Feb.

1, 2016

Economics 203: Intermediate Microeconomics I

Lab Exercise #1

Section 1: Test Your Understanding

True or False?
1) A commodity’s income elasticity of demand may be positive or
negative.
Section 1
1) True
There are five possible income demand curves:
1. High income elasticity of demand:
In this case increase in income is accompanied by relatively larger increase
in quantity demanded. Here the value of coefficient Ey is greater than unity
(Ey>1). E.g.: 20% increase in quantity demanded due to 10% increase in
income.
2. Unitary income elasticity of demand:
In this case increase in income is accompanied by same proportionate
increase in quantity demanded. Here the value of coefficient Ey is equal to
unity (Ey=1). E.g.: 10% increase in quantity demanded due to 10% increase
in income.
3. Low income elasticity of demand:
In this case proportionate increase in income is accompanied by less than
increase in quantity demanded. Here the value of coefficient Ey is less than
unity (Ey<1). E.g.: 5% increase in quantity demanded due to 10% increase in
income.
4. Zero income elasticity of demand:
This shows that quantity bought is constant regardless of changes in income.
Here the value of coefficient Ey is equal to zero (Ey=0). E.g.: No change in
quantity demanded even 10% increase in income.
5. Negative income elasticity of demand:
In this case increase in income is accompanied by decrease in quantity
demanded. Here the value of coefficient Ey is less than zero/negative (Ey<0).
E.g.: 5% decrease in quantity demanded due to 10% increase in income.
Selected income elasticities
 Automobiles 2.98
 Books 1.44
 A person's own life (also called Value of Statistical Life)
0.50 to 0.60
 Restaurant Meals 1.40
 Tobacco 0.64
 Margarine −0.20
 Public Transportation −0.36
True or False?

2) The income elasticity of demand for food is very high.

False
Section 2: discussion
Suppose you are a trustee of a major university. At a
meeting of the board of trustees, one university official
argues that the demand for places in the student body at this
university is completely inelastic. As evidence, he cites the
fact that, although the university has doubled its tuition in
the last decade, there has been no appreciable decrease in the
number of students enrolled. Do you agree?
Other factors, such as the general level of
prices and incomes and the quality of the
students, has not been held constant. Holding
these factors and the tuition rates at other
universities constant, it is almost surely false
that large increases in tuition at this university
would not reduce the number of students
applying for admission to the university.
Section 3: Applications:

1) According to the U.S. Department of Agriculture, the income

elasticity of demand for coffee is about 0.23. If income rose
by 1 percent, what effect would this have on the quantity
demanded of coffee?
ηM=[%ΔQd / %ΔM]=0.23

if %ΔM=0.01

then, 0.01*0.23=0.0023

The effect is .23% increase in demand.

 2) Give the sign of the cross elasticity of demand for each of
the following pairs of commodities:

a) tea and coffee

b) tennis rackets and tennis balls

c) whiskey and gin

a) tea and coffee ---positive
b) tennis rackets and tennis balls ----negative (compliments)
c) whiskey and gin -----positive
3) The Drink-It Distributors concludes that the demand function
for its product is:
Q=95-73P+82PR+ 0.25 M

where Q is the quantity demanded of its product, P is the

price of its product, PR is the price of its rival’s product, and
M is per capita disposable income (in dollars). Currently,
P=$255, PR=$225 and M=$50,650.

Solving for Q=95-73(255)+82(225)+0.25(50,650)

Q=12,592.5
a) What is the income elasticity of demand for the firm’s
product?
Use income elasticity of demand formula for a point.

 Q  M 
  
 M  Q 

0.25 (50,650/12592.5) =1.00556

b) What is the cross elasticity of demand between its product
and its rival’s product?

Use Cross elasticity of demand formula for a point:

 Q  PR 
  
 P  Q
 R  
82 (225/12592.5) =1.4652
Question:
Carl is equally fond of oatmeal and waffles at UVic’s
Market and spends all of his food budget of $30 per week on
these breakfast treats. If oatmeal is $3, draw Carl’s price
consumption curve for waffles and the corresponding
demand curve.
Oatmeal and waffles are perfect substitutes for Carl, and
his indifference curves are shown as the heavy
downward-sloping 45° lines in the diagram. The lighter
downward-sloping straight lines, B1_B4, are the budget
constraints that correspond to four arbitrarily chosen
prices of waffles, namely, $10, $6, $2.5, and $2,
respectively. The first two of these prices exceed the
price of oatmeal, so Carl ends up spending all of his
food budget on oatmeal.
Bundle A denotes the optimum purchase of waffles
when the price of waffles is $10 (budget constraint B1);
and bundles C, D, and F are the corresponding bundles
for the remaining prices (budget constraints B2, B3, and
B4, respectively). As noted, the amount of waffles at
both A and C is zero. Once the price of waffles falls
below the price of oatmeal, Carl does best to spend all of
his food budget on waffles. When waffles cost $2.50,
for example, he will buy ($30/wk)/($2.50)=12/wk
(bundle D on B3); and at $2, he will buy 15/wk (bundle
F on B4). The heavy green line labelled PCC.
 Oatmeal
15

10 A, C

5 PCC
BL1 BL2 BL3 BL4

D F
0 3 5 10 12 15 Waffles
To construct Carl’s demand curve for waffles, we can
retrieve the price-quantity pairs from his PCC and plot them
in a separate diagram, just as before. But an even easier way
is available in this particular case. It is to note that his
behaviour may be summarized by the following purchase
rule: when the price of waffles, PW, is below the price of
oatmeal, he will buy $30/PW of waffles, and when PW is
above the price of oatmeal, he will buy no waffles at all.
The demand curve that corresponds to this purchase rule is
plotted as the heavy line in the diagram below. In sum, the
demand for waffles is: X=30/PX if PX 3, and X=0 if PX >3.
Price $
7

5 Demand for waffles

0 5 10 15 20 25 30 waffles
Question:

To Carl, oatmeal and waffles at UVic’s Market are perfect

one-to-one complements and he spends all of his food
budget of $30 per week on these breakfast treats. If oatmeal
is $3, draw Carl’s price consumption curve for waffles and
the corresponding demand curve.
X=Y and PX X + 3Y=30 implies X=30 / (PX + 3).
Oatmeal
10
PCC
8

6 Utility functions

2
BL BL BL
0 waffles
0 2 4 6 8 10 12 14 16

30/6 30/5 30/4 30/3 30/2

Price of waffles X=30 / (PX + 3).
0 30/3=10 Table your demand
1 30/4=7.5
2 30/5=6
3 30/6=5
4 30/7=4.3
5 30/8=3.75
6 30/9=3.33
7 30/10=3
8 30/11=2.7
9 30/12=2.5
10 30/13=2.3
11 30/14=2.1
Price of Waffles

10

4
demand
2

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 waffles
Microeconomics is better than waffles!