Problem set 1

Microeconomics: 33001
Daniel Rappoport

1. Suppose worldwide annual supply and demand for wheat are given by the following
equations:
QS = 300P − 600
QD = 3600 − 300P
where P is the price of wheat in dollars per bushel, and Q is the quantity in million
metric tons. (A negative quantity in the equation – for supply at low price, or demand
at high price – should be interpreted as a zero.)

(a) Carefully draw the supply and demand diagram representing this market, with Q
on the x-axis and P on the y-axis. Label where the curves intersect, and where
each curve intersects the axes of the graph.
(b) Solve for the equilibrium price and quantity of wheat?
(c) Would there be excess supply or excess demand if the price were 8 dollars per
bushel?
(d) Now assume that a weather event shifts supply for wheat to the following: QS =
300P − 1200. Solve for the new equilibrium price and quantity of wheat?
(e) Calculate the implied arc elasticity of demand between the two equilibria
(f) Now calculate the point elasticity of demand at both equilibria, and explain why
we would expect differences

2. Use supply and demand curves to illustrate the effects of the following actions on the
equilibrium price and quantity of tea. Explain your answer both graphically and in
words.

(a) A decrease in the price of coffee.

(b) An increase in income levels.
(c) A fungus causes widespread coffee blight.
(d) An announcement from scientists that coffee reduces risk of cancer.

3. Due to the recent financial crisis, the CTA must raise prices. It raises fares by 40%.
After a month, the revenue is 5% greater than the month before the fare increase.

(a) Without any math, explain intuitively whether the number of riders has increased
or decreased.
(b) Estimate the % change in riders as a result of the fare increase.

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 (c) Estimate the (arc) price elasticity of demand.
(d) The CTA had been considering an experiment where it would only raise prices
on a few randomly chosen routes at first. Then it would decide whether or not to
expand the fare increase to all routes based on the results of the test. Given your
knowledge of the actual experiment it ran – raising prices on ALL rides by 40%
led to a 5% increase in revenue – what would you expect would have happened
if it had run the more limited experiment? That is, if it had raised the price by
40% on only a few routes, would you expect that after a month the revenue on
those routes would have gone up by the same 5%, by more than 5%, or by less
than 5%?
(e) Assume that the fare increase is permanent. Would we expect the revenue increase
over many years to be greater or less than the original increase? Why?

4. Demand can be any decreasing function of the price offered. Below are a few such
demand curves of the sort economists use, plotting both the demand function and the
revenue as a function of price. For each of these demand functions, tell us what range
of prices lead to elastic demand [|ε| > 1], and what range of prices lead to inelastic
demand [|ε| < 1]. This can be determined just from the graphs. Hint: how do price
changes affect revenue, depending on the elasticity?

(a) Linear Demand:

Demand Q = 10 − 3P Revenue P · Q = 10P − 3P 2

Rev�P�
P 10
5
8
4
6
3
4
2
2
1
P
5
Q 0 1 2 3 4
0 2 4 6 8 10 12 3

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(b) Log-Linear Demand (where e denotes the exponential constant 2.718....):

Demand Q = 10e−3P Revenue P · Q = 10P e−3P

Rev�P�
P
1.4
3.0
1.2
2.5
1.0
2.0 0.8
1.5 0.6

1.0 0.4
0.2
0.5
P
1
Q 0 1 2 3
0 2 4 6 8 10 12 3

(c) Constant Elasticity Demand:

Demand Q = 10P −3 Revenue P · Q = 10P −2

P Rev�P�
5 25

4 20

3 15

2 10

1 5

Q P
0 2 4 6 8 10 12 0 1 2 3 4 5