# Chapters 5-6

Extra Stuff. . Chapter 5 . . Chapter 6
Answers to Questions as They Appeared In July, 2006

# Chapter 5 Elasticity

1. When you cut through all the economic jargon, elasticity is simply a description of stimulus-response patterns--how high will you jump if I pinch you. In fact, the formula for any elasticity measurement is:

(percentage change in response) divided by (percentage change in stimulus).

When I say something mildly rude to my sister-in-law, she blows up. A small stimulus leads to a big response--an economist would say that this situation is very elastic. On the other hand, my brother-in-law never reacts much at all no matter what I say--even a big stimulus prompts only a small or inelastic response.

a) In 2005 and 2006 there was a substantial rise in oil prices. If you are OPEC, do you want consumers to respond a little or a lot to the stimulus of higher gasoline prices? Explain. Then put this in the economic jargon of elasticity.

Only a little--you want people to continue driving--you want inelastic demand

b) Suppose that you are leading a campaign to reduce teenage smoking and you want to tax cigarettes more. Do you want teenagers to respond a little or a lot to the tax? Explain. Then use the economic jargon of elasticity to restate this situation.

A lot--you want to curb smoking--you want elastic demand

c) Suppose that you are legislator trying to balance a budget and you are raising the tax on cigarettes. Do you want smokers to respond a little or a lot? Explain. Then use the economic jargon of elasticity to restate this situation.

Only a little--you want inelastic demand

d) Suppose that you are a college president who has just raised tuition. Do you want students to respond a little or a lot to the stimulus of higher prices? Explain. Then use the economic jargon of elasticity to restate this situation.

Only a little--if they respond a lot, you will have few students next fall--you want inelastic demand

e) Suppose you are an automobile manufacturer who has just offered a rebate on some of your car models. Do you want the public to respond a little or a lot to the stimulus of lower prices? Explain. Then use the economic jargon of elasticity to restate this situation.

A lot--you want buyers to be rushing to your dealers--you want elastic demand

2. The demand curve is the relationship between the amount of a product that people are willing to buy and the price of the product. An Engel curve is the relationship between the amount of a product that people are willing to buy and their income. An Engel curve is shown below.

a) Does the Engel curve in the graph illustrate an inverse or direct relationship? direct

b) Will the income elasticity of shirts be positive or negative with this Engel curve? positive

c) If this curve were sloped the other way, so that the relationship were inverse, shirts would be an inferior good.

d) If the curve were vertical, how many more shirts would a person buy if he got an extra \$5000 in income? none

e) A vertical Engel curve will have an elasticity of zero.

f) If the price of shirts rose, what would happen to the Engel curve? Shift left. At each level of income, people would buy fewer shirts.

g) What is the only change that can increase the number of shirts people will buy, but will not move the Engel curve at all? A change in income. It moves people along the Engel curve.

## Various Elasticities: A Review

3. The text discusses four types of elasticity: price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross-price elasticity. (There are many others possible--wherever there is a stimulus-response pattern that can be measured, there is a possible elasticity.) In the following hypothetical cases, identify the stimulus and the response, and then decide what type of elasticity is being described.

a) The price of gasoline rises 50% and the sale of cars drops by 10%.

Stimulus: price; Response quantity of a different good; this is cross-price elasticity

b) The income of Chinese workers rises by 50% and their purchases of new cars rises by 40%.

Stimulus: income; Response quantity; this is income elasticity

c) The price of gasoline rises by 50% and people buy 20% less.

Stimulus: price; Response quantity demanded; this is price elasticity of demand

d) The price of gasoline rises by 50% and gasoline production rises by 10%

Stimulus: price; Response quantity supplied; this is price elasticity of supply

e) Bread and butter are complements because a 10% increase in the price of butter reduces the sales of bread by 2%

Stimulus: price; Response quantity of a different good; this is cross-price elasticity

f) Shoe repair is an inferior good because as income goes up by 20%, the numbers of shoes repaired goes down by 1%.

Stimulus: income; Response quantity; this is income elasticity

g) A 5% rise in the price of cotton causes farmers to plant 10% more acres in cotton.

Stimulus: price; Response quantity supplied; this is price elasticity of supply

h) A 10% rise in the price of gasoline reduces the amount people buy only 1% in the short run but by 8% in the long run.

Stimulus: price; Response quantity demanded; this is price elasticity of demand

4 (Now JavaScript) Below is a demand curve. From it, compute total revenue and marginal revenue.

 Output Price Total Revenue Marginal Revenue 1 \$9 \$9 \$9 2 7 \$14 \$5 3 5 \$15 \$1 4 4 \$16 \$1 5 3 \$15 -\$1

5. (Now JavaScript) Below is a table showing sales and marginal revenue. Compute total revenue and average revenue.

 Sales Marginal Revenue Total Revenue Average Revenue 1 \$12 \$12 \$12 2 11 23 11.5 3 10 33 11 4 9 42 10.5

6. After six semesters of college, Greta Grouch had a grade-point average of 3.25. After her seventh semester her grade-point average dropped to 3.20. What can you tell about her grades for the seventh semester?

They were below 3.2. If average is falling, marginal must lie below.

7. Marginal revenue and elasticity are related. Let us see if you can figure out how they are related in the following situations:

a) If the firm is a price taker, it faces a perfectly flat demand curve. This demand curve is perfectly elastic; that is, its elasticity is infinity. What is true of the marginal revenue relative to price in this case? (Hint: Use the equation that links marginal revenue and elasticity.)

Price is the same as marginal revenue.

b) If elasticity is unitary elastic (hat is, has a value of 1), what will be the value of marginal revenue?

zero (0)

c) If elasticity is less than 1, what range of values can marginal revenue take? In this case, what will happen to total revenue if the firm sells more by cutting price?

It is negative; if the firm cuts price, people do not respond very much, and revenue falls.

d) If elasticity is greater than 1, what range of values can marginal revenue take? In this case, what will happen to total revenue if the firm sells more by cutting price?

It is positive; if the firm cuts price, people respond a lot, and revenue rises.

e) (Now JavaScript) Fill in the following table, putting in the words "increase," "decrease," and "stay the same" where they belong.

 IF and the firm increases sales, total revenue will: and the firm decreases price, total revenue will: e < 1 decrease decrease e = 1 stay the same stay the same e > 1 increase increase

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Extra Stuff . . Chapter 5 . . Chapter 6

# Chapter 6 Allocating and Rationing

1. "Such staples as milk, rice, coffee, meat, and even sugar, are rationed. So are some consumer items such as clothes and cloth. U.S. officials often cite the very existence of rationing as proof of Cuba's economic failure. In fact, the system has little to do with shortages. It was introduced in 1962, when the U.S. embargo helped create true scarcity. It exists today as a social program." ("Under Castro, The System Is Broken--But Working," Chicago Tribune, Sunday, May 18, 1986, Section 1, page 14) An economist would say that the author does not understand the difference between scarcity and shortages. Explain.

Scarcity exists both in the United States and Cuba. It simply means that people want more than they can have. Shortages result when prices are not allowed to ration. This is not a passage anyone who knows a bit of economics would want to claim. It seems to deny that price controls create shortages.

2. In the late 1970s, gasoline prices were rising rapidly and there was considerable public support for proposals to set a price ceiling and issue ration coupons. Supporters of rationing wanted to ration gasoline on the basis of "need," but were not in agreement on how need could be measured for the actual distribution of coupons. Some bases for distribution include the number of cars a household has, the number of licensed drivers a household has, equally to all households or persons, and the number of miles each household must drive to work. Explain why some people would consider each of these bases unfair. Can you think of a method that you believe is clearly superior to any of the above methods?

This is a good discussion questions.

When price controls were being discussed in the 1970s, I found that my non-economist acquaintances had great faith that even though they might not be able to administer controls, there were experts out there who could. If we got the right people to do it, everything would be OK. They did not want to listen to my objections. They just upset with me when I tried to point out that there were serious problems in implementing controls.

Need not only cannot be measured accurately, the very notion of need is questionable. If one bases need on the number of cars a household has, one will find cases of a household with two individual who hardly ever drive but who have five cars. Should they get more gas than a household of five drivers who drive a lot and have only two cars?

3. Search Google news for the topic "water rights." Can you find any interesting conflicts over water that are in the news? (It is likely that you will because many states have laws that make no sense either from a hydrologic or economic point of view. As a result, conflicts and confusion are inevitable.) (Comment: A whole economics course could be developed around the issue of water rights.)

4. There are a number of places in which our society does not allow a market to function. There is no legal market for babies, for example (although there are markets for sperm, eggs, and wombs for rent). Markets for transplantable organs are also not legal. You cannot, for example, sell a kidney on ebay. What would be the advantage of allowing markets to function freely in these areas? On the other hand, what is the case for prohibiting these markets from forming?

You may learn more about the market for human organs on the internet. Search for "organ trafficking" in both the web and in news. Where do the markets for human organs seem most active? How widespread are they? Can you find the current market value of a kidney?

(The web site marginalrevolution.com likes to find strange markets. Visit is and see if they have found anything strange lately.)

4. Is income today distributed more or less equally than it was in 1978? You can find out by updating the income distribution table in the reading. If you cannot find the data you need elsewhere, you should be able to find them here:

During the administration of Ronald Reagan, people noted that the data suggested that income distribution was becoming less equal and they blamed the policies of Ronald Reagan for this change. Look at the data and find the year in which income seems to be most equal. What has happened since? Does the trend towards inequality begin at or after the time Reagan became president? Does it stop when he left office? Does the trend toward inequality seem to be something that Reagan caused?

They should find that income distribution is less equal now than in 1978. The inequality has grown shows no respect for presidential administrations.

5. Search the internet for "Gini coefficient." What is it and what does it have to do with this section?

Gini coefficient is a number that measures inequality.

6. In the past usury laws were common. A usury law establishes a price ceiling for interest rates, and anyone who charges more is guilty of being a loan shark.

a) Use supply and demand to show what will happen in the market if the legal rate is below the equilibrium rate.

There will be a shortage.

b) The case against usury laws usually assumes that people are rational, that is, they have well-defined goals and act to attain those goals as best they can. Why do usury laws look bad when we make this assumption?

If people know what is best for themselves, why should the government keep them from acting?

c) Some people reject the assumption that people are rational as economists assume. They argue that some people have self control problems and are compulsive spenders who ignore the long-run consequences of their actions. Even though they may be legally adult, they still cannot act in a responsible, adult manner. Others people are stupid and are easily duped by people who are smarter and more cunning than they are. If you view people in this way, why might usury laws look beneficial?

If people are stupid, they may benefit if we protect them from their own stupidity.

d) What view do you take?

7. Search the web for "payday loans." You should find sites of companies that make these loans as well as a few sites that are critical of them. How do payday loans work? What is the argument that they are socially useful? What is the argument that they should be curtailed or more tightly regulated?

Answers will vary. But if people know what is best for themselves, they will use them when they really need them. If people are stupid or compulsive, they will be duped and exploited.

8. (Now JavaScript) Decide whether each of the following cases of feedback represents positive or negative feedback.

a. The temperature rises as the furnace runs; as the temperature rises, the furnace turns off. N
b. A teacher praises a child when she performs well; the child performs well when she is praised. P
c. A valve releases more steam as the pressure rises; the pressure drops as steam is released. N
d. When less gasoline is available, the price rises; when price rises, people use less gasoline. N
e. When Joe studies more, he gets higher test scores; as he gets higher test scores, he studies less. N
f. When wood burns, it creates heat; when heated, wood burns more readily. P
g. When income goes up, people spend more; when people spend more, income goes up. P

9. In competitive markets higher-than-normal profits cause more people to enter the industry and lower-than-normal profits cause people to leave the industry. Let's test your web-searching ability. Search for the pair of words "grapefruit" and "Lipitor." Based on what you find, should people be leaving or entering the grapefruit industry? Then do a search on "grapefruit production statistics" to see what is happening. When will the industry stabilize?

Grapefruit is not recommended for uses of Lipitor. People are leaving the grapefruit industry. When enough have left, normal profits will be re-attained and the market will stabilize.

10. In the distant past when Hong Kong was a very poor city, people used rickshaws instead of taxis. The rickshaw was a human-powered vehicle, and labor was at this time very cheap in Hong Kong. Many people from Europe, unaccustomed to the very low wage level of Hong Kong, paid much more than the going rate for rickshaw rides. You may be tempted to say that this was good for the rickshaw drivers, and in the short-run it might have been. But once you allow for entry and exit, what adjustment should these very generous payments cause? Explain why in the long run these generous payments had no effect on the income of of the average rickshaw driver. (Adapted from David Friedman, Hidden Order: The Economics of Everyday Life, 1996)

High initial profits attracted more people into the industry. They continued entering until there was normal profit, which meant that there were a lot of idle rickshaw operators.

11. The same analysis can be applied to crop subsidies. If the government guarantees the price of corn, who will benefit in the long run, the farmer or the owner of the land? (Comment: Farmers often cultivate land that they do not own.)

High grain prices attract more farmers, who bid up the price of the land. In the long run all the benefits go to those who own the land on which the crop can be grown and none goes to the actual farmer of the land. (Of course, if they are the same person, it does not matter. But often they are not.)

Extra Stuff . . Chapter 5 . . Chapter 6