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Business Microeconomics

Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
PROBLEM SET OF HOME ASSINGMENT # 2
Textbook chapters: MP: Ch.4, Ch.8, and Ch.9;
CFO: Ch.5, Ch.6

1. Recall the following two equations that describe market activities in the Shimkent
City tire market.
Let X=number of tires per month and P=price per tire
Demand Equation: X= 500-2P
Supply: X= -25+P

a) Find the market equilibrium price and number of tires traded, i.e., P* and X* and graph
the situation.

b) Find the own price elasticity of demand and own price elasticity of supply at the
market equilibrium. Use the "exact point formula."

c) Suppose the akim of Shimkent City decides to place a per unit tax of $5.00 per tire on
each tire sold. The mayor decides to collect the tax revenue from the suppliers of tires.
Determine the new market situation and figure out the economic price incidence of the
tax to the demanders and to the suppliers. What side of the market bears relatively more
of the economic price incidence?

d) Suppose instead of the tax, the akim decides to enact a $10 per tire SUBSIDY on
each tire sold. The akim decides to send the subsidy payments to the suppliers of tires.
Determine the new market equilibrium situation. Include the final price demanders now
pay and the final price suppliers now receive. Why might the akim want to do this?

2. Batima is a vegetable farmer in Taraz. She prays to her God for a good crop every year.
Unfortunately, her wish didn't come true this year, because a tornado destroyed 30% of
everyone's crops in Taraz. However, she still earned more revenue than she did last year.
Assume that the demand for vegetables did not change. How could this have happened?
Use demand-supply analysis and the elasticity concept to explain this paradox.

3. Suppose that on January 1st of 2013, the Pavlodar Transit Authority increased fares on
all its bus lines from 40 tenge to 60 tenge. Private bus companies in Pavlodar did not
change their fares. The Vechorka of January 8th reports that the total number of rides on
city-owned buses decreased from 2200 to 1800 per day; on those city lines competing
with private bus lines, the number of rides decreased from 1150 to 850 per day.

a) Compute the own price elasticity of demand (over the one-week period) for all city-
owned bus lines. Compute the own price elasticity of demand for city-owned lines
competing with private companies.

b) Is the demand for bus rides elastic or inelastic? Explain.

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
c) Why is the demand for rides on those city-owned lines competing with private lines
more elastic (than on other city lines)?

d) The Pavlodar Transit Authority expects that, solely as a result of the fare increase on
January 1st fewer rides will be purchased in March than in January. Explain.

4. Consider the following demand and supply equations: (where p = price of imported
candy in dollars per box and X = quantity of imported candy)

pD = 100 - 5X (demand equation)

pS = 10 + X (supply equation)

a) Find the equilibrium price and quantity of candy.

b) Find the price elasticity of demand at the equilibrium point.

c) Find the price elasticity of supply at the equilibrium point.

d) What revenue do sellers earn at the equilibrium?

e) At what price and quantity would sellers receive maximum revenue?

5. The following chart shows some information about the demand function for oranges.
Three distinct sets of information were gathered on three separate occasions.

Xoranges poranges papples income


date 1 10 lbs $5/lb $1/lb $100
date 2 15 lbs $5/lb $1/lb $200
date 3 8 lbs $5/lb $.50/lb $100

a) There are two elasticities that can be calculated from this table of information. Which
two are they?

b) Set up the numbers and calculate these two elasticities.

c) What broad generalizations can you make about oranges from examining your answers
above.

6. Consider an economy with three individuals A, B and C. There are 2 commodities


being sold in this economy: food (F) and luxuries (L) with price pF and pL respectively.

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
The individuals are price-takers. Initially: A, B, C have equal incomes = $50.00 each; pF
= $2 per unit; and, pL = $10 per unit.

a) Draw the budget line for the individuals. (Put food on the horizontal axis; luxuries on
the vertical axis.)

b) Now the government has designed two alternative policies aimed at improving the
welfare (increasing utility) of A, B and C. Policy I: Income subsidy of $20 to each
individual. Policy II: Food-subsidy policy to lower pF to $1 per unit. Based on this
information, draw the new budget lines for Policy I and II.

c) The government asks A, B, and C for their preferences regarding the two alternative
policies. The individuals reply as follows: A prefers Policy I; B prefers Policy II; C is
indifferent between Policies I and II. Using indifference curve analysis illustrate the
above situations for A, B and C. Note: We recommend using separate graphs for A, B
and C in Part (c).

7. Answer the question or critically evaluate the statement and explain why or in what
way the statement is true, false, or uncertain.

a) If salt is an inferior good, then we know that the demand curve for salt will be
positively sloped and that salt is therefore a Giffen good.

b) A survey shows that most people prefer Saabs to Toyotas. If this is true, why do more
people drive Toyotas than Saabs?

c) If a consumer's tastes change, the slope of the budget line must change.

d) At the optimal bundle, a rational utility maximizing consumer will obtain the same
marginal utility from the last unit of each commodity he consumes.

e) Zarina is consuming widgets and zambowies and has typical, nicely behaved
preferences over these two goods. At her current level of consumption the marginal
utility of widgets is 3 and zambowies is 6. The price of widgets is $1, and the price of
zambowies is $3. Sue is maximizing her utility.

8. Initially Indira Zaman receives a Social Security check of $100 and chooses between
goods x and y (there are no other goods) which have prices px and py both equal to $2.00.
Ima buys 30 units of x and 20 units of y.

a) Graph Indira's initial equilibrium assuming that she has chosen a best bundle.

b) Now suppose that prices change so that px = $3.00 and py remains at$2.00. What is the
cost of the original bundle at the new set of prices? Is the original bundle affordable?
What will Indira do in response to the change in price? Is she better off, worse off, or the
same after the price change?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices

c) Suppose that Majilis of RK decides to add a cost of living adjustment (COLA) to


Indira's social security check which is indexed to prices in such a way that Indira will be
able to afford her original bundle at the new set of prices. How much extra will she get in
her social security check once the adjustment is made?

d) What will Indira do in response to the change in price and increase in social security?
Relative to her original situation, is Indira better off, worse off, or the same after the price
change and increase in social security? Explain.

e) President of RK states that Majilis has overcompensated Indira for the price change.
Do you agree or disagree and why?

9. Draw indifference curve diagrams representing what you believe would be a typical
person's preferences over bundles that contain the following goods:

a) right and left shoes (perfect complements); (Hint: if you start with four left shoes and
four right shoes, will it increase your satisfaction to have more additional right shoes
without left ones?)

b) road quality in Almaty and road quality in Astana, Kazakhstan;

c) 12 oz cans of Coke and 12 oz cans of Pepsi (perfect substitutes);

d) food and garbage; (Hint: is garbage a "good"?);

e) pizza and doners.

In the above five examples add to your diagram a budget line such that the consumer is in
equilibrium. Indicate in each case whether the economic rate of substitution (ERS) or
marginal rate of transformation (MRT) is equal to the marginal rate of substitution
(MRS). Why or why not?

10. Almas Ali, a consumer in Almaty with a very nicely behaved indifference curve map,
has an income of $480 and consumes only two goods, food and clothing. The price of
food is $10 per unit and the price of clothing is $12 per unit. Almas is a utility optimizer
and chooses a bundle that maximizes her happiness subject to her budget constraint. In
this personal "best bundle" she buys 30 units of food.

(a) Draw a carefully labeled and detailed indifference-curve/budget-line diagram


illustrating Almas' equilibrium. Put food on the horizontal and clothing on the vertical.
How many units of clothing are in the optimal bundle? What must be the value of his
marginal rate of substitution (MRS) between food and clothing at her optimal bundle?

Suppose we give Almas the opportunity to join a village food co-op. The membership
fee is $120. Members can then buy food for $9 per unit and clothing for $6 per unit.

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices

(b) Illustrate on your graph for part (a) how joining the co-op affects Almas'sbudget-
line/indifference-curve diagram. Should he join the co-op? Explain. If he joins the co-
op and re-optimizes, what will be the value of the MRS of food for clothing at the new
equilibrium bundle? If he decides to join the co-op, what is the MRS of food for clothing
at the original optimal bundle?

11. Anvar, Aibek, and Ali have identical demand curves. Anvars demand curve for
wine is given by the equation

QD = 30 - P/3,

where price is given in dollars and quantity is measured in bottles.

(a) Draw the market demand curve for wine.

(b) Calculate total consumers' surplus if wine is sold at $20 a bottle.

12. Given the following demand schedule:

Demand schedule
PRICE QUANTITY REVENUE
15 10
10 55
5 100

a. Fill in the revenue column; without doing any further computations, is the
demand curve elastic or inelastic? Why?
b. Compute the coefficient of elasticity between a price of $5 and of $15
using the midpoint formula.

13. Given the following demand schedule:

Demand schedule
PRICE QUANTITY REVENUE
100 100
300 90
500 80

a. Fill in the revenue column; without doing any further computations, is the
demand curve elastic or inelastic? Why?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
b. Compute the coefficient of elasticity between a price of $100 and of $500
using the midpoint formula.

14. Given the demand curve Q = 200 - 4P

a. Graph the demand curve, showing exactly where it cuts the axes.
b. How much is demanded at a price of 10 dollars? 11 dollars? 9 dollars?
c. Use the above information to find the elasticity of the curve at a price
of $10, that is between prices of $9 and $11. (Note: given a demand
curve in algebraic form, we can find the elasticity at a point by raising
and lowering the price by a dollar. We then construct a table similar to
the tables in the first problems 12 and 13 and compute the elasticity
between the points defined by the given price plus or minus one
dollar.)

15. Using the same demand curve, Q = 200 4P

a. How much is demanded at a price of 40 dollars? At a price of 39


dollars? at a price of 41 dollars?

b. What is the coefficient of elasticity at a price of 40 dollars?

16. How does this compare with the coefficient of elasticity found in the previous
problem15? Is elasticity the same anywhere along a straight line demand curve? How
does it vary with price?

17. Given the demand curve Q = 100 1/2 P

a. Can we say it is less elastic than the previous demand curve in


problem 14 ?

b. Is it less elastic than the previous demand curve at a price of 30


dollars?

c. Is it less elastic than the previous demand curve at a price of one


dollar?

d. Does elasticity vary along this demand curve? Explain how -- does
elasticity increase or decrease with price? Is this the same as the
previous curve?

18. When Sony cut the price of the PS3 by 25% from 200 to 150, sales rose by 20%.
What was the price elasticity and how could they use the knowledge when setting future
prices?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
19. A second hand car dealer sells 60 cars each year. Currently he charges his customers
2,500 per car. This means the business has a total revenue of:

Total revenue = 2,500 X 60 = 150,000

From past experience the salesman believes the price elasticity of his cars is
approximately 0.75. The dealer is thinking of increasing his prices to 3000 per car, an
increase of 20%.

a) Calculate the anticipated % change in his revenue.

b) Calculate the new total revenue

c) Should the dealer change his pricing strategy? Justify your answer

20. The following is a demand schedule for jogging shoes:

Price per Pair Quantity demanded (pairs per day)


$140 2
120 6
100 10
80 14
60 18
40 22
20 26

a. Draw the demand curve on the graph below.

b. Calculate the arc elasticity coefficient as price decreases from $120 to $100,
$80 to $60, and $60 to $40.

c. What happens to the coefficient of elasticity as P decreases along the


demand curve?
What happens to TR as P decreases?
Explain the relationship between P, TR, and elasticity.

21. Suppose that, because of the impact of Hurricane Mitch in Central America, the
price of bananas rises from $0.50 to $1.00 per pound and the quantity demanded falls
from 1000 pounds to 400 pounds.

a. Calculate the midpoints elasticity (arc elasticity) of demand for bananas in


this price range.

b. Are bananas elastic, unitary elastic, or inelastic in this price range?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
c. What is the interpretation of that price elasticity of demand?

d. If the price of bananas were to increase by 15 percent, what would be the


percentage change in the quantity demanded?

e. If the price of bananas were to increase by 20 percent, what would be the


percentage change in the quantity demanded?

f. What happens to total revenue for banana sellers when the price of
bananas increases? Explain your answer.

g. Give 2 factors that would cause bananas to have this elasticity of demand
calculated in part (a) above.

22. Define the following concepts (please give definition, formula, and graph if needed):

(a) Price elasticity of demand

(b) Income elasticity of demand

23. Define the following concepts (please give definition, formula, and graph if needed):

(a) Cross-price elasticity of demand

(b) Price elasticity of supply

24. In the table below are some estimates of price elasticities for different products. Use
the estimates to answer the questions below.

Demand elasticities Supply elasticities


Product
Retail level Farm level Short run Long run
Beef -0.64 -0.42 0.31 0.75
Chicken -0.78 -0.60 0.90 1.25
Maize -0.35 -0.20 0.40 1.35

(a) Interpret the value of the price elasticity of demand for beef at the retail level and
at the farm level. Interpret the value of the price elasticity of supply of maize in the short
run and long run.
(b) Which of the elasticities are elastic, inelastic and unitary elastic?

(c) Explain why farm level price elasticities of demand are smaller, in absolute value
terms, than the retail level price elasticities. Does this make sense?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
(d) Explain why the long run price elasticities of supply are larger in magnitude when
compared with the short-run price elasticities. Does this make sense? Would you
expect long-run price elasticities of demand to be greater than short-run
elasticities? Explain.

25. The table below presents some hypothetical relationship between income earned in a
day and the number of hamburgers consumed. Study the data to complete table
and answer questions.

Type of good
Income Quantity Income
% Demand % Income based on
( /day) demanded elasticity
elasticity
-- -- --
10 2

15 4

20 5

30 6

40 4
(a) Calculate the % change in demand and income to compute the income elasticity
of demand

(b) Interpret the value of the income elasticity of demand reflecting a change in
income from $15/day to $20/day.

(c) Explain which type of good a hamburger is at the various levels of income. Think
about what the meaning of the income elasticity is.

(d) Plot the relationship between income and number of hamburgers consumed in a
day. What does the shape of this curve suggest?

26. In the table below are some estimates of cross-price elasticities for different
products. Use the estimates to answer the questions below.

Value of the
Product cross-price Type of goods
elasticity
Margarine with respect to the price of butter 1.53
Natural gas with respect to the price of 0.80
electricity
Pork with respect to the price of beef 0.40

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
Clothing with respect to the price of food -0.18
Entertainment with respect to the price of food -0.72
Cereals with respect to the price of fresh fish -0.87

(a) Determine what the relationship is between each of the pairs of goods listed based
on the value of the cross-price elasticity of demand. (Are the two products in each row in
the table substitutes or complements?)

(b) Interpret the value of the cross-price elasticity of demand for margarine with
respect to a change in the price of butter. What do values with a small magnitude
imply relative to higher values?

27. Consider the market information in the scenarios below and determine the changes
in equilibrium price and quantity. Determine how demand and supply change and the
new equilibrium price and quantity. (Will the supply or demand shift, and how will the
demand or supply curve shift?)

(a) World grain markets. Australia, one of the main world exporters of grain, has
been experiencing the worst drought on record.

(b) World market for beef. China has experienced growth rates in national income of
around 10% per year for several years consecutively. The trends in income have
caused a shift toward more western diets, including more per capita consumption
of meat.

(c) Orange juice markets. There were record yields in major juice-orange producing
regions. At the same time there have been medical reports have praised orange
juice for its health effects.

(d) World oil market. The Organization of Petroleum Exporting Countries (OPEC)
decides to increase production by 10% over the next 5 years. The US, a major
consumer-importer of oil, has sought to reduce its dependence on oil by
increasing its production of ethanol (made from maize, in particular). The US
goal is to reduce petrol consumption by 20%.

28. On an indifference map with good "X" measured on the horizontal axis and good "Y"
measured on the vertical axis:
a) Construct the price consumption line for good X. Do this by raising the price of
consumption good X from pXa to pXb to pXc where pXa < pXb < pXc.
b) Derive the demand curve for X from your indifference map.
c) Are consumer goods "X" and "Y" complements or substitutes? How do you know?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices

29. Mellow Yellow and Mountain Dew are substitutes. At current prices in Figure 1,
Bobs utility maximizing consumption of both is represented by bundle a on budget
constraint BCa where the price of Mellow Yellow is pa. Depicted in figure below is
Bobs demand curve for Mountain Dew, labeled D. What happens to Bobs demand
curve for Mountain Dew when Mellow Yellows price changes?
a) First, increase the price of Mellow Yellow to pb. Label the new budget
constraint BCb. Then, draw a new indifference curve for Bob representing his
utility maximizing consumption bundle when the price of Mellow Yellow is
pb. Finally, show how the described price change affects Bobs demand curve
for Mountain Dew in Figure 2.
b) Repeat exercise (a) for a decrease in the price of Mellow Yellow from pa to pc.
Mellow
Yellow

pc<pa<pb

U0, with price of pa

BCa
Mountain Dew
Price of
Mountain
Dew
Figure 2

MDa Mountain Dew

30. Draft an income-consumption line for charitable giving with charitable giving
measured on the horizontal axis and "other goods" measured on the vertical axis of your
diagram. How does an increase in income affect the demand curve for charitable giving?
Explain using a well-labeled graph of the demand curve for charitable giving.

31. At the turn of the century over 30% of kazakh families employed domestic help.
Today, in spite of the eight-fold increase in real family income, only 10 % of Kazakh
families employ domestic help. Draft three indifference maps, which explain the
decrease in the employment of servants by:
a) A change in tastes.
b) An increase in income where domestic help is an inferior good.
c) An increase in the price of domestic help.
d) Which explanation do you find most persuasive? Why?

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
32. For this problem, assume that Alexandr has $80 to spend on books and movies each
month and that both goods must be purchased whole (no fractional units). Movies cost $8
each, and books cost $20 each. Alexandr 's preferences for movies and books are summa-
rized by the following information:

MOVIES BOOKS
NO. PER NO. PER
MONTH TU MU MU/$ MONTH TU MU MU/$
1 SO 1 22
2 80 2 42
3 100 3 52
4 110 4 57
S 116 5 60
6 121 6 62
7 123 7 63

a. Fill in the figures for marginal utility and marginal utility per dollar for both movies and
books.
b. Are these preferences consistent with the law of diminishing marginal utility? Explain
briefly.
Given the budget of $80, what quantity of books and what quantity of movies will
maximize Joe's level of satisfaction? Explain briefly.
d. Draw the budget constraint (with books on the horizontal axis) and identify the
optimal combination of books and
movies as point A.
e. Now suppose the price of books falls to $ 10. Which of the columns in the table must be
recalculated? Do the required recalculations.
f. After the price change, how many movies and how many books will Alexandr
purchase?
g. Draw the new budget constraint and identify the new optimal combination of books
and movies as point B.
h. If you calculated correctly, you found that a decrease in the price of books caused
Alexandr to buy more movies as well as more books. How can this be?

33. The table gives the supply schedule of long distance phone calls. Calculate the
elasticity of supply when
Price Quantity supplied
a. The price falls from 40 cents to 30 cents a minute. (cents (millions of
b. The average price is 20 cents a minute. per minute) minutes per day)
10 200
20 400
30 600
40 800
34. Mary enjoys classical CDs and travel books and
spends $50 a month on them. The table shows the utility she gets from each good.

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Business Microeconomics
Problem set 2: Elasticity; Utility and Demand; Possibilities, preferences, and Choices
a. Compare the two utility schedules. Can Quantity Total utility from Total utility from
you say anything about Marys per month classical CDs travel books
preferences? 1 30 30
2 40 38
b. What do the two utility schedules tell 3 48 44
you about Marys preferences? 4 54 46
5 58 47

c. If a classical CD and a travel book cost $10 each, how does Mary spend the $50 a
month?

35. Suppose the price of X is $5 and the price of is $10 and a hypothetical household
has $500 to spend per month on goods X and Y.
a. Sketch the household budget constraint.
b. Assume that the household splits its income equally between X and Y. Show where
the household ends up on the budget constraint.
Suppose the household income doubles to $1,000. Sketch the new budget constraint
facing the household.
d. Suppose after the change the household spends $200 on Y and $800 on X. Does this
imply that X is a normal or an inferior good? What about Y?

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