Unit Answers

Unit 2 Answers to Practice Questions:

Chapter 3

1. Explain what is meant by a purely competitive market.

A purely competitive market is an institution or mechanism which brings together large numbers of independently acting buyers and sellers who want to exchange some standardized product. If the product is not standardized, then the market is not �purely competitive,� although it may be very competitive. Examples of purely competitive markets are a central grain exchange, a stock market or a market for foreign currencies where there are many buyers and sellers acting independently. [text: E p. 39; MA p. 39; MI p. 39]

2. Define �demand.�

Demand is a schedule which shows the various amounts of a product buyers are willing and able to purchase at each price in a series of possible prices during a specified period of time. Demand portrays alternative price/quantity possibilities which can be set down in a table. The key point to be recognized is that demand is more than a statement of quantity purchased at a certain price; it is a schedule of quantities which will be demanded at various prices, other things being equal, for a specified period of time. [text: E p. 40; MA p. 40; MI p. 40]

3. State the law of demand and explain why the other-things-equal assumption is critical to it.

The law states that, other things being equal, as price increases, the corresponding quantity demanded falls. Restated, there is an inverse relationship between price and quantity demanded with everything else held constant. The other-things-equal assumption refers to constant prices of related goods, income, tastes, and other things that affect demand besides price. The law of demand only looks at the relationship between price and quantity demanded. [text: E p. 40; MA p. 40; MI p. 40]

4. Give three explanations for the law of demand:

First, it is explained by common sense. People tend to buy more of a product at a lower price than at a higher price. Second, there is diminishing marginal utility: a decrease in satisfaction that results with an increase in the amounts of a good or service. The second unit of a good yields less satisfaction (or utility) than the first. Third, there are income and substitution effects. With an income effect, a lower price increases the purchasing power of money income, enabling you to buy more at lower price. With a substitution effect a lower price gives an incentive to substitute the lower-priced good for a now relatively high-priced good. [text: E pp. 40-41; MA pp. 40-41; MI pp. 40-41]

5. Suppose the price of beef fell dramatically as the price of feed grain decreased. Use the income effect and the substitution effect to explain why there was an increase in the quantity of beef purchased.

The income effect predicts that the quantity of beef purchased will rise when beef prices fall because people will now be able to afford more. The purchasing power of their income rises when prices fall, assuming other things remain the same.

The substitution effect predicts that the lower price of beef will lead consumers of substitute foods such as chicken and pork to buy more of the relatively less expensive beef and to buy less chicken or pork or other beef substitutes whose prices have not fallen. [text: E pp. 40-41; MA pp. 40-41; MI pp. 40-41]

6. The demand schedules of three individuals (Tom, Dick, and Harry) are shown. If they are the only three buyers of CDs, complete the market demand schedule for CDs. Graphically, is the market demand for a product the horizontal or vertical sum of the individual demand schedules?

Quantity demanded, CDs

Price Tom Dick Harry Total

$15 1 4 0 _____

13 3 5 1 _____

11 6 6 5 _____

9 10 7 10 _____

7 15 8 16 _____

The market demand is the horizontal sum of the individual schedules.

Quantity demanded, CDs

Price Tom Dick Harry Total

$15 1 4 0 5

13 3 5 1 9

11 6 6 5 17

9 10 7 10 27

7 15 8 16 39

[text: E pp. 41-42; MA pp. 41-42; MI pp. 41-42]

7. List five basic determinants of market demand that could cause demand to decrease. (The text mentions seven possibilities.)

(a) Consumers� tastes become less favorable toward the item.

(b) The number of buyers decreases.

(c) Incomes fall and the item is a normal good.

(d) Incomes rise and the item is an inferior good.

(e) A decrease in the price of a substitute product.

(f) An increase in the price of a complementary product.

(g) Consumers expect lower prices in the future.


8. Differentiate between a normal (superior) and an inferior good.

A normal (superior) good is one whose demand varies directly with income as is true for most goods and services the more income one earns, the more one is willing and able to buy. However, there are exceptions, called inferior goods, whose demand varies inversely with income. Inferior goods are those whose demand increases when incomes fall and vice versa. [text: E p. 43; MA p. 43; MI p. 43]

9. Explain how the prices of related goods also affect demand.

Substitute goods are those that can be used in place of each other. The price of the substitute and demand for the other good are directly related. If the price of Coke rises, demand for Pepsi should increase. Complementary goods are those that are used together like tennis balls and rackets. When goods are complements, there is an inverse relationship between the price of one and the demand for the other. Some goods are not related to each other and are independent goods. In these cases, a change in price of one will not affect the demand for the other. [text: E pp. 43-44; MA pp. 43-44; MI pp. 43-44]

10. Give examples of two substitute goods and two complementary goods. In

each case explain why the goods are substitutes or complements.

The pair of substitute goods given should correspond to the explanation that they are substitutes because when the price of one changes, the demand for the other changes in the same direction. When the price of butter rises, one expects the demand for margarine to increase; when the price of butter falls, one expects the demand for margarine to fall as butter lovers switch back to butter consumption.

The pair of complementary goods should fit the explanation that they are complements because when the price of one changes, the demand for the other is inversely related. When the price of tennis equipment rises, the demand for tennis-club memberships should fall (if tennis playing is a normal good). [text: E pp. 43-44; MA pp. 43-44; MI pp. 43-44]

11. What is the difference between a change in demand and a change in quantity demanded?

A change in demand is a shift in the entire demand curve either to the left (a decrease in demand) or to the right (an increase in demand). �Demand� refers

to the entire schedule or curve. By contrast, a change in quantity demanded is a movement along an existing demand curve or schedule from one price-quantity combination to another. A change in product price causes the change in quantity demanded. [text: E pp. 44-45; MA pp. 44-45; MI pp. 44-45]

12. Suppose a producer sells 1,000 units of a product at $5 per unit one year, 2,000 units at $8 the next year, and 3,000 units at $10 the third year. Is this evidence that the law of demand is violated? Explain.

No. The law of demand shows the relationship between price and quantity demanded. In general, as price falls the quantity demanded will increase. One of the assumptions, however, is that all other things are equal or held constant. In this case, this assumption may have been violated and that is why it seems there is a positive relationship between price and quantity. The most likely explanation for the set of events is that demand for the product increased from one year to the next. IF that was true, then price would rise and the equilibrium quantity would increase. [text: E pp. 43-44; MA pp. 43-44; MI pp. 43-44]

13. What effect should each of the following have upon the demand for portable music players in a competitive market? Explain your reasoning in each case.

(a) the development of improved, low-priced devices that compete with music players

(b) an increase in population and incomes

(c) a substantial increase in the number and quality of music for players

(d) consumer expectations of substantial price increases in music players

(a) Would cause a decrease in demand for music players, assuming that other devices are substitutes for music players.

(b) Would cause an increase in demand because there are more consumers and they have more income to spend. This assumes that music players are a normal good and more would be bought with higher incomes.

(c) Should increase demand since increased number and quality of music�s variety of programs should make owning a music player more desirable.

(d) Should increase current demand because expectations about the future have changed and may prompt them to �buy now� to beat the future price increase.

[text: E pp. 43-44; MA pp. 43-44; MI pp: 43-44]

New14. What effect should each of the following have on the demand for gasoline in a competitive market? State what happens to demand. Explain your reasoning in each case and relate it to a demand determinant.

(a) an increase in the number of cars

(b) the economy moves into a recession

(c) an increase in the price of car insurance, taxes, maintenance

(d) consumer expectations of substantial price increases in gasoline

(a) Demand would increase because there would be more buyers of gasoline. The additional buyers would come from the additional cars and trucks.

(b) Demand would decrease because consumer and business incomes would fall. Consumer and businesses would have less money to spend on gasoline.

(c) Demand would decrease because of increase in the price of complementary goods. Car insurance, car taxes, and car maintenance expenses are complements to gasoline.

(d) Current demand for gasoline would increase because expectations about the future have changed and may prompt consumers to �buy now� to beat the future price increases. [text: E pp. 43-44; MA pp. 43-44; MI pp. 43-44]

15. Define �supply.�

The definition of supply is very similar to that of demand. Supply is a schedule which shows the various amounts of a product sellers are willing and able to produce and offer for sale at each price in a series of possible prices during a specified period, other things being equal. [text: E p. 45; MA p. 45; MI p. 45]

16. Describe and give a reason for the law of supply. The law of supply indicates that producers will produce and sell more of their product at a high price than

at a low price. This means that there is a direct relationship between price and quantity supplied. The basic explanation is that, given product costs, a higher price means greater profits and thus more incentive for business to increase the quantity supplied. [text: E p. 45; MA p. 45; MI p. 45]

17. List six basic determinants of market supply.

(a) Resource prices

(b) Changes in technology

(c) Taxes and subsidies

(d) Prices of other related goods

(e) Expectations

(f) Number of sellers [text: E pp. 46-47; MA pp. 46-47; MI pp. 46-47]

18. Suppose the U.S. Congress is considering passing an excise tax that would increase the price of a pack of cigarettes by $1.00. What would be the likely effect of this change on the demand and supply of cigarettes? What is likely to happen to cigarette prices and the quantity consumed if the tax bill is enacted?

In the short run, the excise tax would decrease the supply of cigarettes because in essence it increases the cost of production. The decrease in supply would increase the price of cigarettes and decrease the quantity of cigarettes consumed. The demand for cigarettes would not change, but the quantity demanded would decrease. [text: E pp. 46-47; MA pp. 46-47; MI pp. 46-47]

19. What is the difference between a change in supply and a change in quantity supplied?

A change in supply is a shift in the entire supply curve either to the left (a decrease in supply) or to the right (an increase in supply). A change in supply, therefore, is a change in the entire supply schedule or curve. In contrast, a change in quantity supplied is a movement along an existing supply curve or schedule from one price-quantity combination to another. A change in product price causes the change in quantity supplied. [text: E pp. 47-48; MA pp. 47-48; MI pp. 47-48]

20. Newspaper item: �Due to lower grain prices, consumers can expect retail prices of choice beef to begin dropping slightly this spring with pork becoming cheaper after midsummer,� the Agriculture Department predicted. �This reflects increasing supply,� the department said. Does the statement use the term �supply� correctly? What effects might this announcement have on consumer demand? Explain.

The announcement does use the term �supply� correctly because the drop in price predicted is a result of lower resource (grain) prices. This means that producers of beef and pork will lower prices for each quantity on the existing supply schedule assuming �all other things remain equal.�

Consumer demand at present might decrease as consumers wait to make big purchases of beef and pork in the future when prices are predicted to drop. By spring, if beef prices drop, there should be an increase in the quantity of beef demanded and probably a decrease in the demand for pork, which is a substitute for beef. By midsummer, if pork prices drop, there will be an increase in the quantity of pork demanded, and depending on what is then happening with beef prices, a decline in the demand for beef. If beef prices had continued to fall, it is hard to say whether there would be much of a change in demand due to the price of the substitute pork falling. More likely, there would be only a movement along the curve for beef if the price continued to fall. [text: E pp. 46-48; MA pp. 46-48; MI pp. 46-48]

21. What effect will each of the following have upon the supply of television sets in a competitive market? Explain your reasoning in each case.

(a) an increase in the price of electronic equipment used in producing television sets

(b) a decline in the number of firms producing television sets

(c) a large new tariff on imported TV sets

(d) new inexpensive satellite dishes which make televisions more popular among consumers

(a) This should decrease the supply because a higher price must be charged for each quantity due to the rising price of resources. The supply curve will shift to the left.

(b) The outcome is indeterminate because we don�t know why the firms left the industry. Perhaps remaining firms are more efficient and will produce more. On the other hand, there may be just a few firms remaining and the resulting decline in competition could lead to higher prices for each quantity, or a decrease in supply.

(c) A higher tariff will cause a decrease in the supply of imported television sets because costs, i.e., taxes, have risen. Because the supply of imported TV sets is part of the total market supply, the effect is to decrease the market supply.

(d) New inexpensive satellite dishes should have no effect on the supply schedule. However, demand should increase resulting in a higher equilibrium price and greater quantity supplied. Note that supply does not shift, but that the quantity supplied changes.


New22. What effect will each of the following most likely have on the supply of corn in a competitive market? State what happens to supply. Explain your reasoning in each case and relate it to a supply determinant.

(a) the development of an improved corn seed that resists drought conditions

(b) an increase in the price of soybeans which can also be planted on land used for growing corn

(c) an increase in government payments for growing corn

(d) an increase in the price of fertilizer

(a) The supply of corn will increase because of an improvement in the technology of corn production. More bushels of corn will be produced at each and every price.

(b) The supply of corn will decrease because of a change in the price of another good that can be produced. Some farmers will no longer use their land to grow corn, but instead will grow soybeans.

(c) The supply of corn will increase because of a government subsidy. The government payment reduces the costs of corn production at each and every price.

(d) The supply curve for corn will decrease because of a change in the price of a resource. Fertilizer is used to grow corn and it is now more costly to grow corn at each and every price.


23. Economist Jones defines an increase in supply as a decrease in the prices needed to ensure various amounts of a good being offered for sale. Economist Brown defines an increase in supply as an increase in the amounts that producers will offer at various possible prices. Economist Cole defines an increase in supply as an increase in the amount firms will offer in the market which is caused by an increase in the price of the product. Which, if any, of these is defining an increase in supply correctly? Explain.

Economists Brown and Jones are both correct. Brown recognizes that a shift in supply means greater quantities will be supplied at each of the various prices given for the original supply schedule. In other words, more will be supplied at each of the prices on the original schedule. Jones is correct if a decrease in prices would actually ensure the various amounts of a good being offered for

sale at lower prices than the original. It is an equivalent statement to Brown�s. Cole is not correct. Cole is defining a change in the quantity supplied, or a movement along the supply curve, not an increase in supply. [text: E pp. 46-48; MA pp. 46-48; MI pp. 46-48]

24. Assuming no government intervention, describe the market behavior that should result if the price of a product is below its equilibrium price; then describe the behavior that should occur if the price is above its equilibrium price.

If the price of a product is below its equilibrium price, the quantity demanded will be greater than the quantity supplied and the price will be bid up as buyers compete to obtain the product and sellers realize that they can raise the price. As the price rises, the quantity supplied will increase and the quantity demanded decrease until the two are equal at the so-called equilibrium or market-clearing price.

If the price of a product is above its equilibrium price, the quantity supplied will be greater than the quantity demanded and a temporary surplus exists. As sellers compete, the price will fall and the quantity demanded will increase and the quantity supplied will decrease until the two are equal at the equilibrium or market-clearing price. [text: E pp. 48-50; MA pp. 48-50; MI pp. 48-50]

25. Describe in words how one can recognize the market equilibrium point in a graph of a demand schedule and a supply schedule.

The market equilibrium point is the point where the demand curve intersects the supply curve. The quantity vertically below this point is the equilibrium quantity and the price horizontally opposite this point is the equilibrium price. [text: E pp. 48-49; MA pp. 48-49; MI pp. 48-49]

26. Using the schedules given, plot the demand curve and the supply curve on the below graph. Label the axes and indicate for each axis the units being used to measure price and quantity. Then answer the questions.

Quantity demanded Quantity supplied

Price (bushels of oats) Price (bushels of oats)

$1.50 10,000 $1.50 40,000

1.40 15,000 1.40 35,000

1.30 20,000 1.30 30,000

1.20 25,000 1.20 25,000

1.10 30,000 1.10 20,000

1.00 35,000 1.00 15,000

(a) Give the equilibrium price and quantity for oats.

(b) Indicate the equilibrium price and quantity on the graph by drawing lines from the intersection of the supply and demand curves to the price and quantity axes.

(c) If the Federal government decided to support the price of oats at $1.40 per bushel, tell whether there would be a surplus or shortage and how much it would be.

(d) Demonstrate your answer to part (c) on your graph being sure to label the quantity you designated as the shortage or surplus.

(a) The equilibrium price and quantity for oats will be $1.20 and 25,000 bushels.

0 10 20 30 40

$1.00

$1.50

Qe

Pe

S

D

Quantity (1 000 )

Pric

e Surplu

5 15 25 35

(b) The equilibrium price and quantity on the graph are labeled Pe and Qe.

(c) If the Federal government decided to support the price of oats at $1.40 per bushel, there would be a surplus of 35,000 � 15,000 = 20,000 bushels.

(d) See surplus labeled on above figure.

[text: E pp. 48-50, 54; MA pp. 48-50, 54; MI pp. 48-50, 54]

27. Using the schedules given, plot the demand curve and the supply curve on the below graph. Label the axes and indicate for each axis the units being used to measure price and quantity. Then answer the questions.


Price (bushels of wheat) Price (bushels of wheat)

$4.20 125,000 $4.20 230,000

4.00 150,000 4.00 220,000

3.80 175,000 3.80 210,000

3.60 200,000 3.60 200,000

3.40 225,000 3.40 190,000

3.20 250,000 3.20 180,000

3.00 275,000 3.00 170,000

(a) Give the equilibrium price and quantity for wheat.

(b) Indicate the equilibrium price and quantity on the graph by drawing lines from the intersection of the supply and demand curves to the price and quantity axes.

(c) If the Federal government decided to support the price of wheat at $4.00 per bushel, tell whether there would be a surplus or shortage and how much it would be.

(d) Demonstrate your answer to part (c) on your graph being sure to label the

quantity you designated as the shortage or surplus.

(a) The equilibrium price and quantity for wheat will be $3.60 and 200,000 bushels.

(b) The equilibrium price and quantity on the graph are labeled Pe and Qe.

(c) If the Federal government decided to support the price of wheat at $4.00 per bushel, there would be a surplus of 220,000 � 150,000 = 70,000 bushels.

(d) See surplus labeled on figure.

[text: E pp. 48-50, 54; MA pp. 48-50, 54; MI pp. 48-50, 54]

New28. (Consider This) Is demand more important than supply in determining equilibrium price and quantity in a competitive market? Explain.

Demand and supply are equally important. It is the intersection of the demand and supply curve that determines equilibrium price and quantity. Without demand or without supply there would be no intersection and no price determination. Alfred Marshall likened supply and demand to a pair of scissors. Each blade is needed for the scissors to operate properly and make a cut. [text: E pp. 51-52; MA pp. 51-52; MI pp. 51-52]

29. In the space below each of the following, indicate the effect [increase (+), decrease (�)] on equilibrium price (P) and equilibrium quantity (Q) of each of these changes in demand and/or supply.

P Q

(a) Increase in demand, supply constant ________ ________

(b) Increase in supply, demand constant ________ ________

(c) Decrease in demand, supply constant ________ ________

(d) Decrease in supply, demand constant ________ ________

(a) +, +; (b) �, +; (c) �, �; (d) +, � [text: E pp. 50-51; MA pp. 50-51; E pp. 50-51]

30. In each case below, indicate the effect [increase (+); decrease (−); indeterminate (ind)] upon equilibrium price (P) and equilibrium quantity (Q) and illustrate the change graphically. Where you believe the effect is indeterminate, two graphical illustrations may be necessary to demonstrate your point.

P Q

(a) Increase in demand, supply constant ___ ___

(b) Decrease in supply, demand constant ___ ___

(c) Decrease in demand, decrease in supply ___

___

(d) Decrease in demand, increase in supply ___ ___

P Q

(a) Increase in demand, supply constant + −

(b) Decrease in supply, demand constant + −

(c) Decrease in demand, decrease in supply ind −

(d) Decrease in demand, increase in supply − ind


31. Given the products below and the events that affect them, indicate what happens to demand or supply, and the equilibrium price and quantity in a competitive market. Identify the determinant of demand or supply that causes the shift.

(a) Blue jeans. The wearing of blue jeans becomes less fashionable among consumers.

(b) Computers. Parts for making computers fall in price because of improvements in technology.

(c) Lettuce. El Nino produces heavy rains that destroy a significant portion of the lettuce crop.

(d) Chicken. Beef prices rise because severe winter weather reduces cattle herds.

(a) Demand for blue jeans decreased because of a decline in buyer tastes for blue jeans, thus decreasing the equilibrium price and quantity.

(b) Supply of computers increases because of an improvement in technology, thus decreasing the equilibrium price and increasing the equilibrium quantity.

(c) Supply of lettuce decreases because of a fall in the number of suppliers, thus increasing the equilibrium price and decreasing the equilibrium quantity.

(d) Demand for chicken increases because of an increase in the price of a substitute food (beef prices rose because of a supply decrease), thus increasing the equilibrium price and quantity. [text: E pp. 50-51; MA pp. 50-51; MI pp. 50-51]

New32. Given the products below and the events that affect them, indicate what happens to demand or supply, and the equilibrium price and quantity in a competitive market. Identify the determinant of demand or supply that causes the shift.

(a) Digital cameras. There are improvements in the technology that increase the economic efficiency of production.

(b) Automobiles. Consumer incomes rise as the economy moves out of recession.

(c) Beef. Chicken prices fall because of a decline in the cost of feeding chickens.

(d) Fast-food meals. The government imposes a significant tax on fast-food meals.

(a) The supply of digital cameras will increase because this change in technology lowers production costs, thus decreasing the equilibrium price and increasing equilibrium quantity.

(b) The demand for automobiles will increase because of an increase in consumer incomes, thus increasing the equilibrium price and quantity.

(c) The demand for beef will decrease because chicken and beef are substitutes. A fall in the price of chicken encourages more consumers to buy chicken, and thus buy less beef. The change decreases the equilibrium price and quantity of beef.

(d) The supply will decrease because the tax increases the cost of producing the meals, thus increasing the equilibrium price and decreasing the equilibrium quantity.


33. In the spaces below each of the following, indicate the [increase (+), decrease (�), or indeterminate (?)] on equilibrium price (P) and equilibrium quantity (Q) of each of these changes in demand and/or supply.

P Q

(a) Increase in demand, increase in supply __________ _________

(b) Increase in demand, decrease in supply __________ _________

(c) Decrease in demand, decrease in supply __________

_________

(d) Decrease in demand, increase in supply __________ _________

(a) ?, +; (b) +, ?; (c) ?, �; (d) �, ? [text: E pp. 50-52; MA pp. 50-52; MI pp. 50-52]

34. Given the products below and the events that affect them, indicate what happens to demand, supply, equilibrium quantity, and equilibrium price in a competitive market. Identify the determinant of demand and supply that causes the shifts.

(a) Calculators. More schools require students to buy and use calculators; improved productivity shortens the time it takes to make calculators.

(b) Gasoline. Oil production declines due to a crisis in the Middle East; people take more car vacations and drive more.

(c) New homes. The average incomes fall as the economy moves into recession; the productivity of home construction workers and builders increases.

(d) Tobacco. The government cut its subsidy to tobacco farmers; more people quit smoking.

(a) The demand for calculators increases because of an increase in the number of buyers. The supply of calculators increases because of a fall in resource prices (productivity reduces resource costs). The equilibrium quantity increases, but what happens to the equilibrium price is indeterminant and depends on the magnitudes of the shifts.

(b) The supply of gasoline increases because of a rise in resource price (oil prices increase due to a cutback in production). The demand for gasoline increases due to an increase in the taste for taking driving vacations. The equilibrium price increases, but what happens to the equilibrium quantity is indeterminant and depends on the magnitudes of the shifts.

(c) The demand for new homes decreases because of a decline in consumer incomes. The supply of new homes increases because of a fall in the price of labor resources (productivity increases reduce resource costs). The equilibrium price decreases, but what happens to the equilibrium quantity is indeterminant and depends on the magnitudes of the shifts.

(d) The supply of tobacco decreases because of a cut in government subsidies for tobacco. The demand for tobacco decreases due to a decline in the taste for smoking tobacco. The equilibrium quantity decreases, but what happens to the equilibrium price is indeterminant and depends on the magnitudes of the shifts.


New35. Given the products below and the events that affect them, indicate what happens to demand, supply, equilibrium quantity, and equilibrium price in a competitive market. Identify the determinant of demand and supply that causes the shifts.

(a) Home heating oil. There is a severe winter in the regions using the oil; the cost of a barrel of oil rises for producers of home heating oil.

(b) Organic foods. People become more concerned about chemical additives in food; traditional farms are switching to more organic methods.

(c) Film cameras. The price of digital cameras falls for consumers; there is a decline in the number of stores selling film cameras.

(d) Bread. Many consumers adopt a low carbohydrate diet and avoid bread products; the price of flour falls for bread producers.

(a) The demand for home heating oil increases because of an increase in the number of buyers. The supply of home heating oil decreases because of an increase in resource prices. The equilibrium price increases, but what happens to the equilibrium quantity is indeterminant and depends on the magnitudes of the shifts.

(b) The demand for organic food increases because of an increase in consumer taste or preference for organic food. The supply of organic food increases because of an increase in the number of producers or sellers. The equilibrium quantity increases, but what happens to the equilibrium price is indeterminant and depends on the magnitudes of the shifts.

(c) The demand for film cameras decreases because of a decrease in the price of a substitute (digital cameras). The supply of film cameras decreases because of a decrease in the number of sellers. The equilibrium quantity decreases, but what happens to the equilibrium price is indeterminant and depends on the magnitudes of the shifts.

(d) The demand decreases because of a change in consumer tastes or preferences for bread. The supply of bread increases because of a fall in a resource price (flour). The equilibrium price decreases, but what happens to the

equilibrium quantity is indeterminant and depends on the magnitudes of the shifts.


New 36. What is a price ceiling and what are its economic effects? A price ceiling means that the price is not allowed to rise above the maximum

price set by government. If the price ceiling is set below the equilibrium price in a market, then there will be a shortage of the product at the government-set price. A price ceiling interferes with the rationing function of price that serves to balance the decisions of suppliers and demanders. The shortage indicates that resources are being underallocated to the production of this product and that there is economic inefficiency. Less output is being produced than consumers want. This output is not being produced because some producers cannot make a profit at the price ceiling level. [text: E pp. 52-53; MA pp. 52-53; MI pp. 52-53]

New 37. Use data in the following table to explain the economic effects of a price ceiling at $6, at $5, and at $4. Quantity Quantity

Price demanded supplied

$7 4,500 4,500

6 5,000 3,500

5 5,500 2,500

4 6,000 1,500

A price ceiling means that the price will not be permitted to rise above a

maximum price. If the price ceiling is below the competitive equilibrium price of $7, it would produce a shortage of the product. For example, if the price ceiling was set at $6, the quantity demanded would be 5,000 units and the quantity supplied would be 3,500 for a shortage of 1,500 units. With a price ceiling set at $5, the shortage would be 3,000 units, and with a price ceiling of $4, the shortage would be 4,500 units. A price ceiling interferes with the rationing function of price that serves to balance the decisions of demanders and suppliers. The price ceiling produces a shortage that indicates that resources are being underallocated; output is not being produced because some

producers cannot make a profit at the price ceiling level. [text: E pp. 52-53; MA pp. 52-53; MI pp. 52-53]

New 38. What is a price floor and what are its economic effects?

A price floor means that the price is not allowed to fall below a minimum price set by government. If the price floor is set above the equilibrium price in a market, then there will a surplus of the product. A price floor interferes with the rationing function of price that serves to balance the decisions of suppliers and demanders. The surplus indicates that resources are being overallocated to the production of this product and that there is economic inefficiency; output is being produced which consumers do not want to purchase at the price floor. [text: E p. 54; MA p. 54; MI p. 54]

New39. Use data in the following table to explain the economic effects of a price floor

at $8, at $9, and at $10. Explain the economic effects.

Quantity Quantity

Price demanded supplied

$10 3,000 7,500

9 3,500 6,500

8 4,000 5,500

7 4,500 4,500

A price floor means that the price is not allowed to fall below a minimum price set by government. If the price floor is above the competitive equilibrium price of $7, a surplus of the product would result. If the price floor was set at $8, the quantity demanded would be 4,000 units but the quantity supplied would be 5,500 units for a surplus of 1,500 units. At a price floor of $9, the surplus would be 3,000 units, and with a price floor of $10, the surplus would be 4,500 units. A price floor interferes with the rationing function of price that serves to balance the decisions of suppliers and demanders. The price floor that produces a surplus indicates that resources are being overallocated and that there is economic inefficiency; output is being produced which consumers do not want to purchase at the price floor. [text: E p. 54; MA p. 54; MI p. 54]

New40. �Government-set prices undermine the rationing function of competitive prices.� Explain carefully in terms of both price ceilings and price floors.

A ceiling price means that the government may hold prices at a level that is below the market equilibrium price. Since the market equilibrium is where the quantity demanded is equal to the quantity supplied, any price below that would find an excess quantity demanded over that supplied. In other words, a shortage would develop and the market would fail to ration (QD > QS). In unregulated competition, this situation could not persist because competition would drive up the price until the equilibrium quantity and price were reached.

A price floor means that the government may hold prices above the market equilibrium price by agreeing to pay that price for any unsold surplus. The rationing function of the competitive price system will not work because sellers will have no competitive pressure to lower prices to get rid of the surplus, if they can sell it to the government at the supported price there will be a persistent product surplus (QS > QD). [text: E pp. 52-54; MA pp. 52-54; MI pp. 52-54]

New 41. Use economic analysis to explain why tenants in New York City who are covered by rent-controlled laws do not want to move.

The tenants obtain the rights to the apartment at the rent-controlled price. The rent-controlled price is far below the market price for such an apartment. If they move out, they will have to pay market rates for an apartment that can be thousands of dollars higher per month. [text: E pp. 55-56; MA pp. 55-56; MI pp. 55-56]

42. (Last Word) Can ticket �scalping� be justified? Explain using economic analysis. Ticket �scalping� refers to the practice of reselling tickets at a price higher than stated on the ticket. This

economic activity often occurs with athletic and artistic events. It can be justified for several reasons. First, ticket resales are voluntary � both buyer and seller must feel that they gain or they would not agree to the transaction. Second, scalping simply redistributes tickets from those who value them less than money to those who value them more than the money they�re willing to pay. Third, sponsors of the event may be injured, but if that is the case, they should have priced the tickets higher. Fourth, spectators are not hurt because those who want to go the most to the event are getting the tickets. In summary, both seller and buyer benefit and event sponsors are the only ones who may lose, but that is due to their own error in pricing and they would have lost from this error whether or not the scalping occurred. [text: E p. 55; MA: p. 55; MI: p. 55]

Chapter 3W

New 1. What effect will each of the following have upon the equilibrium price and equilibrium quantity of laptop computers in a competitive market? Explain your reasoning in each case.

(a) the price decreases for wireless communications devices that consumers like to buy and attach to laptop computers.

(b) fewer computer companies decide to produce laptop computers.

(c) new technology makes laptop computers cheaper to produce.

(d) the government imposes taxes on computer purchases.

(a) The decrease in the price of wireless communications for laptop computers would represent a decrease in the price of a complement. This price drop in wireless devices will increase the demand for laptop computers. Thus both equilibrium price and quantity will increase.

(b) With fewer companies producing laptops, the supply of laptops will decrease. Thus equilibrium price will increase while equilibrium quantity will decrease.

(c) The decrease in production costs will cause the supply of laptop computers to increase. Thus equilibrium price will decrease while equilibrium quantity increases.

(d) An increase in taxes on computers will cause the demand for laptop computers to decrease. Thus both equilibrium price and quantity will decrease.

[3W: pp. 2-3]

New 2. Explain how the relative magnitudes of changes in supply and demand can affect equilibrium price and quantity, if supply and demand change simultaneously.

When supply and demand change simultaneously and have opposite effects on either equilibrium quantity or price, the relative magnitudes of the changes in supply and demand will determine which shift will have the greatest effect. For example, given that both supply and demand increase, when the shift in supply is greater than the shift in demand the equilibrium price decreases. When the shift in supply is less than the shift in demand, the equilibrium price increases. As for equilibrium quantity, given that supply increases while demand decreases, a greater shift in supply results in an increase in quantity and a greater shift in demand results in a decrease in quantity. [3W: pp. 3-5]

New 3. �If demand increases and supply decreases, then both the equilibrium price and quantity will increase.� What conditions are necessary to make this statement true?

For a demand increase and a supply decrease to result in an increase in both price and quantity, the shift in demand must be greater than the shift in supply. When demand increases this increases both the price and quantity demanded of a good. The decrease in supply further raises the price but causes a decrease in quantity supplied. Quantity can only increase if the increase caused by the shift in demand outweighs the decrease caused by the shift in supply. [3W: p. 4]

New 4. Given the products and conditions below, indicate how the events affect the demand, supply, equilibrium price and quantity of the goods.

(a) Videotapes. The price of DVDs and DVD players decreases. New technology makes videotapes easier to produce. The shift in demand is greater than shift in supply.

(b) Roses. The Valentine�s Day season has just begun for the floral industry. A new pesticide decreases the number of flowers affected by pests. The shift in supply is greater than the shift in demand.

(c) Tomatoes. FDA publicly announces that eating tomatoes and tomato-based products can significantly reduce one�s risk of developing cancer. An unexpected freeze late in the tomato season destroys a significant portion of this year�s crop. The shift in supply is greater than shift in demand.

(d) Healthcare. Highly publicized malpractice cases decrease consumer confidence in healthcare providers. Malpractice insurance premiums paid by doctors increase. The shift in demand is greater than shift in supply.

(a) Videotapes. The equilibrium price will decrease and the equilibrium quantity will decrease.

(b) Roses. The equilibrium price will increase and the equilibrium quantity will increase.

(c) Tomatoes. The equilibrium price will increase and the equilibrium quantity will decrease.

(d) Healthcare. The equilibrium price will decrease and the equilibrium quantity will decrease.

[3W: pp. 3-5]

New 5. Both Economist Flores and Economist Jenkins have been monitoring the cucumber market and have noted that the equilibrium price of cucumbers and quantity of cucumbers sold have risen over the last year. Flores and Jenkins, however, disagree about why this change has occurred. Flores holds that both supply and demand have increased and that the shift in demand has been greater than the shift in supply. Jenkins, however, argues that while demand has increased, supply has decreased and the shift in supply is greater than the shift in demand. Which economist offers the most feasible theory of why the equilibrium price and quantity of cucumbers have risen?

Flores offers the most feasible explanation. By graphing the two explanations, Flores� theory that both supply and demand have increased and that the shift in demand has been greater than the shift in supply does provide a result where both price and quantity increase. Jenkins� theory that while demand has increased, supply has decreased and the shift in supply is greater than the shift in demand produces a result where price increases and quantity decreases. [3W: pp. 3-5]

New 6. How is a preset price similar to a government-imposed price ceiling or a price floor? How is a preset price different from a government-imposed price ceiling or price floor?

A preset price is a predetermined price that is set by a business before sales occur. When a preset price is set below the equilibrium price, a shortage will result. This situation is similar to when a government imposes a price ceiling below the equilibrium price. When a preset price is set above the equilibrium price, a surplus can result. This situation is similar to when the government imposes a price floor above the equilibrium price. Although the outcomes are the same, businesses establish a preset price and government establishes a legal price. [3W: p. 5]

New 7. What condition causes a secondary market to arise?

A secondary market arises when there is a shortage in the primary market of a certain good. When a set price is below the equilibrium price, initial purchasers will enter into a secondary market and sell the good to consumers willing to pay a price higher than the set price and the market will ultimately reach equilibrium. [3W: p. 5]

New 8. The hottest, new boy band, 2Hot2Handle, has just begun their U.S. tour. The supply and demand schedules for the local 2Hot2Handle show is below, with the arena capacity fixed at 2,000 seats.


(tickets) __ Price (tickets)

1000 $60.00 2000

2000 50.00 2000

3000 40.00 2000

4000 30.00 2000

5000 20.00 2000

6000 10.00 2000

Answer the following questions.

(a) Riding on their enormous popularity, 2Hot2Handle decides to set the price of tickets of all tickets at $60. Is the market for tickets at equilibrium? If not, calculate the size of the shortage/surplus.

(b) Hoping to gain publicity by creating long lines for tickets, 2Hot2Handle decides to lower ticket prices to $30. Is the market for tickets at equilibrium? If not, calculate the size of the shortage/surplus.

(c) Will a price of $30 be an efficient outcome? If the price of $30 does not change, how might an efficient outcome be reached?

(a) Given that the price of $60 is above the equilibrium price of $50, there is a surplus of 1000 seats. See table.

(b) Given that the price of $40 is below the equilibrium price of $50, there is a shortage of 2000 seats. See table.

(c) No, it is not an efficient outcome with a shortage of 2000 seats. An efficient outcome could be reached if ticket buyers could then scalp their tickets (and resell them above the market price) in a secondary market.

[3W: pp. 5-6]

New 9. (Consider This) Music superstars used to set their concert prices below the equilibrium prices to attract more fans to concerts, create excess demand, and get publicity. Why have they changed this strategy?

The music superstars could also make money selling music CDs to make up for any lost revenue from pricing concert tickets below the equilibrium price. The advent of illegal downloading of music cut the revenue from CD sales and reduced the value of the concert publicity. To capture more revenue, the

music superstars increase the price of concert tickets so they better reflect the equilibrium price. [3W: p. 6]

New 10. Describe how a �nonpriced good� differs from a �priced good.� Give examples of nonpriced goods.

While a �priced good� is a good that has a market-determined price that regulates the quantity supplied and quantity demanded of the good, a �nonpriced good� is a good owned commonly by society and its price is essentially zero. There is no actual market for nonpriced goods. Possible examples of nonpriced goods include clams and seashells on public beaches, fish and reptiles in public waters, and wild game and mushrooms on public lands. [3W: pp. 7-8]

New 11. Why do nonpriced goods tend to get overconsumed? Give an example of a rationing mechanism that can prevent the overconsumption of a nonpriced good.

There is no market for nonpriced goods, so there is no price mechanism to equate the quantity supplied with the quantity demanded. Since nonpriced goods tend to face excess demand, they are overconsumed and eventually exhausted.

In the case of fish and game on public lands, licenses, seasons and limits can all be used to prevent overconsumption. Licenses force hunters and fishers wanting to hunt and fish on public lands to pay a fee and thus discourage hunters and fishers who are not willing to pay the fee from using public lands. Seasons dictate specific times of year in which hunting and fishing can occur. Limits restrict the amount of public game and fish consumed. [3W: p. 8]

New 12. Iowa, Kansas, Nebraska and Missouri are all agricultural states that depend on the Missouri River as a key water source. Given that these states can use water from the river at no cost, answer the following questions.

(a) What type of good is water from the Missouri River?

(b) Suppose that water the four states consumed from the Missouri River exactly equaled the river�s supply. Show this situation graphically.

(c) Suppose Iowa and Nebraska decided to use other rivers as their main water source. What kind of market situation would arise? Show this situation graphically.

(d) Suppose a severe drought in the Nebraska-Iowa region causes the states to depend more heavily on the Missouri River for water. What kind of market situation would arise? Show this situation graphically.

(e) Water shortages can create large disputes between states using the same source. Name one way that the government could prevent a water shortage.

(a) Water from the Missouri River is a nonpriced good. It is a publicly owned good that any state is free to consume at zero cost. There is no market for Missouri River water.

(b) QD = QS at the equilibrium price ($0) and quantity (Qe). See graph.

(c) A surplus of Missouri River water would arise. QS > QD. See graph.

(d) A shortage of Missouri River water would arise. QD > QS. See graph.

(e) The government could prevent a water shortage by setting a limit on the amount of water that each state can use. [3W: pp. 7-8]

New 13. Define �consumer surplus.�

Consumer surplus is the benefit surplus received by a consumer or consumers through market transactions. A consumer surplus arises because all consumers pay the equilibrium price even though some consumers would be willing to pay more. Consumer surplus is measured as the difference between the maximum price a consumer is (or consumers are) willing to pay minus the actual price. [3W: pp. 8-9]

(c)

QS

P

D

S

Q

Surplus

QD 0

(b)

Qe

P

D

S

Q0

(d)

QS

P

D

S

Q

Shortage

QD 0

New 14. Define �producer surplus.�

Producer surplus is the benefit surplus received by a producer or producers through market transactions. A producer surplus arises because some producers are willing to sell a product at a lower price than the equilibrium price. Producer surplus is measured as the difference between the actual price the producer receives (or producers receive) and the minimum acceptable selling price. [3W: p. 9]

New 15. At the beginning of the school year, used couches are in high demand among State University freshman living on the 6th floor of Beta Dormitory. Fortunately for the freshman, the upperclassmen moving off of the 6th floor are very willing to sell their used couches. Answer the following questions about the 6th floor used-couch market.

(a) Complete the table below containing the market demand for used couches on the 6th floor. What is the total consumer surplus?

Maximum Price Equilibrium Consumer

Freshman Willing to Pay Price Surplus

Rita $100 $ 50 ____

Emily 90 50 ____

Chris 80 50 ____

Pedro 70 50 ____

Zak 60 50 ____

Natalie 50 50 ____

(b) Complete the table below containing the market supply for used couches on the 6th floor. What is the total producer surplus?

Minimum Acceptable Equilibrium Producer

Upperclassman Price Price Surplus

Frank $100 $ 50 ____

Cho 90 50 ____

Toby 80 50 ____

Susie 70 50 ____

Rob 60 50 ____

Anisha 50 50 ____

(a) The total consumer surplus is $150 (= 50+40+30+20+10). See table.

Maximum Price Equilibrium Consumer

Freshman Willing to Pay Price Surplus

Rita $100 $ 50 $50 (=100-50)

Emily 90 50 40 (= 90-50)

Chris 80 50 30 (= 80-50)

Pedro 70 50 20 (= 70-50)

Zak 60 50 10 (= 60-50)

Natalie 50 50 0 (=50-50)

(b) Total producer surplus is $125 (=25+20+15+10+5).

Minimum AcceptableEquilibrium Producer

Upperclassman Price Price Surplus

Frank $ 25 $ 50 $25 (=50-25)

Cho 30 50 20 (= 50-30)

Toby 35 50 15 (= 50-35)

Susie 40 50 10 (= 50-40)

Rob 45 50 5 (= 50-45)

Anisha 50 50 0 (=50-50)

New16. Are consumer surplus and equilibrium price directly or inversely related? Explain your answer.

Consumer surplus is inversely related to price. Consumer surplus is measured by calculating the difference between the maximum price a consumer would be willing to pay and the actual price. As the equilibrium price increases, the difference between the maximum price the consumer will pay and the equilibrium price decreases. Thus the consumer surplus decreases. [3W: p. 9]

New17. In terms of consumer and producer surplus, when is market efficiency achieved?

Market efficiency is achieved when the sum of the producer and consumer surplus is maximized. Also, for market efficiency to occur, the consumer�s maximum willingness to pay must equal the producer�s minimum acceptable price. Since the sum of producer and consumer surplus is measured by calculating the difference of these two prices, it is only when the two prices are equal that society has exhausted all opportunities to increase the sum of producer and consumer surplus that efficiency is achieved. [3W: p. 11]

New18. Define �allocative efficiency.�

Allocative efficiency is achieved when the correct quantity of output is produced relative to other goods and services. Any of the following three conditions define allocative efficiency. At the efficiency point, marginal benefit equals the marginal cost of that level of output. The total of consumer and producer surplus must also be maximized at allocative efficiency. Maximum willingness to pay and minimum acceptable price must also be equal at allocative efficiency. [3W: p. 11]

New19. Explain why underproduction or overproduction of a good results in efficiency losses.

When there is underproduction or overproduction of a good, the area of the consumer and producer surplus is reduced. For output levels below the equilibrium output, the maximum willingness to pay by consumers exceeds the producer�s minimum acceptable price, so there is a deadweight loss to society. For output levels above the equilibrium output, the maximum willingness to pay by consumers is less than the producer�s minimum acceptable price, so there is a deadweight loss to society. [3W: p. 11-12]

New20. (Last Word). How do the expiration of patents on branded drugs and the production of generic drugs affect consumer welfare?

In essence, patents on branded drugs permit drug companies to charge high prices. When the patents expire, generic alternatives can be produced that compete with the branded drug. As a consequence, the price of the drug for consumers falls. A reduction in price increases the consumer surplus. As this surplus increases, efficiency losses are reduced and society is better off. [3W: p. 12]

Chapter 20

New 1. What is the main difference between the law of demand and the price elasticity of demand?

The law of demand tells you that quantity demanded will increase as price falls, or conversely, that quantity demanded will decrease as price rises. So, the law of demand says there is an inverse relationship between price and quantity demanded. By contrast, the price elasticity of demand tells you �how much� quantity demanded changes when price changes. It shows the responsiveness of a change in quantity demanded to a change in price. [text: E p. 356; MI p. 112]

New 2. Why do economists use percentages rather than absolute amounts in measuring the responsiveness of consumers to changes in price?

There are two basic reasons. First, the choice of units when absolute changes are used will have an arbitrary effect on the interpretation of responsiveness. For example, if price is calculated in dollars, then a one-unit drop in price (from $5 to $4) might be associated with a 10-unit increase in quantity. If, however, the price was calculated in cents, then a 100-unit drop in price would be associated with a 10-unit increase in quantity. In the first case, it would appear the demand is inelastic and in the second case it would appear to be elastic. Second, the use of percentages allows comparisons to be made across products. You can compare the percentage change in quantity demanded to a percentage change in price across all products for which you have data on changes in price and quantity demanded. [text: E p. 357; MI p. 113]

New 3. How do you interpret the coefficient of the price elasticity of demand? Explain when Ed is 1.5, 0.7, and 1.0.

The interpretation is based on the elasticity formula. The formula has the percentage change in quantity demanded in the numerator and the percentage change in price in the denominator. A coefficient of 1.5 indicates that demand is elastic because the percentage change in quantity demanded (the numerator) is greater than the percentage change in price (the denominator). A coefficient of 0.7 indicates that demand is inelastic because the percentage change in quantity demanded (the numerator) is less than the percentage change in price (the denominator). A coefficient of 1.0 indicates that demand is unit elastic because the percentage change in quantity demanded (the numerator) is the same as the percentage change in price (the denominator). [text: E p. 357; MI p. 113]

New 4. What is the meaning of perfectly inelastic demand and perfectly elastic demand? How would each be graphed?

Perfectly inelastic demand indicates that there is no change in quantity demanded for a percentage change in price. The elasticity of demand is zero in this case. The graph, with price on the vertical axis and quantity on the horizontal axis, would be a vertical line at the level of quantity demanded. Perfectly elastic demand indicates that a very small change in price results in a

zero to infinite change in quantity demanded. The elasticity of demand is infinite in this case. The graph, with price on the vertical axis and quantity on the horizontal axis, would be a horizontal line across quantity at one price level. [text: E pp. 357-358; MI pp. 113-114]

New 5. (Consider This) Use an ACE bandage and a rubber tie-down to make an analogy for explaining the price elasticity of demand.

The ACE bandage has a high amount of potential stretch, so it would be relatively elastic or responsive to a movement. A rubber tie-down has only a limited amount of stretch, so it would be relatively inelastic or unresponsive to the same movement. [text: E p. 358; MI p. 114]

6. The president of a toy company asks you for advice about whether the company should cut the price of its best-selling doll this year based on the following information: last year the company cut the price of its best-selling doll by 10% and the total revenues from doll sales increased by 10%.

The total revenue test indicates that the price elasticity of demand for the doll in last year�s price range was unit elastic, or 1. If the firm cuts the doll�s price this year, then it will most likely put the price of the doll in the inelastic range of demand, and thus a percentage change in price will lead to a greater percentage change in quantity in this range, causing total revenues to fall. You should advise the president not to cut the price because the firm is maximizing its total revenue. [text: E pp. 359-362; MI pp. 115-118]

7. The owner of a health club asks you for advice about whether the company should raise or lower the price

of its membership this year based on the following information: last year the club raised the price of its membership by 5% and the number of members paying the same fee fell by 7%.

The formula for the price elasticity of demand indicates the demand for memberships is price elastic or 1.4 in this case (7 divided by 5). This result suggests that total revenues for the club should have decreased last year. Another increase in price this year would only decrease total revenues. You should advise the owner to lower membership prices because it should increase total revenue given that the membership price is in the elastic range. [text: E pp. 359-362; MI pp. 115-118]

8. The Metropolitan Transit System recently announced a 50% increase in the price of a transit ticket. The administrators said that they needed an increase in revenue to cover their rising costs. Explain the economic rationale for this decision.

The objective of the administrators is to increase revenue to cover rising costs. If they increase the price of a transit ticket to increase revenue, then the administrators must believe that the demand for transit services is inelastic in this price range. [text: E pp. 359-362; MI pp. 115-118]

9. Ford Motor Company announced a major rebate program for its cars and trucks. The rebate program amounts to a simple reduction in price. The company executives hope to increase revenue as a result of this rebate program. What economic explanation would justify this decision?

The company executives believe that the price decrease will increase total revenue. In this case, the executives must think that demand is elastic in this price range. When demand is elastic, a cut in price will increase total revenue. [text: E pp. 359-362; MI pp. 115-118]

10. A gasoline station very near a professional football stadium parks cars on its lot to make money on game days. Last year it charged $4.00 per car and parked 1,000 cars. This year it raised the parking price to $5.00 and parked 850 cars. Did the station owner make a good economic decision in raising the parking prices from one year to the next? Explain.

The owner made a good decision in raising price. The total revenue test indicates that total revenue increased with the increase in price. The $4.00 price times 1,000 cars produced $4,000 in revenue, but the $5.00 price times the 850 cars produced $4,250 in revenue, for a gain of $250. These results indicate that demand for parking is inelastic in this price range. The midpoints formula also shows that demand is inelastic in the price range because the coefficient is 0.73. [text: E pp. 359-362; MI pp. 115-118]

11. The president of the Micro Brewing Corporation asks you, as the company economist, to forecast changes in consumer beer purchases associated with a proposed price change. You conduct a survey and find that if the price of a six-pack increases from $5.50 to $7.50, the quantity demanded will decrease from 2,200 units to 1,800 units a month. Should the Micro Brewing Corporation raise its price? Explain the economic basis for this recommendation to the president.

Yes, the corporation should increase the price of a six-pack. Over the price range considered, the price elasticity of demand coefficient is 0.65, or inelastic, using the midpoints formula. An increase in price when demand is inelastic will increase total revenue. This increase in total revenue also can be shown by multiplication. With a price of $5.50 times a quantity of 2,200 per month, the total revenue was $12,100. With the higher price of $7.50 times a lower quantity of 1,800, the total revenue is $13,500. Thus, there is a gain of $1,400 in total revenue from raising the price. [text: E pp. 359-362; MI pp. 115-118]

12. The following data shows the relationship between price and quantity demanded at four different prices for a product:

P = $11, Qd = 16

P = $9, Qd = 24

P = $7, Qd = 32

P = $5, Qd = 40

Using the midpoints formula, what is the price elasticity of demand between: (a) $11 and $9; (b) $9 and $7; (c) $7 and $5?

(a) 2.0; (b) 1.2; (c) 0.67 [text: E pp. 358-359; MI pp. 114-115]

13. On the below demand curve, indicate the character of the price elasticity of

demand across all prices.

[text: E pp. 359-360; MI pp. 115-116]

14. The following is a straight-line demand curve that confronts a single firm.

Quantity

Price demanded (3) (4)

$6 1 _____ _____

5 2 _____ _____

4 3 _____ _____

3 4 _____ _____

2 5 _____ _____

1 6 _____ _____

(a) In column 3, compute total revenue. In column 4, compute the coefficient for the price elasticity of demand at each price using the midpoints formula.

(b) Describe the character of elasticity across the prices based on the total revenue test and the elasticity coefficient.

(c) Does a straight-line demand curve have constant elasticity?

(d) Of what practical significance is your answer to (c)?

Quantity

Price demanded (3) (4)

$6 1 $6

3.7

5 2 10

1.8

4 3 12

1.0

3 4 12

0.6

2 5 10

0.3

1 6 6

(a) See the above table for the answers.

(b) Total revenue declines when price drops from $3 to $2, and the elasticity coefficient also becomes less than 1 at that price change. Demand is elastic in the range of prices between $6 and $4, and inelastic below $3. A drop in price from $4 to $3 illustrates unitary elasticity.

(c) The clear answer is �no� based on the answers in the table. Although the slope of a linear demand curve is, by definition, constant, elasticity varies because it measures percentage changes.

(d) The significance is twofold. (1) One cannot tell elasticity by looking at a demand curve because the elasticity changes over the range of the curve. (2) The elasticity of demand for any product will depend on the level of its initial price and quantity, not just on the change in price. Therefore, the demand for a product may be very elastic in one price range (generally the higher price ranges) and very inelastic in another (lower) price range. [text: E pp. 358-361; MI pp. 114-117]

15. Using the demand data given, complete the following table by computing total revenue at each of the prices. Indicate whether demand is elastic, inelastic, or unitary between each set of prices.

Quantity Total Character

Price demanded revenue of demand

$1,000 300 $_______ _________

900 400 _______ _________

800 500 _______ _________

700 600 _______ _________

600 700 _______ _________

500 800 _______ _________

400 900 _______ _________

300 1,000 _______ _________

200 1,100 _______ _________

100 1,200 _______ _________

Quantity Total Character

Price demanded revenue of demand

$1,000 300 $300,000 elastic

900 400 360,000 elastic

800 500 400,000 elastic

700 600 420,000 unitary

600 700 420,000 inelastic

500 800 400,000 inelastic

400 900 360,000 inelastic

300 1,000 300,000 inelastic

200 1,100 220,000 inelastic

100 1,200 120,000

[text: E pp. 360-361; MI pp. 116-117]

16. Use the data from the table in the previous question and the two graphs below for this problem. On the first graph: (a) plot the demand curve; and (b) indicate the elastic, unitary, and inelastic portions of the demand curve. On the second graph: (a) plot the total revenue on the vertical axis and the quantity demanded on the horizontal axis; (b) indicate the elastic, unitary, and inelastic

portions of the demand and total revenue curves. (Note: The scale for quantity demanded that you plot on horizontal axis of each graph should be the same on both graphs.)

[text: E pp. 360-361; MI pp. 116-117]

17. Based on the determinants of elasticity as discussed in the text, explain what the price elasticity of demand of the following products would be: (a) ballpoint pens; (b) Crest toothpaste; (c) diamond rings; (d) sugar; and (e) refrigerators.

(a) Ballpoint pens: Demand should be slightly elastic because there are substitutes, and they are not a complete necessity. However, they are not very durable and the price is small relative to most incomes, and the substitutes are not quite the same so the elasticity will not be high.

(b) Crest toothpaste: Demand should be very elastic because there are very many other brand-name substitutes, and this brand is not a necessity.

(c) Diamond rings: Demand should be elastic because there are other types of rings, the price is high relative to most incomes, they are durable, and they are a luxury item.

(d) Sugar: Demand should be inelastic because there are few close substitutes, the price is small relative to most incomes, it is not a durable good, and not usually viewed as a luxury.

(e) Refrigerators: Demand is probably somewhat elastic because the price is large relative to most incomes and they are durable so an old refrigerator can last until �the price is right.� However, refrigerators are not luxuries and there are no good substitutes, so the demand is probably not very elastic with respect to price. [text: E pp. 362-363; MI pp. 118-119]

18. Explain how each of four different factors can affect the price elasticity of demand. Give an example for each determinant.

First, the price elasticity of demand can be affected by the number of substitutes. In general, the larger the number of substitutes for a product, the greater will be the elasticity of demand. The price elasticity of demand for beef tends to be relatively high because there are many possible substitute sources of protein (e.g., chicken, turkey, or fish). Second, elasticity is also affected by the proportion of income spent on a product. Other things equal, the higher the price of a product relative to people�s incomes (and budgets), the greater the product�s elasticity of demand. Sugar has a relatively low price elasticity of demand because the cost of sugar is a minor part of a consumer�s budget. By contrast, the price elasticity of demand for computers and other consumer appliances such as washing machines is relatively high because they require a large outlay from a consumer�s budget. Third, luxuries will tend to be price-elastic while necessities are price-inelastic. Bread will have a low price elasticity of demand coefficient relative to that for a luxury auto. Fourth, time will influence the elasticity of demand. The greater the amount of time considered, the greater the elasticity of demand. In the short-run the demand for travel to a warm location during the winter will be less price-elastic than the demand for travel to a warm location at other times of the year. [text: E pp. 362-363; MI pp. 118-119]

19. Federal and state governments often seek to raise tax revenue by levying excise or sales taxes on specific products. What economic factors should be considered in determining the products that will raise the most tax revenue? Give examples of products in your answer.

Government officials should consider taxing products for which the price elasticity of demand is inelastic. Liquor, gasoline, and cigarettes are examples of goods with inelastic demand on which tax increases are imposed to raise tax revenue. When a product has an inelastic demand, an increase in taxes will increase total spending on the product and hence the revenue collected by government. There will be a negative effect on the quantity consumed, and thus employment in the industry, but the employment effects will be less harmful than if the product taxed was elastic. Taxing a product for which the demand is relatively elastic is likely to reduce tax revenue from the product and reduce significantly employment in the industry. Such a situation arose in 1991 when the U.S. Congress imposed a luxury tax on yachts costing more than $100,000. Congress thought that the demand for yachts was relatively inelastic, but it proved to be more elastic than originally thought. Employment in the boating industry fell significantly and the tax produced minimal revenue for government. [text: E pp. 363-364; MI pp. 119-120]

20. Explain the perspective that tougher enforcement of drug laws for cocaine or other drug laws may actually increase the crime rate. Use the concepts of demand, supply, and elasticity in your explanation.

Tougher enforcement of drug laws reduces the supply of cocaine and other illegal drugs, thus driving up the street price. The demand for cocaine and other drugs, however, appears to be highly inelastic. The increased price will increase total revenues and profits for sellers, but at the same time it will increase total spending by drug users. To support this increased spending, drug users are likely to commit more crimes. Thus, the increased enforcement of drug laws may have the secondary effect of increasing money-producing crimes such as robbery, burglary, shoplifting, and fraud. [text: E p. 364; MI p. 120]

21. Discuss the pros and cons of legalizing drugs such as heroin or cocaine from an economic perspective using the concepts of supply, demand, and elasticity.

The pro side for legalization looks at the price elasticity of demand for heroin and cocaine. This demand is price-inelastic which means that if the price of these drugs was reduced, there would be less spent on them by users. Legalization of these drugs will tend to increase the supply and reduce the price. The reduced price will reduce the total expenditures on these drugs. Fewer users will have to resort to crime to pay for the drugs and there would be less need for law-enforcement resources used for the �war on drugs.�

The opponents of legalization suggest that there are two types of consumers of illegal drugs � addicts and occasional users. The demand from addicts is price-inelastic as discussed above. The demand by the occasional users, however, is more price-elastic. As price falls, this type of user will spend more on these drugs. This additional consumption in turn may cause some of the occasional users to become addicts. The greater social acceptability for the use of such drugs may also increase the demand for these drugs, which would increase consumption, stimulate more addiction, and increase crime in the long run. The additional social cost from these developments would be much greater than any benefit from simple reduction of expenditures by addicts and short-term reduction in law-enforcement costs. [text: E p. 364; MI p. 120]

New22. What is the price elasticity of supply? How is it measured?

Price elasticity of supply is a measure of the sensitivity of quantity supplied to changes in the price of a product. The price elasticity of supply depends primarily on the ease of substitution of resources between alternative uses. The easier and faster suppliers can respond to changes in price, the greater the price elasticity of supply.

There are both a general formula and a midpoint formula similar to those for the price elasticity of demand, but �quantity supplied� replaces �quantity demanded.� This means that the elasticity of supply is the percentage change in quantity supplied of a product divided by its percentage change in the price of the product. There is a midpoints formula that is an average of quantities and prices and is used for calculating the elasticity of supply across quantity or price ranges. [text: E pp. 364-365; MI pp. 120-121]

New 23. What is the main determinant of the price elasticity of supply? Explain.

The ease of shifting resources to alternative uses is the main one. Time is often a critical factor affecting the ease of substitution. The longer the time, the easier it is for producers to shift resources into production and increase the quantity supplied. The more time the firm has to adjust to a change in price, the greater the elasticity of supply. [text: E pp. 365-366; MI pp. 121-122]

24. Why is there no total revenue test for elasticity of supply?

The simple answer is a semantic one; a firm�s supply curve is based on costs of production, so we would have to use a �total costs� test. Also, according to the �law of supply,� price and quantity are directly related, so a rise in price would always raise potential total revenue and a fall in price would always decrease potential total revenue, so the total revenue test would not be meaningful. [text: E pp. 364-365; MI pp. 120-121]

25. Describe and give reasons for the characteristics of the elasticity of supply of a farm product that is sold at a farmer�s market on a particular day.

The supply is probably perfectly inelastic in this case indicating that a change in price will not bring forth more quantity supplied. The farmer has a specific quantity of the product available for sale that day. Even if the price increases, the farmer cannot increase the quantity he or she wants to sell because the market period is too short of time for a change to be made to production. [text: E pp. 365-366; MI pp. 121-122]

New26. Explain the difference between the market period, the short run, and the long run as they relate to price elasticity of supply.

The price elasticity of supply depends primarily on the ease of substitution of resources between alternative uses, which is often affected by time. In the market period, there is too little time for producers to change output in response

to a change in price. As a consequence supply is perfectly inelastic. Graphically, this means that the supply curve is vertical at that market level of output. In the short run, producers have less flexibility to change output in response to a change in price because they have fixed inputs that they cannot change. They have only limited control over the range in which they can vary their output. As a consequence, supply is price inelastic in the short run. In the long run, producers can make adjustments to all inputs to vary production. As a consequence, supply is price elastic in the long run. [text: E pp. 365-366; MI pp. 121-122]

27. Draw three supply and demand graphs that illustrate the effect of time on the elasticity of supply using the below graphs. The three graphs should show: (a)

the immediate market period; (b) the short run; and (c) the long run.

[text: E pp. 365-366; MI pp. 121-122]

28. Using the supply data in the schedule shown below, complete the table by computing the price elasticity of supply coefficients between each set of prices. Indicate whether supply is elastic, inelastic or unitary at each set of prices.

Quantity Elasticity Character

Price supplied coefficient of supply

$11 130 _________ _________

9 110 _________ _________

7 90 _________ _________

5 70 _________ _________

3 50 _________ _________

Quantity Elasticity Character

Price supplied coefficient of supply

$11 130 0.83 inelastic

9 110 0.80 inelastic

7 90 0.76 inelastic

5 70 0.66 inelastic

3 50

[text: E pp. 365-366; MI pp. 121-122]

New29. Explain how the price elasticity of supply is related to the prices of antiques and gold.

The supply of antiques and gold is relatively inelastic. There is little or no change in quantity supplied to a change in price. As a consequence, increase in demand will often cause large changes in price in the case of antiques. Gold is highly volatile in price because small increases or decreases in demand can cause large changes in price. [text: E pp. 366-367; MI pp. 122-123]

30. Why would it be valuable for a business to know the cross elasticity of demand for the two products it produces: peanuts and popcorn?

The cross price elasticity of demand shows the responsiveness of the quantity demanded for one product to a change in the price of another product. The business can use this concept to determine whether there is a substitute, complementary, or independent relationship between peanuts and popcorn. If peanuts and popcorn are substitutes, a rise in the price of peanuts will cause an increase in the quantity demanded for popcorn (the cross elasticity will be

positive). On the other hand, if peanuts and popcorn are complementary goods, a rise in the price of peanuts will decrease the quantity demanded for popcorn (the cross elasticity will be negative). The business will want to know the nature of the relationship between the two products and how responsive the quantity demanded for one product is to a change in the price of the other before a price is changed. This cross elasticity information will be useful for increasing total revenue and profits. [text: E p. 367; MI p. 123]

31. Use the information in the table below to identify the type of cross elasticity relationship between products X and Y in each of the following five cases, A to E.

Percent change

Percent change in quantity Cross elasticity

Cases in price of Y demanded of X type

A 5 7 ______________

B 9 6 ______________

C 5 �5 ______________

D 3 0 ______________

E �2 10 ______________

Percent change

Percent change in quantity Cross elasticity

Cases in price of Y demanded of X type

A 5 7 substitute

B 9 6 substitute

C 5 �5 complement

D 3 0 independent

E �2 10 complement

[text: E p. 367; MI p. 123]

32. For the following three cases, use a midpoints formula to calculate the coefficient for the cross elasticity of demand and identify the type of relationship between the two products.

(a) The quantity demanded for product A increases from 30 to 40 as the price of product B increases from $0.10 to $0.20.

Coefficient: ______ Relationship: ________________

(b) The quantity demanded for product A decreases from 3000 to 1500 as the price of good B increases from $5 to $10.


(c) The quantity demanded for product A remains 400 units as the price of product B increases from $25 to $30.


(a) Coefficient: 0.71 Relationship: substitutes

(b) Coefficient: �1.00 Relationship: complements

(c) Coefficient: 0.00 Relationship: independent

[text: E p. 367; MI p. 123]

33. Use the information in the table below to identify the income elasticity type of each of the following products, A to E.

Percent change Income

Percent change in quantity elasticity

Product in income demanded type

A 9 12 __________

B �6 6 __________

C 3 3 __________

D 6 �3 __________

E 2 1 __________

Percent change Income

Percent change in quantity elasticity

Product in income demanded type

A 9 12 normal

B �6 6 inferior

C 3 3 normal

D 6 �3 inferior

E 2 1 normal

[text: E p. 368; MI p. 124]

34. You would think that if people�s income increased over time, then all industries in the economy should benefit equally, but this is not the case. Explain why and give examples.

The explanation is based on the income elasticity of demand. Those industries in the economy for which the demand is income elastic (auto, housing, and restaurants) have experienced stronger growth other the years because the percentage change in quantity demanded is greater than the percentage change in income for these normal goods. Other industries such as agriculture have experienced slower growth in output because the demand for the products produced for most agricultural goods is income inelastic. In this case, the percentage change in quantity demanded is less than the percentage change in income. [text: E p. 368; MI p. 124]

35. What is the practical significance of income elasticity coefficients? Explain the significance using as examples an income elasticity of 3.5 for computers and an income elasticity of 0.20 for ice cream.

The income elasticity of demand roughly indicates which industries are likely to be expanding and prosperous and what industries are likely to be declining. The elasticity coefficient of 3.5 for the computer industry indicates that each 1% increase in income leads to a 3.5% increase in the quantity demanded for

computers. This relationship bodes well for the long-term prosperity in the computer industry. Conversely, the 0.2 coefficient for ice cream indicates that a 1% increase in income leads to only 0.2 of a percent of an increase in the quantity demanded of ice cream. This low coefficient indicates that the ice cream industry will not benefit greatly from an increase in consumer incomes, and over the long run may decline. [text: E p. 368; MI p. 124]

New36. (Last Word) Give three examples of how businesses or nonprofit institutions use elasticity of demand to charge consumers different prices.

In the airline industry, business travelers have a relatively more inelastic demand than leisure travelers. So, airlines can charge higher prices to the business travelers because their ticket purchases are not as sensitive to price changes as are leisure travelers. Also, children are often charged a lower price for a good or service because they have a more elastic demand than do adults. Universities charge a different net tuition price based on the income level of the student. Lower income students pay less tuition, and this serves to increase the number of low-income students attending college. [text: E p. 369; MI p. 125]

Chapter 21

1. Explain the income and substitution effects and use the concepts to describe what happens when the price of a product decreases.

Income and substitution effects explain the inverse relationship between price and quantity demanded.

The income effect is the effect of a change in price on consumers� real incomes, and therefore on the quantity of that product demanded. A decrease in price means that more real income is available to buy subsequent amounts of the product. The substitution effect is the effect of a change in a product�s price on its expensiveness relative to other substitute products� prices. A decrease in price for a product with no change in the prices of substitutes means that the product has become relatively less expensive compared to its substitutes. Consumers, therefore, can afford to buy more of this product and have an incentive to buy less of the substitutes, whose prices are relatively higher than was previously the case. [text: E pp. 372-373; MI pp. 128-129]

2. What are two related effects that combine to make a consumer able and

willing to buy more of a specific product at a lower price than a higher price? Explain the logic of both effects.

The two effects are the income and substitution effect. For most products, a price decrease gives consumers more income to spend on that product and other products, so the quantity demanded for that product increases. There are three steps in the logic for a typical product: The price falls, which gives the consumer more income to spend on that product and other products, thus

increasing the quantity demanded for that product. A price decrease also makes the product a more attractive buy relative to its substitutes. Consumers will now purchase more of the relatively cheaper product instead of the now more expensive substitutes, thus increasing the quantity demanded of the product. With both effects, the end result is the same: the quantity demanded of the product increases as its price decreases. [text: E pp. 372-373; MI pp. 128-129]

3. A student asserts in class that the income and substitution effects lead to a decrease in the consumption of a normal good when the price decreases. Do you agree with the statement? Explain using an example.

Disagree with the statement. Just the opposite is true of the income and substitution effects when the price of a normal good decreases. With a normal good such as pizza, if the price of pizza should fall, then the consumer has more real income. This increase in real income can be spent on pizza or other normal goods. Also, pizza is now cheaper relative to other substitute goods, such as hamburgers. The substitution effect means that the lower price of pizza will give the consumer an incentive to increase the quantity demanded for pizza. [text: E pp. 372-373; MI pp. 128-129]

4. Assume that a person only purchases two goods, food and clothing, and has a fixed budget constraint. Both goods are normal goods. If the price of food decreases, what will happen to the consumption of clothing based on the income effect?

The price decrease means that the real income of the person has increased. This income effect will give the person more money to spend on both food and clothing. The consumption of clothing will increase due to this income effect. [text: E pp. 372-373; MI pp. 128-129]

5. In a typical month, a family buys six bags of candy bars as snacks when the price of a bag costs $4.00. When the price of the candy bars falls to $3.00 a bag, the family buys seven bags of candy bars a month. When the price of a bag of candy bars rises to $6.00, the family buys three bags a month. Answer

these questions: (a) How did the fall in the price affect real income in terms of bags of candy bars? (b) How did the rise in the price affect real income in terms of bags of candy bars? [Hint: How many bags of candy bars could the family buy in situation (a) and in situation (b) without changing the amount they spend on candy bars in a typical month?]

In the typical month, the family spends $24.00 on bags of candy bars ($4.00 x 6 bags). (a) When the price of a bag falls to $3.00 a bag that means real income measured in terms of bags of candy bars has increased by 2 bags because the family can now afford to buy 8 bags instead of 6 with the $24.00 they typically spent on candy bars. However, they decide to purchase only 7 bags ($3.00 x 7 = $21.00), so the other $3.00 can be spent on other goods. (b) When the price rises to $6.00 a bag, that means that real income measured in terms of candy bars has fallen by 2 bags because the family can now afford to buy only 4 bags instead of 6 with the $24.00 typically spent on candy bars. [text: E pp. 372-373; MI pp. 128-129]

6. What is the difference between marginal and total utility?

Marginal utility is the additional satisfaction received from consuming one more unit of a product. Total utility is the overall or total satisfaction received from consuming some particular amount of the product. Total utility can be determined by summing the marginal utility for each unit of a product that is consumed. [text: E pp. 373-375; MI pp. 129-131]

7. Can marginal utility be negative? Briefly explain with an example.

Yes. The consumption of an additional unit of a product may be unpleasant. Consider a person who likes pizza. The first four slices of a large pizza taste great. Each slice gives the consumer additional satisfaction, although the amount of satisfaction diminishes with the consumption of each slice. Finally, the consumer eats the fifth slice of pizza and develops a stomachache from overeating. That fifth slice had negative marginal utility for this pizza consumer. [text: E pp. 373-375; MI pp. 129-131]

8. Describe the law of diminishing marginal utility. On what assumptions is this law based?

The law of diminishing marginal utility means that as the consumer obtains more units of a given good or service, the consumer receives increasing amounts of total utility or satisfaction. However, the more units of the item that the consumer obtains, the less additional satisfaction or utility each successive unit of the good or service will provide. Total utility increases but by diminishing amounts.

The law assumes that more is preferred to less; that is, more units of a consumer good or service will bring more total utility. But the law also assumes that consumer satisfaction from the first unit obtained is greater than that for successive units. In other words, the intensity of the want or need declines as it is gradually more and more satisfied. [text: E pp. 373-375; MI pp. 129-131]

New 9. (Consider This) Why does a newspaper dispenser open to a stack of newspapers and essentially �trusts� a consumer to take just one copy whereas a soft drink vending machine does not �trust� consumers and dispenses one can for each purchase?

The difference is explained by the diminishing marginal utility of the two products. The marginal utility

of a second newspaper taken from a newspaper dispenser is essentially zero for the consumer, so they have little incentive to take more than one copy. The marginal utility of the second can of soft drink, however, is not close to zero. The consumer can take that second can and save it for consumption the next day. In fact, the consumer has a great incentive to take all the cans because they can be stored or used in the future or resold whereas multiple newspapers are only good for one day and have little resale value. [text: E p. 375; MI p. 131]

10. Give a brief description of the law of diminishing marginal utility and use it to explain the downward

slope of the demand curve. Utility is a subjective notion in economics, referring to the amount of satisfaction

a person gets from consumption of a certain product. Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline. This situation is known as diminishing marginal utility. The law of diminishing marginal utility can be used to explain the downward sloping demand curve. Consumer wants are insatiable, in general, but wants for specific products can be satisfied. The more units of a product that a consumer obtains, the less he or she will want additional units of that product because additional units provide less and less satisfaction. The only way to get a consumer to purchase more units of a product is to drop the price. What

applies to the individual consumer also applies to consumers as a group. Hence, there is an inverse relationship between price and quantity demanded. [text: E pp. 373-375; MI pp. 129-131]

11. Describe how diminishing marginal utility is related to price elasticity of demand. According the law of diminishing marginal utility, successive units of a product yield smaller and smaller

amounts of marginal utility. The consumer will buy more of a product only if its price falls because otherwise it is not worth buying more. If marginal utility falls sharply as successive units are consumed, demand is predicted to be inelastic. That is, price must fall a relatively large amount before consumers will buy more of the product. If marginal utility falls slowly as successive units are consumed, demand is predicted to be elastic. That is, price must fall only a relatively small amount before consumers will buy more of the product. [text: E p. 375; MI p. 131]

12. What are the four dimensions of the typical consumer�s situation?

First, the consumer is a rational person who tries to maximize total utility. Second, the consumer has preferences for certain types of products and also has an idea of how much marginal utility will be obtained from consuming an additional unit. Third, the consumer has a budget constraint that limits the amount of products purchased, although this constraint is tighter for lower income consumers than higher income ones. Fourth, each product that the consumer wishes to purchase has a positive price that reflects the relative scarcity or value of the product. These conditions serve as the basis for understanding how the consumer allocates money income to purchases of different products to maximize utility. [text: E p. 376; MI p. 132]

13. Explain the utility maximizing rule for two products in words and using algebra. Utility maximizing rule explains how a consumer decides to allocate his or her money income so that the

last dollar spent on each product purchased yields the same amount of marginal or extra utility. The consumer is in equilibrium when marginal utility per dollar spent on each product is equal. When a consumer is in equilibrium, there is no incentive to change spending on products, unless preferences, income, or prices change. The marginal utility per dollar spent is equalized, which means that a consumer compares the extra utility from each product with its cost. In a two-product case, as long as one product provides more utility per dollar than another, the consumer will buy more of the first product. As more of the first product is purchased, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product. The algebraic statement of this utility-maximizing state is that the consumer will allocate income in such a way for these two products (A and B) such that: MU of A/price of A = MU of B/price of B. [text: E pp. 376-378; MI pp. 132-134]

14. Assume that a consumer purchases a combination of products A and B. The

MUa is 5 and the Pa is $5. The MUb is 6 and the Pb is $6. What should this consumer do to maximize utility?

The MUa/Pa = 1. The MUb/Pb = 1. The consumer is maximizing utility and should make no changes in consumption patterns. The marginal utility per dollar is the same for both products. [text: E pp. 376-378; MI pp. 132-134]

15. Assume that a consumer purchases a combination of products Y and Z. The MUy is 50 and the Py is $25. The MUz is 20 and the Pz is $5. What should this consumer do to maximize utility?

The MUy/Py = 2. The MUz/Pz = 4. The consumer should consume more of product Z and less of product Y until the marginal utility per dollar is the same for both products. [text: E pp. 376-378; MI pp. 132-134]

16. Columns 1 through 3 in the table below show the marginal utility which a particular consumer would get by purchasing various quantities of products A, B, and C.

(1) (2) (3)

Unit of Marginal Marginal Marginal

product utility, A utility, B utility, C

First 18 39 12

Second 16 36 10

Third 14 33 9

Fourth 12 30 8

Fifth 10 27 7

Sixth 8 24 5

Seventh 6 21 3

If the prices of A, B, and C are $2, $3, and $1, respectively, and the consumer has $26 to spend on these three products, what combination of the three products should be purchased in order to maximize utility?

2 units of A, 6 units of B, and 4 units of C, shown by the fact that: 16/$2 = 24/$3 = 8/$1. The $26 in income is spent. [text: E pp. 376-378; MI pp. 132-134]

17. A consumer finds only three products, X, Y, and Z, are for sale. The amount of utility which their consumption will yield is shown in the table below. Assume that the prices of X, Y, and Z are $10, $2, and $8, respectively, and that the consumer has an income of $74 to spend.

(a) Complete the following table by computing the marginal utility per dollar for successive units of X, Y, and Z to one or two decimal places.

(b) How many units of X, Y, and Z will the consumer buy when maximizing utility and spending all income? Show this result using the utility maximization formula.

(c) Why would the consumer not be maximizing utility by purchasing 2 units of X, 4 units of Y, and 1 unit of Z?

Product X Product Y Product Z

Quantity

Utility

Marginal

Utility

per $

Quantity

Utility

Marginal

Utility

per $

Quantity

Utility

Marginal

Utility

per $

1 42 _____ 1 14 _____ 1 32 _____

2 82 _____ 2 26 _____ 2 60 _____

3 118 _____ 3 36 _____ 3 84 _____

4 148 _____ 4 44 _____ 4 100 _____

5 170 _____ 5 50 _____ 5 110 _____

6 182 _____ 6 54 _____ 6 116 _____

7 182 _____ 7 56.4 _____ 7 120 _____

Product X Product Y Product Z

Quantity

Utility

Marginal

Utility

per $

Quantity

Utility

Marginal

Utility

per $

Quantity

Utility

Marginal

Utility

per $

1 42 4.2 1 14 7.0 1 32 4.0

2 82 4.0 2 26 6.0 2 60 3.5

3 118 3.6 3 36 5.0 3 84 3.0

4 148 3.0 4 44 4.0 4 100 2.0

5 170 2.2 5 50 3.0 5 110 1.25

6 182 1.2 6 54 2.0 6 116 .75

7 182 0.0 7 56.4 1.2 7 120 .50

(a) See completed table above.

(b) The consumer will purchase 4 units of X, 5 units of Y, and 3 units of Z to maximize utility. The marginal utility per dollar for each of the products is equal to 3.0. Also, all income ($74) is spent on the products ($40 for X, $10 for Y, and $24 for Z equals $74).

(c) Although the marginal utility per dollar spent is equal to 4.0 for X, Y, and Z, the consumer does not spend all available income. There is $74 available but the consumer only spends $36. More goods could be obtained by spending the income to maximize utility as shown in the answer to (b). [text: E pp. 376-378; MI pp. 132-134]

18. A consumer has an income of $24 to spend each day. The only two goods the consumer is interested in purchasing are goods A and B. The marginal-utility schedules for these two goods are shown in the table below. The price of B does not change and is $2. The marginal utility per dollar from B is also shown in the table. But the price of A varies as shown in the table. The marginal utility per dollar from A when the price of A is $8 and $4 is shown in the following table.

Good A Good B

Quantity MU MU/$8 MU/$4 MU MU/$2

1 48 6 12 24 12

2 32 4 8 15 8

3 24 3 6 12 6

4 16 2 4 8 4

5 8 1 2 6 3

6 4 0.5 1 4 2

Complete the table below to show how much of A the consumer will buy each week at each of the two possible prices of A. Also, show how much B will be demanded when the price of A changes.

Quantity of A Quantity of B

Price of A demanded Price of B demanded

$8.00 ______ $2.00 ______

4.00 ______ 2.00 ______

Quantity of A Quantity of B

Price of A demanded Price of B demanded

$8.00 2 $2.00 4

4.00 4 2.00 4

[text: E pp. 378-379; MI pp. 134-135]

19. How can the utility-maximizing rule be used to explain the substitution and income effect? According the utility-maximizing rule, when the price of a product decreases, the consumer will no longer

be in equilibrium. Equilibrium will only be restored when more of the product is purchased and the marginal utility of the product decreases to match the decline in price. The consumer will purchase or substitute this now cheaper product for the relatively more expensive substitute. The income effect is shown by the fact that a decrease in price increases the real income of the consumer. Thus, the consumer can purchase more of this product and other products until equilibrium is achieved for the new level of real income. [text: E p. 379; MI p. 135]

20. A vice president of a company argues that the president of the company

should raise workers� wages if the president wants less absenteeism. The president says that wages probably should be cut so that the workers could not afford to miss so much work. Evaluate the two views using the income and substitution effects in your analysis.

The analysis must be based on the idea that most workers prefer leisure to working for the president of the company. Therefore, the higher their income, the more leisure they can afford (income effect). On the other hand, the higher their wage, the more costly it will be to give up an hour of work, and the less leisure �time-off� they will substitute for work (substitution effect). The income and substitution effects tend to work in opposite directions.

If the income effect outweighs the substitution effect, then the vice president is wrong. Paying the workers more will enable them to work shorter hours and earn enough to afford their added leisure despite the partly offsetting effect of the substitution effect that has made leisure more expensive per hour.

If the substitution effect outweighs the income effect, then the vice president is right and the president is wrong. Paying the workers less will cause them to work fewer hours because they don�t lose as much for each hour not worked. The effect of the lower income will partially offset the lower price of leisure, but not enough to cut the rate of absenteeism. In fact, absenteeism may increase.

Either could be correct. The solution depends on the strength of the income and substitution effects for the workers, and that, in turn, depends on many factors such as their present income status, the opportunities for using one�s leisure time, and so on. [text: E pp. 372-373; MI pp. 128-129]

21. Is the following quotation consistent with the theory of consumer behavior? �The yield on time spent working increases as the result of economic growth. Productivity per hour rises. This means that the time allocation which has represented equilibrium at our previous income level is disrupted. The yield on time devoted to other activities must also be raised. We are aware that time in production becomes increasingly scarce with economic growth. What we will now claim in addition to this is that changes in the use of time will occur, so that the yield on time in all other activities is brought into parity with the yield on working time. In other words, economic growth entails a general increase in the scarcity of time.� (From: Staffan Linder, The Harried Leisure Class)

Since relative scarcity is measured by relative prices, this quote does seem consistent with the theory of consumer behavior. In other words, as productivity per hour and therefore wage rates rise, the value or utility of each production hour rises. In essence, this makes each hour of leisure more expensive, so that to �purchase� leisure (by working fewer hours) one must raise the marginal utility of leisure. In the theory of consumer behavior, the outcome should be such that the utility maximizing rule holds, where the marginal utility of labor relative to its �price� is equated to the marginal utility of every other consumer purchase relative to its price. Here the price of leisure rose relative to the prices of other things, so the marginal utility of leisure must also rise if everything else remains unchanged. [text: E pp. 380-381; MI pp. 136-137]

New22. Use marginal-utility analysis to explain why the growing popularity of digital versatile disks (DVDs) over videocassettes (VCs).

DVDs and DVD players are complementary goods. The price of DVD players has decreased, thus increasing the demand for DVDs. DVDs and VCs are substitute goods. The audio and visual quality of DVDs is better and these features have increased consumer preference for DVDs over VCs. DVDs have gained popularity among consumers relative to VCs because many consumers have concluded that DVDs have higher ratios of marginal utility to price than the ratios for VCs. [text: E pp. 379-380; MI pp. 135-136]

23. Why would an ounce of gold be priced higher than an ounce of coffee beans, even though coffee is generally considered more essential than gold? Explain the paradox in terms of marginal and total utility.

The basic reason is that the gold is relatively scarce, and it has a high price. Coffee is relatively abundant, and has a low price. The utility-maximizing rule indicates that consumers should continue purchasing any product until the ratio of its marginal utility to its price is equal to that for all other products. Gold must have a high marginal utility and price, while coffee must have a low marginal utility and price for consumers to maximize utility. Consumers, however, generally purchase only small quantities of gold because of the high price, and large quantities of coffee because of the low price. Coffee is considered to be more essential than gold, even though its price is lower, because the total utility

from consuming coffee (sum of the marginal utilities) is much greater than the total utility from consuming gold. [text: E p. 380; MI p. 136]

24. A person has a basic choice between eating meals at home and eating meals in a restaurant. The cost of the food that is eaten at home is $10 per meal. The cost of a restaurant meal is $20. It takes two hours to eat a meal at home (including preparation time and cleanup time). It takes one hour of time to eat a meal in a restaurant. The marginal utilities of the home meal and the restaurant meal are the same. The person values time at $12 per hour. What does the theory of consumer behavior suggest the rational consumer will decide to do: eat at home or in a restaurant? Answer by first excluding the value of time from the decision. Then include the value of time in the decision.

If time is not a consideration in the cost of a meal, then the marginal utility per dollar of a meal at home is greater than the marginal utility per dollar of the restaurant meal (MUh/$10 > MUr/$20). The consumer will eat meals at home. If, however, the value of time is included in the cost of a meal, then the marginal utility per dollar spent will be the greater for restaurant meals than home meals. The full cost of a home meal is $34 ($10 food plus $24 in time). The full cost of the restaurant meal is $32 ($20 in food and $12 in time). Since the marginal utility of restaurant and home meals are the same, the marginal utility per dollar of restaurant meals will be greater than the marginal utility per dollar of home meals when the value of time enters the calculation (MUh /$32 > MUr/$34). [text: E pp. 377-378, 380-381; MI pp. 133-134, 136-137]

25. How does the pricing of medical care in the United States affect the quantity consumed?

Health insurance pays most of the cost of medical care for individuals. Most individuals with health care coverage wind up paying only 20-30 percent of the full cost of such care. Thus, the price of medical care to the individual consumer comes at a significant discount. This �lower� price for the consumer encourages them to consume more medical care than they otherwise would if they paid the full cost for treatment. [text E p. 381; MI p. 137]

26. (Last Word) Describe the relationship between raising the marginal cost of crime and the quantity of crime committed. Explain the implications of this relationship as applied to property crimes.

The basic idea is that as the marginal cost of a property crime decreases, more property crimes will be

committed. This relationship means that society can reduce property crimes by increasing their price. The price can be increased by increasing fines, prison sentences, or the probability of getting caught (better surveillance and more police). It is also possible to increase the price by increasing the guilt associated with criminal activity. This latter objective can be achieved through family, religious, or educational experiences. [text: E p. 382; MI p. 138]

C. Appendix Questions

27. What is shown by the budget line in a two-product (A and B) case? Describe what happens when there is a change in income or the price of a product.

28. How will an increase in income affect the budget line for two goods, all other

things equal? How does an increase in the price of one good affect the budget line for two goods, all other things equal?

29. Suppose a consumer has a daily income of $48 and purchases just two goods, A and B. The price of A is $8 and the price of B is $6. In the graph below, draw the budget line for the consumer. Indicate the area of the below graph that is

attainable given the income and the area that is unattainable.

30. Why are indifference curves downsloping? 31. What is the rationale for the slope of an indifference curve in a two-product (A and B) case?

32. Explain two important characteristics of indifference curves for two goods.

33. Explain the meaning of the �marginal rate of substitution.�

34. Why can�t indifference curves intersect?

35. What is shown by the indifference map for two goods? Which indifference curve would a consumer want to be on?

New 36. (Consider This) How is an indifference map like a topographic map? 37. What are the conditions for equilibrium in indifference curve analysis? 38. A consumer has a daily income of $120 and purchases two products, X and Y.

The price of X is $3 and the price of Y is $4. The following six pairs of points for X and Y define an indifference schedule: (7,40), (10,30), (15,20), (20,15), (30,10), and (40,8). In the graph below, draw the budget line and the indifference

curve. What amounts of X and Y will allow the consumer to achieve equilibrium?

39. When does the marginal rate of substitution (MRS) in an indifference curve equal the ratio of marginal utilities in marginal-utility analysis? Explain.

40. What happens to the budget line when the price of a product falls? Use indifference curve analysis to explain how this change affects consumption of the product.

41. Using the below indifference curve graph, determine the demand curve for

product X across four different prices when the income is $60 and price of Y is $1.

D. Answers to Appendix Questions

27. What is shown by the budget line in a two-product (A and B) case? Describe what happens when there is a change in income or the price of a product.

A budget line shows various combinations of two products which can be purchased with a given money

income of a consumer and given the prices of the two products. A decrease in the money income of a consumer shifts the budget line inward to the origin. An increase in the money income of a consumer shifts the budget line outward from the origin. Price changes in either of the two products will rotate the budget line along one axis. Assume that the quantity of product A is shown on the vertical axis. If the price of A rises, less of A will be purchased at each of the possible combinations of A and B, so the budget line will shift downward along the vertical A axis towards the origin. A decrease in the price of A would have the curve shift upward along the A axis away from the origin. [text: E pp. 386-387; MI pp. 142-143]

28. How will an increase in income affect the budget line for two goods, all other

things equal? How does an increase in the price of one good affect the budget line for two goods, all other things equal?

A budget line is defined by the intercepts for the two goods in a two-quadrant graph. These intercept values are calculated by dividing money income by the price of the product. If money income increases and prices stay the same, then the intercept values will increase and the budget line will shift outward from the origin. In the case of an increase in the price of one good, the rise in price will reduce the intercept value for that good. The budget line will shift toward the origin along that axis because the new intercept value will be less than the old intercept value for that good. [text: E pp. 386-387; MI pp. 142-143]

29. Suppose a consumer has a daily income of $48 and purchases just two goods, A and B. The price of A is $8 and the price of B is $6. In the graph below, draw the budget line for the consumer. Indicate the area of the below graph that is

attainable given the income and the area that is unattainable.

[text: E pp. 386-387; MI pp. 142-143]

30. Why are indifference curves downsloping? Indifference curves are downsloping because both products (A and B) yield utility to the consumer. More

of both would increase utility, so for utility to remain constant, more of A means less of B and vice versa. [text: E p. 387; MI p. 143]

31. What is the rationale for the slope of an indifference curve in a two-product (A and B) case? The slope of the curve measures the marginal rate of substitution of one good for the other (B for A) for

the consumer to have a constant level of satisfaction. The rationale for this shape is related to diminishing marginal utility. If the consumer has many units of A and few units of B, B is more valuable at the margin while A has a lower marginal utility. The consumer will then be willing to give up more of A to get more units of B. This relationship changes, however, as the consumer gets more and more of B and gives up more and more A. In this case, the consumer will not be willing to give up many units of A to obtain more units of B. This situation means that the slope of the curve diminishes. It is thus convex to the origin. [text: E pp. 387-388; MI pp. 143-144]

32. Explain two important characteristics of indifference curves for two goods.

First, indifference curves are downsloping because both goods will yield utility for the consumer. Because total utility is constant for each indifference curve, the consumption of more of one good would increase total utility and this must be offset by the decrease in the amount consumed of the other good. More utility is derived from the consumption of one good, less utility is obtained from the other good. This inverse relationship produces the downward (negative) slope of the indifference curves.

Second, indifference curves are convex to the origin. The willingness to substitute one good for the other diminishes as the consumer moves down the curve. Thus indifference curves have a diminishing slope that makes them convex to the origin in a two-quadrant graph. [text: E pp. 387-388; MI pp. 143-144]

33. Explain the meaning of the �marginal rate of substitution.�

An indifference curve shows all the combinations of two products, X and Y that will give the consumer the same level of satisfaction or utility. Indifference curves are downsloping because of the inverse relationship between products X and Y. To obtain more of product X means giving up some total utility from product Y. Indifference curves are also convex to the origin. Thus, the slope of an indifference curve diminishes as you move down the curve. The reason for the diminishing slope is that the marginal rate of substitution of product X and Y falls as you move down the curve. As the consumer moves down the indifference curve, the consumer is willing to give up less of Y to get more of X. The marginal rate of substitution is the slope of the indifference curve at any point. [text: E pp. 387-388; MI pp. 143-144]

34. Why can�t indifference curves intersect?

By definition, an indifference curve shows all the combinations of two products that give the consumer the same level of satisfaction. Also, the higher the indifference curve on an indifference map, the greater the level of satisfaction. If indifference curves intersected, then it would be possible to be higher on one curve than another at one point and lower on the same curve than the other curve at another point. This contradictory result is not possible, and thus indifference curves can�t intersect. [text: E p. 388; MI p. 144]

35. What is shown by the indifference map for two goods? Which indifference curve would a consumer want to be on?

An indifference map shows the set of indifference curves for the consumer. Each curve is convex to the

origin and does not cross the other. Each indifference curve shows a level of utility. The farther an indifference curve is away from the origin, the higher the level of utility. The consumer will want to be on the indifference curve that is the one farthest from the origin. [text: E p. 388; MI p. 144]

New 36. (Consider This) How is an indifference map like a topographic map? Each elevation line on a topographic map shows an equal level of elevation. As you move along a line,

the elevation stays the same. Similarly, each line for an indifference curve in an indifference map shows an equal level of total utility. As you move along an indifference curve, total utility stays the same. Elevation lines do not cross in a topo map, nor do indifference curves intersect. If you switch to another line on a topo map, it will show a higher or lower level of elevation. If you move away from the origin in an indifference map and switch to another indifference curve, it will show a higher level of total utility. If you move toward the origin in an indifference map, and switch to a different curve, it will show a lower level of total utility. Both maps do not show every level or gradation, but just major ones to illustrate differences (elevation for a topo map; total utility for an indifference map). [text: E p. 389; MI p. 145]

37. What are the conditions for equilibrium in indifference curve analysis?

The utility-maximizing combination of two products, A and B, for a consumer will be determined by the

tangency of a budget line with the highest attainable indifference curve. [text: E pp. 388-389; MI pp. 144-145]

38. A consumer has a daily income of $120 and purchases two products, X and Y.

The price of X is $3 and the price of Y is $4. The following six pairs of points for X and Y define an indifference schedule: (7,40), (10,30), (15,20), (20,15), (30,10),

and (40,8). In the graph below, draw the budget line and the indifference curve. What amounts of X and Y will allow the consumer to achieve equilibrium?

The answer is shown by the graph. The point of tangency between the budget line and indifference curve is at 20X and 15Y. [text: E pp. 388-389; MI pp. 144-145]

39. When does the marginal rate of substitution (MRS) in an indifference curve equal the ratio of marginal utilities in marginal-utility analysis? Explain.

In equilibrium for the two good case, the MRS for good A and good B equals the ratio of the price of B to the price of A (Pb /Pa ). Similarly, in equilibrium in marginal utility analysis, the ratio of the marginal utility of B to the marginal utility of A (MUb /MUa ) equals the price of B divided by the price of A (Pb/Pa ). MRS and the MUb/MUa equal the same value and are equal when there is equilibrium. If this equilibrium were not the case, then the consumer could be made better off by buying more of one good and less of the other since the marginal utility of one exceeds the other. This situation will cause the marginal

utilities to change until they reach the equilibrium ratios, and the consumer can be made no better off. [text: E pp. 389-390; MI pp. 145-146]

40. What happens to the budget line when the price of a product falls? Use indifference curve analysis to explain how this change affects consumption of the product.

Changing the price of one product shifts the budget line. When the price falls, the budget line shifts outward along the axis for that good. This means that the consumer can achieve a new equilibrium on a higher indifference curve. For most goods, the new equilibrium will most likely increase the consumption of the now lower-priced good. [text E pp. 387-390; MI pp. 143-146]

41. Using the below indifference curve graph, determine the demand curve for

product X across four different prices when the income is $60 and price of Y is $1.

Each indifference curve is tangent to a budget line at 30 units of Y. Using this point as a reference point, you can calculate the values of X that can be purchased as the price of X falls. The budget line shifts outward along the X axis. The demand schedule for product X has the following values: ($30, 1X) ($15, 2X), ($10, 3X), and ($7.5, 4X). [text: E p. 390; MI p. 146]

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