Introductory Microeconomics: Problem Set 2

1. According to HM Revenue and Customs, the significance of the borderline between cakes and biscuits is that a cake is zero-rated for VAT even if it is covered in chocolate, whereas a biscuit attracts standard-rate VAT if "wholly or partly covered in chocolate or some product similar in taste and appearance." The leading case on the borderline is that concerning Jaffa Cakes which are made by United Biscuits. They are currently zero-rated as cakes. HMRC is considering whether to re-designate them as biscuits, in which case they would be subject to standard rate VAT. You have been given the following information concerning UK sales of Jaffa Cakes.

• Annual UK sales (in millions) = £2
• Price per Jaffa Cake = £0.10
• Price elasticity estimate = -0.5

1. Assuming that the demand curve is linear, derive the inverse demand curve for Jaffa Cakes.
2. Assuming that the price in the table represents an equilibrium price, that the supply curve for Jaffa Cakes is linear and that if the price were zero United Biscuits would not make any, derive an expression for the inverse supply curve.
3. At the equilibrium price, calculate (i) the consumer surplus and explain carefully what it measures, (ii) the producer surplus and explain what it measures. (iii) Draw and fully label a diagram to illustrate your calculations.
4. Suppose that HMRC re-designates Jaffa Cakes as biscuits and applies standard rate VAT. Calculate (i) the deadweight loss of the tax and explain what it measures; (ii) the amount of Government revenue the tax would raise. (iii) Draw a diagram to illustrate your calculations.
5. Explain what your results indicate about the effective incidence of the VAT.
6. You are concerned that the estimate of the price elasticity you have used is too low (i.e. it should be more negative). Without doing any further calculations outline how you would expect your results and conclusions to change if this were the case.

2. The table shows labour endowments of two countries, A and B, and their unit labour requirements for producing two goods, 1 and 2.

 A B Labour endowment 500 300 ULR 1 2 2 ULR 2 4 1

The next table shows the quantities of the two goods that each produces and consumes in autarky.

 A B Good 1 150 100 Good 2 50 100

1. Draw the two production possibility sets for the two countries.
2. Compare the two countries in terms of absolute and comparative advantage.
3. Suppose that each country now specialises completely in the good in which it has a comparative advantage and that, with trade, A consumes three fifths of the two countries' combined output of each good. Draw the joint production possibility set and show the point where aggregate (joint) production will be.
4. How much of each good will each country produce, export and consume?
5. Is there evidence here that the countries have gained from trade?

3. The table below shows the unit labour requirements for four goods in two countries A and B. For our purposes we might wish to think of A as "the rest of the World" and B as some country of interest.

4.  ULR A B Rubber chickens (hrs/chicken) 2 4 Trousers (hrs/pair) 2 2 Poison gas (hrs/kg) 4 3 Beauty products (hrs/millihelen) 3 2

In the absence of trade, wages are £4/hr in A and £8 in B.

1. For each good, calculate the ratio of the unit labour requirement in each country.
2. What are the autarky prices of each good in each country?
3. If the wage in A ("rest of the world") is fixed, in what direction must the wage in B change if the two countries open to free trade, in order for both countries to have something that they can export to the other?
4. What are the highest and the lowest wages that can prevail in B with free trade, given the £4/hr wage in A?
5. For which of the goods can you predict with certainty (given our assumptions) the pattern of trade, and what is it?
6. Suppose that a free trade equilibrium is achieved with a £4/hr wage in A and a wage in B which is exactly at the mid-point of the range that you found on part (d). What will be the world prices of each good, and which country will export it?
7. Suppose that workers in both countries work 40 hours per week, 50 weeks per year. Calculate their annual incomes in units of each good, both in autarky and free trade. In what sense, if any, have these workers gained from trade? Why (briefly) do workers in B appear to have gained, even though their wages are lower due to the effects of trade?
8. What general lessons do you draw from this example?