Economics 200 - California State University, Northridge



Economics 160

Prof. E. McDevitt

STUDY QUESTIONS ON ELASTICITY

1. What does the elasticity of demand measure?

2. Assume that P1 = $100 and Q1 = 10,000. Price now increases to $115, and quantity demanded falls to 9,500. Calculate the elasticity of demand.

3. Suppose the elasticity of demand for cigarettes is 1. The government desires to decrease the quantity demanded for cigarettes from its current level of 1,000,000 packs per day to 800,000 packs per day. They will attempt to do this by increasing the tax on cigarettes, thereby causing

an increase in price. If the current price is $4 per pack, then price would have to increase to what level to achieve the above drop in quantity demanded?

3. What is the relationship between P and TR when e 1? What is the relationship between P and TR when e =1?

4. Suppose CSUN is considering raising the tuition rate in order to increase total revenue. Would raising tuition necessarily cause total revenue to rise? Explain your answer. Is it possible that raising tuition could cause total revenue to fall? Explain.

5. What does it mean to say that demand is relatively elastic? ...relatively inelastic? Use a graph to explain.

6. What are some of the determinants of the elasticity of demand? Would the elasticity of a crowd’s demand for cold lemonade by affected by the proximity of a drinking fountain? Explain.

How does ignorance affect elasticities of demand?

7. Does a society’s transportation system in any way affect elasticities of demand?

8. Define and show on graph: perfectly inelastic demand curve and perfectly elastic demand curve.

9. Suppose demand is perfectly elastic at a price of $5. (That is, the horizontal demand curve hits the vertical axis at $5). What would happen to quantity demanded if the price was raised to $5.01?

10. Assume that P1 = $8 and Q1S = 100,000. Price now falls to $6. At this lower price, quantity supplied now equals 60,000. What is eS?

11. Suppose elasticity of supply equals 0.5. The current price is $1,000 and the current quantity supplied is 1,000,000. If price rises to $1,100, what is the new quantity supplied? Show your answer on a graph as well as providing numerical calculations.

12. What does it mean to say that supply is relatively elastic? ...relatively inelastic? Use a graph to explain.

13. a.Under what circumstances will buyers bear the entire burden of a tax? b. Under what circumstances will sellers bear the entire burden of a tax? Use supply and demand graphs to show your answer.

14. Suppose harvest-time rains destroy a large quantity of strawberries. Do you think that the total revenue received by strawberry producers will go up or down? Hint: your answer depends upon the elasticity of demand. You should be able to explain why. Use a supply and demand graph to explain your answer.

15. Consider the market for cigarettes in Brazil and the U.S. Suppose the supply curve is the same in each country, but demand for cigarettes is more elastic in the US. The initial price and quantity is the same in each country. Suppose each country imposes an excise tax of $1/unit on cigarettes. Using a single supply and demand graph, compare the impact on price in each country.

Answers.

1. It measures how sensitive quantity demanded is to changes in price.

2. The elasticity formula is:

e = (percentage change in Q)/(percentage change in P) = ((Q/Q1) / ((P/P1).

Step one: Let us first calculate (Q (which is read “change in quantity demanded”).

(Q= 10,000-9,500= 500.

Step two: Next, divide this number by Q1 (the original quantity demanded). So we have 500/10,000 = 0.05 (or 5%). This tells us that quantity demanded has fallen by 5%.

Step three: Calculate (P. Doing so, we get (P = $115-$100=$15.

Step four: Divide (P by P1. Doing this,we get $15/$100=0.15 (or 15%). That is, there has been a 15% increase in price.

Step five: Divide the percentage change in Q by the percentage change in P.

e = 0.05/0.15 = 1/3.

3. Set up the problem as follows:

e = ((Q/Q1) / ((P/P1) = (200,000/ 1,000,000)/((P/P1)=1

= (0.20)/((P/P1) = 1.

This tells us that ((P/P1 ) must be equal to 0.20 also. That is, the price must be increased by 20%. Since the original price of cigarettes was $4, the new price would have to be $4.80.

(Note: 20% of $4 is $0.80).

3b. When e 1 (that is, when demand is elastic), P and TR move in opposite directions. In other words, an increase in P will cause TR to fall, and a decrease in P will cause TR to rise.

If e =1 (unit elastic), then a change in P will leave TR unchanged.

4. No. If the demand for schooling at CSUN is elastic (e>1), then raising tuition would cause TR to fall. Explanation: If e = ((Q/Q1) / ((P/P1) >1, then it follows that the percentage change in Q exceeds the percentage change in P. This means that, say, a 10% increase in P will cause Q to fall by more than 10%. Since TR = P*Q, this would mean that TR has fallen. Intuitively, to say that demand is elastic is to say that a relatively small increase in price will lead to a relatively large drop in customers (students).

5. Relatively elastic means the demand curve is relatively flat, and relatively inelastic means the curve is relatively steep. See Graphs.

6. Some of the determinants are (a) the number and knowledge of substitutes, (b) the time interval that a consumer has to adjust to a given price change, and (c) the definition of a market. The larger the number of substitutes available, the more elastic demand will be (that is, consumers will be more responsive to a price change). Likewise, the longer the time interval a consumer has to adjust to a price change, the more elastic demand will be. This is due to the fact that the longer the time a consumer has to respond to a given price change, the greater the number of substitutes a consumer will be able to find.

If a market is defined broadly—for example, the market the gasoline—then fewer the close substitutes there are. And so demand would tend to be relatively inelastic. On the other hand, if the market is defined narrowly—for example, the market for Exxon/Mobil gasoline—then the greater the number of close substitutes there are. (Chevron gasoline, Union 76 gasoline, etc. are very close substitutes for ExxonMobil gasoline). In this case, demand is more elastic.

7. The better the transportation system, and thus the cheaper transportation is, the greater the number of substitutes available. If a person is restricted to a limited geographical area, then the number of substitutes would be small in comparison to someone who was not restricted. The greater the number of substitutes available, the more elastic demand will be.

8. See graphs.

9. It would fall to zero. Any price above $5 would cause quantity demanded to fall to zero if demand was perfectly elastic.

10. The change in quantity supplied = 100,000-60,000=40,000. Dividing this by the original quantity supplied gives us 40,000/100,000=0.40 (40%). The change in price = $8-$6=$2. Dividing this number by the original price gives us $2/$8 =0.25 (25%). Thus:

eS = (0.40)/(0.25) = 1.6.

11. Set up as follows: eS = ((Qs/Q1s)/((P/P1)= ((Qs/Q1s)/(0.10)=0.50.

It follows from this equation that ((Qs/Q1s ) must be equal to 0.05 (5%). A 5% increase in quantity supplied would make the new quantity supplied equal to 1,050,000.

(Note: 5% of 1,000,000 is 50,000).

12. Relatively elastic means relatively flat, and relatively inelastic means relatively steep. See graphs.

13. See graphs and tables.

14. If the supply of strawberries falls (leftward shift in supply curve), then price will increase. If demand for strawberries is inelastic (e1), then TR will fall. See graphs and the answer to question number (4).

Question 8. Question 8.

P Question 5. P Perfectly Inelastic P Perfectly Elastic

D

P1 D

P2 Delastic

Dinelastic

Q1 Q2inelas. Q2elas. Q Q Q

For a given change in price, from P1 to P2,

the increase in quantity demanded is greater

for elastic curve.

Question 13a.

P Question 12. P D

Sinelastic S2

$11

S1

P2 Selastic $10

P1 Vertical gap=$1

Q1Qinelastic Qelastic Quantity Q Quantity

For this problem it is assumed that

an excise tax of $1/unit is imposed on sellers.

P Question 13a.

Table for 13a .Buyers bear entire burden

$11 S2

vertical gap=$1 Before Tax After Tax

$10 S1 Buyers Pay $10 $11 .

Sellers receive net

D price of $10 $11-$1=$10

Q2 Q1 Q Note: Sellers receive the same price before and

after tax, whereas buyers pay a price that is $1 higher.

Question 13b. Question 13b.

P P S1=S2

vertical gap=$1 S2

S1

$10 D $10

D

Q2 Q1 Q Q Quantity

P

Question 15

S2 Table for 13b. Sellers bear entire burden.

Before Tax After Tax

PBrazil S1 Buyers Pay $10 $10 .

PUS Sellers receive net

P1 price of $10 $10-$1=$9

DUS

DBrazil Buyers pay the same price before and after the tax,

whereas sellers receive a net price that is $1 lower.

QUS QBrazil Q1 Quantity

Study Questions on PPF, Comparative Advantage

1. See Figure 1.

Y Figure 1: Fiji’s PPF

200

Y1

X1= 20 50 X

a. Determine the opportunity cost of producing X in Fiji.

b. Find Y1.

2. See Figure two.

Z Figure 2: Siberia’s PPF

10

9

7

4

1 2 3 4 X

Suppose Siberia is initially producing zero X and 10 units of Y. What is the opportunity of producing the first unit of X? …of producing the second unit? ….third unit? …..fourth unit?

3. What factors cause the production-possibility frontier to shift?

4. Elizabeth and Stephanie have each been assigned 3 rooms to clean. Cleaning the floor and dusting is required for each room. It takes Elizabeth 10 minutes to dust one room and 20 minutes to clean the floor for one room. It takes Stephanie 25 minutes to dust one room and 25 minutes to clean the floor for one room. Therefore, Elizabeth is currently spending 90 minutes to clean her three rooms (90 minutes = 10 minutes * 3 rooms + 20 minutes* 3 rooms) and Stephanie is currently spending 150 minutes to clean her three rooms.

a. Who has the comparative advantage in cleaning floors?

Who has the comparative advantage in dusting?

b. What sort of trades can they make that would reduce the time each spends on cleaning?

5. a. It takes Tom 10 hours to produce an X and 5 hours to produce a Y. It takes Maria 18 hours to produce an X and 6 hours to produce a Y. Who has the absolute advantage in the production of good X? Who has the absolute advantage in the production of good Y? Who has comparative advantage in the production of good X? Who has the comparative advantage in the production of good Y? Explain your answers.

b. Suppose Tom has 100 total hours available. He uses 50 hours to produce X and 50 hours to produce Y. Maria has 90 total hours available, and she uses 72 hours to produce X and 18 hours to produce Y. Given this information, fill in the table below.

X produced Y produced

Tom

Maria

TOTAL

c. Now suppose each individual completely specializes in the good that he/she has a comparative advantage in. Based on this assumption, fill in the table below.

X produced Y produced

Tom

Maria

TOTAL

Compared to your answer for part (b), what has happened to the TOTAL production of of X and Y?

6. Use the following information to answer the questions below:

U.S. Great Britain (GB)

Soybean 2hrs. 8hrs.

Textiles 1hr. 2hrs.

Each number in the table represents the number of labor hours required to produce one unit of the respective good. The U.S. has 8,000 labor hours available, and GB has 8,000 hours available.

a. Draw each country’s production possibility curve. What does the slope of the PPF represent?

b. Which country has the absolute advantage in the production of soybeans? ...in the production of textiles? Explain.

c. Which country has the comparative advantage in the production of soybeans? ...in the production of textiles? Explain.

d. Assume that the U.S. is initially producing and consuming 3000 units of soybeans and 2000 units of textiles, and G.B. is initially producing and consuming 600 units of soybeans and . units of textiles. Fill in the following table.

Before Specialization

Soybeans Textiles

US

GB

TOTAL

e. Now assume that each country completely specializes in the good in which it has a comparative advantage. Fill in the following table.

After Specialization, But Before Trade

Soybeans Textiles

U.S.

G.B.

TOTAL

f. Assume that the price of wheat in terms of shoes is 3T per S (that is, it takes 3 units of textiles to purchase one unit of soybeans), and at this price the U.S. desires to export 700S. Fill in the table below showing production and consumption.

After Specialization and Trade

Soybeans Textiles

U.S.

G.B.

TOTAL

g. Would trade take place at a price of 1T per S? Explain.

ANSWERS

Y Fiji’s PPF

200

Y1

X1= 20 50 X

a. The opportunity cost of X in terms of Y is given by the slope of the PPF.

Slope = (rise/run) = 200/50 = 4. Therefore, the cost of producing 1 X is 4 Y.

b. If Fiji is producing 20 units of X ,and given that the opportunity cost of 1X is 4Y, then

Fiji must be giving up 20*4 = 80 units of Y. And so Y1 = 200-80= 120.

2. The opportunity cost of producing the first unit of X is 1Z (output of Z falls from 10 to 9 as Siberia moves from zero X to 1 unit of X.) The opportunity cost of the second unit of X is 2Z (output of Z falls from 9 to 7). The opportunity cost of the third unit of X is 3Z (output of Z falls from 7 to 4). The opportunity cost of the fourth unit of X is 4Z (output of Z falls from 4 to 0).

3. Changes in technology, and changes in the amount of inputs available (land, labor and capital).

4. Elizabeth’s opportunity cost of cleaning one floor = (20 minutes/floor)/ (10 minutes/dusting)=

two dustings per floor. In other words, in the amount of time it takes Elizabeth to clean one floor she could have dusted two rooms.

Stephanie’s opportunity cost of cleaning one floor = (25 minutes/floor)/ (25 minutes/dusting)=

one dusting per floor. In other words, in the amount of time it takes Stephanie to clean one floor she could have dusted one room.

Since Stephanie has the lower opportunity cost of cleaning floors, she has the comparative advantage in floors.

Elizabeth’s opportunity cost of dusting one room = (10 minutes/dusting)/ (20 minutes/floor)=

½ floor per dusting. In other words, in the amount of time it takes Elizabeth to dust one room she could have cleaned ½ of a floor.

Stephanie’s opportunity cost of dusting one room = (25 minutes/dusting)/ (25 minutes/floor)=

one floor per dusting. In other words, in the amount of time it takes Stephanie to dust one room she could have cleaned one floor.

Since Elizabeth has the lower opportunity cost of dusting, she has the comparative advantage in dusting.

4b. Any “price” between 2D per F and 1D per F will make both better off. For example, suppose they agree on a price of 1.5D per F. So Stephanie, who has the comparative advantage in floors, might agree to take over two Elizabeth’s floors in return for Elizabeth dusting all three of Stephanie’s rooms. So after this trade, Elizabeth does 6 dustings plus 1 floor and Stephanie does 5 floors and no dustings.

Time spent by each would now be:

For Elizabeth ( (6 dustings*10 minutes/dusting ) + (1 floor*20 minutes/floor) = 80 minutes. This saves Elizabeth 10 minutes (recall that before the trade it took Elizabeth 90 minutes to complete her three rooms).

For Stephanie ( (5 floors*25 minutes/floor) = 125 minutes. This saves Stephanie 25 minutes (recall that before the trade it took Stephanie 150 minutes to complete her three rooms).

5a. Tom has the absolute advantage in the production of X since it takes him fewer hours to produce one unit of X (10 hours versus 18 hours for Maria). Tom also has the absolute advantage in the production of Y since it takes him fewer hours to produce one unit of Y (5 hours versus 6 hours for Maria).

Tom’s opportunity cost of producing one unit of X = (10 hours per X/5 hours per Y)=2Y per X.

Maria’s opportunity cost of producing one unit of X=(18 hours per X/6 hours per Y)=3Y per X.

Since Tom can produce a unit of X at a lower opportunity cost than Maria (2Y ................
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