ECONOMICS LESSONS THROUGH Q & A: May 2008

Tuesday, May 6, 2008

THE THEORY OF DEMAND: PART TWO

For Bill, clothing has marginal utility of 20 utils and food has a marginal utility of 20 utils. If clothing costs $4 and food $8, is Bill doing the best he can? If not, what can he do to increase his utility?

MU/P for clothing is 5, for food 2.5. Bill should buy more clothing and less food.

Suppose food costs $12 and clothing costs $2, and at the highest level of utility, clothing has a marginal utility of 6 utils. What is the marginal utility of food?

From the equality of MU/P, MUf/$12 = 6 utils/$2. MUf = 36 utils

If you are taking a test that has several questions, how should you allocate your time among the questions in order to get the highest score?

You should allocate your time so that the last minute spent on each question adds the same number of points to your total score.

Mary buys a Cadillac instead of a Chevrolet. The Cadillac costs exactly twice as much as the Chevrolet. What can we conclude about Mary’s marginal utility of owning a Cadillac relative to owning a Chevrolet?

For Mary, the marginal utility of owning a Cadillac must be twice as high, or higher, as the marginal utility of owning a Chevrolet.

What is wrong with the following statement: “According to the law of diminishing marginal utility, if you consume less food, the marginal utility you receive from the last unit of food goes up. So you will have greater total utility from consuming less food.”

As one less unit of food is consumed, total utility decreases by the unit’s marginal utility. As less food is consumed, the law of diminishing marginal utility states that this loss in total utility becomes bigger.

Bill is maximizing his utility. He is consuming (among other goods) beer, which costs $1 a can, and pretzels, which cost $50 a bag. Which good has the higher marginal utility? What is the ratio of his marginal utilities?

The MU of a can of beer will be twice the MU of a bag of pretzels (the ratio of marginal utilities equaling the ratio of prices).

Suppose the government taxed food and either (1) gave the tax revenues back to Americans in the form of reduced income taxes or (2) gave the tax revenues to a foreign government. In which case (1) or (2) will the demand for food go down more? (Food is a normal good).

In case (2), because the loss in real U.S. income is greater, so the income effect reduces food demand more.

Mary has $12 to spend. She buys two beers (which cost $3 each) and three bowls of chili (which cost $2 each). Then the price of beer falls to $2 and chili’s price goes up $3. How will Mary change her consumption of beer and chili? Does this event reflect a substitution effect, an income effect, or both?

Mary will buy more beer and less chili. Since she could have bought her old quantities at the new prices, her real income has not changed. So this event reflects the substitution effect onl

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

THE THEORY OF DEMAND: PART ONE

Why do we add consumers’ demand curves together horizontally to get the market demand curve?

Because economists want to sum the amounts consumers will buy at each price.

How are total utility and marginal utility related?

Marginal utility is the addition to total utility when one more unit of a good is consumed.

Does a good with a higher total utility also have a higher marginal utility?

The total utility and marginal utility of differing goods need not be related. Water, for example, has a high total utility but a small marginal utility.

What happens to total utility as marginal utility diminishes (as one consumes more of a good)?

As long as marginal utility is positive, when more of a good is consumed, total utility increases.

If the marginal utilities per dollar of two goods are not the same, why will consumers change their consumption pattern?

Because consumers will be better off by consuming more of the good that has the higher marginal utility per dollar. By doing this, they will be gaining more utils per dollar than they are giving up.

What is the substitution effect of a price increase?

The substitution effect is the decrease in the quantity demanded of a good that results when the good’s relative price goes up (holding the consumer’s real income constant).

What is the income effect of a price increase? How does it differ for normal and inferior goods?

The income effect of a price increase is the change in the quantity demanded due to the decrease in real income caused by the price increase. For a normal good, the quantity demanded falls; for an inferior good, it rises.

Is the marginal utility of a candy bar greater to a poor person or a rich person?

Since utility between persons cannot be objectively compared, it is impossible to say.

Bill has spent $300 for a video recorder. He would have been willing to pay $500. What is his consumer surplus?

$200 ($500 - $300) is Bill’s consumer surplus.

Even if consumers could still consume the same goods they have been consuming, why will a change in relative prices cause them to change their consumption pattern?

Those goods whose price fell will now have a higher marginal utility per dollar: Consumers will demand more of these goods.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

Thursday, May 1, 2008

ELASTICITY : PART TWO

a. Compare the effect of a $1,000 tax on cars with the effect of a 10% tax on cars. Which tax is likely to have the same impact on the demand for cars (in percentage terms) no matter which year it was imposed?
b. What does your answer imply about the relative advantages of using slopes or elasticities to predict the impact of a price change?

a. Due to inflation, the $1,000 represents a smaller percentage of car prices over time. When cars were sold for $2,000, the $1,000 in added price meant car prices would go up 50%: we’d expect a huge decrease in demand. When cars sell for $10,000, this is only a 10% increase in price: we expect a smaller decrease in demand. On the other hand, the 10% tax would probably have a similar impact if imposed today or 30 years ago.

b. Inflation does not harm the usefulness of elasticities; this is one reason why economists use them.

a. When the wheat harvest falls by 10% due to bad weather, wheat prices go up 40%. What is the price elasticity of demand for wheat?
b. Using this number, what will happen to the wheat bought by consumers if the government raises the price of wheat by 20%? What happens to the total revenue of wheat farmers?
c. Still using the elasticity from (a) above, what will happen to the price of wheat if the government destroys 10% of the crop? To the total revenues of wheat farmers?

a. o.25 (10%/40%).

b. It will decrease by 5% (-.25x 20%). Total revenues will rise 15% [(1-.25)x 20%]

c. Price will go up 40%. (105/.25); total expenditures on wheat will go up 30%.

Why will tourists likely have a more inelastic demand curve for restaurant food than will “locals”?

Tourists have little time to price shop among substitute restaurants, so their demand curve for any one restaurant is likely to be more inelastic. Tourists also lack the substitute of home-cooked meals.

Why do merchants often have sales (and cut their prices) on air-conditioners in spring and early summer when demand is highest?

In spring and early summer, more people are seeking to buy air-conditioners. This makes the advertising cost per customer lower. With more merchants advertising, customers can more easily price shop. So merchants face a more elastic demand curve for their air-conditioners. This leads them to cut prices (to increase their total revenues), causing sales to occur at these times.

Select from each of these groups the good that is likely to have the highest price elasticity of demand :
Group A : Energy, oil, gasoline, Shell Gasoline, Bill’s Shell Station gas.
Group B : The gasoline bought by truckers, the gasoline bought by week-end drivers.
Group C : Gas bought from Joe, who has no competitors, gas bought from Bill, who has many competitors.
Group D : Eyeglasses from Sid’s Glass Emporium in a state that does not permit advertising, eyeglasses from the same store in a state that does permit advertising.

a. Bill’s Shell Station gas.

b. The gasoline bought by truckers (they have more incentive to price-shop).

c. Bill.

d. The store in the state that permits advertising.

When Titantown Bus Company raised its bus fare, its local revenues fell. When Petrogard Bus Company raised its bus fare, its total revenues went up. When can we conclude about the elasticity of demand for each company?

Tintantown’s demand is elastic; Petrogard’s is inelastic.

Which of these groups do you expect to be complements and which do you expect to be substitutes? What is the likely sign of the cross elasticity of demand?
Group A : Tires and cars.
Group B : Buses and airplanes.
Group C : Coal and oil.
Group D : Hot dogs and hamburgers.

Group A : Complements (negative).

Group B : Substitutes (positive).

Group C : Substitutes (positive).

Group D : Substitutes (positive).

You are president of the American Bicycle Federation and you have been asked to predict how the

sale of American bicycles will do next year (giving the percent change from this year’s sales). Give

your answer using the following facts:

1. The price elasticity of demand for American bicycles is 2.5

2. Their income elasticity is 3.0

3. The cross elasticity of demand with foreign bikes is 4.0

4. American bikes will go up 5% in price, foreign bikes will go up 7% in price, and American income will go up 3%

What will happen to the total expenditures of Americans on American bicycles (which equals the total revenues of the American bicycle makers)?

We sum the effect of price, foreign bike prices, and income: (-2.5x5)+(4x7)+(3x3)= 24.9%. With 24.9% more bikes sold at a 5% higher price, total expenditures will be up (by approximately the percent change) in quantity plus the percent change in price, or 29.9%).

As people earn more income, their food purchases go up but their share of income spent on food goes down. What can we conclude about the income elasticity of food demand?

The income elasticity is positive (since food purchases went up) but less than unity (since food’s share of income went down).

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

ELASTICITY : PART ONE

When economists say that the price elasticity of demand for bananas is 2.0, what do they mean?

They mean that the quantity demanded will increase 2% for every 1% decrease in price.

If consumers of a good are very sensitive to its price, is the good’s demand elastic or inelastic?

Elastic.

If the output demanded is the same regardless of the price, what is the price elasticity of demand?

It is perfectly inelastic.

If one demand curve has a steeper slope than another, is the steeper demand curve more inelastic?

You cannot tell unless the two curves cross. At the crossing point, the steeper curve is the more inelastic.

What is the main factor that increases the elasticity of demand for a good?

The greater availability of substitutes.

When will total revenue go up in the price is reduced?

When the good’s demand is elastic.

If the income elasticity of demand for a good is greater than 1, what will happen to the demand for the good and to the good’s share of people’s income when income goes up?

As income goes up, the quantity demanded will go up and the good’s share in income will go up.

How can one tell if two goods are substitutes? Complements?

Two goods are substitutes if when the price of one goes up, the demand for the other also goes up. Two goods are complements if when the price of one goes up, the demand for the other goes down.

Will firms produce where total revenues are highest?

No. Firms will produce where profits are highest.

If the demand for a good goes up, what will be the immediate supply response? The longer-term supply response?

The immediate supply response will be a small increase in supply (or perhaps no increase). But given time, suppliers will increase the quantity supplied.