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ECON1001/1210: Introductory Microeconomics

Problem set #03 Chapter 5 Elasticity and its Applications

Instructions
You do not need to submit the problem set. It is meant to help students stay on track of their
study. Here is a recommended strategy to get the maximum benefits from the assignment:

1. Study the corresponding chapters before working on the assignment.


2. Try to work on the problem set alone first. Discuss with your friends. Write up your
own copy.

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1. The schedule below shows the number of packs of bagels bought in Chicago, Illinois, each day at a variety of
prices.

Price of bagels ($/pack) Number of packs purchased per day


6 0
5 3,000
4 6,000
3 9,000
2 12,000
1 15,000
0 18,000

(a) Graph the daily demand curve for packs of bagels in Chicago.

ANSWER and DISCUSSIONS:

The demand curve for packs of bagels is a function showing the quantity of packs of bagels that consumers
would be willing and able to buy at different prices.
The demand curve tells us, for example, that at a price of $1 per pack the quantity demanded is 15,000 packs
of bagels. When the price increases to $3, the quantity demanded would fall to 9,000 packs. When the price
further increases to $5, the quantity demanded would further decrease to 3,000 packs.
The demand curve can be read in two ways. Read horizontally, it shows that at a price of $3 per pack consumers
are willing to buy 9,000 packs of bagels. Read vertically, it tells us the maximum price that consumers are willing
to pay for 9,000 packs of bagels is $3 per pack.

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(b) Calculate the price elasticity of demand at the point on the demand curve at which the price of bagels is $3
1 P
per packs. (Mid-point formula is not useful here. Use the point elasticity formula, slope Q .)

ANSWER and DISCUSSIONS:


V ertical intercept
Slope of the demand curve = = 6 = 3, 000
1 .
Horizontal intercept 18, 000
Price elasticity at $3 = 1 Q P = 1 3 = -1.
slope 1 9, 000
3, 000

(c) If all bagel shops increased the jprice of bagels from $3 per pack to $4 per pack, what would happen to total
revenues?

ANSWER and DISCUSSIONS:


Total revenue (Price = $3) = PQ = $3(9,000) = $27,000.
Total revenue (Price = $4) = PQ = $4(6,000) = $24,000 < $27,000.
Thus, total revenue will be reduced by $27,000 - $24,000 = $3,000 when the price increases from $3 to $4.

(d) Calculate the price elasticity of demand at a point on the demand curve where the price of bagels is $2 per
pack.

ANSWER and DISCUSSIONS:

1 . (from part (a))


Slope of the demand curve is 3, 000

Price elasticity at $2 = 1 Q P = 1 2 = -0.5.


slope 1 12, 000
3, 000

(e) If bagel shops increased the price of bagels from $2 per pack to $3 per pack, what would happen to total
revenues?

ANSWER and DISCUSSIONS:


Total revenue (Price = $2) = PQ = $2(12,000) = $24,000.
Total revenue (Price = $3) = PQ = $3(9,000) = $27,000 > $24,000.
Thus, total revenue will be increased by $27,000 - $24,000 = $3,000 when the price increases from $2 to $3.

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2. The U.S. Department of Agriculture (USDA) has been concerned that Americans arent eating enough fruits
and vegetables, and theyve considered coupons and other subsidies to encourage peopleespecially lower-
income peopleto eat these healthier foods. Of course, if peoples demand for fruits and vegetables is perfectly
inelastic, then theres no point in giving out coupons. (Thought question: Why?) If instead the demand is only
somewhat elastic, there may be better ways to spend taxpayer dollars. This is clearly a situation where youd
want to know the elasticity of fruit and vegetable demand: If people respond a lot to small changes in price,
then government-funded fruit and vegetable coupons could make poorer Americans a lot healthier, which might
save taxpayers money if they dont have to pay for expensive medical treatments for unhealthy eaters. There
are a lot of links in this chain of reasoningall of which are covered in more advanced economics coursesbut
the first link is whether people actually have elastic demand for fruits and vegetables. The USDAs Economic
Research Service employs economists to answer these sorts of questions, and a recent report contained the
following estimated elasticities (Source: Diansheng Dong and Biing-Hwan Lin. 2009. Fruit and Vegetable
Consumption by Low-Income Americans: Would a Price Reduction Make a Difference? In Economic Research
Report 70, USDA).

Fruit Elasticity of demand (E F ruit )


Apples -0.16
Banana -0.42
Grapefruit -1.02
Grapes -0.91
Oranges -1.14

(a) Based on these demand elasticity estimates, which fruit is the most inelastic in demand? Which is the most
elastic in demand?

ANSWER and DISCUSSIONS:


When 0 < |E| < 1, the demand is inelastic. Since the |E Apples | is 0.16 which is less than one and is the smallest,
apples are the most inelastic in demand.
When |E| > 1, the demand is elastic. Since the |E Oranges | is 1.14 which is larger than one and is the largest,
apples are the most elastic in demand.

(b) For which of these fruits would a 10% drop in price cause an increase in total revenue from that sale of
that fruit?

ANSWER and DISCUSSIONS:


When |E| > 1 (i.e., E < -1), the demand is elastic and thus total revenue and price move in opposite directions.
There fore, for grapefruit and oranges with absolute elasticity larger than 1, a fall in price would cause a rise in
total revenue.

However, if you use the mathematic approach to solve this question, then you can get a slightly different result.
Recall the following formula,

percentage change in quantity demanded


Elasticity of demand =
percentage change in price

Thus, when the price drops by 10%, there is a 1.02(10%) = 10.2% increase in the quantity demanded. If we
assume the original price is $x and the original quantity is y, then the original total revenue is equal to xy.
After a 10% drop in price, the new price becomes $x(1-10%) = $0.9x and the new quantity demanded is
y(1+10.2%) = 1.102y, so the new total revenue becomes $(0.9x)(1.102y) = $0.9918xy. Obviously, a 10$ fall in
frice would cause also a fall in total revenue and we have an unusual result). If the price drops by only 1%,
the new price is $x(1-1%) = $0.99x and the new quantity is y(1+1.02%) = 1.0102y, so the new total revenue
is $(0.99x)(1.0102y) = $1.000098xy. In this case, a fall in price would cause a rise in revenue, i.e., a usual
result. Thus, the size of change would affect the result.

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Elasticity %4P Initial P New P Initial Q New Q Old TR New TR
-1% 0.99x 1.0102y 1.000098xy
100
51 %
50
51 x 1.02y xy
-1.02 x y xy
-5% 0.95x 1.051y 0.99845xy
-10% 0.9x 1.102y 0.9918xy

In order to increase the total revenue from the sale of Grapefruit, the drop of price should not exceed 100
51 %.

(c) If the government could only offer 10% off coupons for three of these fruits, and it wanted to have the
biggest possible effect on quantity demanded, which three fruits should get the coupons?

ANSWER and DISCUSSIONS:


When the demand is more elastic, the quantity demanded would be more responsive to the change in price.
Since the demands for grapefruit, grapes and oranges are the 3 most elastic, these fruits should get the coupons
in order to achieve the biggest possible effect on quantity demanded.

(d) Overall, the authors found that for the average fruit, the elasticity of demand was about -0.5. Is the demand
for fruit elastic or elastic?

ANSWER and DISCUSSIONS:


Since 0 < |Ef ruit | = 0.5 < 1, demand is inelastic.

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3. The table b elow shows 2 demand schedules for motel ro oms when consumer incomes have risen to $60,000
from $50,000. Use this information to answer the following questions. Use the midp oint metho d to calculate
the p ercentage changes used to generate the elasticities.

Price ($) Quantity Demanded when income is $50,000 Quantity Demanded when income is $60,000
20 24 34
40 20 30
60 16 26
80 12 22
100 8 18
120 4 14

(a) What is the income elasticity of demand when motel rooms rent for $40.

ANSWER and DISCUSSIONS:


Using arc elasticity,
percentage change in quantity demanded 34 24
(
34 + 24 )
average of incomes when income is $50, 000 and $60, 000 2
the income elasticity = = 60, 000 50, 000 = 2.2
percentage change in income
average of the 2 income levels (
60, 000 + 50, 000 )
2

(b) What is the income elasticity of demand when motel rooms rent for $100.

ANSWER and DISCUSSIONS:


Using arc elasticity,
percentage change in quantity demanded 18 8
(
18 + 8 )
average of incomes when income is $50, 000 and $60, 000 2
the income elasticity = = 60, 000 50, 000 = 4.23
percentage change in income
average of the 2 income levels (
60, 000 + 50, 000 )
2

(c) Are motel rooms normal or inferior goods? Why?

ANSWER and DISCUSSIONS:

Price ($) Income elasticity of demand


20 1.90
40 2.20
60 2.62
80 3.24
100 4.23
120 6.11

Normal goods, because the income elasticity of demand is positive at any price level of motel room.

(d) Are motel rooms likely to be necessities or luxuries? Why?

ANSWER and DISCUSSIONS:


Luxuries, because the income elasticity of demand is large (greater than 1) at any price level of motel room. In
ease casem an 18% increase in income caused a much larger increase in quantity demanded.

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4. For each pair of goods listed below, which good would you expect to have the more elastic supply? Why?

(a) Televisions; beach front property

ANSWER and DISCUSSIONS:


Televisions because the production of televisions can be increased in response to an increase in the price of
televisions while the quantity of beach front property is fixed.

(b) Crude oil over the next week; crude oil over the next year

ANSWER and DISCUSSIONS:


Crude oil over the next year because production of oil over the next year can more easily be increased or
decreased than the production of oil over the next week.

(c) A painting by van Gogh; a print of the same painting by van Gogh Top of Form

ANSWER and DISCUSSIONS:


A van Gogh print because more of them can be created in response to an increase in price while the quantity
of an original work is fixed.

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4. Consider a constant elasticities model, with demand elasticity equal to 2 in absolute value and supply elasticity
equalto 3. What happens to equilibrium price and quantity when the demand increases by 3% and the supply
decreases by
2%?
ANSWERS and DISCUSSIONS:
Ed = -2
ES = 3
Percentage change in equilibrium price due to the increase in demand = (3%)/(|-2|+3) = 0.6%
Percentage change in equilibrium price due to the decrease in supply = - (-2%)/(|-2|+3) = 0.4%
Total percentage change in equilibrium price = (1+0.6%)(1+0.4%) -1 = +1.0024%
Percentage change in equilibrium quantity due to the increase in demand = 0.6%(3) = 1.8%
Percentage change in equilibrium quantity due to the decrease in supply = 0.4%(-2) = -0.8%
Total percentage change in equilibrium quantity = (1+1.8%)(1-0.8%) -1 = +0.9856%