Ch. 6 Questions and Exercises

Determine the price elasticity of demand if, in response to an increase in price of 10 percent, quantity demanded decreases by 20 percent. Is demand elastic or inelastic?

2; elastic

A firm has just increased its price by 5 percent over last year’s price, and it found that quantity sold remained the same.

a. What is its price elasticity of demand?

b. What additional information would you search for before you did your calculation?

a. 0

b. If other things (besides price) remained constant

When tolls on the Dulles Airport Greenway were reduced from $1.75 to $1.00, traffic increased from 10,000 to 26,000 trips a day. Assuming all changes in quantity were due to the change in price, what is the price elasticity of demand for the Dulles Airport Greenway?

1.49

One football season Domino’s Pizza, a corporate sponsor of the Washington Redskins (a football team), offered to reduce the price of its $8 medium-size pizza by $1 for every touchdown scored by the Redskins during the previous week. Until that year, the Redskins weren’t scoring many touchdowns. Much to the surprise of Domino’s, in one week in 1999, the Redskins scored six touchdowns. (Maybe they like pizza.) Domino’s pizzas were selling for $2 a pie! The quantity of pizzas demanded soared the following week from 1 pie an hour to 100 pies an hour. What was price elasticity of demand for Domino’s pizza?

1.63

Which has greater elasticity: a supply curve that goes through the origin with slope of 1 or a supply curve that goes through the origin with slope of 4?

They both have the same elasticity. Any supply curve that goes through the origin has an elasticity of 1.

Which of the pairs of goods would you expect to have a greater price elasticity of demand?

a. Cars, transportation

b. Housing, leisure travel

c. Rubber during World War II, rubber during the entire 20th century

a. Cars

b. Leisure travel

c. Rubber during the entire 20th century

Economists have estimated the following transportation elasticities. For each pair, explain possible reasons why the elasticities differ.

a. Elasticity of demand for buses is 0.23 during peak hours and 0.42 during off-peak hours.

b. Elasticity of demand for buses is 0.7 in the short run and 1.5 in the long run.

c. Elasticity of demand for toll roads is 4.7 for low-income commuters and 0.63 for high-income commuters.

a. Peak hour travelers are likely to be commuters who have little choice but to go to work and therefore have lower demand elasticity than those who ride buses during off-peak hours and are more likely using buses for errands or other more discretionary activities.

b. Demand tends to be less elastic in the short run because there are fewer substitutes. If fares rose enough, in the long run people could find alternative modes of transportation - purchase a car, find someone to share rides with, etc.

c. Tolls are likely a much smaller portion of high-income commuter’s total income, contributing to a less-elastic demand.

Kean University Professor Henry Saffer and Bentley University Professor Dave Dhaval estimated that if the alcohol industry increased the prices of alcoholic beverages by 100 percent underage drinking would fall by 28 percent and underage binge drinking would fall by 51 percent.

a. What is the elasticity of demand of underage drinking and binge drinking?

b. What might explain the difference in elasticities?

a. Price elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in price. The elasticity of demand for drinking is 0.28; the elasticity of binge drinking is 0.51.

b. Binge drinking is more elastic. One possible explanation is that binge drinking (drinking 5 or more drinks on one occasion) is a larger percent of one’s income and has a close substitute - drinking less. It is easier for students to decrease the amount they drink rather than to quit altogether.

A newspaper recently lowered its price from $5.00 to $3.00. As it did, the number of newspapers sold increased from 240,000 to 280,000.

a. What was the newspaper’s elasticity of demand?

b. Given that elasticity, did it make sense for the newspaper to lower its price?

c. What would your answer be if much of the firm’s revenue came from advertising and the higher the circulation, the more it could charge for advertising?

a. 0.31

b. Since the demand is inelastic, it doesn’t make sense to lower the price because it would reduce the total revenue

c. It would make sense to lower the price as long as the demand for advertising is elastic and the increased revenue more than compensates for the loss of revenue due to circulation

Once a book has been written, would an author facing an inelastic demand curve for the book prefer to raise or lower the book’s price? Why?

If the author is profit maximizing, he or she would prefer to raise the book’s price. Raising prices when the demand is inelastic increases revenue. Since the author’s cost is a sunk cost, profit also rises.

University of Richmond Professor Erik Craft analyzed the states’ pricing of vanity plates. He found that in California, where vanity plates cost an average of $28.75, the elasticity of demand was 0.52. In Massachusetts, where vanity plates cost $50, the elasticity of demand was 3.52.

a. Assuming vanity plates have zero production cost and his estimates are correct, was each state collecting the maximum revenue it could from vanity plates? Explain your reasoning.

b. What recommendation would you have for each state to maximize revenue?

c. If these estimates are correct, which state was most likely to be following a politically unsupportable policy?

a. Neither state is maximizing revenue. Maximum revenue is collected when elasticity is one. Both are collecting less than the maximum revenue. In California, elasticity is less than one and in Massachusetts, elasticity is greater than one.

b. You should recommend that Massachusetts lower its price and California raise its price.

c. Massachusetts, because not only is it not collecting maximum revenue, it is also charging a higher price than is optimal. It could simultaneously lower price and increase revenues, which would please both those who buy vanity plates and the treasury.

How is elasticity related to the revenue from a sales tax?

The more elastic the supply or demand is, the less revenue will come from a tax. With elastic supply and demand, increasing tax rates can decrease quantity supplied and quantity demanded enough to cause a decrease in tax revenue. With inelastic supply and demand, quantity changes little, which means that revenue from a tax is greater than it would be with an elastic supply or demand.

Suppose average movie ticket prices are $8.50 and attendance is 1.2 billion. The price of tickets rises to $9.50 and attendance rises to 1.4 billion.

a. What happened to total revenue?

b. If you were to estimate elasticity from these figures, what would your estimate be?

c. What provisos would you offer about your estimate of elasticity?

a. Total revenue rises from $10.2 billion to $13.3 billion.

b. Using the midpoint method of calculating elasticity, the price elasticity of demand equals percentage change in quantity demanded divided by the percentage change in price. Assuming other things are equal, this is an upward sloping demand curve, which is suspicious.

c. The major proviso is that this is an unexpected result and suggests that something has likely changed, such as income, marketing, etc. You are likely not estimating elasticity at all.

Which of the following producers would you expect to support a tax on beer? Which would not? Explain your answer.

a. Producers of hard liquor. Cross-price elasticity with beer: −0.11.

b. Producers of wine. Cross-price elasticity with beer: 0.23.

a. Liquid producers would not support a tax on beer because the cross-price elasticity between beer and hard liquor is negative (beer and liquor are complements). The beer tax would also reduce liquor consumption.

b. Wine producers would support a tax on beer because the cross-price elasticity between beer and wine is positive. The beer tax would increase wine consumption (beer and wine are substitutes).

For each of the following goods, state whether it is a normal good, a luxury, a necessity, or an inferior good. Explain your answers.

a. Vodka.

b. Table salt.

c. Furniture.

d. Perfume.

e. Beer.

f. Sugar

a. Normal and luxury (except in Russia). Individuals tend to drink more hard liquor as their income rises. (It depends on the type: Absolute vodka is more of a luxury than store brands.)

b. Normal and necessity. It is a small portion of people’s income, and its consumption doesn’t increase much with income.

c. Normal and luxury. Everyone needs some furniture, but as income goes up, people buy much more and much nicer furniture (elasticity is positive and greater than 1 in the short run).

d. Normal and luxury (depends on the type). The rich blow money on perfume; the rest of us get by with toilet water (a less concentrated form of perfume), or we smell a bit.

e. Normal. Income elasticity is positive but less than one.

f. Normal and necessity. It is not used significantly more by rich than by poor.

For each of the following pairs of goods, state whether the cross-price elasticity is likely positive, negative, or zero. Explain your answers.

a. Lettuce, carrots.

b. Housing, furniture.

c. Nike sneakers, Puma sneakers.

d. Jeans, formal suits.

a. It depends. They are complements to the extent that one puts carrots in salads. They are substitutes to the extent that a person wants a vegetable and is choosing between the two.

b. Negative. They are complements.

c. Positive. They are close substitutes.

d. Close to zero. They are at best distant substitutes, otherwise unrelated.

When the price of ketchup rises by 18 percent, the demand for hot dogs falls by 2 percent.

a. Calculate the cross-price elasticity of demand.

b. Are the goods complements or substitutes?

a. -0.11

b. Complements, because the cross-price elasticity of demand is negative

Calculate the income elasticities of demand for the following:

a. Income rises by 20 percent; demand rises by 10 percent.

b. Income rises from $30,000 to $40,000; demand increases (at a constant price) from 17 to 20.

a. 0.50

b. 0.57

Would you expect a shift in supply to have a greater effect on equilibrium quantity in the short run or in the long run? Explain your answer.

In the short-run, there tend to be fewer substitutes, so demand is fairly inelastic. In the long-run, there are more substitutes, so demand is more elastic. Therefore, there is a greater effect on equilibrium quantity in the long run.

Would a shift in demand have a greater effect on the percentage change in equilibrium quantity for a straight-line supply curve that intersects the quantity axis or the price axis?

If supply interests the price axis, it will be elastic. If the supply curve intersects the quantity axis, it will be inelastic. This means that a shift in demand would have a greater effect on the change in equilibrium quantity on the supply curve that intersects with the price axis.

For each of the following assume that the supply curve shifts while the demand curve remains constant. What is the direction of the supply shift and relative elasticity of demand?

a. Price remains nearly constant. Quantity increases enormously.

b. Price falls enormously. Quantity does not change.

c. Price rises slightly. Quantity remains nearly constant

a. The supply curve shifts to the right, causing the equilibrium price to increase. Since the price remains nearly constant and quantity changes enormously, the demand curve is very elastic.

b. The supply curve shifts to the right, causing the equilibrium price to fall. Since equilibrium quantity did not change, demand is perfectly inelastic.

c. The supply curve shifts to the left, causing the equilibrium price to rise. Since equilibrium quantity changes very little, demand is inelastic.