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Demand and PED

What is the own-price elasticity of demand as price increases from \$2 per unit to \$4 per unit? Use the mid-point formula in your calculation.

a) 1/3.
b) 6/10.
c) 2/3.
d) None of the above.

1. Suppose that a 2% increase in price results in a 6% decrease in quantity demanded. Own-price elasticity of demand is equal to:

a) 1/3.
b) 6.
c) 2
d) 3.

1. If own-price elasticity of demand equals 0.3 in absolute value, then what percentage change in price will result in a 6% decrease in quantity demanded?

a) 3%
b) 6%
c) 20%.
d) 50%.

1. Suppose you are told that the own-price elasticity of supply equal 0.5. Which of the following is the correct interpretation of this number?

a) A 1% increase in price will result in a 50% increase in quantity supplied.
b) A 1% increase in price will result in a 5% increase in quantity supplied.
c) A 1% increase in price will result in a 2% increase in quantity supplied.
d) A 1% increase in price will result in a 0.5% increase in quantity supplied.

1. Suppose that a 10 increase in price results in a 50 percent decrease in quantity demanded. What does (the absolute value of) own price elasticity of demand equal?

a) 0.5.
b) 0.2.
c) 5.
d) 10.

1. If goods X and Y are SUBSTITUTES, then which of the following could be the value of the cross price elasticity of demand for good Y?

a) -1.
b) -2.
c) Neither a) nor b).
d) Both a) and b).

1. If pizza is a normal good, then which of the following could be the value of income elasticity of demand?

a) 0.2.
b) 0.8.
c) 1.4
d) All of the above.

1. If goods X and Y are COMPLEMENTS, the which of the following could be the value of cross price elasticity of demand?

a) 0.
b) 1.
c) -1.
d) All of the above could be the value of cross price elasticity of demand.

Exercises 4.2

Use the demand curve diagram below to answer the following TWO questions.

1. What is the own-price elasticity of demand as price decreases from \$8 per unit to \$6 per unit? Use the mid-point formula in your calculation.

a) Infinity.
b) 7.0
c) 2.0.
d) 1.75

1. At what point is demand unit-elastic? a) P = \$6, Q = 12.
b) P = \$4, Q = 8.
c) P = \$2, Q = 12.
d) None of the above.
2. Which of the following statements about the relationship between the price elasticity of demand and revenue is TRUE?

a) If demand is price inelastic, then increasing price will decrease revenue.
b) If demand is price elastic, then decreasing price will increase revenue.
c) If demand is perfectly inelastic, then revenue is the same at any price.
d) Elasticity is constant along a linear demand curve and so too is revenue.

Summary One

Microeconomics:
the behavior of individual firms, consumers, and markets.

• begin with product markets: the markets for goods and services
• origins of consumer demand
• how price/profit allocate resources in competitive market
• market failures in imperfect competition like monopoly
• factor markets
• the role of government in modern, mixed economy

Elasticity of Supply and Demand

• responsiveness of quantity supplied and demanded to changes in price…
• vacation travel (much) vs food and electricity (little)
• allows understanding of impacts of gov. intervention thru taxes, min. wages, tariffs, etc.

Price Elasticity of Demand

• a measures of how much quantity demanded changes when price changes.
• the responsiveness of quantity demanded to changes in price.
• = the percentage change in quantity demanded divided by the percentage change in price.
• = %∆Q/%∆P (percent that quantity changes for every 1% change in price).
• good has elastic demand when Q demanded responds greatly to ∆P.
• good has inelastic demand when Q demanded responds little to ∆P.

1. Suppose BC Ferries is considering an increase in ferry fares. If doing so results in an increase in revenues raised, which of the following could be the value of the own-price elasticity of demand for ferry rides?

a) 0.5.
b) 1.0.
c) 1.5.
d) All of the above.

1. Use the demand diagram below to answer this question. Note that P × Q equals \$900 at every point on this demand curve.

Which of the following statements correctly describes own-price elasticity of demand, for this particular demand curve?

I. Demand is unit elastic at a price of \$30, and elastic at all prices greater than \$30.
II. Demand is unit elastic at a price of \$30, and inelastic at all prices less than \$30.
III. Demand is unit elastic for all prices.

a) I and II only.
b) I only.
c) I, II and III.
d) III only.

1. Suppose that, if the price of a good falls from \$10 to \$8, total expenditure on the good decreases. Which of the following could be the (absolute) value for the own-price elasticity of demand, in the price range considered?

a) 1.6.
b) 2.3.
c) Both a) and b).
d) Neither a) or b).

1. Consider the demand curve drawn below.

At which of the following prices and quantities is revenue maximized? a) P = 40; Q = 0.
b) P = 30; Q = 5.
c) P = 20; Q = 10.
d) P = 0; Q = 20.

Exercises 4.3

1. Which of the following does NOT affect the magnitude of own-price elasticity of demand?

a) The length of the time horizon over which we are looking at the change in consumer behaviour.
b) The availability (or lack thereof) of close substitutes for the good in question.
c) The amount by which quantity supplied will change as price changes.
d) All of the above affect the own-price elasticity of demand.

1. If a demand curve is VERTICAL, then own-price elasticity of demand for this good is equal to:

a) Infinity.
b) Zero.
c) One.
d) None of the above.

Summary 2

factors affecting elasticity
A) – necessities: food, fuel, shoes, prescription drugs – inelastic demand

• luxuries: cruise vacations, designer jeans, Haagen Daz ice cream – elastic demand
B) – goods that have ready substitutes: more elastic demand
• cornflakes vs oatmeal; chicken vs beef; ro insulin for a diabetic…
C) – proportion of income: is price high or low compared to income
• pencil, 10% change in price is a few pennies, will not affect Q much (inelastic)
• car: 10% change in price is thousands of dollars, Q affected a lot (elastic)
D) – amount of time people have to respond: short run inelasticity vs long run elasticity
-people need time to make changes, find substitutes, adjust behaviour
• eg: gasoline demand may be inelastic in short run but more elastic with time (switch car, car pool, driving habits)

calculating elasticity
(coefficient of price elasticity)

price elasticity of demand
ED = Percentage change in quantity demanded/Percentage change in price
= (%∆Q/Q)/(%∆P/P)

• always positive (drop signs)

Price-elastic Demand:
%∆Q > %∆P – a 1% change in price causes a greater than 1% change in quantity demanded

Price-inelastic Demand:
%∆Q < %∆P – a 1% change in price causes a less than 1% change in quantity demanded

Unit-elastic Demand:
%∆Q = %∆P – a 1% change in price causes a 1% change in quantity demanded

example:
Initially P1 = 90, Q1 = 240 units; Price Increase leads to P2 = 110,
Q2 = 160 units.

• show with move along demand schedule
• ED = ∆Q/Q ÷ ∆P/P = -80/200 ÷ 20/100 = 40%/20% = 2
• note: in calculating percent change, use average for base price and quantity, not initial or final….

N.J. Smokers example:
assume inelastic demand for cig.

• 1998: Cig. tax raised price from \$2.40 to 2.80 while consumption dec. from 52M to 47.5M.
• Short run elasticity = 0.59

Price Elasticity in Diagrams

• a) Elastic: graph shows that when price is halved (2x smaller), quantity demanded is tripled
• b) Unit-Elastic: when price is halved, quantity demanded is doubled
• c) Inelastic: When price is halved, quantity increases by one half.
• d) Polar extremes:
• Zero elasticity: completely (perfectly) inelastic – Q does not respond to price at all.
• vertical demand curve
• Infinite elasticity: completely (perfectly) elastic – Q responds (infinitely) to tiniest change in price
• horizontal demand curve (show with slightly sloped curve)

Slope vs Elasticity:

• slope = ∆P/∆Q, not %∆Q/%∆P
• steepness depends upon scale…steep demand curve does not necessarily.
mean inelastic demand
• slope also depends on units, elasticity does not
• straight line demand curve has elasticity from 0-∞

Total Revenue:
Total money taken in by businesses through sales of goods

• Equal to Price times Quantity (R = P x Q).

Will raising price increase or decrease revenue?
effect of a price change on revenue is ambiguous because price and quantity change in opposite directions… so a price increase will cause a decrease in quantity demanded and the new product of price and quantity may be larger,
smaller or remain unchanged…

• answer depends on elasticity of demand.
• if elastic, then the percent decrease in quantity is greater than the percent increase in price.
• revenue therefore declines because Q decreases more than P increases and the new product of P and Q is smaller

Rules:

• When demand is price-inelastic, a price increase increases total revenue (and a price decrease reduces revenue)
• When demand is price-elastic, a price increase reduces total revenue (P dec. raises revenue)
• When demand is unit-elastic, a price change leads to no change in revenue.

Diagrams:
symbolically, revenue shows up as area of rectangle (see blue and grey shaded boxes in the graphs above)

• compare shaded box areas in diagrams for elastic and inelastic demand (grey = revenue at low price, blue = revenue at high price)

Price Discrimination:
practice of charging different prices to different people for the same good or service.

• airlines and airfares
• business travelers: inelastic demand, charge high price to increase revenue
• leisure travelers: elastic demand, charge low price to increase revenue
• telephone service…
• challenge: how to keep both types of buyers separate
• advanced booking, staying over the weekend for lower fares…

• farming has good year (cold winter, spring rains, no frosts, dry fall), farm family counts on huge production
• when calculating income for year, family finds that it is actually lower

How?

• Demand for food relatively inelastic.
• Supply shifts to right due to abundant harvest – so price declines. Lower price does not increase quantity purchased very much, so total revenue declines. See figure c) above.

Price Elasticity of Supply
responsiveness of quantity supplied by business to changes in market price

Price Elasticity of Supply:
the percentage ∆Q supplied divided by the percentage ∆P
ES = %∆QS/%∆P

• similar to Price Elasticity of Demand, except here %∆Q has same sign as %∆P (proportional)

Elastic, Inelastic Supply:
%∆Q > or < %∆P

Infinitely Elastic Supply:
Horizontal supply curve, small ∆P produces huge ∆Q supplied

Zero Elasticity, Completely inelastic supply:
Vertical supply curve, P does not affect Q (fresh fruit in short run)

Factors that affect supply elasticity

• ease: with which production can be increased.
• are extra inputs readily available? (textiles yes, South African gold no)
• time period:
• supply tends to be inelastic in short run, elastic in long run (mangoes – more trees planted, more production, time)

1. If – given consumer preferences – a certain good has many close substitutes available, then:

a) The demand for that good will be relatively inelastic, compared to goods for which there are few close substitutes.
b) The supply of that good will be relatively inelastic, compared to goods for which there are few close substitutes.
c) The demand for that good will be relatively elastic, compared to goods for which there are few close substitutes.
d) The supply of that good will be relatively elastic, compared to goods for which there are few close substitutes.

1. If – given consumer preferences – a certain good has few close substitutes available, then:

a) The demand for that good will be relatively inelastic, compared to goods for which there are many close substitutes.
b) The supply of that good will be relatively inelastic, compared to goods for which there are many close substitutes.
c) The demand for that good will be relatively elastic, compared to goods for which there are many close substitutes.
d) The supply of that good will be relatively elastic, compared to goods for which there are many close substitutes.

Exercises 4.5

The following TWO questions refer to the supply and demand curves illustrated below.

1. A price ceiling of P3 causes:

a) A deadweight loss triangle whose corners are ABC.
b) A deadweight loss triangle whose corners are ACD.
c) A deadweight loss triangle whose corners are BEC.
d) A deadweight loss triangle whose corners are CDE.

1. A price floor of P1 causes:

a) Excess demand equal to the distance AB.
b) Excess supply equal to the distance AB.
c) Excess supply equal to the distance DE.
d) Excess demand equal to the distance DE.

1. Which of the following statements about price ceilings is TRUE? (Assume the price ceiling is set below the unregulated equilibrium price.)

a) Price ceilings make sellers worse off.
b) Price ceilings make buyers better off.
c) Both a) and b) are true.
d) Neither a) nor b is true).

1. Which of the following statements about minimum wages is true?

a) Minimum wage laws may make some workers better off and others worse off.
b) Minimum wage laws make employers worse off.
c) Both a) and b) are true.
d) None of the above are true.

1. Consider diagram below, which illustrates the market for low-skilled labour.

Suppose that the equilibrium quantity is reduced from Q1 to Q2 units, through the introduction of a price floor. Which of the following correctly describes the resulting decrease in MARKET surplus?

a) Market surplus will decrease by a – c.
b) Market surplus will decrease by by e + c.
c) Market surplus will decrease by a + b + e + c.
d) Market surplus will decrease by b – e.

1. Consider diagram below, which illustrates the market for low-skilled labour.

If the government introduces a minimum wage law set at \$9 per hour, then, in the new equilibrium, which of the following statements is TRUE?

I. There will be 11,000 workers willing to work who cannot find work, given the wage.
II. The number of workers employed will decrease by 11,000.
III. The number of workers that employers are prepared to hire will decrease by 5,000.

a) I only.
b) I and II only.
c) I, II, and III.
d) I and III only.

1. Suppose that the BC government wishes to reduce the quantity of beer sold in the Province by 20%. It has calculated that this goal can be achieved EITHER through a price floor set at \$2 per six-pack of beer OR a price ceiling of \$20 per six-pack of beer. Assume that the current price of beer is \$10 per six-pack. Which of the following statements about these policies is TRUE?

a) The deadweight loss from the price floor will be greater than the deadweight loss from the price ceiling.
b) The deadweight loss from the price ceiling will be greater than the deadweight loss from the price floor.
c) There is insufficient information to determine which policy will have the large deadweight loss.
d) None of the above statements is true.

1. Consider the supply and demand diagram below. Assume no externalities.

If a price floor of \$20 is introduced, then which area will represent the deadweight loss?

a) e.
b) e + d.
c) e + b + d.
d) The deadweight loss will be zero.

1. If a price ceiling (set below the initial equilibrium price) is introduced in a market, then:

a) Producer surplus definitely decreases.
b) Consumer surplus definitely increases.
c) Neither a) nor b) are true.
d) Both a) and b) are true.

1. In Canada, the prices of most medical services are regulated by the Provinces (that is, they are subject to price ceilings). This type of regulation is likely to result in which of the following (relative to an unregulated market)?

a) An increase in the quantity of medical services provided.
b) Consumption of medical services such that the marginal benefit is less than the marginal cost.
c) Lower incomes for providers of medical services.
d) Higher tax revenues for Provincial governments.

Exercises 4.6

1. Which of the following CANNOT reduce the equilibrium quantity sold in a market?

a) A price ceiling.
b) A price floor.
c) A quota.
d) All of the above can decrease equilibrium quantity sold.

Exercises 4.7

Refer to the supply and demand curves illustrated below for the following THREE questions. Consider the introduction of a \$20 per unit tax in this market.

1. Which areas represent the loss to consumer AND producer surplus as a result of this tax?

a) k + f.
b) j + g.
c) k + j.
d) k + f + j + g.

1. Which areas represent the gain in government revenue as a result of this tax?

a) k + f.
b) j + g.
c) k + j.
d) k + f + j + g.

1. Which areas represent the deadweight loss associated with this tax?

a) f + g.
b) k – g.
c) j – f.
d) k + f + j + g.

1. Assume that the marginal cost of producing socks is constant for all sock producers, and is equal to \$5 per pair. If government introduces a constant per-unit tax on socks, then which of the following statements is FALSE, given the after-tax equilibrium in the sock market? (Assume a downward-sloping demand curve for socks.)

Summary 3

Excise Tax:
tax levied on sale of a specific good or service (as opposed to sales taxes or income taxes)

• used to raise revenue, to affect behavior (sin taxes)

Incidence:
ultimate economic impact of a tax on the real incomes of producers and consumers.

• who bears the burden, who pays the tax.
• relative elasticities of supply and demand determine incidence of excise tax

Gasoline Tax

• to curb consumption, curb pollution, encourage alternative energy sources; reduce foreign dependence
• burden of tax may be shifted forward to consumers or backwards onto firm

Example:

• \$1 tax shifts supply curve upwards by \$1 (producers only supply same quantity when they receive same net price as before); quantity supplied before at price of \$0.90 is now supplied for \$1.90
• demand curve not affected by tax (no shift)
• new equilibrium price: higher (supply shift left); quantity: lower
• P rises from \$1 to \$1.90, Q declines 100-80billion gallons
• burden born mostly by consumer (pays 90cents of \$1 tax), oil companies less (10 cents).
• note: revenue of oil industry declines, though total revenue increases (inelastic demand)
• extra is tax revenue.

General rules for tax shifting (Ramsey tax rule)

• key issue in determining incidence is relative elasticities of supply and demand.
• tax shifted forward onto consumers if demand is inelastic relative to supply
• tax is shifted backward to producers if supply is relatively more inelastic than demand.
• price rises less, more of tax paid by oil comp (see graph, right)

Subsidy

• reverse of a tax: used to encourage (rather than discourage) production
• a payment made by government to firms to cover part of the cost of production
• shift down supply curve

Price Floors and Ceilings

• society may decide that prices set by market are too high for buyers or too low for sellers.
• government can set legal limit restricting how high or low price can go…
• examples: interest rates (usury laws), gasoline prices, medical costs, rent controls, minimum wages
• fundamental difference than taxing: where ultimately market and supply and demand still function, market still clears
• gum up market mechanism, remove rationing function of price, cause major economic distortions

Price Floors:
legal minimum price for a good, service or factor of production

• in general, create surplus by reducing quantity demanded and increasing quantity supplied
• remove equilibrating role of price as balance wheel…

Price Supports for Agriculture

• alternative way of dealing with low farm incomes
• price floor (say for corn) set above eq. price (graph to right)
• effect of price floor:
• quantity demanded now less than quantity supplied: persistent surplus…
• size of surplus depends on elasticity of demand, supply
• if demand is inelastic, aggregate farm income does increase…(graph)
• to cope with surplus, government must
• enhance demand (research new uses)
• restrict supply (crop restrictions, import tariffs),
• when surplus is bought, this becomes a subsidy, and farm revenue increases even more.

efficiency:
price floors are inefficient because they cause allocative inefficiency

• demand curve is downwardly sloping marginal benefit curve: represents how much consumers are willing to give up to get one more bushel of corn.
• supply curve is upwardly sloping marginal cost curve: represents how much consumers must give up to get one more bushel
• when market reaches equilibrium, where supply and demand intersect, what consumers are willing to give up just equals what they have to give up to get one more bushel – the efficient outcome
• when a price floor is imposed, and government buys the surplus, MC is greater than MB and over-allocation of resources to corn results…