Chapter 5

MOIZ ALI ABBAS (SP18-BBA-165)

MUHAMMAD HAROON (SP18-BBA-153)

KAINAT ASIF (FA19-BBA-100)

7. You have the following information about good X and good Y:

• Income elasticity of demand for good

X: –3

• Cross-price elasticity of demand for good X with respect to the price of good Y: 2

Would an increase in income and a decrease in the price of good Y unambiguously decrease the
demand for good X? Why or why not?

ANS)

Income elasticity of demand refers to a percentage change in quantity demanded due to a percentage
change in price. The cross-price elasticity of demand refers to a percentage change in quantity
demanded of a good due to a change in the price of other goods.

If the price of good X is less than the price of good Y, then an increase in income and a decrease in the
price of good Y decreases the demand for good X.

On the other hand, if the price of good X is greater than the price of good Y, then an increase in income
and a decrease in the price of good Y will increase the demand for good X.

8. Maria has decided always to spend one-third of her income on clothing.

a. What is her income elasticity of clothing demand?

b. What is her price elasticity of clothing demand?

c. If Maria’s tastes change and she decides to spend only one-fourth of her income on clothing, how
does her demand curve change? What is her income elasticity and price elasticity now?
ANS)

In an economy, economists determine the consumer behavior towards a product according to his
income elasticity and price elasticity. Here, Maria decided to use one-third of her income on clothing.

A)

Her decision explains that any change in income level has a proportionate change in the money spent on
clothing. As a result, her preferences remain constant, which explains unit elasticity of income. As a
result, the income elasticity of clothing demand would be one.

B)

At the same time, when she decided to spend one-third on the income clothes, any change in the price
level will proportionally change its quantity demanded to maintain the spending level to be one-third. As
a result, there will be a constant or same percentage change in demand whenever price level changes.
As a result, price elastic of clothing demand will also be one.

C)

Here, Maria changes her consumption decision to spend one-fourth proportion of her income on
clothes. In this situation also, he used to change her consumption level proportion to its income level
and price level in constant percentage. As a result, income elasticity and the price elasticity of demand
for clothes will be same as earlier, that is, one.

Q 11

Consider public policy aimed at smoking.

a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of cigarettes
currently costs $2 and the government wants to reduce smoking by 20 percent, by how much should it
increase the price?

b. If the government permanently increases the price of cigarettes, will the policy have a larger effect
on smoking 1 year from now or 5 years from now?

c. Studies also find that teenagers have a higher price elasticity than do adults. Why might this be
true?

a. With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20%
requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes currently $2, this
would require an increase in the price to $3.33 a pack using the midpoint method (note that ($3.33 –
$2)/$2.67 = .50).

b. The policy will have a larger effect five years from now than it does one year from now. The
elasticity is larger in the long run, because it may take some time for people to reduce their cigarette
usage. The habit of smoking is hard to break in the short run.

c. Because teenagers do not have as much income as adults, they are likely to have a higher price
elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult to
reduce their quantity demanded in response to a higher price.

17)Suppose the demand curve for a product is Q=60/P. Compute the quantity demanded at prices of
$1, $2, $3, $4, $5, and $6. Graph the demand curve. Use the midpoint method to calculate the price
elasticity of demand between $1 and $2 and between $5 and $6. How does this demand curve
compare to the linear demand curve?

Question: 8

A case study in this chapter discusses the federal minimum-wage law.

a. Suppose the minimum wage is above the equilibrium wage in the market for unskilled labor. Using
a supply-and-demand diagram of the market for unskilled labor, show the market wage, the number
of workers who are employed, and the number of workers who are unemployed. Also show the total
wage payments to unskilled workers.

b. Now suppose the secretary of labor proposes an increase in the minimum wage. What effect would
this increase have on employ-ment? Does the change in employment depend on the elasticity of
demand, the elas-ticity of supply, both elasticities, or neither?

c. What effect would this increase in the mini-mum wage have on unemployment? Does the change in
unemployment depend on the elasticity of demand, the elasticity of supply, both elasticities, or
neither?

d. If the demand for unskilled labor were inelastic, would the proposed increase in the minimum wage
raise or lower total wage payments to unskilled workers? Would your answer change if the demand
for unskilled labor were elastic?

ANS)

a. In the absence of the minimum wage, the market wage would be w1 and Q1 workers would be
employed. With the minimum wage (wm) imposed above w1, the market wage is wm, the number of
employed workers is Q2, and the number of workers who are unemployed is Q3 - Q2. Total wage
payments to workers are shown as the area of rectangle ABCD, which equals wm times Q2. Figure shows
the effect of the minimum wage.

b. An increase in the minimum wage would decrease employment. The size of the effect on employment
depends only on the elasticity of demand. The elasticity of supply does not matter, because there is a
surplus of labor.

c. The increase in the minimum wage would increase unemployment. The size of the rise in
unemployment depends on both the elasticities of supply and demand. The elasticity of demand
determines the change in the quantity of labor demanded, the elasticity of supply determines the
change in the quantity of labor supplied, and the difference between the quantities supplied and
demanded of labor is the amount of unemployment.

d. If the demand for unskilled labor were inelastic, the rise in the minimum wage would increase total
wage payments to unskilled labor. With inelastic demand, the percentage decline in employment would
be lower than the percentage increase in the wage, so total wage payments increase. However, if the
demand for unskilled labor were elastic, total wage payments would decline, because then the
percentage decline in employment would exceed the percentage increase in the wage.

Question:12
At Fenway Park, home of the Boston Red Sox, seating is limited to 34,000. Hence, the number of
tickets issued is fixed at that figure. (Assume that all seats are equally desirable and are sold at the
same price.) Seeing a golden opportunity to raise revenue, the City of Boston levies a per ticket tax of
$5 to be paid by the ticket buyer. Boston sports fans, a famously civic-minded lot, dutifully send in the
$5 per ticket. Draw a well-labeled graph showing the impact of the tax. On whom does the tax burden
fall—the team’s owners, the fans, or both? Why?

Since the supply of tickets is fixed at 34,000, the supply curve is completely inelastic, i.e. vertical.
Assuming a normal, downward sloping demand curve, a tax on consumers shifts the demand curve
down by a vertical distance equal to the amount of the tax—here that is $5.

Without the tax, the equilibrium price would be P*--this is what consumers would pay and what
producers would receive. With the tax, the demand curve shifts down by $5 and the amount producers
receive is reduced to PP. However, the amount consumers must pay is PC, which is exactly what they
would pay without the tax, P*. Hence, the burden on consumers, PC - P*, is zero, while the burden on
producers is P* − PP = $5.

This results from the fact that supply is completely inelastic—the Red Sox cannot alter supply in
response to changes in price. So they absorb the entire tax in lower ticket prices.

Question 14
In the spring of 2008, Senators John McCain and Hillary Clinton (who were then running for President)
proposed a temporary elimination of the federal gasoline tax, effective only during the summer of
2008, in order to help consumers deal with high gasoline prices.

a. During the summer, when gasoline demand is high because of vacation driving, gasoline refiners are
operating near full capacity. What does this fact suggest about the price elasticity of supply?

b. In light of your answer to (a), who do you predict would benefit from the temporary gas tax holiday

A) inelastic price elasticity of supply, because most of them are already functioning on full capacity ,
however demand will rise after the removal of the tax. Supply will rise but almost insignificant change.

B) Most of the benefits will go the consumer as fuel prices are controlled by the government so the
profits of fuel companies will not change but the consumers will benefit alot from lower prices. Tax is
collected by the government, so elemination of it only creates room for demand, which will only
increase sale of fuel , but will not increase profits but a margin. By much of a margin

Consider public policy aimed at smoking.

a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of cigarettes
currently costs $2 and the government wants to reduce smoking by 20 percent, by how much should it
increase the price?

b. If the government permanently increases the price of cigarettes, will the policy have a larger effect
on smoking 1 year from now or 5 years from now?

c. Studies also find that teenagers have a higher price elasticity than do adults. Why might this be
true?

a. With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20%
requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes currently $2, this
would require an increase in the price to $3.33 a pack using the midpoint method (note that ($3.33 –
$2)/$2.67 = .50).

b. The policy will have a larger effect five years from now than it does one year from now. The
elasticity is larger in the long run, because it may take some time for people to reduce their cigarette
usage. The habit of smoking is hard to break in the short run.

c. Because teenagers do not have as much income as adults, they are likely to have a higher price
elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult to
reduce their quantity demanded in response to a higher price.