This Document Contains Chapters 5 to 6 Chapter 5 Price Controls and Quotas: Meddling with Markets 1. In order to ingratiate himself with voters, the mayor of Gotham City decides to lower the price of taxi rides. Assume, for simplicity, that all taxi rides are the same distance and therefore cost the same. The accompanying table shows the demand and supply schedules for taxi rides. Quantity of rides (millions per year) Fare (per ride) Quantity demanded Quantity supplied $7.00 10 12 6.50 11 11 6.00 12 10 5.50 13 9 5.00 14 8 4.50 15 7 a. Assume that there are no restrictions on the number of taxi rides that can be supplied (there is no medallion system). Find the equilibrium price and quantity. b. Suppose that the mayor sets a price ceiling at $5.50. How large is the shortage of rides? Illustrate with a diagram. Who loses and who benefits from this policy? c. Suppose that the stock market crashes and, as a result, people in Gotham City are poorer. This reduces the quantity of taxi rides demanded by 6 million rides per year at any given price. What effect will the mayor’s new policy have now? Illustrate with a diagram. d. Suppose that the stock market rises and the demand for taxi rides returns to normal (that is, returns to the demand schedule given in the table). The mayor now decides to ingratiate himself with taxi drivers. He announces a policy in which operating licenses are given to existing taxi drivers; the number of licenses is restricted such that only 10 million rides per year can be given. Illustrate the effect of this policy on the market, and indicate the resulting price and quantity transacted. What is the quota rent per ride? 1. a. The equilibrium in the market for taxi rides is shown by E1 in the accompanying diagram. The equilibrium price is $6.50; at that price, the quantity demanded equals the quantity supplied—11 million taxi rides per year. The demand and supply curves (D1 and S) illustrate this initial situation. Fare (per ride) S $7.00 6.50 E1 6.00 5.50 5.00 4.50 0 D1 5 7 9 11 13 15 17 Quantity of rides (millions per year) b. With a price ceiling of $5.50, the quantity supplied is 9 million taxi rides and the quantity demanded is 13 million. So the shortage is 13 million - 9 million = 4 million. Taxi drivers clearly lose out: there are fewer taxi rides supplied than before, and at a lower price. The impact on consumers is unclear: fewer people now manage to get rides, but those who do, get them at a lower price. Fare (per ride) $7.00 S 6.50 E1 6.00 Price ceiling 5.50 5.00 Shortage 4.50 0 D1 5 7 9 11 13 15 17 Quantity of rides (millions per year) c. The new demand curve is D2. Now the price ceiling has no effect: the equilibrium is point E2 and the market price settles at $5, which is below the mandated price ceiling of $5.50. There will be 8 million taxi rides demanded and supplied, at a price of $5 each. Fare (per ride) $7.00 S 6.50 E1 6.00 Price ceiling 5.50 E2 5.00 4.50 0 D2 5 7 8 9 D1 11 13 15 17 Quantity of rides (millions per year) d. The accompanying diagram illustrates the effect of the quota of 10 million taxi rides. The quantity of taxi rides is now 10 million, at a price of $7. The quota rent per ride is $1. Fare (per ride) S $7.00 Quota rent 6.50 6.00 E1 5.50 5.00 Quota 4.50 0 D1 5 7 9 10 11 13 15 17 Quantity of rides (millions per year) 2. In the late eighteenth century, the price of bread in New York City was controlled, set at a predetermined price above the market price. a. Draw a diagram showing the effect of the policy. Did the policy act as a price ceiling or a price floor? b. What kinds of inefficiencies were likely to have arisen when the controlled price of bread was above the market price? Explain in detail. One year during this period, a poor wheat harvest caused a leftward shift in the supply of bread and therefore an increase in its market price. New York bakers found that the controlled price of bread in New York was below the market price. c. Draw a diagram showing the effect of the price control on the market for bread during this one-year period. Did the policy act as a price ceiling or a price floor? d. What kinds of inefficiencies do you think occurred during this period? Explain in detail. 2. a. Panel (a) of the accompanying diagram illustrates the effect of this policy. Since the price is set above the market equilibrium price, this policy acts as a price floor: it raises the price artificially above the equilibrium. As a result, too much bread is produced: there is a surplus. Panel (a) Price of bread Panel (b) S1 Surplus Price floor E1 D Quantity of bread S2 Price of bread E2 Price ceiling Shortage D Quantity of bread b. As with all price floors above the equilibrium price, there are several associated inefficiencies. First, there is deadweight loss from inefficiently low quantity. Some transactions that would have occurred at the unregulated market price no longer occur. Second, there is inefficient allocation of sales among bakers. Some bakers who are willing to sell at a lower price don’t get to operate, while bakers who will only operate by selling at a higher price do get to operate. Third, there are wasted resources from surplus production of bread that must be given or thrown away. Fourth, there is inefficiently high quality as bakers produce bread of higher quality than consumers want. Consumers would instead prefer a lower price. c. Panel (b) illustrates the effect of the fixed price if the market equilibrium is above that price. The set price now acts like a price ceiling, preventing the price from rising to the equilibrium. There is a shortage, as occurs with every price ceiling below the equilibrium price. d. As with all price ceilings below the equilibrium price, there are several associated inefficiencies. First, there is deadweight loss from inefficiently low quantity. There is a persistent shortage of bread, and some transactions that would have occurred at the equilibrium price no longer occur. Second, there is inefficient allocation to consumers, as some who want bread very much are not able to find any, while those who value bread less are able to purchase some. Third, there are wasted resources as consumers expend resources to find bread. Fourth, there is inefficiently low quality of bread that is offered for sale. 3. In 2014, the U.S. House of Representatives approved a new farm bill establishing the Margin Protection Program (MPP) for dairy producers. The MPP supports dairy farmers when the margin between feed costs and milk prices falls below $0.08 per pound. Assume that current feed costs are $0.10 per pound, which means the program creates a price floor for milk at $0.18 per pound. At that price, the quantity of milk supplied is 240 billion pounds, and the quantity demanded is 140 billion pounds. To support the price of milk at the price floor, the U.S. Department of Agriculture (USDA) has to buy up 100 billion pounds of surplus milk. The supply and demand curves in the following diagram illustrate the market for milk. Price of milk (per pound) S $0.25 0.18 0.15 Price floor 0.05 0 D 140 200 240 Quantity of milk (billions of pounds) a. In the absence of a price floor, how much consumer surplus is created? How much producer surplus? What is the total surplus (producer surplus plus consumer surplus)? b. With the price floor at $0.18 per pound of milk, consumers buy 140 billion pounds of milk. How much consumer surplus is created now? c. With the price floor at $0.18 per pound of milk, producers sell 240 billion pounds of milk (some to consumers and some to the USDA). How much producer surplus is created now? d. How much money does the USDA spend to buy surplus milk? e. Taxes must be collected to pay for the purchases of surplus milk by the USDA. As a result, total surplus is reduced by the amount the USDA spent buying surplus milk. Using your answers from parts b, c, and d, what is the total surplus when there is a price floor? How does this total surplus compare to the total surplus without a price floor from part a? 3. a. In the absence of a price floor, consumer surplus is the area below the demand curve but above the equilibrium price of $0.15: it is (($0.25 − $0.15) × 200 billion)/2 = $10 billion. Producer surplus is the area above the supply curve but below the equilibrium price of $0.15: it is (($0.15 − $0.05) × 200 billion)/2 = $10 billion. Total surplus therefore is $10 billion + $10 billion = $20 billion. b. With the price floor at $0.18 per pound, consumer surplus is the area below the demand curve but above the price of $0.18: it is (($0.25 − $0.18) × 140 billion)/2 = $4.9 billion. c. With the price floor at $0.18 per pound, producer surplus is the area above the supply curve but below the price of $0.18: it is (($0.18 − $0.05) × 240 billion)/2 = $15.6 billion. d. The USDA buys 100 billion pounds of milk at a price of $0.18 per pound, for a total of $0.18 × 100 billion = $18 billion. e. Total surplus when there is a price floor is consumer surplus plus producer surplus minus the money spent by the USDA. It is $4.9 billion + $15.6 billion − $18 billion = $2.5 billion. This is less than the $20 billion total surplus without any price support. 4. The accompanying table shows hypothetical demand and supply schedules for milk per year. The U.S. government decides that the incomes of dairy farmers should be maintained at a level that allows the traditional family dairy farm to survive. So it implements a price floor of $1 per pint by buying surplus milk until the market price is $1 per pint. Quantity of milk (millions of pints per year) Price of milk (per pint) Quantity demanded Quantity supplied $1.20 550 850 1.10 600 800 1.00 650 750 0.90 700 700 0.80 750 650 a. In a diagram, show the deadweight loss from the inefficiently low quantity bought and sold. b. How much surplus milk will be produced as a result of this policy? c. What will be the cost to the government of this policy? d. Since milk is an important source of protein and calcium, the government decides to provide the surplus milk it purchases to elementary schools at a price of only $0.60 per pint. Assume that schools will buy any amount of milk available at this low price. But parents now reduce their purchases of milk at any price by 50 million pints per year because they know their children are getting milk at school. How much will the dairy program now cost the government? e. Explain how inefficiencies in the form of inefficient allocation to sellers and wasted resources arise from this policy. 4. a. The deadweight loss is shown in the accompanying diagram by the shaded triangle. b. With demand of D1 and supply of S, the equilibrium would be at point E1 in the accompanying diagram. However, with a price floor at $1, the quantity supplied is 750 million pints and the quantity demanded is 650 million pints. So the policy causes a surplus of milk of 100 million pints per year. Price of milk (per pint) $1.20 S Surplus of 100 million pints 1.10 1.00 0.90 0.80 0 Price floor E1 Deadweight loss D1 500 550 600 650 700 750 800 850 Quantity of milk (millions of pints per year) c. In order to sustain this price floor (to prevent black market sales of surplus milk below the price floor), the government has to buy up the surplus of milk. Buying 100 million pints of milk at a price of $1 each costs the government $100 million. d. As a result of sales of cheap milk to schools, the quantity demanded falls by 50 million pints per year at any price: the demand curve shifts leftward to the new demand curve D2. Without the price floor, the equilibrium would now be at point E2. However, with the price floor at $1, there is now a surplus of 150 million pints. In order to sustain the price floor of $1, the government must buy up 150 million pints at $1 each; that is, it must spend $150 million. It does, however, sell those 150 million pints to schools at $0.60 each (and from those sales makes $0.60 × 150 million = $90 million), so that the policy costs the government $150 million − $90 million = $60 million. Price of milk (per pint) S Surplus of 150 million pints $1.20 1.10 1.00 0.90 0.85 0.80 0 E2 E1 D2 500 600 D1 Price floor 675 700 750 800 850 Quantity of milk (millions of pints per year) e. Some milk producers are inefficient: if the price was allowed to reach equilibrium, they would find it too costly to produce. In their absence, milk would be produced only by the most efficient producers. Furthermore, resources are being wasted: although no milk is poured away outright, the government spends significant amounts of money on purchases of milk. This is money that might be used more effectively for purposes other than providing cheap milk to schoolchildren, such as improving the quality of public schools. 5. European governments tend to make greater use of price controls than does the U.S. government. For example, the French government sets minimum starting yearly wages for new hires who have completed le bac, certification roughly equivalent to a high school diploma. The demand schedule for new hires with le bac and the supply schedule for similarly credentialed new job seekers are given in the accompanying table. The price here—given in euros, the currency used in France—is the same as the yearly wage. Wage (per year) Quantity demanded (new job offers per year) Quantity supplied (new job seekers per year) €45,000 200,000 325,000 40,000 220,000 320,000 35,000 250,000 310,000 30,000 290,000 290,000 25,000 370,000 200,000 a. In the absence of government interference, what are the equilibrium wage and number of graduates hired per year? Illustrate with a diagram. Will there be anyone seeking a job at the equilibrium wage who is unable to find one—that is, will there be anyone who is involuntarily unemployed? b. Suppose the French government sets a minimum yearly wage of €35,000. Is there any involuntary unemployment at this wage? If so, how much? Illustrate with a diagram. What if the minimum wage is set at €40,000? Also illustrate with a diagram. c. Given your answer to part b and the information in the table, what do you think is the relationship between the level of involuntary unemployment and the level of the minimum wage? Who benefits from such a policy? Who loses? What is the missed opportunity here? 5. a. The equilibrium wage is €30,000, and 290,000 workers are hired. There is full employment: nobody is involuntarily unemployed. The equilibrium is at point E. Wage (thousands per year) Surplus $45 S Minimum wage $40,000 40 35 25 0 Minimum wage $35,000 E 30 D 200 220 250 290 310 370 320 325 Quantity of workers (thousands per year) b. With a minimum wage of €35,000, there is a surplus of workers of 60,000 (the quantity supplied is 310,000 and the quantity demanded is 250,000). That is, there are 60,000 workers who are involuntarily unemployed. At a minimum wage of €40,000, there is a surplus of workers of 100,000: this is the number of involuntarily unemployed workers. c. The higher the minimum wage, the larger the amount of involuntary unemployment. The people who benefit from this policy are those workers who succeed in getting hired: they now enjoy a higher wage. Those workers who do not get hired, however, lose: if the market was allowed to reach equilibrium, more workers would be employed. Employers also lose: fewer employers can now afford to hire workers, and they need to pay higher wages. The missed opportunity is that there are workers who want to work even at a wage lower than the minimum wage and firms that would willingly hire them at a lower wage; but because the wage is not allowed to fall below the minimum wage, these hires are not made. 6. In many European countries high minimum wages have led to high levels of unemployment and underemployment, and to a two-tier labor system. In the formal labor market, workers have good jobs that pay at least the minimum wage. In the informal, or black market for labor, workers have poor jobs and receive less than the minimum wage. a. Draw a demand and supply diagram showing the effect of the imposition of a minimum wage on the overall market for labor, with wage on the vertical axis and hours of labor on the horizontal axis. Your supply curve should represent the hours of labor offered by workers according to the wage, and the demand curve should represent the hours of labor demanded by employers according to the wage. On your diagram show the deadweight loss from the imposition of a minimum wage. What type of shortage is created? Illustrate on your diagram the size of the shortage. b. Assume that the imposition of the high minimum wage causes a contraction in the economy so that employers in the formal sector cut their production and their demand for workers. Illustrate the effect of this on the overall market for labor. What happens to the size of the deadweight loss? The shortage? Illustrate with a diagram. c. Assume that the workers who cannot get a job paying at least the minimum wage move into the informal labor market where there is no minimum wage. What happens to the size of the informal market for labor as a result of the economic contraction? What happens to the equilibrium wage in the informal labor market? Illustrate with a supply and demand diagram for the informal market. 6. a. The shortage created is a shortage of jobs: at the minimum wage there are more job-seekers than there are jobs available. Wage Minimum wage S (Overall labor market) E Deadweight loss D (Overall labor market) Shortage Hours worked b. The contraction in the economy causes the demand for labor to fall, shifting the demand curve leftwards from D to its new position at D′. Both the deadweight loss and the shortage of jobs caused by the minimum wage increase as a result of the fall in the demand for labor. Wage S (Overall labor market) Minimum wage Deadweight loss E D (Overall labor market) Old shortage D’ (Overall labor market) Hours worked New shortage c. As a result of the economic contraction, which reduces the demand for workers in the overall market, workers move to the informal labor market. This increases the supply of labor in the informal labor market. The supply curve for labor shifts rightwards from S to its new position at S′. The equilibrium wage in the informal labor market falls from w* to w** and the quantity of hours transacted increases from Q* to Q**, as the informal labor market expands. S (Informal labor market) Wage S’ (Informal labor market) W* W** E D (Informal labor market) Q* Q** Hours worked 7. For the last 80 years the U.S. government has used price supports to provide income assistance to American farmers. To implement these price supports, at times the government has used price floors, which it maintains by buying up the surplus farm products. At other times, it has used target prices, a policy by which the government gives the farmer an amount equal to the difference between the market price and the target price for each unit sold. Consider the market for corn depicted in the accompanying diagram. Price of corn (per bushel) S $5 4 3 E 2 1 0 D 800 1,000 1,200 Quantity of corn (bushels) a. If the government sets a price floor of $5 per bushel, how many bushels of corn are produced? How many are purchased by consumers? By the government? How much does the program cost the government? How much revenue do corn farmers receive? b. Suppose the government sets a target price of $5 per bushel for any quantity supplied up to 1,000 bushels. How many bushels of corn are purchased by consumers and at what price? By the government? How much does the program cost the government? How much revenue do corn farmers receive? c. Which of these programs (in parts a and b) costs corn consumers more? Which program costs the government more? Explain. d. Is one of these policies less inefficient than the other? Explain. 7. a. With a price floor of $5, the quantity of corn supplied is 1,200 bushels. The quantity demanded is only 800 bushels: there is a surplus of 400 bushels. The government therefore has to buy up the surplus of 400 bushels, at a price of $5 each: the program costs the government 400 × $5 = $2,000. Corn farmers sell 1,200 bushels (800 to consumers and 400 to the government) and therefore make 1,200 × $5 = $6,000 in revenue. b. If the government sets a target price of $5, the market reaches equilibrium at a price of $3 and a quantity of 1,000 bushels. There is no surplus (or shortage). The government does not buy any corn under this policy. For each bushel sold, the government pays farmers $2 (to make up the difference between the market price of $3 and the target price of $5), so the government pays a total of 1,000 × $2 = $2,000. Corn farmers sell 1,000 bushels and make $5 for each bushel ($3 come from consumers and $2 from the government), for a total of $5,000 of revenue. c. The price-floor policy is more expensive for consumers: they pay $5 per bushel (compared to the $3 under the target-price policy). Both policies are equally expensive for the government. d. The target-price policy avoids the inefficiency of wasted resources: surplus corn bought by the government and either given or thrown away. It is less inefficient than the price-floor policy. 8. The waters off the North Atlantic coast were once teeming with fish. But due to overfishing by the commercial fishing industry, the stocks of fish became seriously depleted. In 1991, the National Marine Fishery Service of the U.S. government implemented a quota to allow fish stocks to recover. In 2016 the quota limited the amount of swordfish caught per year by all U.S.-licensed fishing boats to 7 million pounds. As soon as the U.S. fishing fleet had met the quota limit, the swordfish catch was closed down for the rest of the year. The accompanying table gives the hypothetical demand and supply schedules for swordfish caught in the United States per year. Quantity of swordfish (millions of pounds per year) Price of swordfish (per pound) Quantity demanded Quantity supplied $20 6 15 18 7 13 16 8 11 14 9 9 12 10 7 a. Use a diagram to show the effect of the quota on the market for swordfish in 1991. In your diagram, illustrate the deadweight loss from inefficiently low quantity. b. How do you think fishermen will change how they fish in response to this policy? 8. a. The quantity sold is 7 million pounds, at a price of $18 per pound. On each pound of fish caught, each fisherman earns quota rent of $6, as shown in the accompanying diagram. The shaded triangle shows the deadweight loss. Price of swordfish (per pound) Quota $20 S Quota rent 18 16 14 12 0 Deadweight loss E D 6 7 8 9 10 11 12 13 14 15 Quantity of swordfish (million pounds per year) b. Because each pound of swordfish gives a fisherman $6 quota rent, each fisherman will attempt to fish as much as possible as soon as the swordfish catch opens. You should therefore see fishermen scramble to fish right at the beginning of the season, and you should see the catch being closed down very soon thereafter. (Which is exactly what happens.) 9. In Maine, you must have a license to harvest lobster commercially; these licenses are issued yearly. The state of Maine is concerned about the dwindling supplies of lobsters found off its coast. The state fishery department has decided to place a yearly quota of 80,000 pounds of lobsters harvested in all Maine waters. It has also decided to give licenses this year only to those fishermen who had licenses last year. The accompanying diagram shows the demand and supply curves for Maine lobsters. Price of lobster (per pound) $22 20 18 16 14 12 10 8 6 4 E S D 0 20 40 60 80 100 120 140 Quantity of lobsters (thousands of pounds) a. In the absence of government restrictions, what are the equilibrium price and quantity? b. What is the demand price at which consumers wish to purchase 80,000 pounds of lobsters? c. What is the supply price at which suppliers are willing to supply 80,000 pounds of lobsters? d. What is the quota rent per pound of lobster when 80,000 pounds are sold? Illustrate the quota rent and the deadweight loss on the diagram. e. Explain a transaction that benefits both buyer and seller but is prevented by the quota restriction. 9. a. Without government restrictions, the equilibrium in the market for lobsters is at point E. The equilibrium price for lobsters is $10 per pound. At that price, the quantity demanded and the quantity supplied are 120,000 pounds of lobsters. Price of lobster (per pound) $22 20 18 16 14 12 10 8 6 4 0 Quota Deadweight loss E Quota rent 20 40 60 S D 80 100 120 140 Quantity of lobsters (thousands of pounds) b. The demand price of 80,000 pounds of lobsters is $14. c. The supply price of 80,000 pounds of lobsters is $8. d. The quota rent per pound of lobster is $14 - $8 = $6. e. Under the quota policy, the producer and consumer of the 80,001st pound of lobster could both be better off: the producer would be willing to sell for just a little more than $8, and the consumer would be willing to buy for just a little less than $14. The quota, however, prevents this trade. 10. The Venezuelan government has imposed a price ceiling on the retail price of roasted coffee beans. The accompanying diagram shows the market for coffee beans. In the absence of price controls, the equilibrium is at point E, with an equilibrium price of PE and an equilibrium quantity bought and sold of QE . Price of coffee beans S E PE Price ceiling PC D QC QE Quantity of coffee beans a. Show the consumer and producer surplus before the introduction of the price ceiling. After the introduction of the price ceiling, the price falls to PC and the quantity bought and sold falls to QC. b. Show the consumer surplus after the introduction of the price ceiling (assuming that the consumers with the highest willingness to pay get to buy the available coffee beans; that is, assuming that there is no inefficient allocation to consumers). c. Show the producer surplus after the introduction of the price ceiling (assuming that the producers with the lowest cost get to sell their coffee beans; that is, assuming that there is no inefficient allocation of sales among producers). d. Using the diagram, show how much of what was producer surplus before the introduction of the price ceiling has been transferred to consumers as a result of the price ceiling. e. Using the diagram, show how much of what was total surplus before the introduction of the price ceiling has been lost. That is, how great is the deadweight loss? 10. a. Consumer surplus is the area labeled CS1 and producer surplus is the area labeled PS1 in panel (a) of the accompanying diagram. b. Consumer surplus after the introduction of the price ceiling is made up of the sum of the two areas labeled CS2A and CS2B in panel (b). c. Producer surplus after the introduction of the price ceiling is the area labeled PS2 in panel (b). d. The amount of surplus transferred from producers to consumers as a result of the introduction of the price ceiling is the area labeled CS2B in panel (b). e. The amount of total surplus lost as a result of the introduction of the price ceiling, the deadweight loss, is the area labeled deadweight loss in panel (b). Price of coffee beans (a) Before the Introduction of the Price Ceiling S Price of coffee beans (b) After the Introduction of the Price Ceiling Deadweight loss CS2A CS1 PE PE E PS1 PC E CS2B Price ceiling PS2 D D QE S QC Quantity of coffee beans QE Quantity of coffee beans 11. The accompanying diagram shows data from the U.S. Bureau of Labor Statistics on the average price of an airline ticket in the United States from 1975 until 1985, adjusted to eliminate the effect of inflation (the general increase in the prices of all goods over time). In 1978, the United States Airline Deregulation Act removed the price floor on airline fares, and it also allowed the airlines greater flexibility to offer new routes. Price of airline ticket (index: 1975 = 100) 160 140 120 19 75 19 76 19 77 19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 100 Year Data from: U.S. Bureau of Labor Statistics. a. Looking at the data on airline ticket prices in the diagram, do you think the price floor that existed before 1978 was binding or nonbinding? That is, do you think it was set above or below the equilibrium price? Draw a supply and demand diagram, showing where the price floor that existed before 1978 was in relation to the equilibrium price. b. Most economists agree that the average airline ticket price per mile traveled actually fell as a result of the Airline Deregulation Act. How might you reconcile that view with what you see in the diagram? 11. a. When a binding price floor—one that is set above the equilibrium price—is removed, you should expect the price of the good to fall. From looking at the data in the figure, you should think that the pre-1978 price floor was ineffective, since the price of an airline ticket actually rose after 1978. In the accompanying diagram, the price floor, PF, is nonbinding: it is set below the equilibrium price, PE. In that case, removing the price floor would not lead to a decrease in price. Price of airline ticket PE S Price floor E PF D QE Quantity of airline tickets b. Many things that determine the price of an average airline ticket changed in 1978; the removal of the price floor on airline tickets was just one of them. What also changed was that airlines now could—and did—offer longer-range flights. So although the average ticket price increased, so did the distance of the average airline flight. As a result, the cost per mile traveled actually fell— leading most economists to claim that the Airline Deregulation Act resulted in lower airfares. Remember that when you want to analyze the effect of one change, you have to hold other things equal. And in this case, many other things changed at the same time. 12. Many college students attempt to land internships before graduation to burnish their resumes, gain experience in a chosen field, or try out possible careers. The hope shared by all of these prospective interns is that they will find internships that pay more than typical summer jobs, such as waiting tables or flipping burgers. a. With wage measured on the vertical axis and number of hours of work on the horizontal axis, draw a supply and demand diagram for the market for interns in which the minimum wage is nonbinding at the market equilibrium. b. Assume that a market downturn reduces the demand for interns by employers. However, many students are willing and eager to work in unpaid internships. As a result, the new market equilibrium wage is equal to zero. Draw another supply and demand diagram to illustrate this new market equilibrium. As in Figure 5-7, include a shaded triangle that represents the deadweight loss from the minimum wage. Using the diagram, explain your findings. 12. a. Here the market-clearing wage, W1, is nonbinding because it is above the minimum wage. In this case the minimum wage has no effect on the market for interns: the number of hours transacted in the market equilibrium, X1, is the same as if there had been no minimum wage. Wage S1 E1 W1 Minimum wage W* D X1 Hours of work b. The economic downturn will result in an increase in the supply of interns. The supply curve will shift outward to its new position at S2 and result in a new equilibrium wage of zero. The minimum wage is now binding and, as a result, there is a deadweight loss. Wage S1 Minimum wage W* S2 E1 E2 Deadweight loss Equilibrium wage equals zero D Hours of work WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 13. Suppose it is decided that rent control in New York City will be abolished and that market rents will now prevail. Assume that all rental units are identical and so are offered at the same rent. To address the plight of residents who may be unable to pay the market rent, an income supplement will be paid to all low-income households equal to the difference between the old controlled rent and the new market rent. a. Use a diagram to show the effect on the rental market of the elimination of rent control. What will happen to the quality and quantity of rental housing supplied? b. Use a second diagram to show the additional effect of the income-supplement policy on the market. What effect does it have on the market rent and quantity of rental housing supplied in comparison to your answers to part a? c. Are tenants better or worse off as a result of these policies? Are landlords better or worse off? Is society as a whole better or worse off? d. From a political standpoint, why do you think cities have been more likely to resort to rent control rather than a policy of income supplements to help low-income people pay for housing? 13. a. With a price ceiling at PC, the quantity bought and sold is QC, indicated by point A. The ceiling at PC is eliminated and the rent returns to the market equilibrium E1, with an equilibrium rent of P1. The quantity supplied increases from QC to the equilibrium quantity Q1. At the same time, you should expect the quality of rental housing to improve. As you learned in this chapter, one of the inefficiencies caused by price ceilings is inefficiently low quality. As the rent returns to the equilibrium rent, landlords again have the incentive to invest in the quality of their apartments in order to attract renters. Monthly rent P1 PC S E1 Price ceiling A D1 QC Q1 Quantity of apartments b. The income-supplement policy causes a rightward shift of the demand curve from D1 to D2. This results in an increase in the equilibrium rent, from P1 to P2, and an increase in the equilibrium quantity, from Q1 to Q2, as the equilibrium changes from E1 to E2. Monthly rent S P2 E2 P1 E1 D1 Q1 D2 Q2 Quantity of apartments c. Landlords are clearly better off as a result of these two policies: more landlords rent out apartments, and at a higher monthly rent. It is not clear whether tenants are better or worse off. Some tenants who previously could not get apartments can now do so, but at a higher rent. In particular, those tenants who do not receive the income supplement and who used to rent cheap apartments under the price ceiling are now worse off. Society as a whole is better off because the deadweight loss caused by a price ceiling has been eliminated: there are now no missed gains from trade. d. It is likely that tenants who currently live in rent-controlled housing are better organized than people who cannot currently find rental housing. And more organized groups can generally exert greater influence over city policy. Elasticity Chapter 1. Do you think the price elasticity of demand for Ford sport-utility vehicles (SUVs) will increase, decrease, or remain the same when each of the following events occurs? Explain your answer. a. Other car manufacturers, such as General Motors, decide to make and sell SUVs. b. SUVs produced in foreign countries are banned from the American market. c. Due to ad campaigns, Americans believe that SUVs are much safer than ordinary passenger cars. d. The time period over which you measure the elasticity lengthens. During that longer time, new models such as four-wheel-drive cargo vans appear. 1. a. The price elasticity of demand for Ford SUVs will increase because more substitutes are available. b. The price elasticity of demand for Ford SUVs will decrease because fewer substitutes are available. c. The price elasticity of demand for Ford SUVs will decrease because other cars are viewed as less of a substitute. d. The price elasticity of demand for Ford SUVs will increase over time because more substitutes (such as four-wheel-drive cargo vans) become available. 2. In the United States, 2015 was a bad year for growing wheat. And as wheat supply decreased, the price of wheat rose dramatically, leading to a lower quantity demanded (a movement along the demand curve). The accompanying table describes what happened to prices and the quantity of wheat demanded. Quantity demanded (bushels) Average price (per bushel) 2014 2015 2.2 billion 2.0 billion $3.42 $4.26 a. Using the midpoint method, calculate the price elasticity of demand for winter wheat. b. What is the total revenue for U.S. wheat farmers in 2014 and 2015? c. Did the bad harvest increase or decrease the total revenue of U.S. wheat farmers? How could you have predicted this from your answer to part a? 2. a. Using the midpoint method, the percent change in the quantity of U.S. winter wheat demanded is -0.2 billion 2.0 billion - 2.2 billion × 100 = × 100 = -9.5% 2.1 billion 2.1 billion and the percent change in the price of U.S. winter wheat is $0.84 $4.26 - $3.42 × 100 = × 100 = 21.9% $3.84 $3.84 6 Dropping the minus sign, the price elasticity of demand is therefore 9.5% = 0.43 21.9% so that demand is inelastic. b. The total revenue in 2014 is the price per bushel in 2014 times the quantity of bushels demanded in 2014. That is, total revenue in 2014 is $3.42 × 2.2 billion = $7.524 billion. Similarly, total revenue in 2015 is $4.26 × 2.0 billion = $8.52 billion. c. The rise in price from 2014 to 2015 increased U.S. wheat farmers’ total revenue. This could have been predicted by knowing that demand is inelastic: in part a we calculated a price elasticity of demand of 0.43. The price effect of this price rise (which tends to increase total revenue) outweighed the quantity effect (which tends to decrease total revenue). 3. The accompanying table gives part of the supply schedule for personal computers in the United States. Price of computer Quantity of computers supplied $1,100 12,000 900 8,000 a. Calculate the price elasticity of supply when the price increases from $900 to $1,100 using the midpoint method. b. Suppose firms produce 1,000 more computers at any given price due to improved technology. As price increases from $900 to $1,100, is the price elasticity of supply now greater than, less than, or the same as it was in part a? c. Suppose a longer time period under consideration means that the quantity supplied at any given price is 20% higher than the figures given in the table. As price increases from $900 to $1,100, is the price elasticity of supply now greater than, less than, or the same as it was in part a? 3. a. Using the midpoint method, the percent change in the quantity supplied is 4,000 12,000 - 8,000 × 100 = 40% × 100 = 10,000 (8,000 + 12,000)/2 and the percent change in the price is $200 $1,100 - $900 × 100 = × 100 = 20% $1,000 ($900 + $1,100)/2 The price elasticity of supply is therefore 40% = 2 20% b. The elasticity estimate would be lower. A price change from $900 to $1,100 is a 20% price change, just as calculated in part a. Previously, when the quantity supplied changed from 8,000 to 12,000, that was a 40% change in the quantity supplied. Now that the quantity supplied at each price is higher by 1,000, the same price change would imply a change in the quantity supplied from 9,000 to 13,000, which is a 36% change using the midpoint method. The new price elasticity of supply is 36%/20% = 1.8, which is lower than in part a. c. The elasticity estimate would be unchanged. The price increase from $900 to $1,100 is a 20% increase, just as calculated in part a. But now that all quantities are 20% higher, the quantity supplied increases from 9,600 to 14,400. Using the midpoint method, this is an increase of 14,400 - 9,600 4,800 × 100 = 40% × 100 = (9,600 + 14,400)/2 12,000 so that the price elasticity of supply is 40% = 2 20% Therefore the price elasticity of supply is the same as in part a. 4. The accompanying table lists the cross-price elasticities of demand for several goods, where the percent quantity change is measured for the first good of the pair, and the percent price change is measured for the second good. Good Cross-price elasticities of demand Air-conditioning units and kilowatts of electricity −0.34 Coke and Pepsi +0.63 High-fuel-consuming sport-utility vehicles (SUVs) and gasoline −0.28 McDonald’s burgers and Burger King burgers +0.82 Butter and margarine +1.54 a. Explain the sign of each of the cross-price elasticities. What does it imply about the relationship between the two goods in question? b. Compare the absolute values of the cross-price elasticities and explain their magnitudes. For example, why is the cross-price elasticity of McDonald’s burgers and Burger King burgers less than the cross-price elasticity of butter and margarine? c. Use the information in the table to calculate how a 5% increase in the price of Pepsi affects the quantity of Coke demanded. d. Use the information in the table to calculate how a 10% decrease in the price of gasoline affects the quantity of SUVs demanded. 4. a. A negative cross-price elasticity of demand implies that the two goods are complements. So air-conditioning units and kilowatts of electricity are complements, as are sport-utility vehicles and gasoline. A positive cross-price elasticity of demand implies that the two goods are substitutes. So Coke and Pepsi are substitutes, as are McDonald’s and Burger King burgers as well as butter and margarine. b. The larger (and positive) the cross-price elasticity of demand is, the more closely the two goods are substitutes. Since the cross-price elasticity of butter and margarine is larger than the cross-price elasticity of McDonald’s burgers and Burger King burgers, butter and margarine are closer substitutes than are McDonald’s and Burger King burgers. Similarly, the greater (and negative) the cross-price elasticity of demand is, the more strongly the two goods are complements. c. A cross-price elasticity of 0.63 implies that a 1% increase in the price of Pepsi would increase the quantity of Coke demanded by 0.63%. So a 5% increase in the price of Pepsi would increase the quantity of Coke demanded by five times as much, that is, by 5 × 0.63% = 3.15%. d. A cross-price elasticity of −0.28 implies that a 1% fall in the price of gasoline would increase the quantity of SUVs demanded by 0.28%. So a 10% fall in the price of gasoline would increase the quantity of SUVs demanded by 10 times as much, that is, by 10 × 0.28% = 2.8%. 5. What can you conclude about the price elasticity of demand in each of the following statements? a. “The pizza delivery business in this town is very competitive. I’d lose half my customers if I raised the price by as little as 10%.” b. “I owned both of the two Jerry Garcia autographed lithographs in existence. I sold one on eBay for a high price. But when I sold the second one, the price dropped by 80%.” c. “My economics professor has chosen to use the Krugman/Wells textbook for this class. I have no choice but to buy this book.” d. “I always spend a total of exactly $10 per week on coffee.” 5. a. This statement says that a 10% increase in price reduces the quantity demanded by 50%. That is, the price elasticity of demand is 50% = 5 10% So demand is elastic. b. The fact that it was necessary for price to drop by 80% in order to sell one more unit (an increase in quantity of 67%, using the midpoint method) indicates that the demand for Jerry Garcia autographed lithographs is inelastic. c. There is no substitute available, so demand is inelastic. (Although, over time, as more used Krugman/Wells textbooks become available, the price elasticity of demand will increase.) d. Demand is unit-elastic: no matter what the price of coffee is, the total revenue to the producer (which is my total expenditure on coffee) remains the same. 6. Take a linear demand curve like that shown in Figure 6-5, where the range of prices for which demand is elastic and inelastic is labeled. In each of the following scenarios, the supply curve shifts. Show along which portion of the demand curve (that is, the elastic or the inelastic portion) the supply curve must have shifted in order to generate the event described. In each case, show on the diagram the quantity effect and the price effect. a. Recent attempts by the Colombian army to stop the flow of illegal drugs into the United States have actually benefited drug dealers. b. New construction increased the number of seats in the football stadium and resulted in greater total revenue from box-office ticket sales. c. A fall in input prices has led to higher output of Porsches. But total revenue for the Porsche Company has declined as a result. 6. a. Attempts to stop the flow of drugs into the United States shift the supply curve leftward, raising the price of drugs and reducing the quantity demanded. If this benefits drug dealers, their total revenue must have increased. That is, we must be on the inelastic portion of the demand curve, where a rise in price results in an increase in revenue (the price effect outweighs the quantity effect). In the accompanying diagram, as supply shifts from S1 to S2, revenue decreases by area B but increases by area A. Price Elastic P2 S2 E2 A P1 Inelastic E1 B Q2 S1 D Q1 Quantity b. An increase in the number of seats shifts the supply curve rightward, reducing the price of stadium seats and increasing the quantity demanded. If this increases total revenue, we must be on the elastic portion of the demand curve, where a fall in price results in an increase in total revenue from boxoffice sales (the quantity effect outweighs the price effect). In the accompanying diagram, as supply shifts from S1 to S2, total revenue decreases by area A but increases by area B. (The supply curve is a vertical line because the supply of seats is perfectly inelastic: whatever the price, the supply of seats is just how many seats there are in the stadium.) Price S1 S2 Elastic P1 P2 E1 A E2 Inelastic B D Q1 Q2 Quantity c. Increasing production shifts the supply curve rightward, lowering the price of Porsches and increasing the quantity demanded. If this reduces total revenue, we must be on the inelastic portion of the demand curve, where a fall in price results in a fall in total revenue (the price effect outweighs the quantity effect). In the accompanying diagram, as supply shifts from S1 to S2, total revenue decreases by area A but increases only by area B. Price Elastic P1 P2 S1 E1 A Inelastic E2 B Q1 S2 D Q2 Quantity 7. The accompanying table shows the price and yearly quantity of souvenir T-shirts demanded in the town of Crystal Lake according to the average income of the tourists visiting. Price of T-shirt Quantity of T-shirts demanded when average tourist income is $20,000 Quantity of T-shirts demanded when average tourist income is $30,000 $4 3,000 5,000 5 2,400 4,200 6 1,600 3,000 7 800 1,800 a. Using the midpoint method, calculate the price elasticity of demand when the price of a T-shirt rises from $5 to $6 and the average tourist income is $20,000. Also calculate it when the average tourist income is $30,000. b. Using the midpoint method, calculate the income elasticity of demand when the price of a T-shirt is $4 and the average tourist income increases from $20,000 to $30,000. Also calculate it when the price is $7. 7. a. Suppose the average tourist income is $20,000. Using the midpoint method, the percent change in the quantity demanded is 1,600 - 2,400 -800 × 100 = × 100 = -40% (2,400 + 1,600)/2 2,000 and the percent change in the price is $1 $6 - $5 × 100 = 18.2% × 100 = $5.50 ($5 + $6)/2 Dropping the minus sign, the price elasticity of demand is therefore 40% = 2.2 18.2% Now suppose the average tourist income is $30,000. The percent change in the quantity demanded is 3,000 - 4,200 -1,200 × 100 = × 100 = -33.3% (4,200 + 3,000)/2 3,600 and the percent change in the price is, as before, $6 - $5 $1 × 100 = 18.2% × 100 = ($5 + $6)/2 $5.50 Dropping the minus sign, the price elasticity of demand is therefore 33.3% = 1.8 18.2% b. Suppose the price of a T-shirt is $4. Using the midpoint method, the percent change in the quantity demanded is 2,000 5,000 - 3,000 × 100 = × 100 = 50% 4,000 (3,000 + 5,000)/2 and the percent change in income is $30,000 - $20,000 $10,000 × 100 = 40% × 100 = ($20,000 + $30,000)/2 $25,000 The income elasticity of demand is therefore 50% = 1.25 40% Now suppose the price is $7. The percent change in the quantity demanded is 1,000 1,800 - 800 × 100 = 76.9% × 100 = 1,300 (800 + 1,800)/2 and the percent change in income is, as before, $30,000 - $20,000 $10,000 × 100 = × 100 = 40% ($20,000 + $30,000)/2 $25,000 The income elasticity of demand is therefore 76.9% = 1.9 40% 8. A recent study determined the following elasticities for Volkswagen Beetles: Price elasticity of demand = 2 Income elasticity of demand = 1.5 The supply of Beetles is elastic. Based on this information, are the following statements true or false? Explain your reasoning. a. A 10% increase in the price of a Beetle will reduce the quantity demanded by 20%. b. An increase in consumer income will increase the price and quantity of Beetles sold. 8. a. True. The price elasticity of demand for Beetles is 2. That is, a 1% increase in the price would reduce the quantity demanded by 2%. Therefore, a 10% increase in the price would reduce the quantity demanded by 20%. b. True. The income elasticity of demand for Beetles is positive (they are a normal good). That is, an increase in income will increase the demand for Beetles. The demand curve shifts rightward, and the price and quantity of Beetles supplied both increase. 9. In each of the following cases, do you think the price elasticity of supply is (i) perfectly elastic; (ii) perfectly inelastic; (iii) elastic, but not perfectly elastic; or (iv) inelastic, but not perfectly inelastic? Explain using a diagram. a. An increase in demand this summer for luxury cruises leads to a huge jump in the sales price of a cabin on the Queen Mary 2. b. The price of a kilowatt of electricity is the same during periods of high electricity demand as during periods of low electricity demand. c. Fewer people want to fly during February than during any other month. The airlines cancel about 10% of their flights as ticket prices fall about 20% during this month. d. Owners of vacation homes in Maine rent them out during the summer. Due to the soft economy this year, a 30% decline in the price of a vacation rental leads more than half of homeowners to occupy their vacation homes themselves during the summer. 9. a. Supply is perfectly inelastic: the quantity of cabins on the Queen Mary 2 is fixed. As demand increases (a rightward shift in the demand curve), the price of a cabin on the Queen Mary 2 increases, without an increase in the quantity supplied. See the accompanying diagram. Price S E2 P2 E1 P1 D2 D1 Quantity Q b. Supply is perfectly elastic. As demand changes (for instance, as demand increases in times of high electricity demand), price does not change but the quantity supplied does change. See the accompanying diagram. Price E1 P E2 S D2 D1 Q1 Q2 Quantity c. Supply is inelastic. As price falls by 20%, the quantity supplied falls by 10%. This implies a price elasticity of supply of 10% = 0.5 20% which is inelastic. See the accompanying diagram. Price S E1 P1 E2 P2 D1 D2 Q2 Q1 Quantity d. Supply is elastic. As price falls by 30%, the quantity supplied falls by more than 50%. This implies a price elasticity of supply greater than 50% 30% that is, a price elasticity of supply greater than 1.7. See the accompanying diagram. Price S P1 E1 P2 E2 D1 D2 Q2 Q1 Quantity 10. Use an elasticity concept to explain each of the following observations. a. During economic booms, the number of new personal care businesses, such as gyms and tanning salons, is proportionately greater than the number of other new businesses, such as grocery stores. b. Cement is the primary building material in Mexico. After new technology makes cement cheaper to produce, the supply curve for the Mexican cement industry becomes relatively flatter. c. Some goods that were once considered luxuries, like a telephone, are now considered virtual necessities. As a result, the demand curve for telephone services has become steeper over time. d. Consumers in a less developed country like Guatemala spend proportionately more of their income on equipment for producing things at home, like sewing machines, than consumers in a more developed country like Canada. 10. a. During times of economic boom, incomes rise. Whether, and by how much, demand responds to changes in income is determined by the income elasticity of demand. Since the demand for personal care services increases as income increases, personal care services are a normal good. If the demand for personal care services is more responsive to changes in income than the demand for other products, the income elasticity of demand for personal care services is greater than the income elasticity of demand for other products. As a result of the proportionately greater increase in demand, you would see the quantity of personal care services supplied increase by proportionately more. b. New technology has made cement easier to produce. This implies that as the price of cement rises, many more firms are now willing to supply cement than before; that is, supply has become more elastic, leading to a relatively flatter supply curve. c. As telephones have become less and less of a luxury, the price elasticity of demand for telephones has fallen: telephones have become so much a necessity of daily life that it is now more difficult for consumers to substitute away from telephones. As demand for telephones has become less elastic (less responsive to changes in the price), the demand curve for telephones has become steeper. d. Incomes in Canada are higher than those in Guatemala. The statement therefore implies that as income rises, the demand for sewing machines increases by proportionately less than the change in income, making the income elasticity of demand inelastic. Maybe the demand for sewing machines even decreases as income rises, implying that sewing machines are an inferior good, with a negative income elasticity of demand. 11. Taiwan is a major world supplier of semiconductor chips. A recent earthquake severely damaged the production facilities of Taiwanese chip-producing companies, sharply reducing the amount of chips they could produce. a. Assume that the total revenue of a typical non-Taiwanese chip manufacturer rises due to these events. In terms of an elasticity, what must be true for this to happen? Illustrate the change in total revenue with a diagram, indicating the price effect and the quantity effect of the Taiwan earthquake on this company’s total revenue. b. Now assume that the total revenue of a typical non-Taiwanese chip manufacturer falls due to these events. In terms of an elasticity, what must be true for this to happen? Illustrate the change in total revenue with a diagram, indicating the price effect and the quantity effect of the Taiwan earthquake on this company’s total revenue. 11. a. The earthquake shifts the supply curve to the left, leading to a price increase. If the increase in price results in an increase in total revenue, then the price effect (which tends to increase total revenue) must outweigh the quantity effect (which tends to reduce total revenue). That is, demand must have been inelastic. In the accompanying diagram, as supply shifted leftward from S1 to S2, the fall in total revenue due to the quantity effect (area A) is outweighed by the gain in total revenue due to the price effect (area B). Price Elastic P2 P1 S2 E2 B Inelastic E1 A Q2 S1 D Q1 Quantity b. If the increase in price results in a fall in total revenue, then the quantity effect (which tends to reduce total revenue) must outweigh the price effect (which tends to increase total revenue). That is, demand must have been elastic. In the accompanying diagram, as supply shifted leftward from S1 to S2, total revenue falls by the amount of the quantity effect (area A) but rises by the amount of the price effect (area B). The quantity effect (area A) is larger than the price effect (area B), so total revenue declines. Price S2 P2 E2 B Elastic E1 P1 S1 Inelastic A D Q2 Q1 Quantity 12. There is a debate about whether sterile hypodermic needles should be passed out free of charge in cities with high drug use. Proponents argue that doing so will reduce the incidence of diseases, such as HIV/AIDS, that are often spread by needle sharing among drug users. Opponents believe that doing so will encourage more drug use by reducing the risks of this behavior. As an economist asked to assess the policy, you must know the following: (i) how responsive the spread of diseases like HIV/AIDS is to the price of sterile needles and (ii) how responsive drug use is to the price of sterile needles. Assuming that you know these two things, use the concepts of price elasticity of demand for sterile needles and the cross-price elasticity between drugs and sterile needles to answer the following questions. a. In what circumstances do you believe this is a beneficial policy? b. In what circumstances do you believe this is a bad policy? 12. a. Handing out free needles lowers the price of needles to zero. First consider the demand for needles. The higher the price elasticity of demand for sterile needles, the greater the increase in the quantity of sterile needles demanded in response to a decrease in the price. And the greater the increase in the quantity of sterile needles demanded, the lower the spread of diseases like HIV/AIDS. Now consider the demand for drugs. Drugs and sterile needles are complements: as the price of sterile needles falls, the demand for drugs increases. This implies that the cross-price elasticity of demand between drugs and sterile needles is negative. The less negative (the closer to zero) the crossprice elasticity of demand between drugs and sterile needles, the less responsive is the demand for drugs to the price of sterile needles. So the policy would be beneficial if the price elasticity of demand for sterile needles is high (elastic) and the cross-price elasticity of demand between drugs and sterile needles is negative and low (close to zero, that is, weakly complementary). b. Similar reasoning as in part a implies that the policy would be a bad idea if the price elasticity of demand for sterile needles is low (inelastic) and the cross-price elasticity of demand between drugs and sterile needles is high and negative (strongly complementary). 13. Worldwide, the average coffee grower has increased the amount of acreage under cultivation over the past few years. The result has been that the average coffee plantation produces significantly more coffee than it did 10 to 20 years ago. Unfortunately for the growers, however, this has also been a period in which their total revenues have plunged. In terms of an elasticity, what must be true for these events to have occurred? Illustrate these events with a diagram, indicating the quantity effect and the price effect that gave rise to these events. 13. An increase in the amount of acreage that is cultivated results in a rightward shift in the supply of coffee. This reduces the price of coffee and increases the quantity demanded. If total revenue from coffee sales has decreased, this means that the price effect (which tends to lower total revenue) must have outweighed the quantity effect (which tends to increase total revenue). This implies that demand must be inelastic. As shown in the accompanying diagram, the price effect results in a loss of total revenue equal to the size of area A. The quantity effect (the quantity demanded increases as a result of the price fall) results in an increase in total revenue equal to the size of area B. Area A exceeds area B, so total revenue falls. Price Elastic P1 P2 S1 E1 A E2 B Q1 S2 Inelastic D Q2 Quantity 14. A 2015 article published by the American Journal of Preventive Medicine studied the effects of an increase in alcohol prices on the incidence of new cases of sexually transmitted diseases. In particular, the researchers studied the effects that a Maryland policy increasing alcohol taxes had on the decline in gonorrhea cases. The report concluded that an increase in the alcohol tax rate by 3% resulted in 1,600 fewer cases of gonorrhea. Assume that prior to the tax increase, the number of gonorrhea cases was 7,450. Use the midpoint method to determine the percent decrease in gonorrhea cases, and then calculate the cross-price elasticity of demand between alcohol and the incidence of gonorrhea. According to your estimate of this cross-price elasticity of demand, are alcohol and gonorrhea complements or substitutes? 14. The percent decrease in the cases of gonorrhea is 1,600 1,600 × 100 = × 100 = 24.1% (7,450 + 5,850)/2 6,650 Since the price of alcohol increased by 3%, the cross-price elasticity of demand is 24.1% = -8.0 3% Since the cross-price elasticity of demand is negative, alcohol and gonorrhea are complements. 15. The U.S. government is considering reducing the amount of carbon dioxide that firms are allowed to produce by issuing a limited number of tradable allowances for carbon dioxide (CO2) emissions. In a recent report, the U.S. Congressional Budget Office (CBO) argues that “most of the cost of meeting a cap on CO2 emissions would be borne by consumers, who would face persistently higher prices for products such as electricity and gasoline . . . poorer households would bear a larger burden relative to their income than wealthier households would.” What assumption about one of the elasticities you learned about in this chapter has to be true for poorer households to be disproportionately affected? 15. For poorer households to be disproportionately affected by an increase in energy prices, it is necessary that those households spend a larger share of their income on energy products than wealthier households. In other words, as income rises, the quantity of energy products demanded has to increase less than proportionately. So the CBO must think that the income elasticity of demand for energy products, although positive, is less than 1: energy products are income-inelastic. In fact, this is just what the CBO report says: “lower-income households tend to spend a larger fraction of their income than wealthier households do and . . . energy products account for a bigger share of their spending.” 16. According to data from the U.S. Department of Energy, sales of the fuel-efficient Toyota Prius hybrid fell from 194,108 vehicles sold in 2014 to 180,603 in 2015. Over the same period, according to data from the U.S. Energy Information Administration, the average price of regular gasoline fell from $3.36 to $2.43 per gallon. Using the midpoint method, calculate the cross-price elasticity of demand between Toyota Prii (the official plural of “Prius” is “Prii”) and regular gasoline. According to your estimate of the cross-price elasticity, are the two goods complements or substitutes? Does your answer make sense? 16. A fall in price of regular gasoline from $3.36 to $2.43 per gallon, using the midpoint method, is a percent change of -$0.93 $2.43 - $3.36 × 100 = × 100 = -32.1% $2.90 $2.90 And a fall in the quantity of Prii demanded from 194,108 to 180,603 vehicles, using the midpoint method, is a percent change of 180,603 - 194,108 × 100 = -13,505 × 100 = -7.2% 187,356 187,356 So the cross-price elasticity of demand is -7.2% = 0.22 -32.1% Since the cross-price elasticity of demand between Toyota Prii and regular gasoline is positive, this estimate indicates that the two are substitutes. This answer might seem perplexing because cars and gasoline are generally complements: you need gasoline to run a (gasoline-powered) car like a Toyota Prius. The generally complementary relationship between gas and cars implies that the crossprice elasticity between them would be negative. But a Toyota Prius adds another dimension to the comparison: it is a fuel-efficient car, not a gas-guzzler. And fuel-efficient cars and gas-guzzlers are substitutes. So as gasoline prices rise, the demand for gas-guzzling cars falls and the demand for fuel-efficient cars (such as the Toyota Prius), which are substitutes, rises. So the substitute nature of gasguzzlers and Toyota Prii implies a positive cross-price elasticity between gas and Toyota Prii. Which effect is stronger? Clearly the substitution effect is stronger because the data show a positive cross-price elasticity. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 17. Nile.com, the online bookseller, wants to increase its total revenue. One strategy is to offer a 10% discount on every book it sells. Nile.com knows that its customers can be divided into two distinct groups according to their likely responses to the discount. The accompanying table shows how the two groups respond to the discount. Group A (sales per week) Group B (sales per week) Volume of sales before the 10% discount 1.55 million 1.50 million Volume of sales after the 10% discount 1.65 million 1.70 million a. Using the midpoint method, calculate the price elasticities of demand for group A and group B. b. Explain how the discount will affect total revenue from each group. c. Suppose Nile.com knows which group each customer belongs to when he or she logs on and can choose whether or not to offer the 10% discount. If Nile.com wants to increase its total revenue, should discounts be offered to group A or to group B, to neither group, or to both groups? 17. a. Using the midpoint method, the percent change in the quantity demanded by group A is 1.65 million - 1.55 million 0.1 million × 100 = × 100 = 6.25% (1.55 million + 1.65 million)/2 1.6 million and since the change in price is 10%, the price elasticity of demand for group A is 6.25% = 0.625 10% Using the midpoint method, the percent change in the quantity demanded by group B is 0.2 million 1.7 million - 1.5 million × 100 = × 100 = 12.5% 1.6 million (1.5 million + 1.7 million)/2 and since the change in price is 10%, the price elasticity of demand for group B is 12.5% = 1.25 10% b. For group A, since the price elasticity of demand is 0.625 (demand is inelastic), total revenue will decrease as a result of the discount. For group B, since the price elasticity of demand is 1.25 (demand is elastic), total revenue will increase as a result of the discount. c. If Nile.com wants to increase total revenue, it should definitely not offer the discount to group A and it should definitely offer the discount to group B. Solution Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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