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Demand, Supply and Elasticity: Applications and Exercises
Lecture 3 – academic year 2015/16Introduction to Economics
Dimitri Paolini
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 developmentQuestion
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 is needed.Moreover: competition reduces the expectation reduces the expectations 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 < MBMC = 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 IQuestion
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 IAnswer (i)
Price of organges
Quantity of oranges0
Decrease in supply
Supply curve, S2 Supply curve, S1
Demand curve
Price before the chilling
Price after the chilling
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
9
Price of rooms in Costa Brava
P2
P1
0 Q2 Q1 Demand for rooms in Costa Brava
Supply
New equilibrium
Initial equilibrium
D2
D1
3. …and a reduction in the quantity sold.
1. The nice weather reduces the demand for holidays abroad
2. … which causes a reduction in price
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 – PSupply: QO= 3P – 3where 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?
12
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
13
Price of cheese
Quantity 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
9
D
Ex. 3.4 – Demand and Supply II
14
Price of cheese
Quantity of cheese
The the QO is equal to zero, the price P is equal to 1
1
If the price P is equal to 5, the QO is equal to 12
12
5S
Ex. 3.4 – Demand and Supply II
15
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:
P33Q
P 9 Q
Ex. 3.4 – Demand and Supply II
16
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
17
Price of cheese
Quantity of cheese
3
6
D
S
In equilibrium QD = QD = 6, while price P is equal to 3
Ex. 3.4 – Demand and Supply II
18
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:d) > 1 ; e) < 0 ; f) none of the above.
Ex. 3.5 – Elasticity I
19
For each of these pair of goods say which good has the most elastic demand?
(a)Textbooks vs. Science fiction booksAnswer: Science fiction books, because they are “luxury” goods. Textbooks are necessary for most young people
b) Beethoven’s CD vs. Classical CD in generalAnswer: Beethoven’s CD. Beethoven and Brahms are closer substitute than a classical and a jazz CD
Ex. 3.6 – Elasticity II
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(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. waterAnswer: Beer. Water is a necessary goods, whereas beer is a “luxury” goods (it has many substitutes)
Ex. 3.6 – Elasticity II
21
Hp.: business men and tourists have the following demand for flight tickets on route New York-Boston
Price Qd –Business men
Qd -Tourists
150 2100 1000
200 2000 800
250 1900 600
300 1800 400
Ex. 3.7 – Travellers
22
Question:
1) Compute the elasticity for the two categories of travellers2) Which one of the two categories is characterized by a less elastic demand? Why?
Ex. 3.7 – Travellers
23
Solution
ED(p) is computed as the ratio between the percentage variation in the quantity demanded and the percentage variation in price.
ED(p) =
Ex. 3.7 – Travellers
24
1) Business menNumerator: (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
25
2) TouristsNumerator: (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
26
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
27
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. 3.7 – Travellers
28
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
29
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.
Ex. 3.8 – Tom & Jerry
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