Principles of Macroeconomics 11th Edition by Karl E. Case, Ray C. Fair, Sharon E. Oster -Test Bank

Principles of Macroeconomics 11th Edition by Karl E. Case, Ray C. Fair, Sharon E. Oster -Test Bank

 

Instant Download – Complete Test Bank With Answers

 

 

Sample Questions Are Posted Below

 

 

 

Chapter 5

Elasticity

 

Price Elasticity of Demand

 

1. What does elasticity measure?

 

Elasticity measures the response in one variable when another variable changes.

 

Diff: 1                   Skill: Definition          Topic: elasticity

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2. Define price elasticity of demand. What does it measure?

 

Price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price.  It measures the responsiveness of quantity demanded to changes in price.

 

Diff: 1                   Skill: Definition          Topic: elasticity

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3. Why isn’t slope as useful as elasticity to measure the responsiveness of one variable to another?

 

The numerical value of slope depends on the units used to measure the variables on the axes.  Thus, if two demand curves represent the same demand behavior but are measured in different units (ounces versus pounds, for example), we will get two different measures of responsiveness.  Elasticity does not have this problem because it is calculated using percentage change.

 

Diff: 1                   Skill: Conceptual        Topic: slope and elasticity

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4. Explain how it is possible for a downward-sloping demand curve to have a constant slope but still have a variation of elasticity of demand along it.

 

Slope measures rise over run. However, elasticities measure percent changes in the quantity demanded divided by the percent change in the price. Even along a linear demand curve with a constant slope the demand is more elastic in the upper left-hand corner and becomes less elastic as one moves down and to the right until it becomes unitary and then inelastic.

 

Diff: 1                   Skill: Conceptual        Topic: slope and elasticity

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5. What does it mean for a good to have a perfectly inelastic demand? Draw a demand curve of this type.  Explain why it has the shape that it does.

 

If a product has a perfectly inelastic demand, this means that the quantity demanded does not respond at all to a change in price.  This implies that the demand curve will be vertical.  No matter what the price is, quantity demanded is always the same.

 

 

Diff: 1                   Skill: Conceptual        Topic: perfectly inelastic demand

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6. Why is the price elasticity of demand generally a negative number?

 

The law of demand says that an increase in the price of a product will lead to a decrease in quantity demanded.  Thus, price and quantity demanded are inversely related to one another.  This means that if either the numerator or the denominator of the ratio is positive, the other will be negative.

 

Diff: 1                   Skill: Conceptual        Topic: elasticity coefficient

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7. If the elasticity of demand were positive what would this imply about the shape of the demand curve? Why is it that we are unlikely to find a price elasticity of demand with a positive value?

 

If the price elasticity of demand were positive this would mean that demand curve is upward-sloping. We are unlikely to find a price elasticity of demand that is positive because this would contradict the law of demand.

 

Diff: 2             Skill: Analytic             Topic: elasticity coefficient

AACSB: Reflective Thinking

 

8. How does one determine whether demand is elastic, inelastic, or unit elastic?

 

If the absolute value of the price elasticity of demand is greater than one, demand is elastic.  If it is less than one, demand is inelastic.  If the absolute value of the price elasticity of demand is equal to one, demand is unit elastic.

 

Diff: 1                   Skill: Conceptual        Topic: elasticity coefficient

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9. Assume a customer of natural gas is negotiating with his supplier over the telephone. At the time prices of all the supplier’s competitors are precisely the same. The customer tells the supplier that if he raises his price even one penny he will walk away.  What does the perceived demand curve for natural gas look like for this customer? Why?

 

The elasticity of demand is perfectly elastic. The demand curve is horizontal at the current price. The customer is likely to behave this way since he sees that there are other suppliers willing to offer the same price for essentially what he perceives to be a homogeneous good.

 

Diff: 1                   Skill: Conceptual        Topic: elasticity

AACSB: Analytic Skills

 

10. In the past dating was a fairly simple activity in the United States. If there was someone you wanted to go out with you would call them or ask them to go out for dinner and a movie. Nowadays it appears that many people are willing to pay large amounts of money to professional dating services to find a compatible mate. This idea is not a new one but it has increased quite dramatically in popularity. What does this suggest about what kind of good dating services might be and why? Are we likely to find this type of service be more or less prevalent in poorer countries?

 

The country has become much richer over the past few decades and even though people want to date just as much today as they always have, the fact that they have more disposable income that they can use to pay someone else to find them a date probably means that dating services are a normal good. As a consequence this is likely to be a less prevalent practice in poorer countries where there are lower incomes and a decreased ability and willingness to pay.

 

Diff: 2                   Skill: Conceptual        Topic: normal goods

AACSB: Reflective Thinking

 

11. What does it mean for a good to have a perfectly elastic demand? Draw a demand curve of this type. Explain why it has the shape that it does.

 

If a product has a perfectly elastic demand, this means that the quantity demanded will drop to zero if the price rises.  This implies that the demand curve will be horizontal.  At any price higher than P₁, quantity demanded will be zero.

 

 

 

 

 

 

 

 

 

 

 

Diff: 1                   Skill: Conceptual        Topic: perfectly elastic demand

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12. Compare and contrast the two demand curves depicted in the graph below.

 

 

The figure on the left shows a perfectly inelastic demand curve. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes. The figure on the right shows a perfectly elastic demand curve. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price.

 

Diff: 1                   Skill: Conceptual        Topic: perfectly elastic

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13. In many large American cities it is common to witness private motorists pulling up to municipal bus stations and allowing perfect strangers to ride into downtown with them in order to take advantage of the high occupancy vehicle lanes that require two or more drivers. Using the concept of elasticity of demand and total revenue explain why public transit authorities might be concerned with this practice.

 

Public transit authorities may be concerned about this practice because it provides a very good substitute for their services and may make municipal bus service more price elastic and could have a deleterious impact on the revenue generated by the public transit system.

 

Diff: 2                   Skill: Conceptual        Topic: price elasticity

AACSB: Reflective Thinking

 

 

Calculating Elasticities

 

14. When the price of toothpaste increases by 15 percent, the quantity of toothpaste demanded falls by 30 percent. Calculate the price elasticity of demand. Is the demand for toothpaste elastic, inelastic, or unit elastic?

 

Price elasticity of demand = [-30/15] = -2.  Since the absolute value of the price elasticity is greater than one, the demand for toothpaste is elastic.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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15. When the price of toilet paper falls by 20 percent, the quantity of toilet paper demanded rises by 10 percent. Calculate the price elasticity of demand. Is the demand for toilet paper elastic, inelastic, or unit elastic?

 

Price elasticity of demand = [10/-20] = -0.5.  Since the absolute value of the price elasticity is less than one, the demand for toilet paper is inelastic.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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16. Assume that that the two graphs below are identical demand curves for hamburger. The only difference is that the one on the left measures hamburger in pounds and the one on the right measures hamburger in ounces. The elasticity of demand between the prices of $3 and $2 should be the same in both cases. However, prove that calculating the slopes between these two points on each graph would not be helpful in determining elasticity of demand.

 

 

Slope is calculated by taking the ratio of the rise and dividing it by the run in both cases as illustrated below:

 

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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17. If the price elasticity of demand for chocolate is -2.0 what should we expect would happen to consumption of chocolate if the price falls by 10%? What about a 50% decrease?

 

Consumption of chocolate should increase by 20%. If the price falls by 50% the increase in consumption may be less than 100%. The reason is that price cut is moving consumers into the inelastic portion of the demand curve. In other words, the absolute value of the price elasticity of demand for chocolate may no longer be 2.0 but rather much lower and even be less than 1.0.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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18. The price elasticity of demand for new stereos is –2. Suppose a stereo store wishes to increase its sales by 15 percent. What should the firm do?

 

[15]/ [percentage change in price] = -2.  Therefore, the store should lower the price by 7.5 percent.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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19. The price elasticity of demand for gasoline is –0.8. What must occur to the price of gasoline in order for quantity demanded to rise by 20 percent?

 

[20]/ [percentage change in price] = -0.8.  Therefore, price must fall by 25 percent.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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Refer to the information provided in Scenario 1 below to answer the following questions.

 

SCENARIO 1: The following diagram represents the U.S. market for oil.

 

 

 

20. Refer to Scenario 1. Use the total revenue test (on all oil sold) to determine elasticity of demand with a price drop from $18 to $16.

 

      Revenue at P = $18, R = 18 x 140 = 2520

Revenue at P = $16, R = 16 x 160 = 2560

As price falls from $18 to $16, revenue rises. Therefore demand is elastic. 

 

Diff: 2                   Skill: Analytic             Topic: total revenue test

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21. Refer to Scenario 1. Use the midpoint formula to calculate the price elasticity of demand between $18 and $16.

 

By using the midpoint formula, we calculate an elastic demand. 

(20/150 -2/17) = (1/15 1/17) = 1.133.

 

Diff: 2                   Skill: Analytic             Topic: price elasticity of demand

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22. What is the likely price elasticity of demand for crabs? Why?

 

It is likely that the price is relatively elastic, as there are other types of seafood available. 

 

Diff: 3                   Skill: Conceptual        Topic: price elasticity of demand

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23. Using the graph below explain why the elasticity of demand will be greater between $15 and $9 as opposed to between $9 and $4. Hint: You do not need to perform any calculations to prove that this is true.

 

 

Price elasticity will be greater between the prices of $15 and $9 compared to $9 and $4 because  of the fact that elasticity of demand declines along any linear downward sloping demand curve.

 

Diff: 3                   Skill: Conceptual        Topic: price elasticity of demand

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24. Customers often complain about the high price of accessories for their cell phone including batteries, chargers and head sets. Often these items can cost even more than the price of the phone. Explain using price elasticity why this might be the case.

 

Once you have purchased a cell phone you are likely to have a more price inelastic demand for the accessories. Even though it would be nice to shop around the accessories of the competitors products are typically not interchangeable and in any event you likely have a two-year contract with your service provider that makes shopping around unattractive.

 

Diff: 2                   Skill: Conceptual        Topic: price elasticity of demand

AACSB: Analytic Skills

 

25. Refer to Scenario 2. Over a long period of time, in the absence of any restrictions in the market, would you expect the price elasticity of demand for crabs to be more elastic or inelastic? Explain.

 

The longer the period of time, the price elasticity of demand will be greater as everyone has time to adjust and more goods become available for substitution. 

 

Diff: 3                   Skill: Conceptual        Topic: price elasticity of demand

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Refer to the information in Scenario 3 below to answer the questions that follow.

 

SCENARIO 3: Assume the following information on the price of small-screen televisions and quantity demanded.

 

 

26. Refer to Scenario 3. Plot the demand curve.

 

 

Diff: 2                   Skill: Analytic             Topic: demand curve

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27. Refer to Scenario 3. Compute the price elasticity of demand between $280 and $240.

 

 

 

Diff: 2                   Skill: Analytic             Topic: price elasticity of demand

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28. Refer to Scenario 3. Compute the price elasticity of demand between $200 and $160.

 

 

 

 

 

Diff: 2                   Skill: Analytic             Topic: price elasticity of demand

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29. Refer to Scenario 3. Compare and discuss the two elasticity estimates computed above. Without doing any more calculations what would you expect to happen to the value of the elasticity estimates as price continues to fall? Assume a linear demand curve.

 

Elasticity is greater for the higher prices.  As price continues to fall we would expect that the elasticity would fall as well.

 

Diff: 1                   Skill: Fact                    Topic: price elasticity of demand

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30. Refer to Scenario 3. Why are elasticities of demand rather than slopes used to measure and compare responsiveness?

 

Elasticities are useful because they are unit-free, and one can therefore compare elasticities between different types of goods. In contrast, slopes are not unitless. Hence, comparison between different products is much easier with elasticity. 

 

Diff: 3                   Skill: Conceptual        Topic: price elasticity of demand

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31. Even though airfares have been increasing, the revenue earned by airlines has declined. Based on this statement, what may be concluded about price, cross-price, or income elasticity of demand?

 

The statement suggests that the price elasticity of demand for airlines is price elastic. 

 

Diff: 3                   Skill: Conceptual        Topic: elasticity

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32. What is the “midpoint formula” and why is it used?

 

The midpoint formula is a convention of calculating elasticity percentages using the values halfway between the initial and new price and quantity demanded values. It is used so an elasticity calculation will not depend on the direction of the change in quantity demanded due to a change in price. 

 

Diff: 2                   Skill: Definition          Topic: midpoint formula

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33. Assume you are working at a department store and you are told by the manager to cut prices by 20% for all the new women’s sweaters that are currently priced at $50. What will be the new price of these sweaters? Suppose the manager tells you to raise the prices back up by 20%. What is the new price of the sweaters? Why is your answer not the same as the original price of the sweaters? What importance does this have for why the midpoint formula is used in calculating price elasticity?

 

The new price of the sweaters will be $40. If you are asked to increase the price of the sweaters back up by 20% the new price will be $48, not $50. The reason is that the even though the price change in percentage terms was the same going in both directions the starting point was different. The same percentage change for a smaller number is going to be an absolutely smaller number. This fact has an important factor to play in why we use the midpoint formula. If we didn’t use the midpoint formula we would get different price elasticities of demand depending on whether their was a price increase or a price decrease. The bias concerning which base you are using is eliminated using the midpoint formula.

 

Diff: 3                   Skill: Conceptual        Topic: midpoint formula

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Refer to the information provided in Scenario 5 below to answer the following questions.

 

SCENARIO 5: In 1999 Disk Monger sold 1,100 digital video disks (DVD) at a price of $15 each. Across the street, Audio Haven sold 700 DVD players at a price of $500 each. In 2000, Audio Haven reduced the price of DVD players to $250 each and sold 3,000 players. In the same year, Disk Monger sold 1,300 DVDs at a constant price of $15 each.

 

34. Refer to Scenario 5. Calculate the price elasticity of demand for DVD players. Is demand for players elastic, inelastic, or unitary?

 

Percentage change in quantity demanded is 1.24. Percentage change in price is -0.67. The price elasticity of demand for DVD players is 1.86 or relatively elastic. 

 

Diff: 2                   Skill: Analytic             Topic: price elasticity of demand

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35. Refer to Scenario 5. What will be the effect on total revenue for Audio Haven if it raises the price for DVD players?

 

Because the price elasticity of demand for DVD players is relatively elastic, a price increase will decrease total revenue, ceteris paribus. 

 

Diff: 2       Skill: Analytic             Topic: price elasticity of demand

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36. The university you attend needs to increase total revenue. The president suggests that by raising tuition by 5%, total revenue will increase. However, after the tuition increase, total revenue actually fell. What can you infer about the price elasticity of demand for an education at your university? Why is this likely to be true? What did your university president assume to be true about the price elasticity of demand for an education at your university?

 

If after tuition increased total revenue fell, then the demand for an education at your university must be price elastic. It is likely to be price elastic because there are many substitutes for an education at this particular university and tuition represents a large share of an individual’s income. The university president assumed that the demand was price inelastic. 

 

Diff: 3                   Skill: Conceptual        Topic: total revenue test

AACSB: Analytic Skills

 

37. Suppose a movie theater raises its ticket prices by 10% and the total revenue it receives in ticket sales doesn’t change one bit from the previous week. What can you say about the price elasticity of demand at that new price? Could this go on indefinitely? In other words, would continued price increases leave total revenue unchanged without bound? Why or why not?

 

You could conclude that the movie theater tickets unitary price elastic at this point on the demand curve. This could not go on forever. As ticket prices rose further there would come a point where one would reach the elastic portion of the demand curve and this would lead to a decline in revenue.

 

Diff: 1                   Skill: Conceptual        Topic: total revenue test

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38. Suppose that the price elasticity of demand for museum tickets is equal to –1.8. If the price of a museum ticket rises by 30 percent, what will happen to quantity demanded?

 

[percentage change in quantity demanded]/[30] = -1.8.  If the price rises by 30 percent, quantity demanded will fall by 54 percent.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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39. The price of pizza falls by 25 percent. If the elasticity of demand for pizza is equal to –1.5, what will happen to the quantity of pizza demanded?

 

[percentage change in quantity demanded]/[-25] = -1.5.  If the price of pizza falls by 25 percent, the quantity of pizza demanded will rise by 37.5 percent.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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40. What is the midpoint formula for calculating a percentage change?

 

The midpoint formula is a more precise way of calculating percentage changes.  It uses the value that is halfway between P₁ and P₂ for the base in calculating the percentage change in price, and the value halfway between Q₁ and Q₂ as the base for calculating the percentage change in quantity demanded.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

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41. Suppose that the price of a pound of potatoes increases from $0.75 to $0.90. Use the midpoint formula to calculate the percentage change in price.

 

% change in price = [$0.90 – $0.75]/[($0.90 + $0.75)/2] = [$0.15]/ [($1.65)/2] = [$0.15/$0.825]= 18.2.

 

Diff: 1                   Skill: Analytic             Topic: midpoint formula

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42. Suppose that the quantity of staplers demanded falls from 10,000 per week to 8500. Use the midpoint formula to calculate the percentage change in quantity demanded.

 

% change in quantity demanded = [8,500 -10,000]/[(8,500 + 10,000)/2] =

[-1500]/[(18,500/2]= [-1500]/[9,250] = -16.2.

 

Diff: 1                   Skill: Analytic             Topic: midpoint formula

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43. The price of cabbage rises from $0.20 per pound to $0.30 per pound. The quantity of cabbage demanded falls from 800 pounds per week to 600 pounds per week. Use the midpoint formula to calculate the price elasticity of demand for cabbage.  Is the demand elastic, inelastic, or unit elastic?

 

percentage change in quantity demanded = [600 – 800]/700 = -200/700 = -28.6.

      percentage change in price = [$0.30 – $0.20]/$0.15 = $0.10/$0.15 = 66.7.

      price elasticity of demand = [-28.6]/[66.7] = -0.43.

 

Since the absolute value of the price elasticity of demand is less than one, the demand is inelastic.

 

Diff: 2                   Skill: Analytic             Topic: midpoint formula

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44. The price of a new portable CD player falls from $100 to $90. The quantity of CD players demanded rises from 15,000 per year to 20,000 per year. Use the midpoint formula to calculate the price elasticity of demand for portable CD players. Is the demand elastic, inelastic, or unit elastic?

 

percentage change in quantity demanded = [20,000 –15,000]/17,500 = 5,000/17,500 = 28.6.

      percentage change in price = [$90 – $100]/$95 = -$10/$95 = -10.5.

      price elasticity of demand = [28.6]/[-10.5] = -2.7.

 

Since the absolute value of the price elasticity of demand is greater than one, the demand is elastic.

 

Diff: 2                   Skill: Analytic             Topic: midpoint formula

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45. Suppose that the price elasticity of demand for snow shovels is –1.2. What would have to happen to the price of a snow shovel for the quantity demanded to fall from 2,000 to 1,800? Use the midpoint formula in your calculations.

 

percentage change in quantity demanded = [1,800 – 2,000]/[1,900] = -200/1,900

= -10.5.

[-10.5]/[percentage change in price] = -1.2.

 

Therefore, the price of snow shovels must rise by 8.75 percent.

 

Diff: 2                   Skill: Analytic             Topic: price elasticity of demand

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46. Suppose that the price elasticity of demand for mittens is –2.5. What would happen to the quantity of mittens demanded if the price of mittens rose from $5 to $6? Use the midpoint formula in your calculations.

 

percentage change in price = [6 – 5]/[5.5] = 1/5.5 = 18.2.

[percentage change in quantity demanded]/[18.2] = -2.5.

 

Therefore, the quantity of mittens demanded will fall by 45.5 percent.

 

Diff: 1                   Skill: Analytic             Topic: midpoint formula

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47. Comment on the following statement: “Elasticity is constant along a straight-line demand curve”.

 

The statement is false.  While the slope is constant along a straight line, the elasticity is not.  In fact, at high prices (the upper area of a demand curve) the demand is elastic.  As price falls (and quantity demanded increases), the price elasticity of demand gets smaller (in absolute value).

 

Diff: 1                   Skill: Conceptual        Topic: elasticity and linear demand

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48. The demand for tobacco is price inelastic. Suppose there is a drought that destroys a large portion of the tobacco crop. What will happen in the market for tobacco?  Will the equilibrium price and quantity change?  If so, how?  What will happen to the total revenue earned by tobacco farmers?

 

The drought will lower the supply of tobacco.  The supply of tobacco will shift to the left, increasing price but lowering the equilibrium quantity sold.  However, since the demand for tobacco is price inelastic, the percentage increase in price will be larger than the percentage decrease in quantity demanded.  Therefore, the total revenue earned by tobacco farmers will rise.

 

Diff: 2                   Skill: Analytic             Topic: price inelastic demand

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49. An art museum raises its admission price, and ends up with a decrease in its total revenue. How could you explain this situation to the museum director?

 

If price goes up, quantity demanded will fall.  If total revenue fell, this must mean that the percentage decrease in quantity demanded was larger than the percentage increase in price.  Therefore, the demand for museum admission must be elastic.

 

Diff: 1                   Skill: Analytic             Topic: total revenue test

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50. When the price of bread rises from $1.25 to $1.50 per loaf, quantity demanded falls from 5,800 per week to 5,500. Calculate total revenue both before and after the price change. What can we tell about the price elasticity of demand for bread?

 

Total revenue (before price change) = $1.25 ´ 5,800 = $725,000.

      Total revenue (after price change) = $1.50 ´ 5,500 = $825,000.

 

Because total revenue increased when the price increased, this must mean that the demand for bread is inelastic.

 

Diff: 1                   Skill: Analytic             Topic: total revenue test

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51. Explain with the use of a graph how total revenue changes along a linear downward-sloping demand curve.

 

 

At a high enough price quantity demanded will be zero and so will be zero as well. As price Falls the total revenue will rise but at a decreasing rate. Eventually total revenue will reach its maximum at the point of unitary elasticity. After this point price decreases will lead to a decline in total revenue in the inelastic segment of the demand curve.

 

Diff: 1                   Skill: Analytic             Topic: total revenue test

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52. When the price of a Sony portable CD player rises from $125 to $150, quantity demanded falls from 750 per week to 600. Calculate total revenue both before and after the price change. What can we tell about the price elasticity of demand for Sony portable CD players?

 

Total revenue (before price change) = $125 ´ 750 = $93,750.

      Total revenue (after price change) = $150 ´ 600 = $90,000.

 

Because total revenue fell when the price increased, this must mean that the demand for Sony portable CD players is elastic.

 

Diff: 1                   Skill: Analytic             Topic: total revenue test

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53. Suppose that the price elasticity of demand for an ice cream cone is -1.9. If the local ice cream shop owner wants to increase total revenue, what would you recommend he or she do?

 

The owner should lower the price of ice cream cones.  Since demand is elastic, the percentage increase in quantity demanded will be larger than the percentage decrease in price.  Therefore, total revenue will rise.

 

Diff: 1                   Skill: Analytic             Topic: total revenue test

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54. Why is it a bad business practice to assume that raising prices will lead to increases in total revenue?

 

The reason is that revenue could move in either direction. What is crucial in determining whether it will rise or fall is dependent upon the elasticity of demand at the point where price is increased.

 

Diff: 1                   Skill: Analytic             Topic: total revenue test

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The Determinants of Demand Elasticity

 

55. Name three determinants of elasticity identified in the text. Explain how each one affects the responsiveness of demand.

 

(1) Availability of substitutes. Where fewer substitutes are available, demand will tend to be more inelastic. (2) The importance of being unimportant. Where an item represents a smaller portion of a total budget, demand will tend to be more inelastic. (3) The time dimension. The greater the time available to adjust behavior, the more elastic demand tends to be. 

 

Diff: 3                   Skill: Conceptual        Topic: elasticity determinants

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56. In the face of gasoline prices approaching $4.00 automobile dealerships are heavily marketing their compact cars and hybrid vehicles. However, an interesting development is that many of these dealerships are offering their economy cars at MSRP (manufacturers suggested retail price) without offering discounts. What do you suppose these dealerships believe about the price elasticity of demand for these economy cars?

 

The dealerships may be assuming that the economy cars now have become more price inelastic in demand as consumers who are dumping their gas guzzling vehicles don’t have many other choices.

 

Diff: 2                   Skill: Conceptual        Topic: elasticity

AACSB: Reflective Thinking

 

57. “The recent availability of satellite television has reduced the price of cable television subscriptions.” Based on this statement, what may be concluded about price, cross-price, or income elasticity of demand?

 

The availability of a substitute will likely increase the price elasticity of demand for Cable TV. The cross-price elasticity of satellite TV and cable TV is positive, suggesting that these goods are substitutes.

 

Diff: 3                   Skill: Conceptual        Topic: elasticity

AACSB: Reflective Thinking

 

 

 

 

 

 

 

 

58. The local barber in a small town has decided to raise the price of his haircuts by 25% because he realizes he is the only barber in town and of course “everyone has to get a haircut”. His rational is that the demand for his services is price inelastic? What mistake is he making?

 

The mistake that he is making is that he is ignoring possible substitutes right where he lives and works. A 25% increase in the price of haircuts may induce many people to start cutting their hair at home and have their parents or spouses do it for them.

 

Diff: 3                   Skill: Conceptual        Topic: price elasticity

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59. Explain how the availability of substitutes affects demand elasticity.

 

Typically the more substitutes that are available for a given product the more price elastic that product will become. That is, consumers will likely be more sensitive to a given price change. By contrast, in markets where there are few or poor quality substitutes this will likely lead to be more price inelastic because of the smaller number of choices available. In this case consumers are likely to be less sensitive to a given price change.

 

Diff: 2                   Skill: Conceptual        Topic: elasticity determinants

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60. Explain using price elasticity of demand why air conditioning manufacturers would actually have sales in the middle of the summer when customers have the most acute need? Explain this apparent paradox.

 

During the winter months customers can postpone their decision to buy an air conditioner. So it would seem that manufacturers would not offer sales in the summer when customers can least afford to postpone their decision. But the reason that they do is that during the summer there is increased competition and manufacturers realize that you have choices. These choices lead to an increase in the price elasticity of demand.

 

Diff: 1                   Skill: Analytic             Topic: price elasticity of demand

AACSB: Analytic Skills

 

 

 

 

 

 

 

 

61. Over twenty years ago the city of Washington D.C. was facing a budgetary shortfall. In a plan to increase tax revenue the mayor and city council agreed to raise the excise tax on gasoline. Typically for goods like gasoline which are price inelastic this should have led to an increase in tax revenue. However, just the opposite happened – tax revenue plummeted! What could explain this seemingly paradoxical result?

 

In order to determine whether a good or service is price elastic or inelastic it is important how narrow or broad the market is defined. Typically, the broader the market, the more inelastic is the demand and vice versa. In the case of Washington D.C. gasoline the market is defined very narrowly. There are many substitutes for Washington D.C. gasoline. Commuters can simply pump for gas near their homes in Maryland and Baltimore before heading to work. In other words, even though gasoline broadly speaking is price inelastic in the present case Washington D.C. gasoline was quite price elastic because of the relatively large number of nearby substitutes.

 

Diff: 2                   Skill: Analytic             Topic: total revenue test

AACSB: Analytic Skills

 

62. The average price of gasoline in June of 2008 in the United States was $3.79. This was up by 82 cents from the previous year. Forecasters are expecting a drop in gasoline consumption of about 1% for the first time in 16 years. Even though this is a historic moment what do the figures still demonstrate about the elasticity of demand for gasoline? If the price increases go unabated what is likely to happen to the long-run price elasticity for gasoline and why?

 

The increase in the price in percentage terms is about 26%. A drop in consumption of only 1% still implies that gasoline is price inelastic. If prices for gasoline continue to rise unabated it is very likely that in the long run people will gradually flock to alternative forms of fuel or transportation. Economy cars will become more popular, more people will turn to mass transit and still others may car pool, bike or walk to work where feasible.

 

Diff: 2                   Skill: Conceptual        Topic: price elasticity of demand

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63. Which is likely to be more elastic: the demand for orange juice or the demand for a particular brand of orange juice? Explain.

 

The demand for a particular brand of orange juice will be more elastic.  There are many close substitutes (other brands).  There are fewer substitutes for orange juice.

 

Diff: 1                   Skill: Conceptual        Topic: price elasticity

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64. Is demand more elastic in the short run or the long run? Why?

 

Demand is generally more elastic in the long run.  In the long run, people have time to make adjustments to changes in price and find alternative products.

 

Diff: 1                   Skill: Conceptual        Topic: elasticity in short run and long run

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65. Many people have bemoaned the fact that hand-written personal letters have become largely a thing of the past. They have also noted that the number of emails they receive have increased quite dramatically and can hardly be compared to the volume of letters that they used to receive by mail. Explain in terms of opportunity cost why this might be the case. Explain why junk email is probably more of a problem than traditional junk mail delivered to our mail box.

 

The opportunity cost of sending an email is much lower than writing and sending personal hand-written letters. First, there is no postage required for sending an email and secondly copies of an email can be easily and effortlessly made to send to many more recipients. The same is true for junk email. It is relatively costless to reproduce a letter sent via email whereas the cost of printing, distributing and mailing traditional junk mail is much higher.

 

Diff: 1                   Skill: Conceptual        Topic: determinants of elasticity

AACSB: Analytic Skills

 

 

66. Compare and contrast the relative elasticities that you are likely to find between toothpicks and furniture. Explain your answer.

 

Toothpicks since they represent a relatively small part of a typical consumer’s budget are likely to be inelastic in demand. Furniture by contrast is a big ticket item and is likely to be more price elastic since consumers are going to be more sensitive to a given price change.

 

Diff: 1                   Skill: Conceptual        Topic: elasticity determinants

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67. Compare and contrast the relative price elasticities of Marlboro brand cigarettes with cigarettes in general. Why is there a difference?

 

How broadly the market is defined determines the price elasticity of a good. In the case of Marlboro brand cigarettes the good is defined narrowly. Since Marlboro has many other close substitutes it has a fairly price elastic demand. However, cigarettes in general tend to be more price inelastic in demand since we are defining the good more broadly.

 

Diff: 1                   Skill: Conceptual        Topic: elasticity determinants

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68. Explain the time dimension as it relates to elasticity. Be sure to include in your answer the difference in elasticity between the short run and the long run.

 

In the short run consumers often don’t have as many choices available to them when prices change. Therefore demand for most goods tends to be inelastic in the short run or at least less elastic then they would otherwise be with the passage of time. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods.

 

Diff: 2                   Skill: Conceptual        Topic: elasticity determinants

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Other Important Elasticities

 

69. The recent reduction in the price of oil has increased the demand for foreign automobiles. Based on this statement, what may be concluded about price, cross-price, or income elasticity of demand?

 

The cross-price elasticity of demand between foreign automobiles and oil is negative, suggesting complementary products. 

 

Diff: 1                   Skill: Fact                    Topic: elasticity

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70. The owner of a local restaurant comes to you for help. He needs to know whether or not he should increase the price of the meals he serves. To answer his question, what information would you like to know?

 

Ideally, you would want to be able to calculate the price elasticity of demand for meals at the restaurant. It would also be helpful to determine the cross-price elasticity between meals at this restaurant and other restaurants in the area. 

 

Diff: 3                   Skill: Conceptual        Topic: cross-price elasticity

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71. What does the income elasticity of demand measure? How is it calculated?

 

The income elasticity of demand measures the responsiveness of demand to changes in income.  It is calculated by dividing the percentage change in quantity demanded by the percentage change in income.

 

Diff: 1                   Skill: Definition          Topic: income elasticity

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72. Billy’s income elasticity of demand for ground beef is -0.5 and his income elasticity of demand for pork chops is 1.2. Is ground beef a normal or inferior good? Explain.  What about pork chops?

 

Because his income elasticity of demand for ground beef is negative, Billy views ground beef as an inferior good. Because his income elasticity of demand for pork chops is positive, Billy views pork chops as a normal good.

 

Diff: 1                   Skill: Analytic             Topic: income elasticity

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73. In the 1970s a typical college student’s consumption might be represented by the following items: a small used car, black and white television set, macaroni and cheese and generic brand beer. As many of these students graduated from college what do you expect happened to the composition and quantity of the goods mentioned? Explain.

 

In all likelihood the consumption of these items either dropped off dramatically or disappeared altogether. The reason is that these items are what economists would classify as inferior goods. As these college students graduated and started to earn more income their demand for these goods fell. It is likely that the composition of goods in their bundle would move towards more normal goods.

 

Diff: 1                   Skill: Conceptual        Topic: income elasticity

AACSB: Reflective Thinking

 

74. When Frank’s income rises from $29,000 to $34,000 per year, he increases his purchases of tomatoes from 20 pounds to 28 pounds per year. What is Frank’s income elasticity of demand for tomatoes? (Use the midpoint formula.)  According to Frank, are tomatoes an inferior or normal good?

 

Percentage change in quantity demanded = (28-20)/24 = 8/24 = 33.3

Percentage change in income = ($34,000 – $29,000)/$31,500 = 5,000/31,500 =         15.9. Therefore, income elasticity of demand = (33.3/15.9) = 2.1

 

Because Frank increased his demand for tomatoes when his income increased, he views tomatoes as a normal good.  Therefore, his income elasticity of demand for tomatoes is positive.

 

Diff: 2                   Skill: Analytic             Topic: income elasticity

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75. What does the cross-price elasticity of demand measure? How is it calculated?

 

The cross-price elasticity of demand measures the responsiveness of the quantity of one good demanded to changes in the price of another good.  It is calculated by dividing the percentage change in quantity of good Y demanded by the percentage change in the price of good X.

 

Diff: 1                   Skill: Definition          Topic: cross-price elasticity

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76. The cross-price elasticity between natural gas and heating oil is estimated to be 2.3. The cross-price elasticity between natural gas and electricity is estimated to be -0.8. What is the relationship between natural gas and heating oil?  What is the relationship between natural gas and electricity?  Explain.

 

Because the cross-price elasticity is positive, natural gas and heating oil are substitutes.  As the price of one goes up, the demand for the other increases.  On the other hand, natural gas and electricity are complements because the cross-price elasticity is negative.  When the price of one goes up, the demand for the other falls.

 

Diff: 1                   Skill: Conceptual        Topic: cross-price elasticity

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77. When the price of a bagel rises from $0.45 to $0.65, the quantity of cream cheese demanded falls from 12,000 to 10,000 ounces per year. Use the midpoint formula to calculate the cross-price elasticity between bagels and cream cheese. What does the sign imply about the relationship between these two goods?

 

percentage change in quantity of cream cheese demanded = (10,000-12,000)/11,000 = -2,000/11,000 = -18.2.

                        percentage change in the price of a bagel = ($0.65 – $0.45)/$0.55 = 0.20/0.55 =

                        36.4. Therefore, the cross price elasticity = -18.2/36.4 = -0.5.

 

            Because the cross-price elasticity is negative, this implies that the two goods are complements.

 

Diff: 2                   Skill: Analytic             Topic: cross-price elasticity

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78. Would you expect the income elasticity of demand for Cadillacs to be positive or negative? Why is this true?

 

The income elasticity of demand for Cadillacs should be positive because Cadillacs are a normal good.  When income rises, the demand for Cadillacs will rise as well.

 

Diff: 1                   Skill: Conceptual        Topic: income elasticity

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79. If leisure is a normal good and the economy expands so that national income rises by 3% next year then theoretically what ought to happen to the amount of work that should take place?

 

Theoretically the amount of work could either rise, fall or stay the same. As income rises in the country as a whole there are actually two effects that are taking place at the same time. The higher wages are making the opportunity cost of leisure more expensive which should induce people to work more. But the higher income allows workers to be able to afford more leisure. Unless we know which effect is stronger – the income effect or the substitution effect there isn’t any way to answer this question definitively by appealing to economic logic alone. It’s largely an empirical question.

 

Diff: 2                   Skill: Conceptual        Topic: normal goods

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80. If a good is income inelastic what does this imply would happen to consumption of this good if you were to win the lottery?

 

By definition an income inelastic good is one whereby the consumer does not change their consumption very much compared to the change of their income. If the consumption changes in the same direction by a percentage less than the change in income then the good in question is income inelastic or a necessity good. In the case of winning the lottery it is unlikely that consumption of the good in question will rise very much compared to the increase income from the winnings.

 

Diff: 1                   Skill: Conceptual        Topic: total revenue test

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81. When the price of a gallon of orange juice rises from $1.50 to $2.00, the number of gallons of apple juice demanded rises from 20,000 to 30,000 per year. Use the midpoint formula to calculate the cross-price elasticity between orange juice and apple juice. What does the sign imply about the relationship between these two goods?

 

Percentage change in quantity of apple juice demanded = (30,000-20,000)/25,000

= 10,000/25,000 = 40. Percentage change in the price of orange juice = ($2.00 – $1.50)/$1.75 = 0.50/1.75 = 28.6.

                        cross price elasticity = 40/28.6 = 1.4.

 

            Because the cross-price elasticity is positive, this implies that the two goods are substitutes.

 

Diff: 2                   Skill: Analytic Topic: cross-price elasticity

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82. Would you expect the cross-price elasticity of demand between ham and turkey to be positive or negative? Why?

 

The cross-price elasticity of demand between ham and turkey should be positive because ham and turkey are substitutes.  When the price of ham rises, the demand for turkey increases as well.

 

Diff: 1                   Skill: Conceptual        Topic: cross-price elasticity

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83. What does the elasticity of supply measure? How is it calculated?

 

The elasticity of supply measures the response of quantity supplied to a change in price.  It is calculated by dividing the percentage change in quantity supplied by the percentage change in price.

 

Diff: 1                   Skill: Definition          Topic: elasticity of supply

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84. Assume a tomato farmer owns one truck and employs one driver. One Saturday a month he brings one truck load of tomatoes to the Farmer’s Market. Over time he discovers that the demand for his tomatoes has increased dramatically as a result of increased marketing and advertising for the market. Explain both the short run and the long run impact on the equilibrium price and quantity of the farmer’s tomatoes. Explain in terms of elasticity of supply.

 

The short run impact will likely be that the equilibrium price will rise but the equilibrium quantity of tomatoes is likely to stay the same. The reason is that in the short run the farmer’s supply of tomatoes is relatively inelastic since he only has one truck and one delivery driver. However, with the passage of time his supply curve is likely to become more elastic if he is able to obtain another truck and deliver driver. In the long run the equilibrium quantity of tomatoes supplied will likely increase by more.

 

Diff: 1                   Skill: Definition          Topic: elasticity of supply

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85. When the price of corn rises from $8.00 per bushel to $10.00 per bushel, the quantity of corn supplied rises from 20,000 to 24,000 bushels per year. Use the midpoint formula to calculate the price elasticity of supply. Is it elastic, inelastic, or unit elastic?

 

Percentage change in quantity supplied = (24,000-20,000)/22,000 = 4,000/22,000 = 18.2. Percentage change in price = ($10.00-$8.00)/$9.00 = 2.00/9.00 = 22.2. Elasticity of supply = 18.2/22.2 = 0.8.

 

      Because the elasticity is less than one, supply is inelastic.

 

Diff: 2                   Skill: Analytic             Topic: elasticity of supply

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86. The cross-price elasticity between X and Y is positive. Illustrate on two graphs, one for good X and one for good Y, what will happen if the supply of X decreases.

 

 

If the supply of X decreases, the price of X will increase, the demand curve for good Y will shift to the right, and the amount of Y purchased will increase.

 

Diff: 2      Skill: Analytic             Topic: cross-price elasticity

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87. Draw a supply curve that has a zero elasticity of supply. What might be an example of a good with a zero elasticity of supply?

 

 

The supply curve will be a vertical line. Agricultural products after they have been harvested or land are examples.

 

Diff: 2                   Skill: Analytic             Topic: elasticity of supply

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88. Assume that a union representative argues that the social security tax is essentially paid for completely by the worker in the form of a lower wage equal to the amount of the tax. If this person were correct what is implicitly assumed to be the shape of the labor supply curve and why? Is this a reasonable assumption? Why or why not?

 

The implicit assumption is that the labor supply curve is perfectly vertical. That is workers will not change their labor supply decisions when wages change. This appears unlikely because it argues that workers do not respond to changes in incentives which appears unlikely.

 

Diff: 2                   Skill: Conceptual        Topic: elasticity of supply

AACSB: Analytic Skills

 

89. Explain why a single labor supply curve can have both a positive and negative elasticity.

 

The labor supply curve will have a positive elasticity when an increase in wages induces more people to enter the workforce. However, as wages rise workers become better off and may trade some labor for more leisure. At this higher wage level the elasticity of labor supply becomes negative as higher wages cause a reduction in the labor supply.  

 

Diff: 3                   Skill: Conceptual        Topic: elasticity of supply

AACSB:

 

90. Show with the use of a graph what a labor supply curve would look like if it had a positive wage elasticity over most of the supply curve but a negative wage elasticity at higher wages. Explain why this might be true.

 

 

The reason that the supply for labor may eventually bend backwards is that it is possible that the income effect of an increase in the wage rate will outweigh the substitution effect which would otherwise induce workers to work more as the wage rate rises.

 

Diff: 3                   Skill: Conceptual        Topic: elasticity of supply

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