Chapter 04 - Individual and Market Demand

Chapter 4 Individual and Market Demand

Answers to Questions for Review
1. a) Salt is generally considered a necessity.
1. b) As the text points out, the income effect for salt is extremely small.

Unlike salt, education at a large private university has a large income effect because it is so
expensive.

See Figure 4-5 in the text.

Some examples: hamburger, generic beer, almost anything purchased at stores selling "as is"
damaged or discontinued merchandise.

Yes. A downward-sloping PCC simply implies that as the price of a good falls, the consumer
purchases so much more of the good that the proportion of income spent on the good
actually increases.

Vertical summation would mean that each good could be jointly consumed. Horizontal
summation means each person consumes their commodity and excludes others from it.
Vertical summation is only possible for public goods.

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Chapter 04 - Individual and Market Demand

An elastic demand leads to revenue increases if price falls. An inelastic demand leads to
revenue increases if the price increases. A unitary demand curve results in constant revenue
no matter what price does. If price goes the opposite direction from that listed above, the
revenue moves in the opposite direction also.

The slope of the demand will give only an absolute change number. It does not give a
proportionate change. Since price sensitivity has little meaning apart from the proportion of
change, elasticity is far better than slope at showing a useful responsiveness of demand to
price.

Unitary

10. Since other good substitutes abound, a university will likely have a fairly elastic demand
curve. Some elite universities have more applications than what they can accommodate and
will likely have a less elastic demand curve, because students know the market will reward
them better than if they attend a lesser known university.

11. If income is shifted from the rich to the poor, those products consumed by poor people and
not by rich will increase in demand and those goods consumed by the rich and not the poor
will have a decrease in demand.

12. Companies that produce more necessary items rather than luxuries would be better to invest
in than companies that produce luxury items since people will be paring down their
expenditures.

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Chapter 04 - Individual and Market Demand

13 False. In the diagram below, an increase in the price of X leads to a reduction in the amount
of X consumed, but an increase in the quantity of Y.

Positive income effect for both X and

Y because the quantity of both X and
Y increase when income is increased
.

Change
in Y

X
Change in X
14 True. The demand for tennis balls is elastic. When its price goes up, the total expenditure on
the balls goes down. Thus, the share of income available for tickets increases. Since their price
is constant, he consumes more tickets.

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Chapter 04 - Individual and Market Demand

15 False. Look at Figure 4-16 in the text. Both individuals have linear demand curves, but the
aggregate demand curve is kinked, not straight.
16 No. If bread is an inferior good, then as income increases, quantity demanded of bread
decreases. If butter were an inferior good also, then likewise, quantity demanded of butter
would decline as income grows. However, spending on both goods cannot decline, because
there would be no way of spending the added income. Thus, not all goods can be inferior.
17 Comment: See faxed copy of graph. Basically the same as review question 6 in chapter 5. The
figure must be added here.
The most important reason is the increase in income. Assume that, 30 years ago, the budget
constraint was b and the optimal consumption was q0. Although the price of petrol has
increased, so has income. The budget constraint (a) has become steeper, but it has also shifted
outward. Optimal consumption increases to q1, despite the increase in price.
18 The interest rate is the premium required to move future income to the present. Since future
goods are on the vertical axis and present goods are on the horizontal axis the budget line
becomes an exchange rate between future and present income.

Answers to Chapter 4 Problems

1 Sams budget constraint is 2OJ + AJ = 6 (10OJ + 5AJ = 30) or OJ = 3 (1/2)AJ. Sams
indifference curves are straight lines with constant MRS = 1/3. Sams optimal bundle is to
consume no apple juice and three cups of orange juice. When the price of apple juice doubles,
Sam would not need any additional income to afford his original comsumption bundle, since
he does not consume any apple juice.

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Chapter 04 - Individual and Market Demand

Orange Juice in
Cups
3

Bs' = B1
0

B0

ICs

3
6
Apple Juice in cups/week

2 Bruces budget constraint is the same as Sams, but his indifference curves have constant
MRS = 1. Thus Bruces optimal bundle is to consume six cups of apple juice per week and no
orange juice. To afford his original consumption bundle, Bruce would need additional income
(P'AJ PAJ)AJ = (10 5)6 = R30/wk. At his new income of R60/wk and facing the higher price
of apple juice, Bruces budget constraint would become OJ + AJ = 60 or OJ = 60 AJ, which
contains Bruces original consumption point of six cups of apple juice and no orange juice.

Orange Juice in
cups/week
6

ICB = BB
3
B1

3
Apple Juice in cups per week

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B0

Chapter 04 - Individual and Market Demand

3
3 Maureens budget constraint is the same as Sam and Bruces but her indiffernece curves are
right angles (L-shaped) at bundles where the cups of orange juice and apple juice consumed
are the same. Setting OJ = AJ in her budget constraint gives OJ = AJ = 2 as her optimal
consumption bundle: two cups of orange juice and two cups of apple juice per week. To afford
her original consumption bundle, Maureen would need additional income (P'AJ PAJ)A =
(10 5)2 = R10/wk. At her new income of R40/wk and facing the higher price of apple juice ,
Maureens budget constraint would become OJ + AJ = 4 (10OJ + 10AJ = 40) or OJ = 4 AJ,
which contains Maureens original consumption point of two cups of apple juice and two cups
of orange juice per week.

Orange Juice
in cups/week
4
OJ = AJ
3
2
1
B1
0

B0
BM

2
3
4
Apple Juice in cups/week

First solve the demand curve for Q and multiply the result by 10. Then solve back in terms of
P to get P = 101 Q for the market demand. At price R1/box the individual consumes 10
boxes and the market consumes 100 boxes.
Price
101

10.1

101 Cups

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Chapter 04 - Individual and Market Demand

a) P=10, Q=100;

So = (P/Q)(1/slope) = (10/100)[1/(-0.5)] = -0.2

Or with calculus: Q = 120 2P, so

5. b)
P

P stays the same, Q increases, and the slope (or derivative) stays the same. Therefore,
elasticity decreases.

6. a)

elastic

unit-elastic

inelastic

50

100

6. b) At (50, 1), total revenue is maximized since this is the unit-elastic point. At higher prices,
revenue decreases since it is the elastic region. At lower prices, revenue again decreases since
it is the inelastic region.

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Chapter 04 - Individual and Market Demand

a) P=R30, Q=8 000, Revenue=R2 100 000

7. b) Ep

-1000) = - 3/7

Or Ep =

7. c) A price increase will increase revenue since current price is in the inelastic region.

8. We cant know. We are only given that income elasticity of demand for safety (Ei) is positive.
For necessities, we have 0 < Ei < 1, and for luxury goods we have Ei > 1.
We need more information to determine whether Ei > 1 or not.
9 QA=25-0.5P, QB=50-P, So Q=QA+QB=75 - 1.5P and hence P=50-(2/3)Q.
10 Elasticity at A =(PA/QA)( Q/ P)=(400/300)(-20/200)=-40/300=-2/15. Elasticity at
B=(PB/QB)( Q/ P)=(600/280)(-20/200)=-60/280=-3/14.

Alternatively it can be solved with calculus. The linear demand curve is in the format

P = mQ + c to get m=

That means 400 = -10(300) + c, c = 3400.

P = -10Q + 3 400 which means Q = 340 0.1P. Ep = -0.1 (400/300) = -0.13. At the other
point Ep = -0.1(600/280) = -0.21.

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Chapter 04 - Individual and Market Demand

11 Price elasticity = -CE/AC =-3/7 (using segment-ratio method). Because demand is inelastic
with respect to price, total revenue will go up with an increase in price. From the graph it is
clear that they are operating on the inelastic part of the demand curve and that an increase in
price will lead to an increase in revenue.

12 Total expenditure = PQ=27Q - Q3, which is shown in the diagram. It attains its maximum
value, 54, when Q = 3.

Total Expenditure
54

Quantity
1

For students who have had calculus, an easier approach is to set d(PQ)/dQ=0:
d(PQ)/dQ = 27 - 3Q2 = 0,

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Chapter 04 - Individual and Market Demand

which solves for Q = 3. Plugging Q = 3 back into the equation for the demand curve, we
have P = 27 32 = 18, and this is the price that maximizes total expenditure. If P = 18
and Q = 3, total expenditure is 54.

13 a) 300 = 1800 - 15P, so P = 100, which gives TR = 100(300) = R30 000/day.

13 b) Expressing the demand curve in terms of price, we have P = 120 - Q/15. Price elasticity =

(P/Q) (1/slope) = (1/3)(-15) = -5 . Or Ed =

13 c) Since demand is elastic with respect to price, a reduction in price will increase total
revenue.

13 d) Maximum total revenue occurs where price elasticity = -1.

(P/Q)(1/slope) = (P/Q)(-15) = -1, so maximum TR will occur when P = Q/15. Substituting
P = Q/15 back into the demand curve we get Q/15 = 120 - Q/15, or

2Q/15 = 120, which

solves for Q = 900. At Q = 900, we have P = 60.

With calculus. TR = 1 800P 15 P2. Then TR = 1 800 -30P = 0; P = 60.

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Chapter 04 - Individual and Market Demand

14 In absolute value terms, where price elasticity = Ep

Ep A = Q2A/AP2 = 2
Ep B = Q2B/P2B = 1
Ep C = Q1C/P1C = 1
Ep D = Q1D/P1D = 3
Ep E = Q1E/P2E = 1

So Ep D > Ep A > Ep B = Ep C = Ep E

15 The income elasticity for food is positive but less than 1; for Hawaiian vacations, greater than
1; for cashews probably greater than 1; and for cheap sneakers, less than 0. These elasticity
values are reflected in the Engel curves shown below.

food in general

lobster

food

vacations

16

a) Tennis balls and tennis racquets are complements, so negative.

16

b) Negative, same reason.

16

c) Hot dogs and hamburgers are substitutes, so positive.

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cheap sneakers

Chapter 04 - Individual and Market Demand

17 The cross price elasticity of good X with respect to good Y is 5/4 for the point represented
by 2010. This is calculated by taking the location and slope of a function representing the
quantity of X in terms of the price of Y and putting that data into the standard elasticity
equation. Accordingly, EpXY = (Py/X)(dQx/dPy) = (Py/X)(1/slope) = 10/400)[1/(1/50)] =
5/4. The graph below illustrates this situation, but it is an unusual graph which cannot be
interpreted as a typical demand curve since the price of the vertical axis is not for the product
on the horizontal axis.
Py
12
10

300 400

Quantity of X

18 Wheat and rice are perfect substitutes for Smith, and her indifference curves are shown as the
heavy downward-sloping 45 lines in the diagram. The lighter downward-sloping straight
lines, B1_B4, are the budget constraints that correspond to four arbitrarily chosen prices of
wheat, namely, R120/kg, R40/kg, R20/kg, and R15/kg, respectively. The first two of these
prices exceed the price of rice, so Smith ends up spending all of her food budget on rice.
Bundle A denotes the optimum purchase of wheat when the price of wheat is R120/kg
(budget constraint B1); and bundles C, D, and F are the corresponding bundles for the
remaining prices (budget constraints B2, B3, and B4, respectively). As noted, the amount of
wheat in both A and C is zero. Once the price of wheat falls below the price of rice, Smith
does best to spend all of her food budget on wheat. When wheat costs R20/kg, for example,
she will buy (R240/wk)/(R20/kg)=12 kg/wk (bundle D on B3); and at R15/kg, she will buy
16 kg/wk (bundle F on B4). The heavy line labeled PCC is Smith's price-consumption curve.

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Chapter 04 - Individual and Market Demand

To construct Smith's demand curve for wheat, we can retrieve the price-quantity pairs from
her PCC and plot them in a separate diagram, just as before. But an even easier way is
available in this particular case. It is to note that her behavior may be summarized by the
following purchase rule: when the price of wheat, PW, is below the price of rice, she will buy
R240/PW kg of wheat, and when PW is above the price of rice, she will buy no wheat at all.
The demand curve that corresponds to this purchase rule is plotted as the heavy line in the
diagram below

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Chapter 04 - Individual and Market Demand

19 Kathy's intertemporal budget constraint is C2 = (1 + r)55 000 + 60 000 - (1 + r)C1. Her

maximum current consumption would occur by setting C2 = 0 and solving for C1 = 55 000 +
60 000/(1 + r). To achieve C1 = 105 000, then 55 000 + 60 000/(1 + r) = 105 000 implies
60 000/(1 + r) = 50 000, which solves for r = 0.2 (20% interest). Similarly, her maximum
future consumption would occur by setting C1 = 0 and solving for C2 = (1 + r)55 000 + 60 000.
If C2 = 120 500, then (1 + r)55 000 + 60 000 = 120 500, and so (1 + r)55 000 = 60 000, which
solves for r = 0.1 (10% interest).

20 a) The new policy represents a decline in the price of cappuccino by less than 20% (the
nominal price, including the R5 for the milk, declines by exactly 20% but the implicit cost
of the effort of buying the milk separately must now be added to the nominal price),
accompanied by a quantity increase of 60%. It follows that the absolute value of the price
elasticity of demand for cappuccino is greater than 3. So false.

20 b) The policy has the effect of making milk more valuable to those users who supply their
own milk to receive the discount. At a given price of milk, the quantity demanded will
rise, and hence total revenue will rise, no matter what the value of the price elasticity of
demand for milk. So false.

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