CHAPTER 2

CLASS AND HOMEWORK EXCERSISES MEMO

QUESTION 1
Are the following statements true or false? Explain your answers.
a. The elasticity of demand is the same as the slope of the demand curve.
False. Elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in the price of the product. In contrast, the slope of the demand curve is the
change in quantity demanded (in units) divided by the change in price (typically in dollars).
b. The cross-price elasticity will always be positive.
False. The cross-price elasticity measures the percentage change in the quantity demanded of
one good due to a 1% change in the price of another good. This elasticity will be positive for
substitutes (an increase in the price of hot dogs is likely to cause an increase in the quantity
demanded of hamburgers) and negative for complements (an increase in the price of hot dogs is
likely to cause a decrease in the quantity demanded of hot dog buns).
c. The supply of apartments is more inelastic in the short run than the long run.
True. In the short run it is difficult to change the supply of apartments in response to a change in
price. Increasing the supply requires constructing new apartment buildings, which can take a year
or more. Therefore, the elasticity of supply is more inelastic in the short run than in the long run.

QUESTION 2
Use supply and demand curves to illustrate how each of the following events would affect the
price of butter and the quantity of butter bought and sold:
a. An increase in the price of margarine (only need to illustrate)

Butter and margarine are substitute goods for most people. Therefore, an increase in the price of
margarine will cause people to increase their consumption of butter, thereby shifting the demand
curve for butter out from D1 to D2 in Figure 2.2.a. This shift in demand causes the equilibrium
price of butter to rise from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2.
b. An increase in the price of milk.

Note: Milk is the main ingredient in butter. An increase in the price of milk increases the cost of
producing butter, which reduces the supply of butter. The supply curve for butter shifts from S1 to
S2, resulting in a higher equilibrium price, P2 and a lower equilibrium quantity, Q2, for butter.
c. A decrease in average income levels.

Note: Assuming that butter is a normal good, a decrease in average income will cause the demand
curve for butter to decrease (i.e., shift from D1 to D2). This will result in a decline in the equili-
brium price from P1 to P2, and a decline in the equilibrium quantity from Q1 to Q2.

QUESTION 3

Price Demand Supply

(Rand) (Millions) (Millions)

60 22 14
 80 20 16

100 18 18

120 16 20
Using the table above, calculate the price elasticity of demand when the price is $80 and
a.
when the price is $100.
QD
Q P QD
ED  D  .
P QD P
P
With each price increase of $20, the quantity demanded decreases by 2 million. Therefore,
 QD  2
   0.1.
 P  20
At P 80, quantity demanded is 20 million and thus:
 80 
ED    (0.1)  0.40.
 20 
Similarly, at P 100, quantity demanded equals 18 million and
 100 
ED    (0.1)  0.56.
 18 

b. Calculate the price elasticity of supply when the price is $80 and when the price is $100.
QS
Q P QS
ES  S  .
P QS P
P
With each price increase of $20, quantity supplied increases by 2 million. Therefore,
 QS  2
 P   20  0.1.
 
At P 80, quantity supplied is 16 million and
 80 
ES    (0.1)  0.5.
 16 
Similarly, at P 100, quantity supplied equals 18 million and
 100 
ES   (0.1)  0.56.
 18 
c. What are the equilibrium price and quantity?
The equilibrium price is the price at which the quantity supplied equals the quantity demanded.
Using the table, the equilibrium price is P* = $100 and the equilibrium quantity is Q* = 18 million.
Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how
d.
large will it be?
With a price ceiling of $80, price cannot be above $80, so the market cannot reach its equilibrium
price of $100. At $80, consumers would like to buy 20 million, but producers will supply only
16 million. This will result in a shortage of 4 million units.
 QUESTION 4
Much of the demand for SA agricultural output has come from other countries. In 1998, the total
demand for wheat was Q  3244  283P. Of this, total domestic demand was QD  1700  107P,
and domestic supply was QS  1944  207P. Suppose the export demand for wheat falls by 40%.
SA farmers are concerned about this drop in export demand. What happens to the free-
a.
market price of wheat in South Africa? Do farmers have much reason to worry?
Before the drop in export demand, the market equilibrium price is found by setting total demand
equal to domestic supply:
3244  283P  1944  207P, or
P  R2.65.
Export demand is the difference between total demand and domestic demand: Q  3244  283P
minus QD  1700  107P. So export demand is originally Qe  1544  176P. After the 40% drop,
export demand is only 60% of the original export demand.
The new export demand is therefore, Q′e  0.6Qe  0.6(1544  176P)  926.4  105.6P.
The new total demand becomes
Q′  QD  Q′e  (1700  107P)  (926.4  105.6P)  2626.4  212.6P.
Equating total supply and the new total demand,
1944  207P  2626.4  212.6P, or
P  R1.63,
which is a significant drop from the original market-clearing price of $2.65 per bushel. At this
price, the market-clearing quantity is about Q  2281 million bushels. Total revenue has
decreased from about $6609 million to $3718 million, so farmers have a lot to worry about.
Now suppose the SA government wants to buy enough wheat to raise the price to R3.50 per
b. bushel. With the drop in export demand, how much wheat would the government have to
buy?
With a price of R3.50, the market is not in equilibrium. Quantity demanded and supplied are
Q′  2626.4  212.6(3.50)  1882.3, and
QS  1944  207(3.50)  2668.5.
Excess supply is therefore 2668.5  1882.3  786.2 million bushels
c. And how much would this cost the government?
The government must purchase this amount to support a price of R3.50, and will have to spend
R3.50(786.2 million) = R2751.7 million.

QUESTION 5
In 2010, Americans smoked 315 billion cigarettes, or 15.75 billion packs of cigarettes. The
a. average retail price (including taxes) was about $5.00 per pack. Statistical studies have shown
that the price elasticity of demand is = 0.4, and the price elasticity of supply is 0.5.
Let the demand curve be of the form Q  a  bP and the supply curve be of the form Q  c  dP,
where a, b, c, and d are positive constants. To begin, recall the formula for the price elasticity of
demand
P Q
EPD  .
Q P
We know the demand elasticity is –0.4, P  5, and Q  15.75, which means we can solve for the
slope, −b, which is Q/P in the above formula.
5 Q
0.4 
15.75 P
Q  15.75 
 0.4    1.26  b.
P  5 
To find the constant a, substitute for Q, P, and b in the demand function to get 15.75  a  1.26(5),
so a  22.05. The equation for demand is therefore Q  22.05  1.26P. To find the supply curve,
recall the formula for the elasticity of supply and follow the same method as above:
P Q
EPS 
Q P
5 Q
0.5 
15.75 P
Q  15.75 
 0.5    1.575  d.
P  5 
To find the constant c, substitute for Q, P, and d in the supply function to get 15.75  c  1.575(5)
and c  7.875. The equation for supply is therefore Q  7.875  1.575P.

In 1998, Americans smoked 23.5 billion packs cigarettes, and the retail price was about $2.00
per pack. The decline in cigarette consumption from 1998 to 2010 was due in part to greater
b. public awareness of the health hazards from smoking, but was also due in part to the
increase in price. Suppose that the entire decline was due to the increase in price. What
could you deduce from that about the price elasticity of demand?
Calculate the arc elasticity of demand since we have a range of prices rather than a single price.
The arc elasticity formula is
Q P
EP 
P Q
Q
where P and are average price and quantity, respectively. The change in quantity was
15.75 23.5  7.75, and the change in price was 5  2  3. The average price was (2  5)/2 
3.50, and the average quantity was (23.5  15.75)/2  19.625. Therefore, the price elasticity of
demand, assuming that the entire decline in quantity was due solely to the price increase, was
Q P 7.75 3.50
EP    0.46.
P Q 3 19.625
 HOMEWORK EXCERSISES

QUESTION 4
A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound.
Unlimited quantities are available for import into the United States at this price. The U.S. domestic
supply and demand for various price levels are shown as follows:

U.S. Supply U.S. Demand

Price
(Million Lbs.) (Million Lbs.)
3 2 34
6 4 28
9 6 22
12 8 16
15 10 10
18 12 4

a. What is the equation for demand? What is the equation for supply?

The equation for demand is of the form Q  a  bP.

Q 6
First find the slope, which is   2  b. You can figure this out by noticing that every time
P 3
price increases by 3, quantity demanded falls by 6 million pounds. Demand is now Q  a  2P.
To find a, plug in any of the price and quantity demanded points from the table.
For example: Q  34  a  2(3) so that a  40 and demand is therefore Q  40  2P.
The equation for supply is of the form Q  c  dP.
Q 2
First find the slope, which is   d.
P 3
You can figure this out by noticing that every time price increases by 3, quantity supplied
increases by 2 million pounds.
2
Supply is now Q  c  P. To find c, plug in any of the price and quantity supplied points from the
3
2 2
table. For example: Q  2  c  (3) so that c  0 and supply is Q  P.
3 3

b. At a price of $9, what is the price elasticity of demand? What is it at a price of $12?
P Q 9 18
Elasticity of demand at P  9 is  (2)   0.82.
Q P 22 22
P Q 12 24
Elasticity of demand at P  12 is  (2)   1.5.
Q P 16 16
c. What is the price elasticity of supply at $9? At $12?
 P Q 9  2  18
Elasticity of supply at P  9 is      1.0.
Q P 6  3  18
P Q 12  2  24
Elasticity of supply at P  12 is     1.0.
Q P 8  3  24
d. In a free market, what will be the U.S. price and level of fiber imports?
With no restrictions on trade, the price in the United States will be the same as the world price,
so P = $9. At this price, the domestic supply is 6 million lbs. while the domestic demand is
22 million lbs. Imports make up the difference and are 16 million lbs.

QUESTION 8
In Example 2.8 (textbook) we examined the effect of a 20% decline in copper demand on the price
of copper, using the linear supply and demand curves developed in Section 2.6. Suppose the long-
run price elasticity of copper demand were -0.75 instead of -0.5.
Assuming, as before, that the equilibrium price and quantity are P* = $3 per pound and
a. Q* = 18 million metric tons per year, derive the linear demand curve consistent with the
smaller elasticity.
Following the method outlined in Section 2.6, solve for a and b in the demand equation
QD = a - bP. Because -b is the slope, we can use b rather than Q/P in the elasticity.
formula.
 P*
Therefore, ED  b   . Here ED = -0.75 (the long-run price elasticity), P*  3
Q*
and Q*  18. Solving for b,
 3
0.75  b   , or b  0.75(6)  4.5.
 18 
To find the intercept, we substitute for b, QD ( Q*), and P ( P*) in the demand equation:
18  a  4.5(3), or a  31.5.
The linear demand equation is therefore:
QD  31.5  4.5P.

Using this demand curve, recalculate the effect of a 20% decline in copper demand on the
b.
price of copper.
The new demand is 20% below the original (using our convention that quantity demanded is
reduced by 20% at every price); therefore, multiply demand by 0.8 because the new demand is
80% of the original demand:
QD  (0.8)(31.5  4.5P)  25.2  3.6P.
Equating this to supply,
25.2  3.6P  9  9P, so
P  $2.71.
With the 20% decline in demand, the price of copper falls from $3.00 to $2.71 per pound.