Transcript Answer - Fabio Landini

Demand, Supply and Elasticity:
Applications and Exercises
Lecture 3 – academic year 2014/15
Introduction to Economics
Fabio Landini
Ex. 3.1 – The lottery
Question
Suppose you win 100 € at the lottery. You can
spend all the money in beers or invest them at
5%. How much does it cost to spend the money
you win in beers?
Hint: Reason in terms of opportunity cost…
Ex. 3.1 – The lottery
Answer
By investing 100 € today you would obtain 105 €
tomorrow.
Therefore: the opportunity cost of beer is 105 €,
that is the amount of money you renounce to
buy beers.
Ex. 3.2 – Product development
Question
A company invested 5 mln. € to develop a new product,
expecting an equal return from the investment.
Problem: 5 mln are not enough to complete the product, 1
mln more is needed.
Moreover: competition reduces the expectation to just 3
mln € sales.
Is it more convenient to stop or to continue the
commercialization of the product?
Hint: Reason in terms of MB vs. MC
Ex. 3.3 – Product development
Answer
It is convenient to continue, because MC < MB
MC = 1mln €
MB = 3mln €
In this way you can contain losses…
If the company stops: costs = 5mln €, revenues =
0mln € => losses = 5mln €
If the company continues: costs = 6mln €, revenues
= 3mln € => losses = 3mln €
Ex. 3.3 – Demand and Supply I
Question
Use the Demand & Supply model to answer the
following questions:
i) When a chill hits Sicily, what happens to the price of
oranges in Italy? Increases or decrease?
ii) When UK benefits of a mild winter, what happens to
the price of hotel rooms in Costa Brava? Increase or
decrease?
iii) When a war breaks out in Middle East, what
happens to the price of petrol an second-hand
Cadillac in US? Increase or decrease?
Ex. 3.3 – Demand and Supply I
Answer (i)
Price of
organges
Supply curve, S2
Supply curve, S1
Decrease in
supply
Price after
the chilling
Price before
the chilling
Demand curve
0
Quantity of oranges
Ex. 3.3 – Demand and Supply I
Answer (ii)
In this case mild winter in UK and hotel rooms in Costa
Brava are SUBSTITUTE goods.
The nice weather reduces the UK’s demand for holidays
abroad, and thus it diminishes the demand on the
market for hotel rooms in Costa Brava.
Ex. 3.3 – Demand and Supply I
Price of rooms in
Costa Brava
Supply
P1
Initial equilibrium
D1
0
Q1
Demand for rooms
in Costa Brava
Ex. 3.3 – Demand and Supply I
Price of rooms in
Costa Brava
1. The nice weather reduces the
demand for holidays abroad
Supply
P1
P2
2. … which causes
a reduction in
price
Initial equilibrium
New equilibrium
D1
D2
0
Q2
3. …and a reduction in
the quantity sold.
Q1
Demand for rooms
in Costa Brava
Ex. 3.3 – Demand and Supply I
Answer (iii)
The price of petrol increases, because the supply of oil
from the countries that take part to the conflict reduces.
The value of second-hand Cadillac reduces remarkably,
because they consume a lot of petrol. All wants to buy
cars that consumes less petrol. Cadillac and petrol are
COMPLEMENYTARY goods.
Ex. 3.4 – Demand and Supply II
Question
The market for cheese is characterized by the following
demand and supply curve:
Demand: QD= 9 – P
Supply: QO= 3P – 3
where P represent the price (in Euro per Kg.) and Q
represent the quantity (in Kg.).
How do the demand curve and supply curve look like
(draw)? Which is the value of the equilibrium prices and
quantities?
Ex. 3.4 – Demand and Supply II
Solution:
Both the demand and supply curves are straight
lines of the type y = a + bx , where y=Q and x=P .
For instance, in our case:
– for the demand: a = 9 and b= – 1
– for the supply: a = – 3 and b= 3
Important: Usually, the two curves are drawn with
P on the vertical axis and Q on the horizontal axis.
Ex. 3.4 – Demand and Supply II
Price of
cheese
If QD is equal zero, the
price P is equal to 9
9
If the price
P is equal to
zero, the QD
is equal to 9
D
9
Quantity of cheese
Ex. 3.4 – Demand and Supply II
Price of
cheese
If the price P is equal to
5, the QO is equal to 12
S
5
1
The the QO is equal to
zero, the price P is
equal to 1
12
Quantity of cheese
Ex. 3.4 – Demand and Supply II
To find the equilibrium price
and quantity you must
compute the intersection
point of the two lines.
Algebraically, this problem
involves the solution of a
system of two equations:
 Q 9P

Q  3  3  P
Ex. 3.4 – Demand and Supply II
Which can be solved by the mean of standard
substitution:
QD = 9 – P
QO= 3P – 3
Therefore, 9 – P = 3P – 3, from which we get:
P= 3 and Q = 6
Ex. 3.4 – Demand and Supply II
Price of
cheese
In equilibrium QD = QD = 6,
while price P is equal to 3
S
3
D
6
Quantity of
cheese
Ex. 3.5 – Elasticity I
If the % variation in quantity is smaller than the %
decrease in price, the value of E(p) is:
a) > 1 ;
b) < 1 ;
c) = 1.
If the quantity demanded is constant after a change
in the level of price, the value of E(p) is:
a) > 1 ;
b) < 0 ;
c) none of the above.
Ex. 3.6 – Elasticity II
For each of these pair of goods say which good has
the most elastic demand?
(a) Textbooks vs. Science fiction books
Answer: Science fiction books, because they are
“luxury” goods. Textbooks are necessary for most
young people
b) Beethoven’s CD vs. Classical CD in general
Answer: Beethoven’s CD. Beethoven and Brahms are
closer substitute than a classical and a jazz CD
Ex. 3.6 – Elasticity II
(c) Fuel in the short period (6 months) vs. petrol in the
long period (5 years)
Answer: Petrol in the long period. In the short period D
for fuel in inelastic, it is determined by the
technological conditions (given cars and industry) and
weather (heating). In the long period D for fuel is
instead relatively elastic (technological constraint are
lessened)
(d) Beer vs. water
Answer: Beer. Water is a necessary goods, whereas
beer is a “luxury” goods (it has many substitutes)
Ex. 3.7 – Travellers
Hp.: business men and tourists have the following
demand for flight tickets on route New York-Boston
Qd –
Business men
150
2100
Price
Qd Tourists
1000
200
2000
800
250
1900
600
300
1800
400
Ex. 3.7 – Travellers
Question:
1) Compute the elasticity for the two categories
of travellers
2) Which one of the two categories is
characterized by a less elastic demand? Why?
Ex. 3.7 – Travellers
Solution
ED(p) is computed as the ratio between the percentage
variation in the quantity demanded and the
percentage variation in price.
(q1 - q 0 )/q 0
ED(p) = (p1 - p 0 )/p 0
Ex. 3.7 – Travellers
1) Business men
Numerator: (2000 - 2100) / 2100 = - 0,048
Denominator: (200 - 150) / 150 = 0,33
ED(p) Business men is – (– 0,048/0,33) = 0,14
Ex. 3.7 – Travellers
2) Tourists
Numerator: (800 - 1000) / 1000 = - 0,2
Denominator: (200 - 150) / 150 = 0,33
ED(p) tourists is – (– 0,2/0,33) = 0,60
Ex. 3.7 – Travellers
The price elasticity for business men is LOW: if
the price increase/decrease by nearly 30 %, the
quantity demanded decrease/increase by 4%
The price elasticity for tourists is HIGH (>1): if
the price increase/decrease by nearly 30 %, the
quantity demanded decrease/increase by 22%
Ex. 3.7 – Travellers
Why?
For those who travel for business reasons the
demand for flight is LESS ELASTIC: the
commitments to travel cannot be easily modified
even if the price changes.
For tourists the demand for flights is MORE
ELASTIC: the choice of the flight can be made in
order to have more convenient prices, without fixed
dates
Ex. 3.8 – Tom & Jerry
Question:
Tom and Jerry go to the petrol station. Tom
always demand 10 litres without even looking at
the price. Jerry always demand 10 euro of
petrol. Which is Tom’s and Jerry’s ED(p) ?
Ex. 3.8 – Tom & Jerry
Answer:
Tom’s ED(p) is equal zero, since he wants the
same quantity regardless of the price. Jerry’s
ED(p) is 1, since he spends the same amount on
gas, no matter what the price, which means his
percentage change in quantity is equal to the
percentage change in price.