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Chapter 3 DEMAND AND SUPPLY APPLICATIONS5080412750 Chapter in a Nutshell00 Chapter in a NutshellThe price elasticity of demand measures how sensitive buyers are to a change in price. Depending on the response of buyers to a change in price, demand is characterized as elastic, inelastic, or unit elastic.Demand tends to be more elastic for some products and less elastic for others. Among the major determinants of the price elasticity demand are the availability of substitutes, the proportion of buyer income spent on a product, and the time period under consideration.If a firm’s price and total revenue move in opposite directions, demand is elastic. If the firm’s price and total revenue move in the same direction, demand is inelastic. If the firm’s total revenue does not respond to a change in price, demand is unit elastic.Occasionally, the government will impose price controls on individual markets in which prices are considered unfairly high to buyers or unfairly low to sellers. When government imposes a price ceiling on a product, it establishes the maximum legal price a seller may charge for that product. Conversely, government establishes a price floor to prevent prices from falling below the legally mandated level.Although price controls on individual markets attempt to make prices more “fair” for buyers and sellers, they interfere with the market’s allocation of resources. Price ceilings that are set below the equilibrium price level result in market shortages of a product. Price floors that are set above the equilibrium level entail market surpluses.Chapter ObjectivesAfter reading this chapter, you should be able to:Explain the relationship between the responsiveness of quantity demanded to a change in price and the manner in which a firm’s total revenue is influenced by price changes.Describe the nature and operation of the price elasticity of supply.Assess the advantages and disadvantages of governmental price ceilings and price supports on individual markets.10160-259715Knowledge Check00Knowledge CheckKey Concept Quizprice elasticity of demandelastic demandinelastic demandunit elastic demandtotal revenueprice elasticity of supplyprice ceilingprice floorrent controlusury usury lawagricultural price floor_____ a.percentage change in quantity demanded is greater than the percentage change in price_____ b.measures how sensitive buyers are to a change in price_____ c. = P x Q_____ d.the maximum legal price a seller may charge for the product_____ e.a type of price ceiling_____ f.percentage change in quantity demanded is less than the percentage change in price_____ g.percentage change in quantity demanded equals the percentage change in price_____ h.measures how quantity supplied responds to a change in the price_____ i.the minimum legal price a seller may charge for the product_____ j.all payments for the use of money_____ k.a legally mandated minimum price_____ l.interest-rate ceilingMultiple Choice QuestionsPrice elasticity of demand measuresa.the responsiveness of quantity demanded to a change in the priceb.the responsiveness of demand to a change in the pricethe responsiveness of price to changes in quantity demandedthe responsiveness of price to changes in demandPrice elasticity of supply measuresthe percentage change in supply due to a percentage change in pricethe percentage change in price due to a percentage change in supplythe percentage change in quantity supplied due to a percentage change in the pricethe percentage change in price due to a percentage change in the quantity suppliedPrice elasticity of demand is alwayspositivenegativenon-zerozero or negativeThe supply curve must always assumenon-negative valuesnegative valuesnon-positive valuesvalues close to infinityDemand is relatively inelastic whenEd = 1Ed > 1Ed < 1Ed = 0Demand is relatively elastic whenEd = 1Ed > 1Ed < 1Ed = ?When the price of a product rises and Ed = 1, the total revenueremains unchangedincreasesdecreasescannot be determinedWhen the Seattle Mariners decide to increase the price of their tickets to baseball games hoping to increase total revenues earned, they are working on the assumption thatEd = 1Ed > 1Ed < 1Ed = 0If Gateway cuts prices on all of its desktop computers on the prediction that total revenues will rise, then Gateway is assuming thatEd = 1Ed > 1Ed < 1Ed = 0All the following factors affect the price elasticity of demand except theavailability of substitutesproportion of income spent on the producttime to adjust to a change in the pricechange in the consumer’s incomeIf a tax is placed on a life-saving drug that happens to be the only drug on the marketconsumers will pay most of the taxdrug companies will pay most of the taxthe drug companies will stop producing the drugthe consumers will boycott the drugIf steel producers are successful in lobbying Congress for subsidies, we may expect all of the following exceptincrease in the quantity suppliedincrease in the price of steeldecrease in the price of steelreallocation of government fundsA gas tax is more effective for collecting revenues in the short run rather than the long run sincegovernments usually realize their mistakes over the long rundemand is more elastic in the long runconsumers always get used to the idea of a tax over the long runproducers are very responsive to a tax in the short run but not the long runIf cigarettes are subject to price ceilings, all of the following may happen, exceptthe price of cigarettes falls an underground market for cigarettes developsa surplus develops in the market for cigarettesthe quality of the product may deteriorateIf a tax is imposed on handguns and the demand and supply for handguns are both elasticthe tax will be shared by the sellers and buyers, and the quantity of handguns sold will decreasethe tax will be borne entirely by the buyersthe tax will be borne entirely by the sellersthe tax will have no effect on the market for handgunsWhen the price of oil is $20 a barrel, 25 million barrels are demanded each day, but when the price of oil is $30 a barrel, only 20 million barrels are demanded. We can conclude that the demand for oil isa.perfectly inelasticb.relatively inelasticc.relatively elasticd.perfectly elasticThe supply of wheat will be more inelastic thea.shorter the time period under considerationb.greater the number of farmers growing wheatc.easier it is to substitute capital for labor in farmingd.greater the number of buyers in the wheat marketThe burden of a tax on gasoline is born entirely by consumers if the demand for gasoline isa.perfectly elasticb.relatively elasticc.relatively inelasticd.perfectly inelasticInterestRateQuantity of Money SuppliedQuantity of Money Demanded4%$1million$5 million8%$2 million$4 million12%$3 million$3 million16%$4 million$2 million20%$5 million$1 millionThe table above shows the market for mortgage loans. If the government imposes a ceiling on interest rates at 8 percent, the ceiling:does not protect borrowers from the interest rate set by the marketb.results in borrowers paying an interest rate higher than the market equilibrium ratec.leads to an excess demand for mortgage fundsd.increases profits that lenders make on mortgage loansIf the federal government levied an effective ceiling on interest rates charged by MasterCard and Visa, we would anticipate a decrease in the:a.annual credit card fees paid by householdsb.prices charged by merchants who accept credit cards for paymentc.amount of credit made available by banks issuing credit cardsfee that banks charge merchants for processing credit card salesIf the University of Wisconsin increases tuition which results in rising total tuition revenue, student demand for education at the university isa.inelasticb.elasticc.unit elasticd. all of the aboveIn 1997, the U.S. government levied a 10-percent excise tax on the sale of domestic airline tickets, yet airlines increased fares by 4 percent. Apparently, the demand for tickets wasa. perfectly inelasticb. perfectly elasticc. somewhat elasticd. all of the aboveIn 2002, the Pittsburgh Pirates increased season ticket prices to generate additional revenue. However, fan attendance at baseball games fell more than that anticipated by the team’s management, resulting in decreases in revenue. Apparently, the demand for tickets was a. relatively inelastic b. relatively elastic c.perfectly inelastic d. perfectly elasticHealth care would become more expensive ifa. the increase in the demand curve for health care is more than the increase in supplyb. the increase in the demand curve for health care is less than the increase in supplyc. the decrease in the demand curve for health care is more than the decrease in supplyd. the decrease in the demand curve for health care is the same amount as the decrease in supply. Below-equilibrium rent controls are plagued by all of the following problems except: a.discrimination may occur in the rationing of apartmentsb. rent controls encourage the production of more apartmentsc. the quality of apartments may deterioratelandlords my develop under-the-table markets to collect extra incomeIf federal ceilings were imposed on the interest rate you pay on your Master Card, the bank that issued your credit card would have the incentive tolengthen your interest-free grace periodreduce the annual fee that you pay on your credit cardraise the fee they charge merchants for processing credit card salesprovide more services with your credit card, such as discounts on motelsTrue-False Questions1.TFElasticity of supply decreases when price increases.2.TFIf demand is elastic, the demand curve shifts to the right when price increases.3.TFElasticity of demand and total revenue are unrelated.4.TFUnit elasticity implies that total revenue is unresponsive to changes in price.5.TFIf a firm increases total revenue by raising prices, it must be experiencing inelastic demand.6.TFWhen a product has many substitutes, its elasticity is relatively high.7.TFThe price elasticity of demand is insensitive to time.8.TFBuyers and sellers will always share a gas tax equally.9.TFWhen the demand curve is vertical and the supply curve is positively sloped, a new tax will be borne entirely by the sellers.10.TFPrice ceilings are always higher than the equilibrium price.11.TFPrice floors are always lower than the equilibrium price.12.TFFarm subsidies provide an example of price floors.13.TFA price ceiling on gas will always benefit consumers.14.TFImposition of interest rate ceilings amounts to market interference.15.TFA price floor typically causes a shortage.16.TFA price ceiling may lead to improvement of the quality of the product or service.17.TFWhen demand increases in a market experiencing a price ceiling, a shortage develops in the market.18.TFWhen demand is elastic and a firm raises the price of its product, it does so because it correctly predicts an increase in total revenue.19.TFInelastic supply curves may become elastic given enough time.20.TFUnit elasticity implies that a rise in price leads to a one-unit decline in the quantity demanded.21.TFRent controls and minimum wage laws provide examples of price floors.22.TFIf the price elasticity of demand for first-class letters is 0.3, an increase in price will result in additional revenues for the U.S. Postal Service.23.TFThe rising significance of email results in the demand for letter mail delivered by the U.S. Postal Service becoming more elastic. 24.TFIf the demand for airline tickets is perfectly elastic, a 10 percent increase in the excise tax on tickets will entirely be absorbed by passengers in the form of a higher price.25.TFIf the increase in the supply of health care exceeds the increase in demand, health care becomes more expensive.26.TFIf the federal government imposes a ceiling on the interest rate that banks could charge users of VISA, a bank would have the incentive to tighten credit standards so as to decrease collection costs and write-offs of bad debt.27.TFAn increase in the minimum wage will result in an increase in total wages paid to workers if the demand for labor is inelastic.Application QuestionsThe following table shows Homer Simpson’s demand for comedy show tickets.Price($/ticket)Quantity Demanded$1020$2015$3010$405$500Use the following midpoint formula to calculate the price elasticities of demand.a.Calculate the price elasticity of demand between the prices of $10 and $20.b.Calculate the price elasticity of demand between the prices of $20 and $40.c.Calculate the price elasticity of demand between the prices of $40 and $50.d.Is Homer Simpson more sensitive to price increases when the price is $10 than when it is $40?e.Let’s assume that the price of a comedy show ticket is $40 and everyone in the community has a demand schedule that is identical to Homer Simpson’s. If the organizers raise the ticket prices, will they succeed in increasing their revenues?The following table shows the demand and supply for comedy show tickets in the Simpson neighborhood.Price($/ticket)Quantity DemandedQuantity Supplied$104020$203030$302040$401050$50060What is the equilibrium price? What is the equilibrium quantity? Draw the supply and demand curves for comedy show tickets.Assume that a $10 tax is imposed on each ticket. Draw the new supply curve.What is the new equilibrium price? What is the new equilibrium quantity?The following table represents a new demand schedule for the suburb of Consistent, which borders the Simpson’s neighborhood.Price($10/ticket)Quantity Demanded$1040$2040$3040$4040$5040Assume that the supply schedule of tickets is identical to the one described in question 2.Draw demand and supply curves of tickets and identify the equilibrium.What is the equilibrium price and quantity?Assume that a tax of $10/ticket is imposed. Draw a new supply curve of tickets.Who pays for the tax?Are the effects of the tax in this market different from the effects in the market described in question 2? Why?-628652540Answers to Knowledge Check Questions00Answers to Knowledge Check QuestionsKey Concept Answers1.b7.d2.a8.i3.f9.e4.g10.j5.c11.l6.h12.kMultiple Choice Answers1.a6.b11.a16.b21.a26.c2.c7.a12.c17.a22.c3.d8.c13.b18.d23.b4.a9.b14.c19.c24.a5.c10.d15.a20.c25.bTrue-False Answers1.F6.T11.F16.F21.F26.T2.F7.F12.T17.T22.T27.T3.F8.F13.F18.F23.T4.T9.F14.T19.T24.F5.T10.F15.F20.F25.FApplication Question Answers1.a.Ed = 0.43Ed = 1.5Ed = 9No. Homer is less sensitive to price increases when the price is $10 than when it is $40.No. Because the price elasticity of demand is greater than one, total revenue will decrease when price is increased.139700-21780550102030405010203040??Market for Comedy Show TicketsD60??S??S??Price ofTicket($)Quantity?????Post-tax Supply CurvePre-tax Supply Curve60???0050102030405010203040??Market for Comedy Show TicketsD60??S??S??Price ofTicket($)Quantity?????Post-tax Supply CurvePre-tax Supply Curve60???2.a.Equilibrium price = $20Equilibrium quantity = 30 ticketsc.New equilibrium price = $25New equilibrium quantity = 25 tickets533400-21336050102030405010203040??Market for Comedy Show TicketsD60??S??S??Price ofTicket($)QuantityPre-tax Supply CurvePost-tax Supply Curve600???0050102030405010203040??Market for Comedy Show TicketsD60??S??S??Price ofTicket($)QuantityPre-tax Supply CurvePost-tax Supply Curve600???3.a.The new demand curve is vertical.b.Equilibrium price = $30Equilibrium quantity = 40 ticketsc.Yes. In this market suppliers do not share the tax burden. Also, the same quantity of tickets (40 tickets) is bought and sold in this market before and after the imposition of the tax. In the neighborhood in which the Simpsons reside, the suppliers share part of the tax and less is bought and sold after the tax is imposed.2245360140843000 ................
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