Questions to Accompany the Deadweight Loss of Overconsumption

Questions to accompany “The Deadweight Loss of Overconsumption”

Frances Woolley, Carleton University, September, 2012

“The Ontario Building Code has required direct-wired smoke alarms be installed in all new home construction since 1986, with amendments and additional requirements over the years.” Source: http://www.windsorfire.com/divisions-prevention-smoke-alarm-guidelines a. The marginal cost of installing a direct-wired smoke alarm system into a new home is constant at $100 per alarm system. The smoke alarm market is perfectly competitive. Draw the supply curve for smoke alarms (Hint: see review problem done in class in the first lecture). b. Some people place a high value on having smoke alarms, some people place a low value on having smoke alarms. There are 100,000 buyers of new homes in Ontario. The aggregate demand curve for smoke alarms is given by P=1,000-Q/100 or Q=100,000 – 100P. Draw the demand curve on your diagram from part (a). c. Suppose new home buyers can choose whether or not to buy a direct-wired smoke alarm. Work out the equilibrium quantity of smoke alarms. Hint: part (a) tells you that the price of smoke alarms is ______. d. Work out the consumer surplus in the market, and label it on your diagram. e. Now suppose that all new home buyers are required by law to buy a smoke alarm. On your diagram show, for the people who wouldn’t buy a smoke alarm without the law, the difference between the marginal cost of smoke alarms, and the marginal benefits people receive from the alarms. This is called a deadweight loss. f. The total (gross) benefit of installing smoke alarms is the entire area under the demand curve. Explain, in your own words, why that’s the case. What’s the difference between this total (gross) benefit and the consumer surplus? The total cost of installing smoke alarms is the entire area under the supply curve (assuming fixed costs are zero). Explain, in your own words, why that’s the case. Now: i. Calculate the difference between the total benefits and the total costs of having mandatory smoke alarms. Are the benefits of mandatory smoke alarms greater than the costs? ii. Calculate the difference between the total (gross) benefits received by consumers and the total costs of installing the alarms at the equilibrium in (c). iii. According to this simple cost-benefit analysis, which policy is best? g. Explain, in one to three paragraphs why, despite the analysis in part (f), it might still be a good idea to require direct wired smoke alarms in all homes. I want you to think about the assumptions that are implicit in the analysis in part (f), and the kinds of considerations that the analysis in part (f) leaves out.