Microeconomics

1. For each of the following pairs of goods, state which good you expect to have the more elastic demand and explain why. a) Required textbooks or mystery novels. ANSWER: Mystery Novels will have more elastic demand compared to required textbooks. This is because demand tends to be less elastic for goods that are considered essential by consumers. In this case, the textbooks are necessary to consumers whereas Mystery Novels may be seen more as a discretionary spending. b) Beethoven recordings or classical music recordings in general. ANSWER: Classical music recordings will have more elastic demand compared to Beethoven recordings. This is because the elasticity tends to be less for goods for which substitutes are not available. Beethovens recordings are unmatched by any other music as well as rare to find. Thus, consumers will be willing to buy them even if the price increases. c) Heating oil during the next six months or heating oil during the next five years. ANSWER: Heating oil in the next six months will have more demand elasticity. This is because, consumers may react sharply to any changes in price in the short term(six months) but they will accommodate change in prices over a longer period of time (five years), assuming heating oil is a necessity and there are no alternatives. d) Root beer or water. ANSWER: Root beer will have more demand elasticity compared to water. This is because Goods which are necessities for consumers are less demand elastic. In this case, water is clearly a necessity while beer may come under discretionary spending.

2. Suppose vacationers and business travelers have the following demand for airline tickets from New York to Boston: Quantity Demanded (Business Quantity Demanded Price Travelers) (Vacationers) 150 2100 1000 200 2000 800 250 1900 600 300 1800 400 a) As the price of tickets rises from $200 to $250, what is the price elasticity of demand for (i) business travelers and (ii) vacationers? ANSWER: (i) Price Elasticity for Business Traveller: Elasticity(Business Traveller) = =

Elasticity(Business Traveller)

= -0.2

(ii)

Price Elasticity for Vacationers: Elasticity(Vacationers) = = Elasticity(Vacationers) = -1

b) Why might vacationers have a different elasticity than business travelers? ANSWER: Vacationers have more elasticity than business travelers since vacationers have more choices for their date and mode of travel while on vacation. For example, they may opt to travel by automobile or fly on a day with lower fares while on vacation. On the other hand, Business travelers have fixed dates to travel which have to be adhered to irrespective of prices.

3. Two drivers - Tom and Jerry - each drive up to a gas station. Before looking at the price, each places an order. Tom says, "I'd like 10 gallons of gas." Jerry says, "I'd like $10.00 of gas." Can you guess about the shape of the demand curve for gas for bot Tom and Jerry? ANSWER: Below are approximations of demand curves for Tom and Jerry

4. Consider Public policy aimed at smoking. a) Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of cigarettes currently costs $2.00 and the government wants to reduce smoking by 20 percent, by how much should it increase the price? ANSWER: Elasticity= 0.4 =

0.4 = =1 Government should increase price of Cigarettes by $1.

b) If the government permanently increases the price of cigarettes, will the policy have a larger effect on smoking one year from now or five years from now? ANSWER: NO. This is because; smoking is habitual and hence cannot be stopped easily. Although smokers will reduce their consumption immediately following the price increase, they will eventually adjust to the increased prices. The effect of this price rise on smoking will reduce as the time passes from a year to five years.

c) Studies also find that teenagers have higher price elasticity than do adults. Why might this be true? ANSWER: Demand tends to be more price elastic when consumers are more price sensitive. Since teenagers usually have limited funds and consequently limited budgets, they will be more elastic to price rise than adults who earn more and can spend money on habits such as smoking.