CHAPTER 4APPLICATIONS OF SUPPLY AND DEMAND

I. CHAPTER OVERVIEW

There is a common expression among people who think about economic issues: “It’s all a matter of supply anddemand.” This expression is, for the most part, exactly correct. Properly framed, the essence of mosteconomic questions can be approached using the basic market analysis you learned in Chapter 3; properlyinterpreted, the answer to almost any question concerning resource allocation can be explained in terms ofsupply-demand intuition.

In Chapter 3 you learned the laws of supply and demand, and you became familiar with the effects ofchanges in supply and demand on market prices and quantities exchanged. For example, you found that whendemand increases in a market, prices rise and quantities exchanged increase.

This leads naturally to the related question: “By how much?” How large are the responses to changes inthe market, and upon what does this responsiveness depend? This chapter will provide you with the tools youneed to answer this question and with the opportunity to apply your tools in the arena of policy-making.

II. LEARNING OBJECTIVES

After you have read Chapter 4 in your text and completed the exercises in this Study Guide chapter, you shouldbe able to:

1. Define the term price elasticity of demand.2. Discuss the factors that determine whether price elasticity of demand is elastic, unitary-elastic, orinelastic, and compare consumer behavior in the short run and the long run. Describe elastic and inelasticregions that exist along most demand curves.3. Calculate price elasticity of demand using a method of averages and interpret your result.4. Explain, using diagrams, the relationship between total revenue and price elasticity of demand.5. Define the term price elasticity of supply.6. Discuss the factors that determine whether price elasticity of supply is elastic, unitary-elastic, orinelastic, and compare producer behavior in the short run and the long run.7. Calculate price elasticity of supply using a method of averages, and interpret your result.8. Apply supply, demand, and elasticity concepts to the following situations and markets: (a) agriculturemarkets, (b) taxes, and (c) price ceilings and price floors.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.A B

__ Price elasticity 1. The ultimate economic impact or burden of a tax.of demand

__ Price elasticity 2. Legal maximum price that sellers can charge for a good or serviceof supply as defined by government.

__ Elastic demand 3. Demand or supply is infinitely responsive to changes in price.__ Inelastic demand 4. The multiplicative product of price and quantity sold.__ Unit-elastic 5. Measures the percentage change in quantity demanded of a good

demand when its price changes.__ Perfectly elastic 6. Legal minimum price that sellers can receive for a good or service as defined by

government.__ Perfectly 7. Percentage change in quantity demanded is less than percentage

inelastic change in price.__ Total revenue 8. Demand or supply is not responsive at all to changes in price.__ Tax incidence 9. Percentage change in quantity demanded is greater than percentage change in

price.__ Price ceiling 10. Measures the percentage change in quantity supplied of a good when its price

changes.

62

__ Price floor 11. Means that total revenue will not change when the price of the good changes.

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Elasticity of Demand and Supply1. Any elasticity that you encounter in economic analysis measures, in percentage terms, the responsivenessof some economic variable to a change. All elasticities are designed to answer the question “How much?” Forexample, we know from the law of demand that as price falls, quantity demanded increases. Price elasticity ofdemand describes the percentage change in quantity demanded of a product caused by some percentage changein its price. Thus, price elasticity of demand helps us to describe movement along a demand curve. Because itis expressed in percentage terms and is hence devoid of all scale measurements, it can be used to compareconsumer responsiveness across goods and at different price levels.2. Price elasticity of demand between any two points on a demand curve can be calculated using the followingformula:

ED = percentage change in quantity demanded =percentage change in price

[ (Q2 - Q1) / ((Q2 + Q1) / 2) ][ (P2 - P1) / ((P2 + P1) / 2) ]

Notice that the numerator and the denominator both contain percentage changes rather than absolute changes inquantities and prices. These percentage changes (and any percentage change, for that matter) are found by takingan absolute change and dividing it by a reference point. For example, to find percentage change in quantitydemanded, find the difference between the initial and final quantities at two points on your demand curve.Divide this difference by your reference point, which in our case will be the average quantity. This gives youthe percentage change in quantity demanded. Follow the same method for the percentage change in price;divide the absolute difference in prices by the average price. Plug these values into the equation above to find acoefficient for price elasticity of demand between two points on your demand curve.

Notice that the sign of this coefficient will always be negative. That is, as long as the demand curve isdownward-sloping, there will be an inverse relationship between price and quantity demanded. Therefore, whenyou interpret this coefficient, just look at its absolute size, or absolute value. Ignore the negative sign andsimply ask yourself if the coefficient is greater than, less than, or equal to 1.3. a. Demand is defined as elastic when the percentage change in quantity demanded is greaterthan the percentage change in price. (ED > 1)

b. Demand is defined as inelastic when the percentage change in quantity demanded is less thanthe percentage change in price. (ED < 1)

c. Demand is defined as unit elastic when the percentage change in quantity demanded is equalto the percentage change in price. (ED = 1)4. The demand for any good is more elastic when there are more substitutes available, when the item isconsidered to be more a luxury than a necessity and when a longer time frame is considered. Demand for mostgoods will be more elastic in the long run than in the short run, since a longer time frame allows consumersto search more carefully for substitutes.5. Demand curves that are flat tend to be relatively more elastic than demand curves that are steep. However,all linear demand curves are elastic at the top, are unitary elastic at their midpoint, and are inelastic at thebottom. Notice that when prices are high, the same percentage change means a greater absolute change inprice. For example, suppose the price of a good is $1.00. A 10 percent increase in price means the new priceis $1.10. Suppose the price of a good is $100. The same 10 percent increase in price means the new price is$110! Consumers tend to be more responsive to a $10 change in price than to a $.10 change in price.6. Price elasticity of supply describes how much quantity supplied increases when the price of a product rises.Thus, it helps us to describe movement along a supply curve.7. Price elasticity of supply between any two points on a supply curve can be calculated using the followingformula:

63

ES = percentage change in quantity SUPPLIED =percentage change in price

[ (Q2 - Q1) / ((Q2 + Q1) / 2) ][ (P2 - P1) / ((P2 + P1) / 2) ]

Price elasticity of supply takes the same general form as price elasticity of demand. Again, you are usingpercentage changes in the numerator and denominator rather than absolute changes, and again, you are usingaverage quantity supplied and price for your reference points.8. The supply of any good is more elastic when there is greater flexibility in the production process, allowingincreases in output without significant increases in the price of inputs, and when a longer time frame isconsidered.

B. Applications to Major Economic Issuesl. Elasticities help to determine the impact of government policies because they describe the responsivenessof agents in the economy to change.2. When the government decides to levy a tax, the incidence of the tax describes who bears its ultimateeconomic burden, buyers or sellers. The larger portion of the tax tends to be paid by the side of the market thatresponds more inelastically to changes in price. For example, if demand is relatively inelastic, consumers willnot alter their buying patterns significantly when price increases, giving sellers the opportunity to pass the taxonto the consumers without fearing large decreases in sales. As demand becomes more elastic, sellers have toworry about larger and larger decreases in sales when they raise prices.3. Prices are sometimes fixed by law. Price floors are legal minimum prices; they hold prices artificiallyabove equilibrium to protect sellers. For example, minimum wages set by governments hold wages aboveequilibrium in order to achieve policy objectives. Price ceilings are legal maximum prices; they hold pricesartificially below equilibrium to protect buyers. For example, in markets for gasoline the government hasconsidered holding prices low to protect consumers.

V. HELPFUL HINTS

l. Elasticities make an important contribution to the study of economics. As we have seen, they help todefine responsiveness to changes at the margin. You will find many interesting uses for the concept ofelasticity as you make your way through this course.2. The elasticity of demand is not the slope of the demand curve. Remember that the slope of the demandcurve as we draw it always measures the absolute change in the price divided by the absolute change in thequantity demanded between any two points on the curve. Elasticity, on the other hand, is the percentagechange in quantity demanded divided by the percentage change in price. There is a relationship between thesetwo concepts, but they are not the same thing.3. The elasticity of demand is not constant as you move down a linear demand curve. Remember that thesame percentage changes result in smaller absolute changes as you move down the curve; consumers tend to beless responsive to smaller changes in price than they are to larger changes.4. Some of the most fun and challenging uses for economics are in the area of government policy. Byapplying basic economic concepts, you can get a feel for the impact of policy in the areas of taxation and pricecontrols, among others. However, remember that policymakers often have normative economic goals that theyare trying to achieve. For example, using the positive economics generated in this chapter, you can see thatminimum wage policy raises wages and costs for firms and also restricts employment. This may seeminefficient. However, wages do increase for some workers; as an antipoverty measure, it may achieve desiredresults. The bottom line is that good policymakers have to consider both positive and normative economics.5. Remember, the person who actually sends the tax money into the government (producer or consumer) maynot be the one actually bearing the burden of the tax. The burden is determined by the relative elasticities ofthe supply and demand curves. For example, taxes on gasoline are most often collected by suppliers.However, when a new tax is levied by government, prices on the gas pumps often rise, indicating thatconsumers are bearing at least some of the burden of the new tax.

64

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the optionsavailable.

A. Elasticity of Demand and Supply1. The price elasticity of demand equals the:

a. absolute price change divided by the absolute quantity change between two points on a demand curve.b. percentage change in revenue divided by the percentage decrease in price.c. percentage change in revenue divided by the percentage increase in quantity demanded.d. percentage change in quantity demanded divided by percentage change in price.e. slope of the demand curve.

2. Suppose Mr. Gray has budgeted a fixed amount of money to buy eggs. Within a certain range of prices, hewill spend neither more nor less than this amount of money on eggs, regardless of the price. His demand inthis price range would properly be designated as being:

a. in equilibrium.b. perfectly elastic.c. perfectly inelastic.d. highly inelastic, but not perfectly so.e. unit-elastic.

Use the following information to answer questions 3 and 4: The Dark Movie Theater raised the price ofpopcorn from $2.00 per barrel to $2.30 per barrel. This caused the quantity of barrels sold to fall from 100 perday to 80 per day.3. At this time, the price elasticity of demand for popcorn could be estimated to be:

a. -.52.b. -1.c. -1.59.d. -1.9.e. -66.67.

4. The Dark Movie Theater will see its total revenues from popcorn sales:a. rise.b. fall.c. double.d. remain the same.e. fall to zero.

5. When the words “total revenue” are used in any discussion of demand curves, they refer to:a. the profit, after deduction of costs, that the suppliers of a good or service earn from selling toconsumers.b. the total amount of money consumers will spend on a good at any particular price.c. the gross income suppliers will receive from government.d. the quantity of a good that is associated with any particular price.e. nothing; the words “total revenue” cannot have any meaning in relation to demand curves.

Figure 4-1 indicates the demand for air travel between New York City and Chicago. Use it to answer questions6 and 7.

Figure 4-1

6. At point B, total revenue is represented by area:a. EBGO.b. AOD.

65

c. FCHO.d. AEB.e. EBIF.

7. Between points B and C demand is:a. relatively elastic.b. relatively inelastic.c. perfectly elastic.d. perfectly inelastic.e. unit-elastic.

8. If a l0 percent reduction in a commodity’s price brings a 5 percent increase in the amount of money peoplespend to buy that commodity, then in this region of the demand curve, price elasticity of demand is:a. elastic.b. unit-elastic.c. inelastic although not perfectly so.d. perfectly inelastic.e. perhaps any of these—the information given is insufficient to determine elasticity.

9. If a 10 percent reduction in price causes a 5 percent increase in the quantity of a commodity that peoplebuy, then in this region of the demand curve, price elasticity of demand is:a. elastic.b. unit-elastic.c. inelastic, although not perfectly so.d. perfectly inelastic.e. perhaps any of these—the information given is insufficient to determine elasticity.

l0. Which of the following observations would indicate that demand for a good is price-inelastic?a. The good in question is more of a necessity than a luxury for most people.b. Good substitutes for this good do not exist.c. The time period allowed for responding to a change in price is very small.d. All or any of the above.e. None of the above.

l1. Betty notices that no matter how many paper cups she buys, she always pays the same price per cup. Thismeans that the supply curve which confronts her is:a. perfectly inelastic.b. perfectly elastic.c. unit-elastic.d. elastic, but not necessarily perfectly elastic.e. none of these things, necessarily

12. A perfectly inelastic supply curve would be shown in the ordinary supply-and-demand graph as a:a. vertical line.b. horizontal line.c. straight line, but neither horizontal nor vertical.d. curved line.e. any of the above.

13. Which alternative in question 12 would be correct for the graphical portrayal of a perfectly inelastic demandcurve?a. vertical line.b. horizontal line.c. straight line, but neither horizontal nor vertical.d. curved line.e. any of the above.

14. If a demand curve displays unitary price elasticity throughout its entire length, then the demand curve is:a. a straight line, and total expenditure by buyers is the same at all prices.b. not a straight line, and total expenditure by buyers falls as price falls.c. a straight line, and total expenditure by buyers first increases and later decreases as price falls.d. not a straight line, and total expenditure by buyers rises as price falls.e. none of the above is correct.

Use the diagrams in Figure 4-2 to answer questions 15 and 16.

66

Figure 4-2

15. A patient must purchase some exact quantity of a particular drug (no more, no less) and will pay any price,if necessary, in order to obtain it. Which of the five diagrams could be used to illustrate this situation?a. (a)b. (b)c. (c)d. (d)e. (e)

16. Over the past century, consumers of food in the United States have not purchased much more to eat, inspite of the fact that tremendous improvements in technology have led to lower real food prices. Which ofthe five diagrams could be used to illustrate this situationa. (a)b. (b)c. (c)d. (d)e. (e)

17. Assume that consumers buy 100 widgets at $10 and 200 widgets at $5. What is the elasticity of demandin this price range?a. elasticb. inelasticc. unitaryd. not enough information to answer this question

B. Applications to Major Economic Issues18. For farmers, improvements in technology this century have been a mixed blessing. Farmers have seen:

a. large increases in supply and large increases in prices of agricultural products.b. large increases in demand and large increases in prices of agricultural products.c. large increases in supply and large decreases in prices of agricultural products.d. small decreases in supply but large increases in demand; these two forces offset one another.e. none of the above.

Figure 4-3

19. Which of the diagrams in Figure 4-3 reflects the effect of crop restrictions when they are placed on marketsfor agriculture products?a. (a)b. (b)c. (c)

67

d. (d)20. The government levies an excise tax of 5 cents per unit sold on the sellers in a competitive industry. Both

supply and demand curves have some elasticity with respect to price. When this tax is represented on thesupply-and-demand diagram, the entire:a. supply curve shifts upward by exactly 5 cents, but (unless demand is perfectly elastic) the market priceremains constant.b. supply curve shifts upward by less than 5 cents, but (unless demand is highly elastic) the market pricerises by the full 5 cents.c. supply curve shifts downward by less than 5 cents and the market price falls.d. supply curve shifts upward by exactly 5 cents, but (unless supply is perfectly elastic) the market pricerises by less than 5 cents.e. demand curve shifts upward by exactly 5 cents, but the market price rises by less than 5 cents.

21. Suppose that the demand curve for wheat is perfectly inelastic with respect to price. If a tax of 50 cents perbushel sold were imposed on the market and collected by producers, then price would:a. rise, but by less than 50 cents, and there would be some reduction in the quantity bought and sold.b. rise by the full 50 cents, but there would be no reduction in the quantity bought and sold.c. rise, but by less than 50 cents, and there would be no reduction in the quantity bought and sold.d. rise by the full 50 cents, and there could definitely be a reduction in the quantity bought and sold.e. fall, but by less than 50 cents, and there would be some reduction in the quantity bought and sold.

22. The change brought about by the tax levy described in the question above could be described as a decreasein:a. supply followed by an increase in quantity demanded.b. quantity supplied followed by a decrease in quantity demanded.c. supply followed by a decrease in demand.d. quantity supplied followed by a decrease in demand.e. none of the above.

23. Suppose the government imposes an additional tax of $1.00 per bottle of whiskey. In response to this tax,the market price rises from $12.00 to $12.63 per bottle. From this information, you can say that:a. the supply curve is relatively more inelastic than the demand curve.b. the demand curve is relatively more inelastic than the supply curve.c. price elasticity of demand and supply are equal.d. the sellers bear the entire burden of the tax.e. none of the above.

Figure 4-4

Use Figure 4-4, which describes a hypothetical market for carpenters, to answer questions 23 through 25.24. Suppose the government passes a law stating that carpenters must be paid no less than $50 per hour. This

sort of price control would be called a(n):a. price ceiling.b. price floor.c. wage subsidy.d. tax.e. equilibrium price.

68

25. Between the old equilibrium and the new minimum wage, price elasticity of demand is:a. -.66.b. -.73.c. -1.37.d. -1.50.e. none of these.

26. Between the old equilibrium and the new minimum wage, price elasticity of supply is:a. .43.b. .66.c. 1.00.d. 2.33.e. none of these.

27. Energy price controls are a type of:a. tax.b. price floor.c. subsidy.d. price ceiling.

28. Assume the demand for wheat is inelastic and that a blight destroys 1/4 of the wheat crop. What happensto the total revenue of farmers as result of this blight.a. increases.b. decreases.c. stays the same.d. not enough information.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in the chapter.

A. Elasticity of Demand and Supply 1. Please complete the following statements with the correct answers:

a. If we say that “demand is highly price-elastic,” we mean that any price reduction would produce arelatively (large / small) (increase / decrease) in purchases and that a price rise would yield a relatively(large / small) (decrease / increase) in buying.b. To describe supply as “decidedly price-inelastic” would mean that any price increase would cause arelatively (large / small) (increase / decrease) in quantity offered for sale and that any price reductionwould produce a relatively (large / small) (increase / decrease) in the quantity supplied.

2. Table 4-1 shows demand for hamburgers at Sam’s Drive-In at prices from $8 to $0.

TABLE 4-1 Price

Quantity Total Elasticity Price Demanded Revenue of Demand

$8 0 ______________ _______________7 2 ______________ _______________6 4 ______________ _______________5 6 ______________ _______________4 8 ______________ _______________3 l0 ______________ _______________2 12 ______________ _______________1 14 ______________ _______________0 16 ______________ _______________

a. Use the numbers in Table 4-1 to draw a demand curve in Figure 4-5.b. Calculate the total revenue received by Sam’s at each price in Table 4-1.c. Plot the total revenue curve along with your demand curve.d. Calculate the price elasticity of demand at the midpoint between the prices listed in Table 4-1. Use

your diagram and explain the relationship between price, elasticity of demand, and total revenue.3. Use your answers to question 2 to complete the following:

69

a. Notice the interesting behavior of the total revenue curve as you move down the length of the straight-linedemand curve. As price falls, total revenue (remains the same at all quantities / falls throughout the entireprice range / rises first, reaches a peak, and then falls / falls first, reaches a minimum, and then climbs)b. If the price falls from $7 to $6, total revenue (rises / stays the same / falls). How is this possible whenthe lower price means that each unit that was purchased at $7 is now purchased at $6? For the 2 unitsdemanded at $7, lowering the price by $1 results in $2 less revenue being collected. The lower price means alarger quantity is demanded. Is the revenue collected from the sale of these extra units enough to overcome theinitial loss just noted? Four units are demanded if the price is $6—an increase in the quantitydemanded—yielding an additional $___ in revenue. In this case, the increase in revenue generated by sellingmore units (is / is not) enough to offset the initial loss.c. Now suppose that the price falls from $4 to $3. Selling the units demanded at $4 for a dollar less resultsin a revenue loss of $__. The associated increase in the quantity demanded of units brings a counterbalancingrevenue gain of $__. The loss (outweighs / exactly balances / falls short of) the gain, and total revenue (falls/ stays the same / increases).

Figure 4-5

4. Complete the following:a. If an increase in demand is sudden and suppliers have no reserve inventories on hand, then no greaterquantity can be offered immediately, despite the price rise. In this case, the supply curve would have to beshown as (perfectly elastic / perfectly inelastic).b. Given a little time, suppliers can adjust to a demand surge by working their plant and equipment harder(e.g., by adding an extra shift of workers) . The result of this increase in supply would be the new (long-run /short-run) equilibrium.c. If the shift in demand is sustained, then existing and potential new suppliers have even more time to buildnew plants and install new equipment. There is a further increase in the supply. Finally, an equilibrium priceindicating (long-run / short-run) equilibrium may be reached.d. Note carefully that all this is just a statement about price elasticity of supply. It says that the degree ofresponsiveness of supply to a price change will depend on the amount of adjustment time suppliers can have.The longer this time period, the (higher / lower) will be the price elasticity (the elasticity coefficient) of

70

supply. The same sort of relationship between elasticity and time (can / cannot) be defined for the demandside.

Figure 4-6

5. Suppose Figure 4-6 shows the supply curve in the market for sweatshirts at Anywhere State University.a. The slope of this supply curve is ___.b. The price elasticity of supply between points A and B is___; between B and C is___; and between C and Dis ___.c. (advanced concept) The equation for this supply curve is: ____________________________________.d. (advanced concept) The relationship between the slope of a supply curve and its elasticity at a given pointcan be described as follows: _____________________________________________________________.

B. Applications to Major Economic Issues6. One of the most heavily taxed consumer products in the United States, and in many other countries, iscigarettes. Figure 4-7 shows a hypothetical representation of this market:

a. Initially, the equilibrium price is $___ and the equilibrium quantity exchanged is ___ packs per day.b. The federal government is discussing the idea of increasing the tax on cigarettes in order to finance auniversal health care system. Suppose the government decides to levy a $1-per-pack tax. Show the impact ofthis on the market using Figure 4-7.c. After the tax is levied, the equilibrium price becomes approximately $__ and the equilibrium quantityexchanged is approximately ___ packs per day.d. In this case, the buyers must pay approximately $___ of the new tax and the sellers must payapproximately $___ of the new tax. The government will collect $___ per day.e. Carefully compare the relative price elasticities of supply and demand in this price range. How can youexplain the division of the tax that you calculated in part d?

71

Figure 4-7

7. Price controls have been used by many governments in order to achieve policy objectives. Sometimes, as inthe case of price supports in the dairy industry, policymakers are trying to protect sellers’ incomes. Other times, asin the case of rent control, policymakers are trying to protect buyers from high prices.Consider Figure 4-8. The equilibrium price of X is $___ and the equilibrium quantity is ___ units. Suppose thegovernment is considering a number of policy options designed to restrict consumption to 500 units. First, itcould impose a price (ceiling / floor) of $___; the quantity demanded would then be ___ units, but the quantitysupplied would be ___ units. A (shortage / surplus) of ___ units would result in the short run. Second, thegovernment could set a production quota at 500 units; suppliers would receive a price of $___ for every unit thatthey sold. Finally, the government could issue ration tickets and announce that one ticket and no more than $5would be required to purchase 1 unit of X. If the tickets could be bought and sold, they would command a price of$____. Carefully explain why this is true.

Figure 4-8

72

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.l. Are the following statements true or false?

a. If demand is price-elastic, then a 10 percent increase in price is associated with a reduction in thequantity demanded of more than 10 percent. This means that quantity is falling faster than price is rising,and total revenue will fall. (T/F)b. If demand displays unitary price elasticity, then a 10 percent increase in price is matched by a 10percent increase in quantity demanded. This means that total revenue will remain unchanged. (T/F)c. If demand is price-inelastic, then a 10 percent increase in price is associated with a reduction in thequantity demanded of less than 10 percent. This means that total revenue will actually rise with the price.(T/F)

2. Put (E) for price-elastic, (U) for unitary-elastic, or (I) for price-inelastic in the blanks below according towhich term most accurately describes each demand situation:___ a. Price falls from $6 to $5 and revenue falls from $60 to $55.___ b. Price falls from $6 to $5 and revenue stays the same.___ c. Price climbs from $5 to $6 and quantity purchased falls from 80 to 60.___ d. Price drops from $6 to $5 and there is no increase in quantity demanded.___ e. Price climbs from $300 to $301 and there is no reduction in quantity demanded.___ f. Price climbs and revenue climbs by $10.___ g. Price climbs from $5.00 to $5.01 and people stop buying the stuff completely.3. Although we have discussed the extreme case of a good that has a perfectly inelastic demand in all priceranges, there are very few goods that can be categorized in this way. Why is this? Explain.4. Carefully explain why all linear demand curves have elastic, unit-elastic, and inelastic regions. Given this,and the relationship between elasticity and total revenues, which of the following two firms is more likely toincrease the price of its product: (a) a producer of canned soup, whose price elasticity of demand is currently .5;or (b) a producer of fur coats, whose price elasticity of demand is currently -3.8?5. An example in your textbook discusses the relationship between price elasticity of demand and airlinepricing policies. Low-elasticity business travelers are charged higher prices than are higher-elasticity vacationtravelers. Explain the form that this sort of pricing policy might take. Can you think of another market inwhich price differentials exist for consumers with different price elasticities of demand?6. (a) Use a diagram to show the impact of a price ceiling in the market for butter. Why might government

policymakers adopt such a plan? Can you think of any time during this century when this policy mighthave been appropriate?(b) Now use a diagram to show the impact of a price floor in the market for butter. Why mightgovernment policymakers adopt such a plan? Can you think of any time during this century when thispolicy might have been appropriate?

7. During the summer of 1993, severe flooding in the midwestern United States destroyed corn, wheat, andsoybean crops. During the summer of 1994, severe flooding in the southeast destroyed a large portion of thepeanut and cotton crops. Use supply-and-demand diagrams to show the effects of this flooding if demand isrelatively inelastic in the markets for these agriculture products. Now, show the effects of this flooding if thedemand for these agriculture products is relatively elastic. Explain the difference, and make predictionsconcerning farm incomes in light of these disasters.

IX. ANSWERS TO STUDY GUIDE QUESTIONS

111. Review of Key Concepts 5 Price elasticity of demand 10 Price elasticity of supply 9 Elastic demand 7 Inelastic demand 11 Unit-elastic demand 3 Perfectly elastic 8 Perfectly inelastic 4 Total revenue 1 Tax incidence

73

2 Price ceiling 6 Price floor

VI. Multiple Choice Questions1. D 2. E 3. C 4. B 5. B 6. A7. A 8. A 9. C 10. D 11. B 12. A

13. A 14. E 15. E 16. D 17. C 18. C19. A 20. D 21. B 22. E 23. B 24. B25. B 26. A 27. D 28. A

VII. Problem Solvingl. a. large / increase

large / decreaseb. small / decrease

small / increase2. a and b: see Table 4-1.

TABLE 4-1 Quantity Total Elasticity

Price Demanded Revenue of Demand $ 8 0 $ 0 xxx

7 2 14 15.006 4 24 4.335 6 30 2.204 8 32 1.293 10 30 .772 12 24 .451 14 14 .230 16 0 .07

c. see Figure 4-9.d. As price falls in the elastic portion of the demand curve, total revenue increases. As price falls in the

inelastic portion of the demand curve, total revenue decreases.

74

Figure 4-9

3. a. Rises first, reaches a peak, and then falls.b. Rises, $12, is.c. $8, 2 units, $6, outweighs, falls.

4. a. perfectly inelasticb. short-runc. long-rund. higher, can

5. a. 2.5b. 1, 1, 1c. Price = 2.5 • Quantityd. Elasticity = (1/slope) • (P/Q)

6. a. $2.00, 4000 packs per dayb. Shift the supply curve to the left by the amount of the tax.c. $2.75, 3000d. $.75, $.25, $3000e. Demand is relatively more inelastic, so buyers pay more of the tax.

7. $7.00, 750, floor, $9.00, 500, 1000, surplus, 500, $9.00, $4.00. Buyers are willing to pay as muchas $9.00 for 500 units of the item; if the price is $5.00 then people will be willing to pay as much as $4.00 forthe tickets.

VIII. DISCUSSION QUESTIONS

l. a. Tb. Fc. T

2. a. Ib. U

75

c. Ed. Ie. If. Ig. E

3. For most goods and most consumers, price eventually reaches a level beyond which further consumption isimpossible.4. At higher prices, the same percentage change in price is a larger absolute change; thus consumers are moreresponsive to it. The producer of canned soup is more likely to raise the price. Because demand is inelastic, aprice increase will lead to higher total revenues.5. Vacation travelers must stay over a Saturday night in order to guarantee lower fares. In movie theaters,adults pay more for tickets than children do.6. a.

A price ceiling in the market for butter might be appropriate if the government is trying to protectbuyers from high prices. This might have happened during World War II, when much of the economy’sproductive capacity was directed toward military equipment and away from consumer products.b.

A price floor in the market for butter might be appropriate if the government is trying to protect sellersfrom low prices. This might be used currently, as new technology in the dairy industry threatens to bringprices and farm income down further.

76

7. In either case, a significant decrease in supply will raise prices and reduce the quantities of the goodsexchanged. If demand is elastic, the price change will be relatively small while the quantity change is relativelylarge. If demand is inelastic, the price change will be relatively large while the quantity change is relativelysmall. For those farmers unaffected by the floods, incomes will rise as long as demand is inelastic.