# 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

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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Chapter 20

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

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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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Chapter 20

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

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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Supply and Demand: Elasticities and Government-set Prices

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

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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