EC 101.

01&03 Problem Session: Chapter 5 Fall 2021

Solutions

1) A budget constraint is a straight line because:

A) the tastes and preferences of the consumer change along the constraint.
B) a consumer faces a fixed price of both goods that do not change with changes in consumption.
C) the opportunity cost of buying each of the goods changes along the constraint.
D) a consumer has a limited money income.
Answer: B

2) Which of the following will lead to a change in the opportunity cost of buying a pen and a
pencil?
A) An increase in the consumer's income
B) A decrease in the consumer's income
C) A twofold increase in the prices of both pens and pencils
D) A twofold increase in the price of pens and a threefold increase in the price of pencils
Answer: D

3) Jack has an income of $150 per month that has to be spent on two goods: Shoes and Jeans.
From the following table, estimate the bundle that maximizes Jack's well-being.

Quantity (units) Shoes ($20/pair) Jeans ($10/pair)

Marginal Benefits ($) Marginal Benefits ($)
0 - -
1 40 35
2 33 33
3 28 22
4 23 15
5 20 10
6 15 7.5

Answer: To estimate the bundle that maximizes Jack's well-being, the marginal benefit per
dollar spent has to be calculated for both goods.

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To maximize Jack's well-being, the marginal benefit per dollar spent must be equal for both
goods. There are two combinations at which the marginal benefit per dollar spent is identical: 6
pairs of shoes and 6 pairs of jeans; and 5 pairs of shoes and 5 pairs of jeans. If Jack wants to
consume 6 units of shoes and jeans, his expenditure will be equal to = 6 × $20 + 6 × $10 = $180,
which exceeds his income. On the other hand if Jack buys 5 pairs of shoes and 5 pairs of jeans,
his expenditure will be equal to = 5 × $20 + 5 × $10 = $100 + $50 = $150, which exactly
exhausts his income. Therefore, to maximize Jack's well-being he should consume 5 pairs of
shoes and 5 pairs of Jeans.

4) Define the term "consumer surplus." If your willingness to pay for a good is $500 and you
get it at a discount price of $275, what is your consumer surplus?
b) In the following figure, calculate the consumer surplus when the market price is $20.

Answer:
a) Consumer surplus is the difference between the willingness to pay for a given unit of a good
and the price paid. If a consumer is willing to pay $500 for a good and it is available for $275,
the consumer surplus is $500 - $275 or $225.
b) Graphically, the consumer surplus is the area under the demand curve and above the price
line. In the figure, consumer surplus is:
CS = 1/2 × 75 × (45 - 20) = $937.50

5) Sharon consumes 10 chocolates when the price of one chocolate is $2. If her arc elasticity of
demand for chocolates is -1, she consumes ________ chocolates when the price increases to $4.
A) 5
B) 6
C) 8
D) 9
Answer: A

Scenario: Gary purchases 50 shirts when the price of one shirt is $4. When the price of shirts
increases to $6, the quantity he purchases reduces to 20 shirts.

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6) Refer to the scenario above. What is the absolute value of Gary's arc elasticity of demand for
shirts?
A) 1.2
B) 2.14
C) 3.26
D) 5
Answer: B

7) Refer to the scenario above. Instead of the price increase, if there is a fall in price from $6 to
$4, the absolute value of Gary's arc elasticity of demand for shirts is:
A) 1.2.
B) 2.14.
C) 4.
D) 5.
Answer: B

8) At the midpoint of a linear demand curve, the price elasticity of demand is:
A) equal to zero.
B) between zero and one.
C) equal to one.
D) greater than one.
Answer: C

9) Which of the following pairs of goods is most likely to have a positive cross-price elasticity?
A) Printers and ink cartridges
B) A privately-owned car and public transportation
C) Coffee and sugar
D) Motorcycles and typewriters
Answer: B

10) Which of the following statements is true about the income elasticity of demand?
A) The income elasticity of demand for normal goods is always zero.
B) The income elasticity of demand for inferior goods is always zero.
C) The income elasticity of demand for normal goods is always positive.
D) The income elasticity of demand for inferior goods is always positive.
Answer: C

11) From a firm's point of view, when the demand for a good has a price elasticity of 0.5, then,
all things remaining the same, a(n):
A) increase in the price of the good will decrease the firm's revenue.
B) increase in the price of the good will increase the firm's revenue.
C) change in the price of the good will not affect the firm's revenue.
D) change in the price of the good will not affect the quantity of the good demanded by
consumers.
Answer: B

12) The quantity demanded of a particular range of flashlights is 600 units when price per unit is
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$5. When the price increases to $20, the quantity demanded falls to 200 units. Later the price of
cells used to operate these flashlights falls by 200% and the demand for the flashlights increases
from 200 units to 300 units.
a) Calculate the arc price elasticity of demand.
b) Calculate the cross-price elasticity of demand.
c) Joe purchases 20 units of the flashlights when his income is $30 and when his income
increases to $120, his quantity demanded changes to 60 units. Calculate Joe's income elasticity of
demand for flashlights.
Answer:
a) Arc price elasticity of demand = [(200 -600) / [(200 + 600)/2)] / (20 - 5) / [(20 + 5) / 2]
= (-400 / 400) / (15 / 12.5) = -1 / 1.2 = -0.83.
b) Cross-price elasticity of demand of a good is the ratio of the percentage change in the
demand for the good to the percentage change in the price of a related good. The percentage
change in the demand for flashlights when the price of cells falls by 200% = [(300 - 200)/200] ×
100 = 50%.
Hence, cross-price elasticity of demand between flashlights and cells = 50 / -200 = -0.25.
c) Income elasticity of demand for a good is the ratio of the percentage change in the demand
for a good to the percentage change in the consumer's income.
The percentage change in the demand for flashlights when Joe's income increases from $30 to
$120 = [(60 - 20)/20] × 100 = 200%.
The percentage change in Joe's income = [(120 - 30) / 30] × 100 = 300%.
Joe's income elasticity of demand for flashlights = 200 / 300 = 0.67.

13) a) Gary is a heavy smoker who spends $400 per week on cigarettes. The government
decides to levy a 20% tax on all cigarettes. This tax will be completely borne by consumers.
After the tax is levied, Gary's expenditure on cigarettes increases to $432 per week. If each pack
of cigarettes sells for $20, calculate Gary's price elasticity of demand for cigarettes and the
elasticity of demand for addictive goods.
b) If the demand for a good has an absolute price elasticity greater than one, what will happen
to the total expenditure on the good if its price increases?
c) If the demand for a good has an absolute price elasticity equal to one, what will happen to the
total expenditure on the good if its price increases?
Answer:
a) Initially when the price of cigarettes is $20 per pack, Gary's consumption of cigarettes is 20
packs every week.
Price per pack after the tax is levied is $24.
Gary's consumption of cigarettes after the tax is levied = ($432/$24) = 18 packs.
Gary's price elasticity of demand for cigarettes = [(18 -20) / (18 +20)/2] / [(24 - 20) / (24 + 20)/2]
= -0.58.
Given the information, the demand for addictive goods is relatively inelastic.
b) If the demand for a good has an absolute price elasticity greater than one, then an increase in
the price of the good will result in a decrease in the total expenditure on the good.
c) If the demand for a good has an absolute price elasticity equal to one, then an increase in the
price of the good will not affect the total expenditure on the good.