Problems
1.In each of the following situations, describe the substitution effect and, if it is significant, the income effect. In which direction does each of these effects move? Why?
- a. Ed spends a large portion of his income on his children’s education. Because tuition fees rise, one of his children has to withdraw from college.
- b. Homer spends much of his monthly income on home mortgage payments. The interest on his adjustable rate mortgage falls, lowering his mortgage payments, and Homer decides to move to a larger house.
- c. Pam thinks that Spam is an inferior good. Yet as the price of Spam rises, she decides to buy less of it.
2.Nile.com, the online bookseller, wants to increase its total revenue. One strategy is to offer a 10% discount on every book it sells. Nile.com knows that its customers can be divided into two distinct groups according to their likely responses to the discount. The accompanying table shows how the two groups respond to the discount.
| Group A (sales per week) | Group B (sales per week) | |
|---|---|---|
| Volume of sales before the 10% discount | 1.55 million | 1.50 million |
| Volume of sales after the 10% discount | 1.65 million | 1.70 million |
- a. Using the midpoint method, calculate the price elasticities of demand for group A and group B.
- b. Explain how the discount will affect total revenue from each group.
- c. Suppose Nile.com knows which group each customer belongs to when he or she logs on and can choose whether or not to offer the 10% discount. If Nile.com wants to increase its total revenue, should discounts be offered to group A or to group B, to neither group, or to both groups?
3.Do you think the price elasticity of demand for Ford sport-
- a. Other car manufacturers, such as General Motors, decide to make and sell SUVs.
- b. SUVs produced in foreign countries are banned from the American market.
- c. Due to ad campaigns, Americans believe that SUVs are much safer than ordinary passenger cars.
- d. The time period over which you measure the elasticity lengthens. During that longer time, new models such as four-
wheel- drive cargo vans appear.
4.In the United States, 2007 was a bad year for growing wheat. And as wheat supply decreased, the price of wheat rose dramatically, leading to a lower quantity demanded (a movement along the demand curve). The accompanying table describes what happened to prices and the quantity of wheat demanded.
| 2006 | 2007 | |
|---|---|---|
| Quantity demanded (bushels) | 2.2 billion | 2.0 billion |
| Average price (per bushel) | $3.42 | $4.26 |
- a. Using the midpoint method, calculate the price elasticity of demand for winter wheat.
- b. What is the total revenue for U.S. wheat farmers in 2006 and 2007?
- c. Did the bad harvest increase or decrease the total revenue of U.S. wheat farmers? How could you have predicted this from your answer to part a?
5.What can you conclude about the price elasticity of demand in each of the following statements?
- a. “The pizza delivery business in this town is very competitive. I’d lose half my customers if I raised the price by as little as 10%.”
- b. “I owned both of the two Jerry Garcia autographed lithographs in existence. I sold one on eBay for a high price. But when I sold the second one, the price dropped by 80%.”
- c. “My economics professor has chosen to use the Krugman/Wells textbook for this class. I have no choice but to buy this book.”
- d. “I always spend a total of exactly $10 per week on coffee.”
6.The accompanying table gives part of the supply schedule for personal computers in the United States.
| Price per computer | Quantity of computers supplied |
|---|---|
| $1,100 | 12,000 |
| 900 | 8,000 |
- a. Using the midpoint method, calculate the price elasticity of supply when the price increases from $900 to $1,100.
- b. Suppose firms produce 1,000 more computers at any given price due to improved technology. As price increases from $900 to $1,100, is the price elasticity of supply now greater than, less than, or the same as it was in part a?
- c. Suppose a longer time period under consideration means that the quantity supplied at any given price is 20% higher than the figures given in the table. As price increases from $900 to $1,100, is the price elasticity of supply now greater than, less than, or the same as it was in part a?
7.The accompanying table lists the cross-
| Good | Cross- |
|---|---|
| Air- |
−0.34 |
| Coke and Pepsi | +0.63 |
| High- |
−0.28 |
| McDonald’s burgers and Burger King burgers | +0.82 |
| Butter and margarine | +1.54 |
- a. Explain the sign of each of the cross-
price elasticities. What does it imply about the relationship between the two goods in question? - b. Compare the absolute values of the cross-
price elasticities and explain their magnitudes. For example, why is the cross- price elasticity of McDonald’s burgers and Burger King burgers less than the cross- price elasticity of butter and margarine? - c. Use the information in the table to calculate how a 5% increase in the price of Pepsi affects the quantity of Coke demanded.
- d. Use the information in the table to calculate how a 10% decrease in the price of gasoline affects the quantity of SUVs demanded.
8.The accompanying table shows the price and yearly quantity sold of souvenir T-
| Price of T- |
Quantity of T- |
Quantity of T- |
|---|---|---|
| $4 | 3,000 | 5,000 |
| 5 | 2,400 | 4,200 |
| 6 | 1,600 | 3,000 |
| 7 | 800 | 1,800 |
- a. Using the midpoint method, calculate the price elasticity of demand when the price of a T-
shirt rises from $5 to $6 and the average tourist income is $20,000. Also calculate it when the average tourist income is $30,000. - b. Using the midpoint method, calculate the income elasticity of demand when the price of a T-
shirt is $4 and the average tourist income increases from $20,000 to $30,000. Also calculate it when the price is $7.
9.In each of the following cases, do you think the price elasticity of supply is (i) perfectly elastic; (ii) perfectly inelastic; (iii) elastic, but not perfectly elastic; or (iv) inelastic, but not perfectly inelastic? Explain using a diagram.
- a. An increase in demand this summer for luxury cruises leads to a huge jump in the sales price of a cabin on the Queen Mary 2.
- b. The price of a kilowatt of electricity is the same during periods of high electricity demand as during periods of low electricity demand.
- c. Fewer people want to fly during February than during any other month. The airlines cancel about 10% of their flights as ticket prices fall about 20% during this month.
- d. Owners of vacation homes in Maine rent them out during the summer. Due to a soft economy, a 30% decline in the price of a vacation rental leads more than half of homeowners to occupy their vacation homes themselves during the summer.
10.There is a debate about whether sterile hypodermic needles should be passed out free of charge in cities with high drug use. Proponents argue that doing so will reduce the incidence of diseases, such as HIV/AIDS, that are often spread by needle sharing among drug users. Opponents believe that doing so will encourage more drug use by reducing the risks of this behavior. As an economist asked to assess the policy, you must know the following: (i) how responsive the spread of diseases like HIV/AIDS is to the price of sterile needles and (ii) how responsive drug use is to the price of sterile needles. Assuming that you know these two things, use the concepts of price elasticity of demand for sterile needles and the cross-
- a. In what circumstances do you believe this is a beneficial policy?
- b. In what circumstances do you believe this is a bad policy?
11.Worldwide, the average coffee grower has increased the amount of acreage under cultivation over the past few years. The result has been that the average coffee plantation produces significantly more coffee than it did 10 to 20 years ago. Unfortunately for the growers, however, this has also been a period in which their total revenues have plunged. In terms of an elasticity, what must be true for these events to have occurred? Illustrate these events with a diagram, indicating the quantity effect and the price effect that gave rise to these events.
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