsidy, that group is unlikely to change their behavior much if they actually get
the subsidy.They are lobbying not because they plan to change their ways, but
because they won’t.They want to reap the reward of the higher supplier price or
lower demander price without changing their behavior very much.
4. As you learned in the chapter, the elasticities of demand and supply are crucial in
determining how the burden of a tax (or the benefit of a subsidy) is divided
between buyers and sellers. Under what conditions for supply or demand would
a seller actually be able to avoid bearing any of the burden of a tax? Under what
conditions would a subsidy benefit only the sellers of a good?
Solution 4. For the seller to completely escape the tax, the elasticity of supply would have to be
totally, or perfectly, elastic.This means that the supply curve would have to be hori-
zontal, as in Panel A below. In this case, the tax wedge would simply increase the
price paid by buyers, and not affect the seller price.Alternately, sellers could avoid
the tax if buyers had no ability to escape—that is, if demand was perfectly inelastic,
or vertical, as in Panel B below. In this case, the wedge would just sit right on top of
the old equilibrium, and drive up the buyer price without reducing the seller price.
The conditions would have to be reversed for a seller to enjoy all of the benefits
of a subsidy: either perfectly elastic demand (shown in Panel C below) or perfectly
inelastic supply (shown in Panel D below).
A. Perfectly elastic supply B. Perfectly inelastic demand

P P D
S

Q Q

C. Perfectly elastic demand D. Perfectly inelastic supply

P P S
S

Q Q

Cowen3e_CH06_Solutions.indd 10 29/06/15 9:54 AM

 Taxes and Subsidies • C H A P T E R 6 • S-11

5. In the chapter, most of the taxes we discussed were equal to a certain dollar amount
per unit. In this case, a tax on sellers results in a parallel upward shift of the supply
curve; a tax on buyers results in a parallel downward shift of the demand curve. In
reality, however, many taxes are expressed as a percentage. Graphically, how would
you show a 100% tax on the sellers of a good? How would you show a 100% tax
on the buyers of a good? One of the results of this chapter is that it doesn’t matter
on whom the tax is levied—the result is the same. Show graphically that this also
applies to percentage taxes.
Solution 5. A proportional tax would rotate the curves, not just shift them parallel. For a
100% tax, the sellers’ costs would double at every quantity, so it would rotate
counterclockwise. Notice that at Q1 on the diagram below, with no tax, the supply
curve is at $20. Once the tax is imposed, sellers would require 100% more (or
$40) in order to supply the same quantity. If the tax were applied to buyers, their
willingness to pay for the good itself would be cut in half, so the demand curve
would also rotate counterclockwise. Notice that quantity demanded at a price of
$40 is Q2 before the tax. However, after the tax, buyers would not pay $40 for Q2
units of output because they would then owe $40 in taxes. Since the most they are
willing to give up to get this good is $40, they will reduce the price they are willing
to pay to $20 for Q2 units.This way, when they pay the 100% tax, they will have
paid a total of $40 for the good.The drawing below shows that the effect on equi-
librium quantity is the same either way, just like with a per unit tax.
Price

Supplytax

Supplyno tax

$40
20 Demandno tax

Demandtax
Q1 Qtax Q2 Quantity

Cowen3e_CH06_Solutions.indd 11 29/06/15 9:54 AM

Cowen3e_CH06_Solutions.indd 12 29/06/15 9:54 AM