Problem Set 3

Market Demand, Market Equilibrium and Uncertainty

Market Demand

1. Answer the following short questions

(a) An addict’s demand function for a drug may be very inelastic, but
the market demand function might be quite elastic. How can this
be?

(b) If a market demand curve is D ( P) = 100 − 5p, what is the inverse

demand curve?

2. In the town of Gas Pump, there are two kinds of consumer, Buick own-
ers and Dogde owners. Every Buick owner has a demand function for
gasoline DB ( p) = 20 − 5p for p ≤ 4 and DB ( p) = 0 if p > 4. Every Dodge
owner DD ( p) = 15 − 3p for p ≤ 5 and DD ( p) = 0 if p > 5. Suppose that
Gas Pump has a 150 consumers, 100 Buick owners, and 50 Dodge owners.

(a) If the price is $3, what is the total amount demanded by each Buick
owner, and Dodger owner?

(b) What is the total amount demanded by all Buick and Dodge own-
ers?

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 (c) What is the total amount demanded by all consumers in Gas Pump
at a price p = $3.

(d) At what price does the market demand curve have a kink?

(e) When the price of gasoline is p = $1/liter, how much does weekly
demand fall when price rises by 10 cents?

(f) When the price of gasoline is p = $4.5/liter, how much does

weekly demand fall when price rises by 10 cents?

3. The demand for yo-yos is log D ( p) = 1000 − p + log(m) where p is the

price of yo-yos and m is the income.

(a) Compute an expression for the price elasticity of demand for yo-
yos.

(b) Compute an expression for the income elasticity of demand for

yo-yos.

(c) Compute the price elasticity of demand for the following combi-
nations of price and income: ( p = 2, m = 500), ( p = 3, m = 500),
and ( p = 4, m = 1500).

(d) Compute the income elasticity of demand for the following combi-
nations of price and income: ( p = 2, m = 500), ( p = 2, m = 1000),
and ( p = 3, m = 1500).

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Market Equilibrium

4. Answer the following short questions (try to be as prices and short as

possible)

(a) What is the effect of a tax in a market with a horizontal supply

curve?

(b) What is the effect of a tax in a market with a vertical supply curve?

5. Suppose the demand for ski lessons is given by D ( p D ) = 100 − 2p D and

the supply is given by S( pS ) = 3pS .

(a) Compute the equilibrium price and quantity.

(b) Now suppose the government imposes a tax on skying lesson of

$10 per ski lesson on consumers. Write the equilibrium conditions
with taxes (Hint: demand equal supply and price-tax equation).

(c) Solve for the price paid by consumers, by suppliers and the equi-
librium for total number of lessons.

(d) A politician from the area suggests that only consumers (who are
rich) should be taxed and not ski instructors. He proposes a $6
subsidy on production while maintaining the $10 tax on ski lessons.
Would this have any different effects for suppliers and demanders
than a tax of $4 per lesson?

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Uncertainty

6. A risk-averse individual is offered a choice between a gamble that pays

$1000 with probability of 25% and $100 with probability of 75% or a pay-
ment of $325.

(a) Which gamble would he choose?

(b) What is the payment was $320

7. Willy owns a small factory, located near to a river that occasionally

floods with disastrous consequences. If there is no floods the factory is
worth $500,000. If there is a flood what is left of the factory is worth
$50,000. Willy can buy insurance at a cost of $0.1 for each worth of cover-
age. Willy thinks that the probability that there will be a flood is 1/10. Let
c F be the contingent consumption of Willy in the case of flood and c NF the
contingent consumption in case of no flood. Willy has expected utility of
the form
√ √
U (c F , c NF ) = .1 c F + .9 c NF

(a) Suppose Willy does not buy insurance. Compute his contingent
consumption for each contingency.

(b) Now suppose he buys insurance that costs him a premium of $0.1K
and pays $K in case of a flood. Compute again the corresponding
contingent consumption for both events (flood and no-flood).

(c) Use both contingent consumption to find the budget constraint.

(d) Find the optimal bundle of contingent consumption.

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(e) Find the amount of coverage that Willy get in case of a flood and
the insurance premium he will have to pay.