ACTUAL QUESTIONS FROM LAST SEMESTER'S MIDTERM

_____7. If the price of tea increases and the demand for sugar decreases then

A) tea and sugar are complements

B) tea is a normal good and sugar is inferior

C) tea and sugar are substitutes

D) tea is an inferior good and sugar is normal

E) tea and sugar are unrelated to each other

_____8. Generally speaking, demand for a good will be more inelastic

A) if few substitutes exist

B) when the good represents a large share of the consumer=s budget

C) in the long run

D) when many substitutes exist

E) if the good is not a necessity

The correct answer to 7 is A. The correct answer to 8 is A.

Here's an exam question you should be able to answer AFTER today:

A. (5 points) At a price of $5 a bushel, 100 bushels of oranges are demanded. When the price drops to $4 a bushel, 150 bushels are demanded. Calculate the price elasticity of demand.

B. (5 points) Is demand elastic or inelastic?

C. (5 points) What happens to total revenue as a result of the price change?

We will attack the concept of elasticity in four different ways: verbal, numerical, graphical, and algebraic.

I. Verbal

elastic = responsive, flexible, sensitive

demand is elastic when a small change in price causes a big change in quantity demanded

price change can be positive or negative

quantity change can be positive or negative

the two changes will have different signs

definition: e = percentage change in quantity divided by percentage change in price

this ratio will always be negative (for demand) but we will take it's absolute value--that is, ignore the sign of the ratio

the price of CDs goes up by 5%
the quantity demanded goes down by 10% .

e= 10% divided by 5% = 2

Or the price of CDs goes down by 6%, the quantity demanded goes up by 12%.

e= 12% divided by 6% = 2

Why do we look at elasticity in percentage terms? Why not just ask what happens if the price of CD's changes by 1 dollar?

Converting to percentage terms allow us to compare the elasticity of different goods--from CDs to heating oil to airline tickets.

Changes in total revenue or expenditure also tell you something about elasticity.

Revenue (this is what the seller calls it) or expenditure (this is what the buyer calls it) is equal to quantity times price.

Think about this from the seller's point of view:

Pretend you are the seller. If you raise the price of something by 10%, does your revenue increase? It depends on the response of buyers--if they don't change the quantity they buy, your total revenue will go up. This suggests that demand is inelastic (not very responsive to price). 

If they reduce the quantity they buy by exactly 10%,("unitary elasticity") your revenue will be unchanged.

If they reduce the quantity they buy by more than 10%, you will lose money.

II. Numerical

If you are given information about an initial price and quantity, and also about a new price and quantity, you should be able to calculate the elasticity AND the change in revenue.

For purpose of simplicity, assume that you calculate the percentage change from the INITIAL prices and quantities.

Example:

ΔP = 3 

ΔQ=1

%ΔP =1 (or 100%) 

%ΔQ= .25 (or 25%)

e=.25

III. Graphical

Some demand curves are more elastic or inelastic overall than others.

A vertical demand curve is perfectly INELASTIC, because Quantity is fixed.

Remember: slope of a line equals rise over run or

A horizontal demand curve is perfectly ELASTIC because Quantity is infinite (imagine a line very close to horizontal and you can see that a very small change in price causes a very large change in quantity.

But remember, slope is defined as

ΔP

ΔQ

while elasticity is defined as

Δ%Q

Δ%P

The percentage change in Q will be small when the initial Q is large (toward the high end of the Q axis)

The percentage change in P will be large when the initial P is small (toward the low or zero end of the P axis).

Small percentage change in Q, combined with large percentage change in P means INELASTIC.

The opposite is true when the initial P is large and the initial Q is small. In this range, demand will be ELASTIC.

IV. And now for some beautiful algebra....

...that enables us to show how you can calculate elasticity if you know the slope of the demand curve

Multiply the expression on the right by QP/QP:

Notice that (ΔQ/ΔP = the reciprocal of the slope of the demand curve, or 1/slope

Price elasticity at any point along a straight line demand curve equals the ratio of price to quantity at that point times the reciprocal of the slope of the demand curve.

NOTE THAT THERE IS A MISTAKE IN THE FORMULA FOR THIS ON P. 126 OF THE TEXT.

Some hints for the following homework question:

If market forces are efficient, why would you ever want to interfere with them?

You might disagree with the way efficiency is defined.

You might care about things other than efficiency (truth? justice? compassion? beauty? )