EC101 Problem Set 2

Chapter 5
1. Price Elasticity of Demand Suppose that the price of diamonds increases from
$7600 to $8300 per carat. Use the midpoint method for all of the following questions.

(i.) What is the price elasticity of demand if quantity demanded falls from 1.2 to 1.08
carats?

(ii.) Does this make the demand for diamonds elastic, inelastic, or unit elastic? Is this
intuitive? Why?

(iii.) Suppose the federal government can regulate the price of diamonds (e.g. through a
mandate). Suppose the current equilibrium price of diamonds is $13400 per carat
and the current equilibrium quantity demanded is 2.35 carats. The government
wants to see quantity demanded decline to 2.083 due to worker exploitation con-
cerns. If the price elasticity of diamonds is equal to 1.96, what new price should
the government enforce? Round calculations to four decimals.

1
 (iv.) What are some possible strategies the government could take to make the demand
for diamonds more elastic? What would make the demand for diamonds more
inelastic? You can be creative.

2. Price Elasticity of Demand & Revenue Due to the law of demand, we know that
holding everything else fixed, increases in the price yield decreases in quantity demanded.
Use the graph below to answer the following questions.

(i.) Explain why we know that the price elasticity of demand in this case is not unit.

(ii.) Now, suppose you know that (12, 50), (18, 27.5), (30, 17), and (50, 11) are points
on the demand curve.

Page 2
(a.) What is the change in total revenue when the price increases from $11 to $17?
Draw this change on the graph and mark the gain in revenue from raising the
price and the loss in revenue from the decline in quantity demanded. Your
drawing does not need to be to scale.

(b.) What is the change in total revenue when the price increases from $27.5 to
$50? Draw this change on the graph and mark the gain in revenue from raising
the price and the loss in revenue from the decline in quantity demanded. Your
drawing does not need to be to scale.

(c.) Explain how the above results relate to the elasticity of the demand curve.

(d.) Suppose the price jumps from $20 to $30. What is the quantity supplied?

(e.) What is the elasticity of supply? Provide a reason that was specified in class.

Page 3
 (f.) Does the elasticity of a linear supply curve depend on its slope?

3. Income Elasticity & Cross-Price Elasticity Consider the markets for bus rides,
bus rides on the bus with license plate number 3APL6JK, and limousine rides, respec-
tively. Use the concepts of income elasticity and cross-price elasticity to answer the
following questions.

(i.) Choose possible starting and ending incomes and quantities for both bus rides and
limousine rides that show bus rides are an inferior good and limousine rides are a
normal good.

(ii.) Choose possible starting and ending prices and quantities for both bus rides and
limousine rides that show an intuitive relationship between these two goods.

(iii.) Do you think the demand curve in the market for bus rides will be more elastic
than, less elastic than, or just as elastic as the demand curve in the market for bus
rides on the bus with license plate number 3APL6JK? Why?

Chapter 6
4. Price Ceilings & Floors Consider the following market for skilled labor. Suppose
that the government has imposed a minimum wage (price) for skilled labor equal to $15.

Page 4
 (i.) With the minimum wage enforced, what is the quantity demanded in this market?
What is the quantity supplied? What is the market price for skilled labor?

(ii.) Suppose that due to COVID-19, skilled laborers are able to work from home. As a
result, they become more productive workers and, holding everything else constant,
are able to provide 300 additional units of skilled labor at every price point. Show
this change on the graph.

(iii.) After this change, what is the quantity demanded in this market? What is the
quantity supplied? What is the market price for skilled labor?

Page 5
 (iv.) Using your findings, explain the relationship between minimum wages and unem-
ployment. (Unemployment is defined by the number of people who want/are willing
to work minus the number of people who get to work.)

5. Taxes Consider the market for cane sugar.

(i.) Suppose the government wants to discourage consumption of cane sugar for health
purposes and therefore levies a $2.50 tax per unit on buyers. Show the effect of this
tax on the market in the graph. What is the tax burden faced by buyers? What is
the tax burden faced by sellers?

Page 6
(ii.) The government decides the tax isn’t working - they believe that people are still
consuming too much sugar. To solve this problem, the government instead levies
a $2.50 tax per unit on sellers. Show the effect of this tax on the market in the
graph. What is the tax burden faced by buyers now? What is the tax burden faced
by sellers?

(iii.) Explain your findings. What would you tell the government about their decision
to levy the tax on sellers instead of buyers?

(iv.) Suppose now that the slope of the demand curve changes to −2 and the slope of the
supply curve changes to 3/4. Moreover, suppose that the quantity demanded at a
price of $10 is still 0 and the quantity supplied at a price of $0 is still 0. Now what
is the tax burden faced by buyers and what is the tax burden faced by sellers when
the government levies a $2.50 tax per unit on buyers? Explain why this distribution
of the burden makes sense. Hint: Relate this finding to elasticity.

Page 7
 Chapter 7
6. Consumer Surplus Consider the market for lottery tickets.

(i.) Suppose that the equilibrium price of lottery tickets increases from $2 to $3. What
is the change in consumer surplus?

(ii.) What is causing this change? Hint: There are two components to this change. Mark
them clearly on the graph.

(iii.) Suppose now that demand is linear and $6 is the price at which all buyers choose
to completely refrain from taking their shot at winning the lottery. Moreover, at a

Page 8
 price of $0, buyers feel best when they purchase 6 lottery tickets. Given this new
demand, what is the change in consumer surplus now when the equilibrium price
of lottery tickets increases from $2 to $3? Hint: I recommend drawing the demand
curve on the graph.

(iv.) If the government had the ability to influence the shape of the demand for lottery
tickets (e.g. through mandates, regulations, and incentive structures) and their
goal was to maximize consumer welfare in the economy, would they prefer the old
or new demand curve? Why?

7. Producer Surplus Please answer the following questions related to producer surplus.

(i.) What is the relationship between price elasticity of supply and producer surplus?
In other words, will producer surplus be greatest when supply is elastic, inelastic,
or unit-elastic?

(ii.) What can we say about producer surplus when the supply curve in a given market
is a vertical line? What can we say when the supply curve is a horizontal line?
Explain and connect your answer to part (i.) of this question.

(iii.) What can we say about the change in producer surplus in a given market when,
holding all else constant, the demand curve shifts to the right? What can we say
about the change in producer surplus in a given market when, holding all else

Page 9
constant, the supply curve shifts to the right? Use supply & demand graphs to
support your answer.

Page 10