Microeconomics

PGP - I
Problem Set- III
1. You have decided always to spend one-third of your income on clothing.
(a) What is your income elasticity of clothing demand?
(b) What is your price elasticity of clothing demand?
(c) If your tastes change and you decide to spend only one-fourth of your income on
clothing, how does your demand curve change? What sis your income elasticity
and price elasticity now?
(d) a. If Maria always spends one-third of her income on clothing, then her
income elasticity of demand is one, because maintaining her clothing
expenditures as a constant fraction of her income means the percentage
change in her quantity of clothing must equal her percentage change in
income.
(e)
(f) b. Maria's price elasticity of clothing demand is also one, because every
percentage point increase in the price of clothing would lead her to reduce her
quantity purchased by the same percentage.
(g)
(h) c. Because Maria spends a smaller proportion of her income on clothing,
then for any given price, her quantity demanded will be lower. Thus, her
demand curve has shifted to the left. Because she will again spend a constant
fraction of her income on clothing, her income and price elasticities of demand
remain one.

2. Following is an excerpt from The New York Times (Feb. 17, 1996) :
There were nearly four million fewer subway-riders in December 1995, the first full
month after the price of a token increased 25 cents to $1.50, than in the previous
December, a 4.3 percent decline.
(a) Use these data to estimate the price elasticity of demand for subway rides.
(b) According to your estimate, what happens to the transit authoritys revenue when
the fare rises?
(c) Why might your estimate of the elasticity be unreliable?

a. If quantity demanded falls by 4.3% when price rises by 20%, the price
elasticity of demand is 4.3/20 = 0.215, which is fairly inelastic.
b. Because the demand is inelastic, the Transit Authority's revenue rises
when the fare rises.
c.

The elasticity estimate might be unreliable because it is only the first

month after the fare increase. As time goes by, people may switch to other

means of transportation in response to the price increase. So the elasticity

may be larger in the long run than it is in the short run.

3. Pharmaceutical drugs have an inelastic demand and computers have an elastic

demand. Suppose that technological advance doubles the supply of both products,
(a) What happens to the equilibrium price and quantity in each market?
(b) Which product experiences a larger change in price and which one experiences a
larger change in quantity?
(c) What happens to total consumer spending on each product?
a. As Figure 2 shows, the increase in supply reduces the equilibrium price and
increases the equilibrium quantity in both markets.
b. In the market for pharmaceutical drugs (with inelastic demand), the
increase in supply leads to a relatively large decline in the equilibrium
price and a small increase in the equilibrium quantity.

Figure 2
c.

In the market for computers (with elastic demand), the increase in supply
leads to a relatively large increase in the equilibrium quantity and a small
decline in the equilibrium price.

d. Because demand is inelastic in the market for pharmaceutical drugs, the

percentage increase in quantity will be lower than the percentage
decrease in price; thus, total consumer spending will decline. Because
demand is elastic in the market for computers, the percentage increase in
quantity will be greater than the percentage decrease in price, so total
consumer spending will increase.

4. Explain why the following might be true:

A drought around the world raises the total revenue that farmers receive from the sale
of grain, but a drought only in Kansas reduces the total revenue that Kanasas farmers
receive.

A worldwide drought could increase the total revenue of farmers if the price
elasticity of demand for grain is inelastic. The drought reduces the supply of grain,
but if demand is inelastic, the reduction of supply causes a large increase in price.
Total farm revenue would rise as a result. If there is only a drought
inKansas, Kansas production is not a large enough proportion of the total farm
product to have much impact on the price. As a result, price does not change (or
changes by only a slight amount), while the output by Kansas farmers declines,
thus reducing their income.

5. An US senator wants to raise tax revenue and make workers better off. A staff
member proposes raising payroll tax paid by the firms and using part of the extra
revenue to reduce the payroll tax paid by workers. Would this accomplish the
senators goal? Explain.
Increasing the employers contribution and using part of the extra revenue to
reduce the employees would not make workers better off, because the division
of the burden of a tax depends on the elasticity of supply and demand and not
on who must pay the tax. Because the tax wedge would be larger (assuming that
only a proportion of the increase in employer contributions is used to reduce
employee contributions), it is likely that both firms and workers, who share the
burden of any tax, would be worse off.

6. In a perfectly competitive market, the market demand and market supply curves are
given by Qd= 1000 10Pdand Qd= 30Ps. Suppose the government provides a subsidy
of $20 per unit to all sellers in the market.
a) Find the equilibrium quantity demanded and supplied; find the equilibrium market price
paid by buyers; find the equilibrium after-subsidy price received by firms.
b) Find the consumer surplus and producer surplus in the absence of the subsidy.
c) Find the consumer surplus and producer surplus in the presence of the subsidy. What is the
impact of the subsidy on the government budget?

In this case, the after-subsidy price received by sellers is Ps = Pd + 20. The

market-clearing condition is: 1000 10P = 30(P + 20), where P denotes the
market price. This implies P = 10 and Q = 900. Since sellers receive the subsidy,
P = Pd = 10 and Ps = Pd + 20 = 30. The surplus implications of the subsidy are
shown below:

Consumer surplus

With No
Subsidy

With Subsidy

Impact of the
Subsidy

A+B

A+B+C+F+G

C+F+G

($28,125)

($40,500)

($12,375)

C+E

C+E+B+I

B+I

($9,375)

($13,500)

($4,125)

Government
spending on
subsidy

Zero

B+C+F+G+H+I

-B-C-F-G-H-I

($18,000)

(-$18,000)

Net benefits
(consumer surplus
+ producer surplus
government
spending)

A+B+C+E

A+B+C+E-H

-H

($37,500)

($36,000)

(-$1,500)

Deadweight loss

Zero

H ($1,500)

H ($1,500)

Producer surplus

P
100

A
S

30
25

C
10

B
F

S - 20
D

750

900

1,000