Practice

Free response question

Microeconomics · Hard · 30 marks

IEO past paper: 2024 International Economics Olympiad, open questions

Open Question 2. Water Restrictions Residents of Catalonia (autonomous community of Spain) during the winter of 2023-24 faced water usage restrictions due to drought. Fountains were turned off, watering lawns, filling pools, washing streets and house facades were prohibited; restrictions also affected public showers and car washes. When the author of this task asked GPT-4 how the introduction of such restrictions could affect the price of water, he received the following response: "The reduction in water availability can lead to an increase in its cost to cover expenses for extraction, purification, and distribution. When water becomes a scarce resource, its extraction and delivery to consumers require additional costs, for example, through the use of alternative water sources or enhanced purification." Indeed, economics textbooks typically state that a quota (limitation of the quantity of a good) leads to price increases. However, the goal of the restrictions imposed by the government of Catalonia is, on the contrary, to prevent excessive price increases for households (the water consumers).

(a)Construct an economic model of the perfectly competitive market with two groups of consumers (car washes and households), which demonstrates that restricting water consumption for one group of consumers (car washes) can lead to a decrease in price compared to equilibrium without intervention. Provide the analytical or graphical solution of your model. Assume that the quota for car washes is below their level of water consumption at equilibrium but above zero, and that car washes can trade quotas, meaning the most economically efficient among them will buy water. (If you use a graph, type your answer: describe the diagram in words, naming the axes, curves, shifts and areas.)[12](b)How does such government intervention in your model affect the surpluses of each group of consumers and producers, as well as the overall social surplus (welfare)? Provide calculations or show graphically. Can one specify functions and parameters of the model so that the impact on the social surplus is reversed?[9](c)Suppose the government can regulate the price of water for car washes, and resale of water between consumer groups is impossible. Instead of setting a quota for car washes, the government increases the price for them to reduce their consumption to the level of the previous quota. The price for households is set at the equilibrium level (the price that clears the market given the car washes' reduced consumption). Analyze this approach compared to the quota in terms of the surplus of each group of consumers and producers.[9]

Up to 5 AI marks a day. The mark scheme is shown after marking.

Report a mistake