1.

(30 points) For each of the following scenarios, use a supply and demand diagram to illustrate the effect
of the given shock on the equilibrium price and quantity in the specified competitive market. Explain
whether there is a shift in the demand curve, the supply curve, or neither.
(a) (6 points) An unexpected temporary heat wave hits the Northern China. Show the effect in the ice
cream market in Beijing.
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Ans: The temporary heat wave shifts the demand curve to the right from D to D . As a result, equilibrium
price and quantity both go up.

(b) (6 points) The government introduces a tax on ice cream which is paid by producers. What is the
effect in the ice cream market?
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Ans: The supply curve shifts up from S to S by the amount of the tax. As a result, the equilibrium price
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increases and the equilibrium quantity decreases. However, the rise in the equilibrium price from P to P is
smaller than the tax.

(c) (6 points) Apple, Samsung and Huawei are the major producers of smart phones. Recently, it is found
that smart phones of Samsung might have serious security problem. Show the effect on the market for
Huawei and Apple.

Ans: The demand curves for Huawei and Apple shift outward, but which one moves farther depends on
the extent to which they are substitutes of Samsung.
(d) (6 points) Show the effect of the situation described in (c) on the market for Samsung.
Ans: The demand curve for Samsung moves to the left.

(e) (6 points) Suppose the government imposes a price cap on bottled water. Show the effect in the
bottled water market.

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Ans: If the price ceiling P is set below the equilibrium price P, then there will be a shortage of bottled water
in the amount of Q1 − Q2 and bottled water will be rationed. If the price ceiling is above the equilibrium
price, then there is no effect.

2. (20 points) Suppose that business travelers and vacationers have the following demand for airline
tickets from New York to Boston:

(a) (10 points) As the price of tickets rises from $200 to $250, what is the price elasticity of demand for (i)
business travelers and (ii) vacationers? (Use the midpoint method in your calculations.)
Ans: For business travelers, the price elasticity of demand when the price of tickets rises from $200 to
$250 is [(2,000 – 1,900)/1,950]/[(250 – 200)/225] = 0.05/0.22 = 0.23. For vacationers, the price
elasticity of demand when the price of tickets rises from $200 to $250 is [(800 – 600)/700] / [(250 –
200)/225] = 0.29/0.22 = 1.32.
(b) (10 points) Why might vacationers have a different elasticity from business travelers?
Ans: The price elasticity of demand for vacationers is higher than the elasticity for business travelers
because vacationers can choose a substitute more easily than business travelers. For example,
vacationers can choose a different mode of transportation (like driving or taking the train), a different
destination, a different departure date, and a different return date. They may also choose to not travel
at all. Business travelers are less likely to do so because their schedules are less adaptable.

3. (20 points) Suppose that your demand schedule for DVDs is as follows:

(a) (10 points) Use the midpoint method to calculate your price elasticity of demand as the price of DVDs
increases from $8 to $10 if (i) your income is $10,000 and (ii) your income is $12,000.
Ans: If your income is $10,000, your price elasticity of demand as the price of DVDs rises from $8 to
$10 is [(40 – 32)/36]/[(10 – 8)/9] =0.22/0.22 = 1. If your income is $12,000, the elasticity is [(50 –
45)/47.5]/[(10 – 8)/9] = 0.11/0.22 = 0.5.

(b) (10 points) Calculate your income elasticity of demand as your income increases from $10,000 to
$12,000 if (i) the price is $12 and (ii) the price is $16.
Ans: If the price is $12, your income elasticity of demand as your income increases from $10,000 to
$12,000 is [(30 – 24)/27]/[(12,000 – 10,000)/11,000] = 0.22/0.18 = 1.22. If the price is $16, your
income elasticity of demand as your income increases from $10,000 to $12,000 is [(12 –
8)/10]/[(12,000 – 10,000)/11,000] = 0.40/0.18 = 2.22.

4. (30 points) Consider public policy aimed at smoking.

(a) (10 points) Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of
cigarettes currently costs $2 and the government wants to reduce smoking by 20 percent, by how
much should it increase the price?
Ans: With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20%
requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes currently $2, this
would require an increase in the price to $3.33 a pack using the midpoint method (note that ($3.33 –
$2)/$2.67 = .50).

(b)(10 points) If the government permanently increases the price of cigarettes, will the policy have a
larger effect on smoking one year from now or five years from now?
Ans: The policy will have a larger effect five years from now than it does one year from now. The
elasticity is larger in the long run, because it may take some time for people to reduce their cigarette
usage. The habit of smoking is hard to break in the short run.
(c) (10 points) Studies also find that teenagers have a higher price elasticity of demand than do adults.
Why might this be true?
Ans: Because teenagers do not have as much income as adults, they are likely to have a higher price
elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult
to reduce their quantity demanded in response to a higher price.