PROBLEM SET #2

Parkin, #3
The demand schedule for hotel rooms is

a. What happens to total revenue when the price falls from $400 to $250 a night and from $250
to $200 a night?

When the price falls from $400 to $250 a night, the total revenue will be equal to:
𝑇𝑅 = 𝑃×𝑄𝐷
= $400×50, 000, 000
= $20, 000, 000, 000 (20 𝑏𝑖𝑙𝑙𝑖𝑜𝑛)

𝑇𝑅 = 𝑃×𝑄𝐷
= $250×80, 000, 000
= $20, 000, 000, 000 (20 𝑏𝑖𝑙𝑙𝑖𝑜𝑛)
The total revenue does not change when the price falls from $400 to $250 a
night.

b. Is the demand for hotel rooms elastic, inelastic, or unit elastic?

The total revenue does not change when the price falls from $400 to $250 a night. Since
the total revenue is unchanged, demand is unit elastic.
Parkin, #5

In 2003, when music downloading first took off, Universal Music slashed the average price of a
CD from $21 to $15. The company expected the price cut to boost the quantity of CDs sold by
30 percent, other things remaining the same.

a. What was Universal Music’s estimate of the price elasticity of demand for CDs?

Given: % change in 𝑄𝐷 = 30% 𝑃1 = 21 𝑃2 = 15

𝑃2−𝑃1
% change in P = (𝑃2+𝑃1)/2
×100%

Price elasticity of demand = % change in 𝑄𝐷 / % change in P

30%
= (15−21)
(15+21)/2
𝑥 100%
30%
= −6
18
𝑥 100%
30%
= 1
33 3 %
Price elasticity of demand = 0.9

b. If you were making the pricing decision at Universal Music, what would be your pricing
decision? Explain your decision.

If I were to make the pricing decision at Universal Music, it would also be best to cut the
prices. Since downloaded music is a substitute for CDs, and downloaded music is
generally cheaper, the quantity demanded of downloaded music will rise, and the
demand for CDs will fall. The demand is inelastic from the estimate above, so if nothing
else changes, then the price cut leads to a decrease in Universal Music’s total revenue.
Additionally, as the Internet becomes highly accessible and as people gain access to
illegal downloading sites, the price of downloading music would also most likely fall
since people will lean on acquiring free things. If the price of downloaded music falls, it
will also cause a decrease in the demand for Universal Music’s CDs. Slashing the price of
a CD is more like an inflicted decision of an expected decrease in demand for it.
Parkin, #7

The Grip of Gas

U.S. drivers are ranked as the least sensitive to changes in the price of gasoline. For example, if
the price rose from $3 to $4 per gallon and stayed there for a year U.S. purchases of gasoline
would fall only about 5 percent.
Source: Slate, September 27, 2005

a. Calculate the price elasticity of demand for gasoline. Is the demand for gasoline elastic, unit
elastic, or inelastic?
The price rose by $1 from $3 to $4, making the percentage change in price:

𝑃2−𝑃1
%∆in P = (𝑃2+𝑃1)/2
×100%

4−3
= (4+3)/2
×100%
4
%∆in P = 28 7
%

%∆in 𝑄𝐷 = 5%

Price elasticity of demand = % change in 𝑄𝐷 / % change in P

5%
= 4
28 7
%
Price elasticity of demand = 0.175

The price elasticity of demand is between 0 and 1; thus, the price elasticity of
demand is inelastic demand.

b. Explain how the price rise from $3 to $4 a gallon changes the total revenue from gasoline
sales.

The price of gasoline rose from $3 to $4, and because the demand is inelastic, the total
revenue test concludes that a price increase will cause the total revenue to increase.
Parkin, #8

Spam Sales Rise as Food Costs Soar

Sales of Spam are rising as consumers realize that Spam and other lower-cost foods can be
substituted for costlier cuts of meat as a way of controlling their already stretched food budgets.
Source: AOL Money & Finance, May 28, 2008

a. Is Spam a normal good or inferior good? Explain.

An inferior good is describes as a good which demand decreases as the income of

consumers rise. Thus, based on this case, Spam is considered as an inferior good as
consumers purchase it as an alternative for costlier cut of meat. Hence, if the consumers
are looking for cheaper alternatives, then it might root from low incomes; thus, leading
to the rise of sales and demand for Spam.

b. Would the income elasticity of demand for Spam be negative or positive? Explain.

Since the demand of an inferior good and the income of consumer have an inverse
relationship, the income of elasticity of demand for Spam will be negative. As mentioned
in the case, Spam is being consumed and bought as a cheaper alternative and the
tendency is that consumers with less income are more likely to purchase inferior goods
when their income is low.

Parkin, #9

If a 12 percent rise in the price of orange juice decreases the quantity of orange juice demanded
by 22 percent and increases the quantity of apple juice demanded by 14 percent, calculate the:

a. Price elasticity of demand for orange juice.

Given: % change in 𝑄𝐷 of orange juice = 22%

% change in P of orange juice = 12%

 Price elasticity of demand = % change in 𝑄𝐷 / % change in P

22%
= 12%

Price elasticity of demand = 1.833

b. Cross elasticity of demand for apple juice with respect to the price of orange juice.

Given: % change in 𝑄𝐷 of apple juice = 14%

% change in P of orange juice = 12%

Cross elasticity of demand = % change in 𝑄𝐷 / % change in P of substitute/complement

14%
= 12%

Cross elasticity of demand = 1.167

Parkin, #10

When Judy’s income increased from $130 to $170 a week, she increased her demand for
concert tickets by 15 percent and decreased her demand for bus rides by 10 percent. Calculate
Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

Since income increased from $130 to $170, to get the percentage change in income, use:
𝐼2−𝐼1
% change in income (I) = (𝐼2+𝐼1)/2
×100%

a. Income elasticity of demand for concert tickets

Given: % change in 𝑄𝐷 of concert tickets = 15% 𝐼1 = 130 𝐼2 = 170

Income elasticity of demand = % change in 𝑄𝐷 / % change in I

 15%
= (170−130)
(170+130)/2
𝑥 100%

15%
= 40
150
𝑥 100%

15%
= 4
15
𝑥 100%

15%
= 2
26 3 %

Income elasticity of demand = 0.563

b. Income elasticity of demand for bus rides

Given: % change in 𝑄𝐷 of bus rides = 10% 𝐼1 = 130 𝐼2 = 170

Income elasticity of demand = % change in 𝑄𝐷 / % change in I

10%
= (170−130)
(170+130)/2
𝑥 100%

10%
= 40
150
𝑥 100%
10%
= 4
15
𝑥 100%

10%
= 2
26 3 %

Income elasticity of demand = 0.375

Parkin, #17

The table sets out the supply schedule of jeans.

Calculate the elasticity of supply when:

a. The price rises from $125 to $135.

Given: 𝑃1= 125 𝑃2= 135

𝑆1= 28 𝑆2= 36
𝑆2−𝑆1 𝑃2−𝑃1
% change in 𝑄𝑆 = (𝑆2+𝑆1)/2
×100% % change in P = (𝑃2+𝑃1)/2
×100%

Elasticity of supply = % change in 𝑄𝑆 / % change in P

(36−28)
(36+28)/2
𝑥 100%
= (135−125)
(135+125)/2
𝑥 100%
8
64/2
𝑥 100%
= 10
260/2
𝑥 100%
1
4
𝑥 100%
= 1
13
𝑥 100%
25%
= 9
7 13 %

Elasticity of supply = 3.250

b. The average price is $125 a pair.

Given: 𝑃1= 120 𝑃2= 130

𝑆1= 24 𝑆2= 32
𝑆2−𝑆1 𝑃2−𝑃1
% change in 𝑄𝑆 = (𝑆2+𝑆1)/2
×100% % change in P = (𝑃2+𝑃1)/2
×100%
 Elasticity of supply = % change in 𝑄𝑆 / % change in P
(32−24)
(32+24)/2
𝑥 100%
= (130−120)
(130+120)/2
𝑥 100%
8
56/2
𝑥 100%
= 10
250/2
𝑥 100%
2
7
𝑥 100%
= 2
25
𝑥 100%
4
28 7 %
= 8%

Elasticity of supply = 3.571

Mankiw, #3
Suppose 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 midpoint method in calculations)

Given values: E = elasticity, P = price

𝑃1 = $1. 80
𝑃2 = $2. 20
𝐸1 = 0. 2
𝐸2 = 0. 7
Formula:
𝑃2−𝑃1
%∆𝑃 = (𝑃2+𝑃1)/2
×100%

%∆𝑃:
2.20−1.80
= (2.20+1.80)/2
×100%
0.4
= 4/2
×100%
= 0. 2 ×100%
%∆𝑃 = 20%
 Short Run
∆𝑄0
𝐸1 = ∆𝑃
🡪 ∆𝑄0 = 0. 2 𝑥 20% = 0. 04 𝑜𝑟 4%

Demand will decrease by 4% in the short run

Long Run

∆𝑄0
𝐸2 = ∆𝑃
🡪 ∆𝑄0 = 0. 7 𝑥 20% = 0. 14 𝑜𝑟 14%

Demand will decrease by 14% in the long run

b. Why might this elasticity depend on the time horizon?

Based on calculation, the change in quantity demanded in the long run is significantly
higher than the change in the short run which means that the demand in the long run is
more elastic. This elasticity may have been influenced greatly by time horizon as longer
time period gives more time and opportunity for consumers to adapt and respond or
find an alternative for the said product.

Mankiw, #4
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.

The demand curve is inelastic. In the given example, the total revenue of a good increased by 15
percent even though the quantity demanded of that good decreased by 30 percent. Because of
this, we could deduce that the percentage change in price is higher than the percentage change
in quantity demanded. From our learning in this chapter, when the percentage change in
quantity demanded is less than the percentage change in price, the demand is inelastic.
Moreover, when the total revenue increases because of an increase in price, then a good has an
inelastic demand because of the positive relationship between the total revenue and price.

Mankiw, #6
Suppose that your demand schedule for DVDs is as follows:

a. Use the midpoint method to calculate your price elasticity of demand as the price of DVDs increases
from $8 to $10 if (i) your income is $10,000 and (ii) your income is $12,000.

(i) Use the midpoint method to calculate your price elasticity of demand as the price of DVDs
increases from $8 to $10 if your income is $10,000

Price Quantity Demanded (income $10,000)

$8 40 DVDs
$10 32 DVDs

Midpoint Method for Price elasticity of demand:

𝑄2−𝑄1 32−40
(𝑄2+𝑄1)/2 (32+40)/2
𝑃2−𝑃1 = 10−8
(𝑃2+𝑃1)/2 (10+8)/2
 −8
36
= 2
9

=− 1
Price elasticity of demand = 1
The price elasticity of demand is equal to 1; thus, the price elasticity of demand
is unit elastic demand.

(ii) Use the midpoint method to calculate your price elasticity of demand as the price of DVDs
increases from $8 to $10 if your income is $12,000

Price Quantity Demanded (income $10,000)

$8 50 DVDs
$10 45 DVDs

𝑄2−𝑄1 45−50
(𝑄2+𝑄1)/2 (45+50)/2
𝑃2−𝑃1 = 10−8
(𝑃2+𝑃1)/2 (10+8)/2

2
19
= 2
9

= 0. 474
Price elasticity of demand = 0.474
The price elasticity of demand is between 0 and 1; thus, the price elasticity of
demand is inelastic demand.

b. Calculate your income elasticity of demand as your income increases from $10,000 to $12,000 if (i)
the price is $12 and (ii) the price is $16.

(i) Calculate your income elasticity of demand as your income increases from $10,000 to
$12,000 if the price is $12

Price Quantity Demanded Quantity Demanded

(income $10,000) (income $20,000)
 $12 24 30

%∆ 𝑖𝑛 𝑄𝑑
Income elasticity of demand = %∆ 𝑖𝑛 𝐼

𝑄2−𝑄1
%∆in 𝑄𝑑 = (𝑄2+𝑄1)/2
×100%

30−24
= (30+24)/2
×100%
6
= 27
×100%

𝐼2−𝐼1
%∆in 𝐼 = (𝐼2+𝐼1)/2
×100%

12,000−10,000
= (12,000+10,000)/2
×100%
2,000
= 11,000
×100%
2
= 11
×100%

%∆ 𝑖𝑛 𝑄𝑑
Income elasticity of demand = %∆ 𝑖𝑛 𝐼

6
27
×100%
= 2
11
×100%
= 1. 222

Income elasticity of demand = 1.222

(ii) Calculate your income elasticity of demand as your income increases from $10,000 to
$12,000 if the price is $16

Price Quantity Demanded Quantity Demanded

(income $10,000) (income $20,000)
$16 8 12
 𝑄2−𝑄1
%∆in 𝑄𝑑 = (𝑄2+𝑄1)/2
×100%

12−8
= (12+8)/2
×100%
4
= 10
×100%

𝐼2−𝐼1
%∆in 𝐼 = (𝐼2+𝐼1)/2
×100%

12,000−10,000
= (12,000+10,000)/2
×100%
2,000
= 11,000
×100%
2
= 11
×100%

%∆ 𝑖𝑛 𝑄𝑑
Income elasticity of demand = %∆ 𝑖𝑛 𝐼

4
10
×100%
= 2
11
×100%
= 2. 2

Income elasticity of demand = 2.2

Mankiw, #11
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 and the government wants to reduce smoking by 20 percent, by how
much should it increase the price?

%∆𝑄
Price elasticity of demand = %∆𝑃
 %∆𝑄
0.4 = %∆𝑃

%∆𝑄
%∆P = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑

20
= 0.4

= 50%

The government should increase the price of cigarettes by 50%.

The current cost of a pack of cigarettes is $2; thus:

2 x 0.50 = 1

$2 + $1 = $3

The government should increase the price of cigarettes by 50% ($1) and make
the new price $3.

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?

Hypothetically, if the government permanently increases the price of cigarettes, the

policy will have a larger effect five years from now than one year; meaning, if the price
of cigarettes permanently increases, people will find new alternatives to smoke.
Therefore, although the number of cigarettes demanded will fall, the public will discover
new options to continue smoking.

c. Studies find that teenagers have a higher price elasticity than do adults. Why might this be true?

Most teenagers have smaller incomes than adults, limiting teenagers to what and how
much they can smoke, which is why they are likely to have a higher price elasticity.
Pindyck, #2
Consider a competitive market for which the quantities demanded and supplied (per year) at
various prices are given as follows:

a. Calculate the price elasticity of demand when the price is $80 and when the price is $100.

To calculate the price elasticity of demand, the formula is as follows:

∆𝑄
𝐸𝐷 = ∆𝑃
Based on the given values, the quantity demanded decreases by 2 million whenever
there is a price increase worth $20.
∆𝑄 −2
𝐸𝐷 = ∆𝑃
= 20
=− 0. 1

When the price is $80, the quantity demanded is 20 (million):

∆𝑄 𝑃
𝐸𝐷 = ∆𝑃
𝑥 𝑄

= (− 0. 1) ( ) =− 0. 40
80
20

On another hand, when the price is $100, the quantity demanded is 18 (million):
∆𝑄 𝑃
𝐸𝐷 = ∆𝑃
𝑥 𝑄

= (− 0. 1) ( 100
2180 ) =− 0. 56
b. Calculate the price elasticity of supply when the price is $80 and when the price is $100.

To calculate the price elasticity of supply, the formula is as follows:

 ∆𝑄𝑠
𝐸𝑠 = ∆𝑃

Based on the given values, the quantity supplied increases by 2 million whenever there
is a price increase of $20:
∆𝑄𝑠 2
𝐸𝑠 = ∆𝑃
= 20
= 0. 1

When the price is $80, the quantity supplied is 16 (million):

∆𝑄𝑠 𝑃
𝐸𝑠 = ∆𝑃
𝑥 𝑄𝑠

= (0. 1) ( ) = 0. 50
80
16

And, when the price is $100, the quantity supplied is 18 (million):

∆𝑄𝑠 𝑃
𝐸𝑠 = ∆𝑃
𝑥 𝑄𝑠

= (0. 1) ( ) = 0. 56
100
18

c. What are the equilibrium price and quantity?

Equilibrium price and quantity are found when quantity of goods supplied in the market
and the quantity demanded are equal at the same price. In a graph, the equilibrium can
be found when the demand curve and the supply curve meet at a certain point. Thus,
the equilibrium price for this case is $100 while the equilibrium quantity is 18 million.
d. Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how
large will it be?

When the government set the ceiling price to $80, the supply of goods that will be
produced will only be 16 million while consumers demand 20 million worth of supply of
goods. Hence, the ceiling price of $80 will result to a shortage worth 4 million supply of
goods.
Pindyck, #3
Refer to Example 2.5 (page 59) on the market for wheat. In 1998, the total demand for U.S.
wheat was 𝑄1 = 3244 - 283P and the domestic supply was 𝑄𝑠 = 1944 + 207P. At the end of 1998,

both Brazil and Indonesia opened their wheat markets to U.S. farmers. Suppose that these new
markets add 200 million bushels to U.S. wheat demand. What will be the free-market price of
wheat and what quantity will be produced and sold by U.S. farmers?
Wheat:
𝑄𝑠 = 1944 + 207𝑃 -> Domestic Supply

𝑄1 = 3244 − 283𝑃 -> U.S. Wheat Demand

Brazil and Indonesia add 200 million bushels to U.S. Wheat:

𝑄𝐷 = (3244 − 283𝑃) + 200 = 3444 − 283𝑃

To determine the new equilibrium price:

1944 + 207𝑃 = 3444 − 283𝑃
283𝑃 + 207𝑃 = 3444 − 1944
490𝑃 1500
490
= 490
𝑃 = $3. 061/𝑏𝑢𝑠ℎ𝑒𝑙

Find the new equilibrium quantity:

𝑄𝑠 = 1944 + 207𝑃
= 1944 + 207 (3. 061)
= 1944 + 633. 627
= 2577. 627

𝑄𝐷 = 3444 − 283𝑃
= 3444 − 283 (3. 061)
= 3444 − 866. 263
= 2577. 737
Pindyck, #5
Much of the demand for U.S. 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 percent.

a. U.S. farmers are concerned about this drop in export demand. What happens to the
free-market price of wheat in the United States? Do farmers have much reason to worry?

In finding the market equilibrium price before the drop in export demand, total demand
is equated to domestic supply:

3244 − 283𝑃 = 1944 + 207𝑃

3244 − 1944 = 283𝑃 + 207𝑃
1300 490𝑃
490
= 490
𝑃 = $2. 65

To get the export demand, find the difference between total demand and domestic
demand:
𝑄𝑒: 𝑄 = 3244 − 283𝑃 𝑚𝑖𝑛𝑢𝑠 𝑄𝐷 = 1700 − 107𝑃
𝑄𝑒 = (3244 − 283𝑃) − (1700 − 107𝑃)
𝑄𝑒 =− 1700 + 3244 + 107𝑃 − 283𝑃
𝑄𝑒 = 1544 − 176𝑃
So, export demand was originally 𝑄𝑒 = 1544 − 176𝑃.

After the 40% drop, export demand is only 60% of the original export demand. The new
export demand is:
𝑄𝐸 = 0. 6𝑄𝑒
𝑄𝐸 = 0. 6(1544 − 176𝑃)
𝑄𝐸 = 926. 4 − 105. 6𝑃
New total demand is:
 𝑄 = 𝑄𝐷 + 𝑄𝐸
𝑄 = (1700 − 107𝑃) + (926. 4 − 105. 6𝑃)
𝑄 = 926. 4 + 1700 − 105. 6𝑃 + 107𝑃
𝑄 = 2626. 4 − 212. 6𝑃

To calculate what happens in the free market price, equate total supply and the new
total demand:
1944 + 207𝑃 = 2626. 4 − 212. 6𝑃
212. 6 + 207𝑃 = 2626. 4 − 1944
419. 6𝑃 = 682. 4
419.6𝑃 682.4
419.6
= 419.6
𝑃 = $1. 626
We got a price of $1.626.

The free-market price experienced a massive drop from the original market-clearing
price of $2.65 per bushel to $1.626. Farmers do have a lot to worry about because at
this price, the market-clearing quantity is approximately 2281 million bushels [
𝑄 = 2626. 4 − (212. 6 𝑥 1. 626)]. In relation to this, total revenue will decrease from
about $6609 million to $3708 million [𝑇𝑅 = $1. 626 𝑥 2281 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛)].

b. Now suppose the U.S. government wants to buy enough wheat to raise the price to $3.50 per
bushel. With the drop in export demand, how much wheat would the government have to
buy? How much would this cost the government?
If wheat is priced at $3.50, the market will not be in equilibrium. It can be shown by solving for
the quantity demanded and quantity supplied at this price.
Quantity demanded:
𝑄 = 2626. 4 − 212. 6(3. 50)
𝑄 = 1882. 3
Quantity supplied:
𝑄𝑆 = 1944 + 207(3. 50)
𝑄𝑆 = 2668. 5

Because of this, there will be a surplus of 786.2 million bushels (2668. 5 − 1882. 3).
Moreover, the government must purchase this amount of supply, 786.2 million bushels,
to support a raise of price to $3.50. This would cost the government approximately
$2751.7 million [𝐶𝑜𝑠𝑡 = (786. 2)($3. 50)].