CHAPTER 20 by 4A85cp

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									CHAPTER 20
Supply and Demand: Elasticities and
Government-set Prices


A. Short-Answer, Essays, and Problems

New 1. The president of a toy company asks you for advice about whether the company should
       cut the price of its best-selling doll this year based on the following information: last
       year the company cut the price of its best-selling doll by 10% and the total revenues
       from doll sales increased by 10%.


New 2. The owner of a health club asks you for advice about whether the company should raise
       the price of its membership this year based on the following information: last year the
       club raised the price of its membership by 5% and the number of members paying the
       same fee fell by 7%.


       3. The Metropolitan Transit System recently announced a 50% increase in the price of a
          transit ticket. The administrators said that they needed an increase in revenue to cover
          their rising costs. Explain the economic rationale for this decision.


       4. Ford Motor Company announced a major rebate program for its cars and trucks. The
          rebate program amounts to a simple reduction in price. The company executives hope
          to increase revenue as a result of this rebate program. What economic explanation
          would justify this decision?


       5. A gasoline station very near a professional football stadium parks cars on its lot to make
          money on game days. Last year it charged $4.00 per car and parked 1,000 cars. This
          year it raised the parking price to $5.00 and parked 850 cars. Did the station owner
          make a good economic decision in raising the parking prices from one year to the next?
          Explain.


       6. The president of the Micro Brewing Corporation asks you, as the company economist,
          to forecast changes in consumer beer purchases associated with a proposed price
          change. You conduct a survey and find that if the price of a six-pack increases from
          $5.50 to $7.50, the quantity demanded will decrease from 2,200 units to 1,800 units a
          month. Should the Micro Brewing Corporation raise its price? Explain the economic
          basis for this recommendation to the president.


       7. The following data shows the relationship between price and quantity demanded at four
          different prices for a product:

                  P = $11, Qd = 16
                  P = $9, Qd = 24
                  P = $7, Qd = 32
                  P = $5, Qd = 40




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    Using the midpoints formula, what is the price elasticity of demand between: (a) $11
    and $9; (b) $9 and $7; (c) $7 and $5?


 8. On the below demand curve, indicate the character of the price elasticity of demand
    across all prices.




 9. The following is a straight-line demand curve that confronts a single firm.

                     Quantity
          Price     demanded         (3)           (4)
           $6           1           _____        _____
            5           2           _____        _____
            4           3           _____        _____
            3           4           _____        _____
            2           5           _____        _____
            1           6           _____        _____

    (a) In column 3, compute total revenue. In column 4, compute the coefficient for the
    price elasticity of demand at each price using the midpoints formula.

    (b) Describe the character of elasticity across the prices based on the total revenue test
    and the elasticity coefficient.

    (c) Does a straight-line demand curve have constant elasticity?

    (d) Of what practical significance is your answer to (c)?


10. Using the demand data given, complete the following table by computing total revenue
    at each of the prices. Indicate whether demand is elastic, inelastic, or unitary between
    each set of prices.




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Supply and Demand: Elasticities and Government-set Prices


                            Quantity       Total         Character
                  Price    demanded       revenue        of demand
                 $1,000        300       $_______        _________
                    900        400        _______        _________
                    800        500        _______        _________
                    700        600        _______        _________
                    600        700        _______        _________
                    500        800        _______        _________
                    400        900        _______        _________
                    300      1,000        _______        _________
                    200      1,100        _______        _________
                    100      1,200        _______        _________


     11. Use the data from the table in the previous question and the two graphs below for this
         problem. On the first graph: (a) plot the demand curve; and (b) indicate the elastic,
         unitary, and inelastic portions of the demand curve. On the second graph: (a) plot the
         total revenue on the vertical axis and the quantity demanded on the horizontal axis; (b)
         indicate the elastic, unitary, and inelastic portions of the demand and total revenue
         curves. (Note: The scale for quantity demanded that you plot on horizontal axis of each
         graph should be the same on both graphs.)




     12. Based on the determinants of elasticity as discussed in the text, explain what the price
         elasticity of demand of the following products would be: (a) ballpoint pens; (b) Crest
         toothpaste; (c) diamond rings; (d) sugar; and (e) refrigerators.


     13. Explain how each of four different factors can affect the price elasticity of demand.
         Give an example for each determinant.


     14. Federal and state governments often seek to raise tax revenue by levying excise or sales
         taxes on specific products. What economic factors should be considered in determining
         the products that will raise the most tax revenue? Give examples of products in your
         answer.


     15. Explain the perspective that tougher enforcement of drug laws for cocaine or other drug
         laws may actually increase the crime rate. Use the concepts of demand, supply, and
         elasticity in your explanation.




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     16. Discuss the pros and cons of legalizing drugs such as heroin or cocaine from an
         economic perspective using the concepts of supply, demand, and elasticity.


     17. Why is there no total revenue test for elasticity of supply?


New 18. What is the main determinant of the price elasticity of supply? Explain.


New 19. Describe and give reasons for the characteristics of the elasticity of supply of a farm
        product that is sold at a farmer’s market on a particular day.


     20. Draw three supply and demand graphs that illustrate the effect of time on the elasticity
         of supply using the below graphs. The three graphs should show: (a) the market period;
         (b) the short run; and (c) the long run.




     21. Using the supply data in the schedule shown below, complete the table by computing
         the price elasticity of supply coefficients between each set of prices. Indicate whether
         supply is elastic, inelastic or unitary at each set of prices.

                         Quantity          Elasticity       Character
              Price      supplied         coefficient        of supply
              $11          130            _________         _________
                9          110            _________         _________
                7           90            _________         _________
                5           70            _________         _________
                3           50            _________         _________


     22. Why would it be valuable for a business to know the cross elasticity of demand for the
         two products it produces: peanuts and popcorn?


     23. Use the information in the table below to identify the type of cross elasticity relationship
         between products X and Y in each of the following five cases, A to E.




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Supply and Demand: Elasticities and Government-set Prices


                                            Percent change
                        Percent change        in quantity             Cross elasticity
             Cases       in price of Y      demanded of X                  type
              A                 5                  7                 ______________
              B                 9                  6                 ______________
              C                 5                 –5                 ______________
              D                 3                  0                 ______________
              E               –2                  10                 ______________


     24. For the following three cases, use a midpoints formula to calculate the coefficient for the
         cross elasticity of demand and identify the type of relationship between the two
         products.

          (a) The quantity demanded for product A increases from 30 to 40 as the price of
          product B increases from $0.10 to $0.20.

              Coefficient: ______         Relationship: ________________

          (b) The quantity demanded for product A decreases from 3000 to 1500 as
          the price of good B increases from $5 to $10.

              Coefficient: ______         Relationship: ________________

          (c) The quantity demanded for product A remains 400 units as the price of product B
          increases from $25 to $30.

              Coefficient: ______         Relationship: ________________


     25. Use the information in the table below to identify the income elasticity type of each of
         the following products, A to E.
                                              Percent change           Income
                        Percent change          in quantity           elasticity
             Product       in income             demanded                type
                 A               9                   12              __________
                 B             –6                     6              __________
                 C               3                    3              __________
                 D               6                   –3              __________
                 E               2                    1              __________


New 26. You would think that if people’s income increased over time, then all industries in the
        economy should benefit equally, but this is not the case. Explain why and give
        examples.


     27. What is the practical significance of income elasticity coefficients? Explain the
         significance using as examples an income elasticity of 3.5 for computers and an income
         elasticity of 0.20 for ice cream.


New 28. What is a price ceiling and what are its economic effects?




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New 29. Use data in the following table to explain the economic effects of a price ceiling at $6, at
        $5, and at $4.
                                    Quantity          Quantity
                       Price       demanded           supplied
                        $7           4,500              4,500
                         6           5,000              3,500
                         5           5,500              2,500
                         4           6,000              1,500


New 30. What is a price floor and what are its economic effects?


New 31. Use data in the following table to explain the economic effects of a price floor at $8, at
        $9, and at $10. Explain the economic effects.

                                      Quantity         Quantity
                        Price        demanded          supplied
                        $10            3,000            7,500
                          9            3,500            6,500
                          8            4,000            5,500
                          7            4,500            4,500


     32. “Government-set prices undermine the rationing function of competitive prices.”
         Explain carefully in terms of both price ceilings and price floors.


New 33. (Last Word) Use economic analysis to explain why tenants in New York City who are
        covered by rent-controlled laws do not want to move even when they are offered a large
        buyout.




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Supply and Demand: Elasticities and Government-set Prices


B. Answers to Short-Answer, Essays, and Problems

New 1. The president of a toy company asks you for advice about whether the company should
       cut the price of its best-selling doll this year based on the following information: last
       year the company cut the price of its best-selling doll by 10% and the total revenues
       from doll sales increased by 10%.

          The total revenue test indicates that the price elasticity of demand for the doll in last
          year’s price range was unit elastic, or 1. If the firm cuts the doll’s price this year, then it
          will most likely put the price of the doll in the inelastic range of demand, and thus a
          percentage change in price will lead to a greater percentage change in quantity in this
          range, causing total revenues to fall. You should advise the president not to cut the price
          because the firm is maximizing its total revenue. [text: E pp. 377-380; MI pp. 119-122]

New 2. The owner of a health club asks you for advice about whether the company should raise
       or lower the price of its membership this year based on the following information: last
       year the club raised the price of its membership by 5% and the number of members
       paying the same fee fell by 7%.

          The formula for the price elasticity of demand indicates the demand for memberships is
          price elastic or 1.4 in this case (7 divided by 5). This result suggests that total revenues
          for the club should have decreased last year. Another increase in price this year would
          only decrease total revenues. You should advise the owner to lower membership prices
          because it should increase total revenue given that the membership price is in the elastic
          range. [text: E pp. 377-380; MI pp. 119-122]

       3. The Metropolitan Transit System recently announced a 50% increase in the price of a
          transit ticket. The administrators said that they needed an increase in revenue to cover
          their rising costs. Explain the economic rationale for this decision.

          The objective of the administrators is to increase revenue to cover rising costs. If they
          increase the price of a transit ticket to increase revenue, then the administrators must
          believe that the demand for transit services is inelastic in this price range. [text: E pp.
          404-410; MI pp. 146-152]

       4. Ford Motor Company announced a major rebate program for its cars and trucks. The
          rebate program amounts to a simple reduction in price. The company executives hope
          to increase revenue as a result of this rebate program. What economic explanation
          would justify this decision?

          The company executives believe that the price decrease will increase total revenue. In
          this case, the executives must think that demand is elastic in this price range. When
          demand is elastic, a cut in price will increase total revenue. [text: E pp. 378-380; MI pp.
          120-122]

       5. A gasoline station very near a professional football stadium parks cars on its lot to make
          money on game days. Last year it charged $4.00 per car and parked 1,000 cars. This
          year it raised the parking price to $5.00 and parked 850 cars. Did the station owner
          make a good economic decision in raising the parking prices from one year to the next?
          Explain.

          The owner made a good decision in raising price. The total revenue test indicates that
          total revenue increased with the increase in price. The $4.00 price times 1,000 cars
          produced $4,000 in revenue, but the $5.00 price times the 850 cars produced $4,250 in
          revenue, for a gain of $250. These results indicate that demand for parking is inelastic



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   in this price range. The midpoints formula also shows that demand is inelastic in the
   price range because the coefficient is 0.73. [text: E pp. 376-380; MI pp. 118-122]

6. The president of the Micro Brewing Corporation asks you, as the company economist,
   to forecast changes in consumer beer purchases associated with a proposed price
   change. You conduct a survey and find that if the price of a six-pack increases from
   $5.50 to $7.50, the quantity demanded will decrease from 2,200 units to 1,800 units a
   month. Should the Micro Brewing Corporation raise its price? Explain the economic
   basis for this recommendation to the president.

   Yes, the corporation should increase the price of a six-pack. Over the price range
   considered, the price elasticity of demand coefficient is 0.65, or inelastic, using the
   midpoints formula. An increase in price when demand is inelastic will increase total
   revenue. This increase in total revenue also can be shown by multiplication. With a
   price of $5.50 times a quantity of 2,200 per month, the total revenue was $12,100. With
   the higher price of $7.50 times a lower quantity of 1,800, the total revenue is $13,500.
   Thus, there is a gain of $1,400 in total revenue from raising the price. [text: E pp. 376-
   380; MI pp. 118-122]

7. The following data shows the relationship between price and quantity demanded at four
   different prices for a product:

           P = $11, Qd = 16
           P = $9, Qd = 24
           P = $7, Qd = 32
           P = $5, Qd = 40

   Using the midpoints formula, what is the price elasticity of demand between: (a) $11
   and $9; (b) $9 and $7; (c) $7 and $5?

   (a) 2.0; (b) 1.2; (c) 0.67 [text: E pp. 376-377; MI pp. 118-119]

8. On the below demand curve, indicate the character of the price elasticity of demand
   across all prices.




   [text: E pp. 377-378; MI pp. 119-120]




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Supply and Demand: Elasticities and Government-set Prices


      9. The following is a straight-line demand curve that confronts a single firm.

                          Quantity
               Price     demanded         (3)            (4)
                $6           1           _____         _____
                 5           2           _____         _____
                 4           3           _____         _____
                 3           4           _____         _____
                 2           5           _____         _____
                 1           6           _____         _____

         (a) In column 3, compute total revenue. In column 4, compute the coefficient for the
         price elasticity of demand at each price using the midpoints formula.

         (b) Describe the character of elasticity across the prices based on the total revenue test
         and the elasticity coefficient.

         (c) Does a straight-line demand curve have constant elasticity?

         (d) Of what practical significance is your answer to (c)?

                          Quantity
               Price     demanded          (3)          (4)
                $6           1             $6
                                                        3.7
                  5            2           10
                                                        1.8
                  4            3           12
                                                        1.0
                  3            4           12
                                                        0.6
                  2            5           10
                                                        0.3
                  1            6             6

         (a) See the above table for the answers.
         (b) Total revenue declines when price drops from $3 to $2, and the elasticity coefficient
         also becomes less than 1 at that price change. Demand is elastic in the range of prices
         between $6 and $4, and inelastic below $3. A drop in price from $4 to $3 illustrates
         unitary elasticity.
         (c) The clear answer is “no” based on the answers in the table. Although the slope of a
         linear demand curve is, by definition, constant, elasticity varies because it measures
         percentage changes.
         (d) The significance is twofold. (1) One cannot tell elasticity by looking at a demand
         curve because the elasticity changes over the range of the curve. (2) The elasticity of
         demand for any product will depend on the level of its initial price and quantity, not just
         on the change in price. Therefore, the demand for a product may be very elastic in one
         price range (generally the higher price ranges) and very inelastic in another (lower) price
         range. [text: E pp. 376-380; MI pp. 118-122]

     10. Using the demand data given, complete the following table by computing total revenue
         at each of the prices. Indicate whether demand is elastic, inelastic, or unitary between
         each set of prices.




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                       Quantity       Total         Character
             Price    demanded       revenue        of demand
            $1,000        300       $_______        _________
               900        400        _______        _________
               800        500        _______        _________
               700        600        _______        _________
               600        700        _______        _________
               500        800        _______        _________
               400        900        _______        _________
               300      1,000        _______        _________
               200      1,100        _______        _________
               100      1,200        _______        _________


                       Quantity         Total       Character
             Price    demanded        revenue       of demand
            $1,000        300        $300,000           elastic
               900        400          360,000          elastic
               800        500          400,000          elastic
               700        600          420,000         unitary
               600        700          420,000        inelastic
               500        800          400,000        inelastic
               400        900          360,000        inelastic
               300      1,000          300,000        inelastic
               200      1,100          220,000        inelastic
               100      1,200          120,000

    [text: E pp. 378-380; MI pp. 378-380]

11. Use the data from the table in the previous question and the two graphs below for this
    problem. On the first graph: (a) plot the demand curve; and (b) indicate the elastic,
    unitary, and inelastic portions of the demand curve. On the second graph: (a) plot the
    total revenue on the vertical axis and the quantity demanded on the horizontal axis; (b)
    indicate the elastic, unitary, and inelastic portions of the demand and total revenue
    curves. (Note: The scale for quantity demanded that you plot on horizontal axis of each
    graph should be the same on both graphs.)




    [text: E pp. 378-380; MI pp. 120-122]

12. Based on the determinants of elasticity as discussed in the text, explain what the price
    elasticity of demand of the following products would be: (a) ballpoint pens; (b) Crest
    toothpaste; (c) diamond rings; (d) sugar; and (e) refrigerators.




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Supply and Demand: Elasticities and Government-set Prices


         (a) Ballpoint pens: Demand should be slightly elastic because there are substitutes, and
         they are not a complete necessity. However, they are not very durable and the price is
         small relative to most incomes, and the substitutes are not quite the same so the
         elasticity will not be high.
         (b) Crest toothpaste: Demand should be very elastic because there are very many other
         brand-name substitutes, and this brand is not a necessity.
         (c) Diamond rings: Demand should be elastic because there are other types of rings, the
         price is high relative to most incomes, they are durable, and they are a luxury item.
         (d) Sugar: Demand should be inelastic because there are few close substitutes, the price
         is small relative to most incomes, it is not a durable good, and not usually viewed as a
         luxury.
         (e) Refrigerators: Demand is probably somewhat elastic because the price is large
         relative to most incomes and they are durable so an old refrigerator can last until “the
         price is right.” However, refrigerators are not luxuries and there are no good substitutes,
         so the demand is probably not very elastic with respect to price. [text: E pp. 380-381;
         MI pp. 380-381]

     13. Explain how each of four different factors can affect the price elasticity of demand.
         Give an example for each determinant.

         First, the price elasticity of demand can be affected by the number of substitutes. In
         general, the larger the number of substitutes for a product, the greater will be the
         elasticity of demand. The price elasticity of demand for beef tends to be relatively high
         because there are many possible substitute sources of protein (e.g., chicken, turkey, or
         fish). Second, elasticity is also affected by the proportion of income spent on a product.
         Other things equal, the higher the price of a product relative to people’s incomes (and
         budgets), the greater the product’s elasticity of demand. Sugar has a relatively low price
         elasticity of demand because the cost of sugar is a minor part of a consumer’s budget.
         By contrast, the price elasticity of demand for computers and other consumer appliances
         such as washing machines is relatively high because they require a large outlay from a
         consumer’s budget. Third, luxuries will tend to be price-elastic while necessities are
         price-inelastic. Bread will have a low price elasticity of demand coefficient relative to
         that for a luxury auto. Fourth, time will influence the elasticity of demand. The greater
         the amount of time considered, the greater the elasticity of demand. In the short-run the
         demand for travel to a warm location during the winter will be less price-elastic than the
         demand for travel to a warm location at other times of the year. [text: E pp. 380-381;
         MI pp. 122-123]

     14. Federal and state governments often seek to raise tax revenue by levying excise or sales
         taxes on specific products. What economic factors should be considered in determining
         the products that will raise the most tax revenue? Give examples of products in your
         answer.

         Government officials should consider taxing products for which the price elasticity of
         demand is inelastic. Liquor, gasoline, and cigarettes are examples of goods with
         inelastic demand on which tax increases are imposed to raise tax revenue. When a
         product has an inelastic demand, an increase in taxes will increase total spending on the
         product and hence the revenue collected by government. There will be a negative effect
         on the quantity consumed, and thus employment in the industry, but the employment
         effects will be less harmful than if the product taxed was elastic. Taxing a product for
         which the demand is relatively elastic is likely to reduce tax revenue from the product
         and reduce significantly employment in the industry. Such a situation arose in 1991
         when the U.S. Congress imposed a luxury tax on yachts costing more than $100,000.
         Congress thought that the demand for yachts was relatively inelastic, but it proved to be
         more elastic than originally thought. Employment in the boating industry fell



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          significantly and the tax produced minimal revenue for government. [text: E p. 382; MI
          p. 124]

     15. Explain the perspective that tougher enforcement of drug laws for cocaine or other drug
         laws may actually increase the crime rate. Use the concepts of demand, supply, and
         elasticity in your explanation.

          Tougher enforcement of drug laws reduces the supply of cocaine and other illegal drugs,
          thus driving up the street price. The demand for cocaine and other drugs, however,
          appears to be highly inelastic. The increased price will increase total revenues and
          profits for sellers, but at the same time it will increase total spending by drug users. To
          support this increased spending, drug users are likely to commit more crimes. Thus, the
          increased enforcement of drug laws may have the secondary effect of increasing money-
          producing crimes such as robbery, burglary, shoplifting, and fraud. [text: E p. 382; MI
          p. 124]

     16. Discuss the pros and cons of legalizing drugs such as heroin or cocaine from an
         economic perspective using the concepts of supply, demand, and elasticity.

          The pro side for legalization looks at the price elasticity of demand for heroin and
          cocaine. This demand is price-inelastic which means that if the price of these drugs was
          reduced, there would be less spent on them by users. Legalization of these drugs will
          tend to increase the supply and reduce the price. The reduced price will reduce the total
          expenditures on these drugs. Fewer users will have to resort to crime to pay for the
          drugs and there would be less need for law-enforcement resources used for the “war on
          drugs.”

          The opponents of legalization suggest that there are two types of consumers of illegal
          drugs — addicts and occasional users. The demand from addicts is price-inelastic as
          discussed above. The demand by the occasional users, however, is more price-elastic.
          As price falls, this type of user will spend more on these drugs. This additional
          consumption in turn may cause some of the occasional users to become addicts. The
          greater social acceptability for the use of such drugs may also increase the demand for
          these drugs, which would increase consumption, stimulate more addiction, and increase
          crime in the long run. The additional social cost from these developments would be
          much greater than any benefit from simple reduction of expenditures by addicts and
          short-term reduction in law-enforcement costs. [text: E p. 382; MI p. 124]

     17. Why is there no total revenue test for elasticity of supply?

          The simple answer is a semantic one, a firm’s supply curve is based on costs of
          production, so we would have to use a “total costs” test. Also, according to the “law of
          supply,” price and quantity are directly related, so a rise in price would always raise
          potential total revenue and a fall in price would always decrease potential total revenue,
          so the total revenue test would not be meaningful. [text: E p. 383; MI p. 125]

New 18. What is the main determinant of the price elasticity of supply? Explain.

          The amount of time that producers have to respond to a change in price is the main
          determinant. The longer the time, the easier it is for producers to shift resources into
          production and increase the quantity supplied. The more time the firm has to adjust to a
          change in price, the greater the elasticity of supply. [text: E p. 383; MI p. 125]

New 19. Describe and give reasons for the characteristics of the elasticity of supply of a farm
        product that is sold at a farmer’s market on a particular day.




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Supply and Demand: Elasticities and Government-set Prices


         The supply is probably perfectly inelastic in this case indicating that a change in price
         will not bring forth more quantity supplied. The farmer has a specific quantity of the
         product available for sale that day. Even if the price increases, the farmer cannot
         increase the quantity he or she want to sell because the market period is too short of time
         for a change to be made to production. [text: E pp. 383-384; MI pp. 125-126]

     20. Draw three supply and demand graphs that illustrate the effect of time on the elasticity
         of supply using the below graphs. The three graphs should show: (a) the immediate
         market period; (b) the short run; and (c) the long run.




         [text: E pp. 383-384; MI pp. 125-126]

     21. Using the supply data in the schedule shown below, complete the table by computing
         the price elasticity of supply coefficients between each set of prices. Indicate whether
         supply is elastic, inelastic or unitary at each set of prices.

                         Quantity         Elasticity       Character
             Price       supplied        coefficient        of supply
             $11           130           _________         _________
               9           110           _________         _________
               7            90           _________         _________
               5            70           _________         _________
               3            50           _________         _________


                         Quantity        Elasticity        Character
             Price       supplied        coefficient       of supply
             $11           130              0.83            inelastic
               9           110              0.80            inelastic
               7            90              0.76            inelastic
               5            70              0.66            inelastic
               3            50

         [text: E pp. 383-384; MI pp. 125-126]

     22. Why would it be valuable for a business to know the cross elasticity of demand for the
         two products it produces: peanuts and popcorn?

         The cross price elasticity of demand shows the responsiveness of the quantity demanded
         for one product to a change in the price of another product. The business can use this
         concept to determine whether there is a substitute, complementary, or independent
         relationship between peanuts and popcorn. If peanuts and popcorn are substitutes, a rise
         in the price of peanuts will cause an increase in the quantity demanded for popcorn (the
         cross elasticity will be positive). On the other hand, if peanuts and popcorn are



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    complementary goods, a rise in the price of peanuts will decrease the quantity demanded
    for popcorn (the cross elasticity will be negative). The business will want to know the
    nature of the relationship between the two products and how responsive the quantity
    demanded for one product is to a change in the price of the other before a price is
    changed. This cross elasticity information will be useful for increasing total revenue
    and profits. [text: E p. 385; MI p. 127]

23. Use the information in the table below to identify the type of cross elasticity relationship
    between products X and Y in each of the following five cases, A to E.

                                        Percent change
                   Percent change         in quantity            Cross elasticity
        Cases       in price of Y       demanded of X                 type
         A                 5                   7                ______________
         B                 9                   6                ______________
         C                 5                  –5                ______________
         D                 3                   0                ______________
         E               –2                   10                ______________


                                        Percent change
                   Percent change         in quantity           Cross elasticity
        Cases       in price of Y       demanded of X                 type
         A                 5                   7                    substitute
         B                 9                   6                    substitute
         C                 5                  –5                 complement
         D                 3                   0                 independent
         E               –2                   10                 complement

    [text: E p. 385; MI p. 127]

24. For the following three cases, use a midpoints formula to calculate the coefficient for the
    cross elasticity of demand and identify the type of relationship between the two
    products.

    (a) The quantity demanded for product A increases from 30 to 40 as the price of
    product B increases from $0.10 to $0.20.

        Coefficient: ______           Relationship: ________________

    (b) The quantity demanded for product A decreases from 3000 to 1500 as
    the price of good B increases from $5 to $10.

        Coefficient: ______           Relationship: ________________

    (c) The quantity demanded for product A remains 400 units as the price of product B
    increases from $25 to $30.

        Coefficient: ______           Relationship: ________________

    (a) Coefficient: 0.71 Relationship: substitutes
    (b) Coefficient: –1.00 Relationship: complements
    (c) Coefficient: 0.00 Relationship: independent
    [text: E p. 385; MI p. 127]




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     25. Use the information in the table below to identify the income elasticity type of each of
         the following products, A to E.
                                              Percent change           Income
                        Percent change          in quantity           elasticity
             Product       in income             demanded                type
                 A               9                   12              __________
                 B             –6                     6              __________
                 C               3                    3              __________
                 D               6                   –3              __________
                 E               2                    1              __________


                                               Percent change           Income
                         Percent change          in quantity           elasticity
             Product       in income             demanded                 type
                A               9                    12                  normal
                B              –6                     6                 inferior
                C               3                     3                  normal
                D               6                    –3                 inferior
                E               2                     1                  normal

          [text: E pp. 385-386; MI pp. 127-128]

New 26. You would think that if people’s income increased over time, then all industries in the
        economy should benefit equally, but this is not the case. Explain why and give
        examples.

          The explanation is based on the income elasticity of demand. Those industries in the
          economy for which the demand is income elastic (auto, housing, and restaurants) have
          experienced stronger growth other the years because the percentage change in quantity
          demanded is greater than the percentage change in income for these normal goods.
          Other industries such as agriculture have experienced slower growth in output because
          the demand for the products produced for most agricultural goods is income inelastic.
          In this case, the percentage change in quantity demanded is less than the percentage
          change in income. [text: E pp. 384-386; MI p. 126-128]

     27. What is the practical significance of income elasticity coefficients? Explain the
         significance using as examples an income elasticity of 3.5 for computers and an income
         elasticity of 0.20 for ice cream.

          The income elasticity of demand roughly indicates which industries are likely to be
          expanding and prosperous and what industries are likely to be declining. The elasticity
          coefficient of 3.5 for the computer industry indicates that each 1% increase in income
          leads to a 3.5% increase in the quantity demanded for computers. This relationship
          bodes well for the long-term prosperity in the computer industry. Conversely, the 0.2
          coefficient for ice cream indicates that a 1% increase in income leads to only 0.2 of a
          percent of an increase in the quantity demanded of ice cream. This low coefficient
          indicates that the ice cream industry will not benefit greatly from an increase in
          consumer incomes, and over the long run may decline. [text: E pp. 385-386; MI pp.
          127-128]

New 28. What is a price ceiling and what are its economic effects?

          A price ceiling means that the price is not allowed to rise above the maximum price set
          by government. If the price ceiling is set below the equilibrium price in a market, then
          there will be a shortage of the product at the government-set price. A price ceiling


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          interferes with the rationing function of price that serves to balance the decisions of
          suppliers and demanders. The shortage indicates that resources are being underallocated
          to the production of this product and that there is economic inefficiency. Less output is
          being produced than consumers want. This output is not being produced because some
          producers cannot make a profit at the price ceiling level. [text: E pp. 386-387; MI pp.
          128-129]

New 29. Use data in the following table to explain the economic effects of a price ceiling at $6, at
        $5, and at $4.
                                    Quantity          Quantity
                       Price       demanded           supplied
                        $7           4,500              4,500
                         6           5,000              3,500
                         5           5,500              2,500
                         4           6,000              1,500

          A price ceiling means that the price will not be permitted to rise above a maximum
          price. If the price ceiling is below the competitive equilibrium price of $7, it would
          produce a shortage of the product. For example, if the price ceiling was set at $6, the
          quantity demanded would be 5,000 units and the quantity supplied would be 3,500 for a
          shortage of 1,500 units. With a price ceiling set at $5, the shortage would be 3,000
          units, and with a price ceiling of $4, the shortage would be 4,500 units. A price ceiling
          interferes with the rationing function of price that serves to balance the decisions of
          demanders and suppliers. The price ceiling produces a shortage that indicates that
          resources are being underallocated; output is not being produced because some
          producers cannot make a profit at the price ceiling level. [text: E pp. 386-387; MI pp.
          128-129]

New 30. What is a price floor and what are its economic effects?

          A price floor means that the price is not allowed to fall below a minimum price set by
          government. If the price floor is set above the equilibrium price in a market, then there
          will a surplus of the product. A price floor interferes with the rationing function of price
          that serves to balance the decisions of suppliers and demanders. The surplus indicates
          that resources are being overallocated to the production of this product and that there is
          economic inefficiency; output is being produced which consumers do not want to
          purchase at the price floor. [text: E pp. 388-389; MI pp. 130-131]

New 31. Use data in the following table to explain the economic effects of a price floor at $8, at
        $9, and at $10. Explain the economic effects.

                                       Quantity         Quantity
                        Price         demanded          supplied
                        $10             3,000            7,500
                          9             3,500            6,500
                          8             4,000            5,500
                          7             4,500            4,500

          A price floor means that the price is not allowed to fall below a minimum price set by
          government. If the price floor is above the competitive equilibrium price of $7, a
          surplus of the product would result. If the price floor was set at $8, the quantity
          demanded would be 4,000 units but the quantity supplied would be 5,500 units for a
          surplus of 1,500 units. At a price floor of $9, the surplus would be 3,000 units, and with
          a price floor of $10, the surplus would be 4,500 units. A price floor interferes with the
          rationing function of price that serves to balance the decisions of suppliers and
          demanders. The price floor that produces a surplus indicates that resources are being



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         overallocated and that there is economic inefficiency; output is being produced which
         consumers do not want to purchase at the price floor. [text: E pp. 388-389-384; MI pp.
         130-131]

     32. “Government-set prices undermine the rationing function of competitive prices.”
         Explain carefully in terms of both price ceilings and price floors.

         A ceiling price means that the government may hold prices at a level that is below the
         market equilibrium price. Since the market equilibrium is where the quantity demanded
         is equal to the quantity supplied, any price below that would find an excess quantity
         demanded over that supplied. In other words, a shortage would develop and the market
         would fail to ration (QD > QS ). In unregulated competition, this situation could not
         persist because competition would drive up the price until the equilibrium quantity and
         price were reached.

         A price floor means that the government may hold prices above the market equilibrium
         price by agreeing to pay that price for any unsold surplus. The rationing function of the
         competitive price system will not work because sellers will have no competitive
         pressure to lower prices to get rid of the surplus, if they can sell it to the government at
         the supported price there will be a persistent product surplus (QS > QD ). [text: E pp.
         386-389; MI pp. 128-129]

New 33. (Last Word) Use economic analysis to explain why tenants in New York City who are
        covered by rent-controlled laws do not want to move even when they are offered a large
        buyout.

         The tenants obtain the rights to the apartment at the rent-controlled price long ago. The
         rent-controlled price is far below the market price for such an apartment. If they move
         out, they will have to pay market rates for an apartment that can be thousands of dollars
         higher per month. Over a period of years, that value of lower price is substantial. So,
         even when one woman was offered $250,000 as a buyout, she did not accept it because
         the benefits of living in such an apartment at the price of only $8 per day was much
         greater than her opportunity cost (giving up the $250,000 buyout). [text: E p. 390; MI p.
         132]




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