# Answers to Questions in Chapter 2

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## Answers to Questions in Chapter 2

Note: No. before  indicates a page number
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45  Assume that there are 200 consumers in the market. Of these, 100 have schedules like Rachael’s and 100 have schedules like David’s. What would be the total market demand schedule for potatoes now?

 Price Total Market Demand 4 4400 8 2600 12 1400 16 800 20 600

46  1. How much would be demanded at a price of 60c per kilogram?

Reading off from the graph: at a price of 60c per kg, total market demand is 600 000 tonnes per month (or a little under).

46  2. Assuming that demand does not change from month to month, plot the annual market demand for potatoes.

The amount demanded would be 12 times higher at each price. If the scale of the horizontal axis were unaltered, the curve would shift way out to the right. A simple way of showing the new curve, therefore, would be to compress the scale of the horizontal axis. (If each of the numbers on the axis were multiplied by 12, the curve would remain in physically the same position.) 46  1. Draw Rachael’s and David’s demand curves for potatoes on one diagram. Note that you will use the same vertical scale as in Figure 2.1, but you will need a quite different horizontal scale.

This is shown in Diagram 2.1 opposite.

46  2. At what price is their demand the same?

The two curves cross at a price of 10p per kg and at a demand of 10 kg per month.

46  3. What explanations could there be for the quite different shapes of their two demand curves?

One explanation could be that Rachael is quite happy to eat rice, pasta or bread instead of potatoes. Thus when the price of potatoes goes up she switches to these other foods, and switches to potatoes when the price of potatoes comes down. David, by contrast, may not see these other foods as close substitutes and thus his demand for potatoes will be less price sensitive. (See section 2.4 on elasticity.)

47  Do all these six determinants of demand affect both an individual’s demand and the market demand for a product?

All except the distribution of income. The (national) distribution of income simply affects an individual’s income and thus is not a separate determinant from income. Diagram 2.2 Market demand for potatoes (monthly)

48  1. Assume that in Table 2.1 the total market demand for potatoes increases by 20 per cent at each price - due, say, to substantial increases in the prices of bread and rice. Plot the old and the new demand curves for potatoes. Is the new curve parallel to the old one?

See Diagram 2.2 opposite. As you can see, the curves are not parallel. A constant percentage increase in quantity demanded gives a bigger and bigger absolute increase as quantity increases.

48  2. The price of pork rises and yet it is observed that the sales of pork increase. Does this mean that the demand curve for pork is upward sloping? Explain.

No not necessarily. For example, the price of substitutes such as beef, chicken or lamb may have risen by a larger amount. In such cases the demand curve for pork will have shifted to the right. Thus although a rise in the price of pork will cause a movement up along this new demand curve, more pork will nevertheless be demanded because pork is now relatively cheaper than the alternatives.

50  1. How much would be supplied at a price of 14c per kilo?

About 430 000 tonnes per month.

50  2. Draw a supply curve for farmer X. Are the axes drawn to the same scale as in Figure 2.3?

The supply curve for farmer X will merely plot the relevant two columns from Table 2.2. The vertical axis can be drawn to the same scale as in Figure 2.3, but a different scale will have to be used for the horizontal axis (e.g. tonnes rather than thousands of tonnes).

51  1. For what reasons might the supply of potatoes fall?

Examples include:

• The cost of producing potatoes rises.

• The profitability of alternative crops (e.g. carrots) rises.

• A poor potato harvest

• Farmers expect the price of potatoes to rise (short-run supply falls).

51  2. For what reasons might the supply of leather rise?

Examples include:

• The costs of producing leather fall.
• The profitability of producing alternative products decreases.

• The price of beef rises.

• A long-running industrial dispute involving leather workers is resolved.

• Producers expect the price of leather to fall (short-run supply increases).

52  This question is concerned with the supply of oil for the generation of electricity. In each case consider whether there is a movement along the supply curve (and in which direction) or a shift in it (and whether left or right).

(a) New oil fields start up in production. (b) The demand for electricity rises. (c) The price of gas falls. (d) Oil companies anticipate an upsurge in demand for oil in electricity generation. (e) The demand for petrol rises. (f) New technology decreases the costs of oil refining.

(a) Shift right.

(b) Movement up along (as a result of a rise in price).

(c) Movement down along (as a result of a fall in price resulting from a fall in demand as suppliers switch to coal fired stations).

(d) Shift left (if companies want to conserve their stocks in anticipation of a price rise).

(e) Shift right (more of a good in joint supply is produced).

(f) Shift right.

53  Explain the process by which the price of houses would rise if there were a shortage.

People with houses to sell would ask a higher price than previous sellers of similar houses (probably with the advice of a real estate agent). Potential purchasers would be prepared to pay a higher price than previously in order to obtain the type of house they wanted.

54  What would happen to price and quantity if the demand curve shifted to the left? Draw a diagram to illustrate your answer.

Both price and quantity will fall. Imagine in Figure 2.6 that the original curve were D2 and that it shifted to D1. Price would fall from Pe2 to Pe1 and quantity would fall from Qe2 to Qe1.

55  What will happen to the equilibrium price and quantity of butter in each of the following cases? You should state whether demand or supply (or both) have shifted and in which direction. (In each case assume ceteris paribus.)

(a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the price of bread; (d) A rise in the demand for bread; (e) An expected rise in the price of butter in the near future; (f) A tax on butter production; (g) The invention of a new, but expensive, process for removing all cholesterol from butter plus the passing of a law which states that all butter producers must use this process.

(a) Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes).

(b) Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply).

(c) Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods).

(d) Price rises, quantity rises (demand shifts to the right: bread and butter are complementary goods).

(e) Price rises, quantity rises or falls depending on relative sizes of the shifts in demand and supply (demand shifts to the right as people buy now before the price rises; supply shifts to the left as producers hold back stocks until the price does rise).

(f) Price rises, quantity falls (supply shifts to the left).

(g) Price rises, quantity rises or falls depending on the relative size of the shifts in demand and supply (demand shifts to the right as more health-conscious people start buying butter; supply shifts to the left as a result of the increased cost of production).

58  Will a general item of expenditure like food or clothing have a price-elastic or inelastic demand? (Consider both the determinants we have considered so far.)

The income effect will be relatively large (making demand relatively elastic). The substitution effect will be relatively small (making demand relatively inelastic) The actual elasticity will depend on the relative size of these two effects.

58  Demand for oil might be relatively elastic over the longer term, and yet it could still be observed that over time people consume more oil (or only very slightly less) despite rising oil prices. How can this apparent contradiction be explained?

Because there has been a rightward shift in the demand curve for oil. This is likely to be the result of rising incomes. Car ownership and use increase as incomes increase. Also tastes may have changed so that people want to drive more. There may also have been a decline in substitute modes of transport such as rail transport and buses. Finally, people may travel longer distances to work as a result of a general move to the suburbs.

60  Assume that demand for a product is inelastic. Will consumer expenditure go on increasing as price rises? Would there be any limit?

So long as demand remains inelastic with respect to price, then consumer expenditure will go on rising as price rises. However, if the price is raised high enough, demand always will become elastic.

61  Can you think of any examples of goods which have a totally inelastic demand (a) at all prices; (b) over a particular price range?

(a) No goods fit into this category, otherwise price could rise to infinity - but people do not have infinite incomes!

(b) Over very small price ranges, the demand for goods with no close substitutes may be totally inelastic.

61  To illustrate these figures, draw the demand curve corresponding to the following table.

 P Q TE \$2.50 400 \$1000 \$5 200 \$1000 \$10 100 \$1000 \$20 50 \$1000 \$40 25 \$1000

The curve will be a ‘rectangular hyperbola’: it will be a smooth curve, concave to the origin which never crosses either axis. (See Figure 2.13 (c) in text.)

If the curve had an elasticity of -1 throughout its length, what would be the quantity demanded (a) at a price of \$1; (b) at a price of 10c?

(a) 1000 units.

(b) 10 000 units.

62  (Box 2.1) 1. Why may a restaurant charge very high prices for wine and bottled water and yet quite reasonable prices for food?

Because the demand for food is relatively elastic: people may well compare restaurant food prices when deciding where to eat. The demand for drinks in restaurants, however, is likely to be relatively inelastic. People’s decision where to eat is unlikely to be influenced by drink prices. Then, once people are eating in a restaurant, there is no alternative supply of drinks to the restaurant’s own. People either have to pay the high prices or go without.

62  (Box 2.2) 2. Why are clothes with designer labels so much more expensive than ‘own brand’ clothes from a chain store, even though they may cost a similar amount to produce?

Because fashion is an important determinant of demand. The more fashionable a product, the higher will be the demand, and the less elastic will be the demand, at any given price. Thus it is profitable for shops to charge higher prices for fashion products than for own brand products.

61  (Box 2.2) 1. Think of some advertisements which deliberately seek to make demand less elastic.

Those that strongly promote a brand, so that in the consumer’s mind there is no close substitute.

61  (Box 2.2) 2. Imagine that ‘Sunshine’ sunflower margarine, a well-known brand, is advertised with the slogan, ‘It helps you live longer’. What do you think would happen to the demand curve for a supermarket’s own brand of sunflower margarine? Consider both the direction of shift and the effect on elasticity. Will the elasticity differ markedly at different prices? How will this affect the pricing policy and sales of the supermarket’s own brand?

It depends on the extent to which the consumer is led to believe that sunflower margarines generally help you to live longer, in which case the demand for the supermarket’s brand is likely to shift to the right and become less elastic as consumers are less prepared to switch to non-sunflower margarines. If, however, the consumer was led to believe that it was specifically ‘Sunshine’ margarine that made you live longer, then the demand for the supermarket’s brand (and all others) will shift to the left.

63  How else could you have worked out that the elasticity of demand is 1 between P=6 and P=4?

Because total expenditure is unchanged at \$120. Demand increases in exactly the same proportion that price falls.

63  Referring to Table 2.4, use the mid-point formula to calculate the price elasticity of demand between (a) P = 8 and P = 6; (b) P = 4 and P = 2. What do you conclude about the elasticity of a straight-line demand curve as you move down it?

Using the formula: (Q/mid Q)  (P/mid P) gives the following answers:

(a) 10/15  –2/7

= .67  .29

= 2.3 (which is elastic)

(b) 10/35  2/3

= .29  .67

= -0.43 (which is inelastic)

The elasticity decreases as you move down a straight-line demand curve.

64  (Box 2.3) 1. Estimate the price elasticity of demand between 8c and 10c and between 10c and 12c.

The mid-point formula (see pages 62-3 of the text) for price elasticity is Qd/average Qd  P/average P.

Thus between 8c and 10c, price elasticity equals –2/5  2/9

= –9/5 = –1.8 (elastic)

And between 10c and 12c, price elasticity equals –1/3.5  2/11

= –11/7 = –1.57 (elastic)

64  (Box 2.3) 2. Was the 10c fare the best fare originally?

No. A profit of \$400 000 – \$360 000 = \$40 000 was made. At a price of 8c, however, a higher profit of \$480 000 – \$360 000 = \$120 000 could have been made.

64  (Box 2.3) 3. The company considers lowering the fare to 6c, and estimates that demand will be 81/2 million passenger kilometres. It will have to put on extra buses, however. How should it decide?

If it lowers the price to 6c, the revenue will rise to \$510 000 (6c  8.5m). But putting on extra buses will also increase costs. It will only, therefore, be worth lowering the price if the increase in revenue is greater than the increase in costs. (See Chapter 5, section 5.6 of the text.)

65  Given the following supply schedule:

 P: 2 4 6 8 10 Q 0 10 20 30 40

(a) Draw the supply curve.

(b) Using the arc method calculate price elasticity of supply (i) between P=2 and P=4; (ii) between P = 8 and P = 10.

(c) Does the elasticity of the supply curve increase or decrease as P and Q increase? Why?

(d) What would be the answer to (c) if the supply curve had been a straight line but intersecting the horizontal axis to the right of the origin?

(a) The supply curve will be an upward sloping straight line crossing the vertical axis where P = 2.

(b) (i) Using the formula Q/average Q  P/average P, gives:

10/5  2/3 = 3

(ii) 10/35  2/9 = 1.29

(c) The elasticity of supply decreases as P and Q increase. It starts at infinity where the supply curve crosses the vertical axis (Q = 0 and thus P/Q = ).

(d) No. At the point where it crossed the horizontal axis, the elasticity of supply would be zero (P = 0 and thus P/Q = 0). Thereafter, as P and Q increased, so would the elasticity of supply.

66  (Box 2.4) Would you expect the demand for developing countries’ raw material exports to grow rapidly or slowly over time? Does their growth over time give a good indication as to their income elasticity of demand?

Slowly, because of the development of artificial substitutes (e.g. plastics for metal and rubber). Such developments therefore make the income elasticity of demand seem lower than it really is.

67  Which are likely to have the highest cross elasticity of demand: two brands of coffee, or coffee and tea?

Two brands of coffee, because they are closer substitutes than coffee and tea.

68  The income elasticity of demand for good x is 0.5 and that for good y is 2.0. Over a given period income rises by 10%. Compare the effect on the sales of the two goods, ceteris paribus.

Sales of x will rise by 5% and those of y will rise by 20%.