Demand, Supply and Elasticity: Applications and Exercises

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Demand, Supply and Elasticity: Applications and Exercises. Lecture 3 – academic year 2013/14 Introduction to Economics Fabio Landini. Ex. 3.1 – The lottery. Question

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### Demand, Supply and Elasticity: Applications and Exercises

Lecture 3 – academic year 2013/14

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

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 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

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:

• When a chill hits Sicily, what happens to the price of oranges in Italy? Increases or decrease?
• When UK benefits of a mild winter, what happens to the price of hotel rooms in Costa Brava? Increase or decrease?
• When a war breaks out in Middle East, what happens to the price of petrol and second-hand Cadillac in US? Increase or decrease?
Ex. 3.3 – Demand and Supply 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

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

1. The nice weather reduces the demand for holidays abroad

Supply

P1

Initial equilibrium

P2

2. … which causes a reduction in price

New equilibrium

D1

D2

0

Q2

Q1

Demand for rooms in Costa Brava

3. …and a reduction in the quantity sold.

Ex. 3.3 – Demand and Supply I

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: QS= 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?

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

12

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

Quantity of cheese

13

9

Ex. 3.4 – Demand and Supply II

Price of cheese

If the price P is equal to 5, the QS is equal to 12

S

5

The the QS is equal to zero, the price P is equal to 1

1

Quantity of cheese

14

12

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:

Ex. 3.4 – Demand and Supply II

15

Which can be solved by the mean of standard substitution:

QD = 9 – P

QS= 3P – 3

Therefore, 9 – P = 3P – 3, from which we get:

P= 3 and Q = 6

Ex. 3.4 – Demand and Supply II

16

Ex. 3.4 – Demand and Supply II

Price of cheese

In equilibrium QD = QS = 6, while price P is equal to 3

S

3

D

Quantity of cheese

17

6

Ex. 3.5 – Elasticity I

If the % variation in quantity is smaller than the % decrease in price, the value of E(p) is:

• > 1 ;
• < 1 ;
• = 1.

If the quantity demanded is constant after a change in the level of price, the value of E(p) is:

• > 1 ;
• < 0 ;
• none of the above.

Ex. 3.6 – Elasticity II

For each of these pair of goods say which good has the most elastic demand?

• 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

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.

ED(p) =

Ex. 3.7 – Travellers

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: 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