# ECON 200. Introduction to Microeconomics

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1 ECON 200. Introduction to Microeconomics Homework 3 Part I Name: [Multiple Choice] 1. A life-saving medicine without any close substitutes will tend to have (a) a. a small elasticity of demand. b. a large elasticity of demand. c. a small elasticity of supply. d. a large elasticity of supply. 2. The price of a good rises from \$8 to \$12, and the quantity demanded falls from 110 to 90 units. Calculated with the midpoint method, the elasticity is (b) a. 1/5. b. 1/2. c. 2. d A linear, downward-sloping demand curve is (d) a. inelastic. b. unit elastic. c. elastic. d. inelastic at some points, and elastic at others. 4. The ability of firms to enter and exit a market over time means that, in the long run, (c) a. the demand curve is more elastic. b. the demand curve is less elastic. c. the supply curve is more elastic. d. the supply curve is less elastic. 5. An increase in the supply of a good will decrease the total revenue producers receive if (a) a. the demand curve is inelastic. b. the demand curve is elastic. c. the supply curve is inelastic. d. the supply curve is elastic. 6. The price of coffee rose sharply last month, while the quantity sold remained the same. Each of five people suggests an explanation: (c) Tom: Demand increased, but supply was perfectly inelastic. Dick: Demand increased, but it was perfectly inelastic. Harry: Demand increased, but supply decreased at the same time. Larry: Supply decreased, but demand was unit elastic. Mary: Supply decreased, but demand was perfectly inelastic. Who could possibly be right? a. Tom, Dick, and Harry b. Tom, Dick, and Mary c. Tom, Harry, and Mary d. Dick, Harry, and Larry e. Dick, Harry, and Mary

2 7. An efficient allocation of resources maximizes (c) a. consumer surplus. b. producer surplus. c. consumer surplus plus producer surplus. d. consumer surplus minus producer surplus. 8. When a market is in equilibrium, the buyers are those with the willingness to pay and the sellers are those with the costs. (b) a. highest, highest b. highest, lowest c. lowest, highest d. lowest, lowest 9. Producing a quantity larger than the equilibrium of supply and demand is inefficient because the marginal buyer s willingness to pay is (c) a. negative. b. zero. c. positive but less than the marginal seller s cost. d. positive and greater than the marginal seller s cost

3 [Short Answer] 1. If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals zero, is demand perfectly elastic or perfectly inelastic? An elasticity greater than one means that demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There is no change in quantity demanded when there is a change in price. 2. On a supply-and-demand diagram, show equilibrium price, equilibrium quantity, and the total revenue received by producers. The figure presents a supply-and-demand diagram, showing the equilibrium price, P, the equilibrium quantity, Q, and the total revenue received by producers. Total revenue equals the equilibrium price times the equilibrium quantity, which is the area of the rectangle shown in the figure. 3. If a fixed quantity of a good is available, and no more can be made, what is the price elasticity of supply? If a fixed quantity of a good is available and no more can be made, the price elasticity of supply is zero. Regardless of the percentage change in price, there will be no change in the quantity supplied. 4. A storm destroys half the fava bean crop. Is this event more likely to hurt fava bean farmers if the demand for fava beans is very elastic or very inelastic? Explain Destruction of half of the fava bean crop is more likely to hurt fava bean farmers if the demand for fava beans is very elastic. Destruction of half of the crop causes the supply curve to shift to the left resulting in a higher price of fava beans. When demand is very elastic, an increase in price leads to a decrease in total revenue because the decrease in quantity demanded outweighs the increase in price.

4 5. For each of the following pairs of goods, which good would you expect to have more elastic demand and why? a. required textbooks or mystery novels Mystery novels have more elastic demand than required textbooks because mystery novels have close substitutes and are a luxury good, while required textbooks are a necessity with no close substitutes. If the price of mystery novels were to rise, readers could substitute other types of novels, or buy fewer novels altogether. But if the price of required textbooks were to rise, students would have little choice but to pay the higher price. Thus, the quantity demanded of required textbooks is less responsive to price than the quantity demanded of mystery novels. b. Beethoven recordings or classical music recordings in general Beethoven recordings have more elastic demand than classical music recordings in general. Beethoven recordings are a narrower market than classical music recordings, so it is easier to find close substitutes for them. If the price of Beethoven recordings were to rise, people could substitute other classical recordings, like Mozart. But if the price of all classical recordings were to rise, substitution would be more difficult. (A transition from classical music to rap is unlikely!) Thus, the quantity demanded of classical recordings is less responsive to price than the quantity demanded of Beethoven recordings. c. subway rides during the next six months or subway rides during the next five years Subway rides during the next five years have more elastic demand than subway rides during the next six months. Goods have a more elastic demand over longer time horizons. If the fare for a subway ride was to rise temporarily, consumers could not switch to other forms of transportation without great expense or great inconvenience. But if the fare for a subway ride was to remain high for a long time, people would gradually switch to alternative forms of transportation. As a result, the quantity demanded of subway rides during the next six months will be less responsive to changes in the price than the quantity demanded of subway rides during the next five years. d. root beer or water Root beer has more elastic demand than water. Root beer is a luxury with close substitutes, while water is a necessity with no close substitutes. If the price of water were to rise, consumers have little choice but to pay the higher price. But if the price of root beer were to rise, consumers could easily switch to other sodas or beverages. So the quantity demanded of root beer is more responsive to changes in price than the quantity demanded of water. 6. Suppose the price elasticity of demand for heating oil is 0.2 in the short run and 0.7 in the long run. a. If the price of heating oil rises from \$1.80 to \$2.20 per gallon, what happens to the quantity of heating oil demanded in the short run? In the long run? (Use the midpoint method in your calculations.) The percentage change in price is equal to ( )/2.00 x 100 = 20%. If the price elasticity of demand is 0.2, quantity demanded will fall by 4% in the short run[20% x 0.2]. If the price elasticity of demand is 0.7, quantity demanded will fall by 14% in the long run [20% x 0.7].

5 b. Why might this elasticity depend on the time horizon? Over time, consumers can make adjustments to their homes by purchasing alternative heat sources such as natural gas or electric furnaces. Thus, they can respond more easily to the change in the price of heating oil in the long run than in the short run. 7. A price change causes the quantity demanded of a good to decrease by 30 percent, while the total revenue of that good increases by 15 percent. Is the demand curve elastic or inelastic? Explain. If quantity demanded fell, price must have increased according to the law of demand. For a price increase to increase total revenue, the percentage increase in the price must be greater than the percentage decline in quantity demanded. Therefore, demand is inelastic 8. Cups of coffee and donuts are complements. Both have inelastic demand. A hurricane destroys half the coffee bean crop. Use appropriately labeled diagrams to answer the following questions. a. What happens to the price of coffee beans? The effect on the market for coffee beans is shown in the figure. When a hurricane destroys half of the crop, the supply of coffee beans decreases, the price of coffee beans increases, and the quantity decreases. Price S 2 S 1 Demand Quantity b. What happens to the price of a cup of coffee? What happens to total expenditure on cups of coffee? The effect on the market for cups of coffee is shown in the figure above. When the price of coffee beans, an important input into the production of a cup of coffee, increases, the supply of cups of coffee decreases, the price of a cup of coffee increases, and the quantity decreases. Because cups of coffee have an inelastic demand, when the price of a cup of coffee increases, the total expenditure on coffee increases. c. What happens to the price of donuts? What happens to total expenditure on donuts? The effect on the market for donuts is shown in the figure. When the price of coffee increases and the quantity demanded of coffee decreases, consumers demand fewer donuts because coffee and donuts are complements. When demand decreases, the price of donuts decreases. Because donuts have an inelastic demand, when the price of donuts decreases, the total expenditure on donuts decreases.

6 Price Supply D 2 D 1 9. The New York Times reported (Feb.17, 1996) that subway ridership declined after a fare increase: There were nearly 4 million fewer riders in December 1995, the first full month after the price of a token increased 25 cents to \$1.50, than in the previous December, a 4.3 percent decline. a. Use these data to estimate the price elasticity of demand for subway rides. The percentage change in price (using the midpoint formula) is ( )/(1.375) 100% = 18.18%. Therefore, the price elasticity of demand is 4.3/18.18 = 0.24, which is very inelastic. b. According to your estimate, what happens to the Transit Authority s revenue when the fare rises? Because the demand is inelastic, the Transit Authority's revenue rises when the fare rises. c. Why might your estimate of the elasticity be unreliable? The elasticity estimate might be unreliable because it is only the first month after the fare increase. As time goes by, people may switch to other means of transportation in response to the price increase. So the elasticity may be larger in the long run than it is in the short run. 10. You are the curator of a museum. The museum is running short of funds, so you decide to increase revenue. Should you increase or decrease the price of admission? Explain. To determine whether you should increase or decrease the price of admissions, you need to know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of admissions will increase total revenue. If demand is inelastic, an increase in the price of admissions will cause total revenue to rise.

7 11. Melissa buys an iphone for \$120 and gets consumer surplus of \$80. a. What is her willingness to pay? Consumer surplus is equal to willingness to pay minus the price paid. Therefore, Melissa s willingness to pay must be \$200 (\$120 + \$80). b. If she had bought the iphone on sale for \$90, what would her consumer surplus have been? Her consumer surplus at a price of \$90 would be \$200 \$90 = \$110. c. If the price of an iphone were \$250, what would her consumer surplus have been? If the price of an iphone was \$250, Melissa would not have purchased one because the price is greater than her willingness to pay. Therefore, she would receive no consumer surplus. 12. An early freeze in California sours the lemon crop. Explain what happens to consumer surplus in the market for lemons. Explain what happens to consumer surplus in the market for lemonade. Illustrate your answers with diagrams. If an early freeze in California sours the lemon crop, the supply curve for lemons shifts to the left, as shown in the fiigure. The result is a rise in the price of lemons and a decline in consumer surplus from A + B + C to just A. So consumer surplus declines by the amount B + C. In the market for lemonade, the higher cost of lemons reduces the supply of lemonade, as shown in the figure. The result is an increase in the price of lemonade and a decline in consumer surplus from D + E + F to just D, a loss of E + F. Note that an event that affects consumer surplus in one market often has effects on consumer surplus in other markets.

8 13. Suppose the demand for French bread rises. Explain what happens to producer surplus in the market for French bread. Explain what happens to producer surplus in the market for flour. Illustrate your answers with diagrams. A rise in the demand for French bread leads to an increase in producer surplus in the market for French bread, as shown in the figure. The shift of the demand curve leads to an increased price, which increases producer surplus from area A to area A + B + C. The increased quantity of French bread being sold increases the demand for flour, as shown in the figure. As a result, the price of flour rises, increasing producer surplus from area D to D + E + F. Note that an event that affects producer surplus in one market leads to effects on producer surplus in related markets.

9 14. It is a hot day, and Bert is thirsty. Here is the value he places on each bottle of water: Value of first bottle \$7 Value of second bottle \$5 Value of third bottle \$3 Value of fourth bottle \$1 a. From this information, derive Bert s demand schedule. Graph his demand curve for bottled water. Bert s demand schedule is: Price Quantity demanded More than \$7 0 \$5 to \$7 1 \$3 to \$5 2 \$1 to \$3 3 \$1 or less 4 Bert s demand curve is: b. If the price of a bottle of water is \$4, how many bottles does Bert buy? How much consumer surplus does Bert get from his purchases? Show Bert s consumer surplus in your graph. When the price of each bottle of water is \$4, Bert buys two bottles of water. His consumer surplus is shown as area A in the figure. He values his first bottle of water at \$7, but pays only \$4 for it, so has consumer surplus of \$3. He values his second bottle of water at \$5, but pays only \$4 for it, so has consumer surplus of \$1. Thus Bert s total consumer surplus is \$3 + \$1 = \$4, which is the area of A in the figure. c. If the price falls to \$2, how does quantity demanded change? How does Bert s consumer surplus change? Show these changes in your graph. When the price of each bottle of water falls from \$4 to \$2, Bert buys three bottles of water, an increase of one. His consumer surplus consists of both areas A and B in the figure, an increase in the amount of area B. He gets consumer surplus of \$5 from the first bottle (\$7 value minus \$2 price), \$3 from the second bottle (\$5 value minus \$2 price), and \$1 from the third bottle (\$3 value minus \$2 price), for a total consumer surplus of \$9. Thus consumer surplus rises by \$5 (which is the size of area B) when the price of each bottle of water falls from \$4 to \$2.

10 15. Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water: Cost of first bottle \$1 Cost of second bottle \$3 Cost of third bottle \$5 Cost of fourth bottle \$7 a. From this information, derive Ernie s supply schedule. Graph his supply curve for bottled water. Ernie s supply schedule for water is: Price Quantity supplied More than \$7 4 \$5 to \$7 3 \$3 to \$5 2 \$1 to \$3 1 \$1 or less 0 Ernie s supply curve is: b. If the price of a bottle of water is \$4, how many bottles does Ernie produce and sell? How much producer surplus does Ernie get from these sales? Show Ernie s producer surplus in your graph. When the price of each bottle of water is \$4, Ernie sells two bottles of water. His producer surplus is shown as area A in the figure. He receives \$4 for his first bottle of water, but it costs only \$1 to produce, so Ernie has producer surplus of \$3. He also receives \$4 for his second bottle of water, which costs \$3 to produce, so he has producer surplus of \$1. Thus Ernie s total producer surplus is \$3 + \$1 = \$4, which is the area of A in the figure. c. If the price rises to \$6, how does quantity supplied change? How does Ernie s producer surplus change? Show these changes in your graph. When the price of each bottle of water rises from \$4 to \$6, Ernie sells three bottles of water, an increase of one. His producer surplus consists of both areas A and B in the figure, an increase by the amount of area B. He gets producer surplus of \$5 from the first bottle (\$6 price minus \$1 cost), \$3 from the second bottle (\$6 price minus \$3 cost), and \$1 from the third bottle (\$6 price minus \$5 price), for a total producer surplus of \$9. Thus producer surplus rises by \$5 (which is the size of area B) when the price of each bottle of water rises from \$4 to \$6.

11 16. The cost of producing flat-screen TVs has fallen over the past decade. Let s consider some implications of this fact. a. Draw a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of flat-screen TVs sold. The effect of falling production costs in the market for flat-screen TVs results in a shift to the right in the supply curve, as shown in the figure. As a result, the equilibrium price of flat-screen TVs declines and the equilibrium quantity increases. Price of flat-screen TVs S 1 S 2 A P 1 P 2 B E F C D G Demand Q 1 Q 2 Quantity of flat-screen TVs b. In your diagram, show what happens to consumer surplus and producer surplus. The decline in the price of flat-screen TVs increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Because consumer surplus rises by B + C + D and producer surplus rises by F + G B, total surplus rises by C + D + F + G. c. Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling production costs? - consumers or producers of these TVs? If the supply of flat-screen TVs is very elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were horizontal, as shown in the figure. Then there is no producer surplus at all. Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B.

12 Price of flat-screen TVs A B S 1 S 2 Demand Quantity of flat-screen TVs

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