ECON 100 Tutorial: Week 3

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office: LUMS C85
 outline
Q1 – 5 min.
Q2 – 10 min.
Q3 – 5 min
Q4 – 5 min. (skip a &b)
Q5 – 10 min.
Q6 – 10 min.
Practice exam ?’s – 5 min.
 Question 1
Outline three determinants of the price
elasticity of demand for a product and comment
on the importance of these in determining the
degree of elasticity.
Question 1: Price Elasticity of Demand
Less Elastic More Elastic
• Few Close • Many Close
Substitutes Substitutes
• Necessities • Luxuries
• Broadly defined • Narrowly-defined
Markets markets
• Lower Proportion of • Higher Proportion of
Income devoted to Income devoted to
product Product
• Short Time Horizon • Longer Time Horizon
 Question 2(a)
Suppose The Times estimates that if it raises the
subscription price of its online newspaper from
£1.00 to £1.50 then the number of subscribers
will fall from 50,000 to 40,000.
a. What is the price elasticity of demand for the
Daily News when elasticity is calculated using
the midpoint method?
 Question 2(a): Price Elasticity of
Demand
(𝑄2 − 𝑄1 ) (40,000 − 50,000)
(𝑄2 + 𝑄1 )Τ2 (40,000 + 50,000)Τ2
=
(𝑃2 − 𝑃1 ) (1.5 − 1)
(𝑃2 + 𝑃1 )Τ2 (1.5 + 1)Τ2

(−10,000)
45,000
= 0.5 = 0.56
1.25
Price Elasticity of Demand (midpoint method):
% Change in Quantity Demanded = (Q2-Q1)/[(Q2+Q1)/2]
% Change in Price (P2-P1)/[(P2+P1)/2]

Income Elasticity of Demand:

% Change in Quantity Demanded
% Change in Income
Cross-Price Elasticity of Demand:
% Change in Quantity Demanded of Good 1
% Change in Price of Good 2
Price Elasticity of Supply:
% Change in Quantity Supplied
% Change in Price
 Question 2(b) & (c)
(b)What is the advantage of using the midpoint
method?
With the midpoint method, the value of the
elasticity is the same whether you begin at a price
of £1.00 and raise it to £1.50 or begin at a price of
£1.50 and reduce it to £1.00.

(c) If The Times' only concern is to maximise total

revenue, should it raise the price of a newspaper
from £1.00 to £1.50? Why or why not?
Yes. In this price range, the price elasticity of
demand is less than one (inelastic), so an increase in
price will increase total revenue.
 Question 3
The table below provides the demand schedule
for motel rooms at Small Town Motel. Use the
information provided to complete the table.
Answer the following questions based on your
responses in the table. Use the midpoint
method to calculate the percentage changes
used to generate the elasticities.
Price (£) Quantity Total % Change % Change in Elasticity
Demanded Revenue in Price Quantity
20 24
40 20
60 16
80 12
100 8
120 4
 Question 3
Price (£) Quantity Total % Change % Change in Elasticity
Demanded Revenue in Price Quantity
20 24 480 0.67 0.18 0.27
40 20 800 0.40 0.22 0.55
60 16 960 0.29 0.29 1.00
80 12 960 0.22 0.40 1.82
100 8 800 0.18 0.67 3.72
120 4 480
 Question 3(a) & (b)
Price (£) Quantity Total % Change % Change in Elasticity
Demanded Revenue in Price Quantity
20 24 480 0.67 0.18 0.27
40 20 800 0.40 0.22 0.55
60 16 960 0.29 0.29 1.00
80 12 960 0.22 0.40 1.82
100 8 800 0.18 0.67 3.72
120 4 480

a. Over what range of prices is the demand for motel

rooms elastic? To maximise total revenue, should Small
Town Motel raise or lower the price within this range?
Answer: £80 to £120; lower its prices
b. Over what range of prices is the demand for motel
rooms inelastic? To maximise total revenue, should Small
Town Motel raise or lower the price within this range?
Answer: £20 to £60; raise its prices
 Question 3(c)
Price (£) Quantity Total % Change % Change in Elasticity
Demanded Revenue in Price Quantity
20 24 480 0.67 0.18 0.27
40 20 800 0.40 0.22 0.55
60 16 960 0.29 0.29 1.00
80 12 960 0.22 0.40 1.82
100 8 800 0.18 0.67 3.72
120 4 480

c. Over what range of prices is the demand for motel

rooms unit elastic? To maximise total revenue,
should Small Town Motel raise or lower the price
within this range?
Answer: £60 to £80; it doesn’t matter. For
prices in this range, a change in price proportionately
changes the quantity demanded so total revenue is
unchanged.
 Question 4
The demand schedule from Question 3 above is
reproduced below along with another demand
schedule when consumer incomes have risen to
£60,000 from £50,000. Use this information to answer
the following questions. Use the midpoint method to
calculate the percentage changes used to generate the
income elasticities.
Price Quantity Quantity a. What is the income elasticity
(£) Demanded Demanded
Income = Income = of demand when motel rooms
20
£50,000
24
£60,000
34
rent for £40?
40 20 30 Answer:
60 16 26
80 12 22 (10/25)/(£10,000/£55,000) = 2.2
100 8 18
120 4 14
 Question 4
b. What is the income elasticity of demand when
motel rooms rent for £100?
Answer: (10/13)/(£10,000/£55,000) =4.2
c. Are motel rooms normal or inferior goods? Why?
Answer: Normal goods, because the income
elasticity of demand is positive.
d. Are motel rooms likely to be necessities or
luxuries? Why?
Answer: Luxuries, because the income elasticity of
demand is large (greater than 1). In each case, an
18 percent increase in income caused a much larger
increase in quantity demanded.
 Income Elasticity of Demand
A few things we know:
+ Normal good
- Inferior good
>1 Luxury
<1 Necessity
 Question 5
Use Excel and the following supply and demand
schedules for bicycles to answer the questions
below. Price Quantity Quantity
Demanded Supplied
300 60 30
400 55 40
500 50 50
600 45 60
700 40 70
800 35 80
 Question 5(a)
a. Plot the supply and demand curves for
bicycles. On the graph, impose a tax of £300 per
bicycle to be collected from the sellers. After the
tax, what has happened to the price paid by the
buyers, the price received by the sellers, and the
quantity sold when compared to the free market
equilibrium?

Answer: The price buyers pay rises to £700, the

price sellers receive falls to £400, and the
quantity sold falls to 40 units.
 Question 5(b)
b. Again, plot the supply and demand curves for bicycles. On the
graph, impose a tax of £300 per bicycle to be collected from the
buyers. After the tax, what has happened to the price paid by the
buyers, the price received by the sellers, and the quantity sold when
compared to the free market equilibrium?
 Question 5(b)
b. Again, plot the supply and demand curves for
bicycles. On the graph, impose a tax of £300 per
bicycle to be collected from the buyers. After
the tax, what has happened to the price paid by
the buyers, the price received by the sellers, and
the quantity sold when compared to the free
market equilibrium?
Answer: The price buyers pay rises to £700, the
price sellers receive falls to £400, and the
quantity sold falls to 40 units.
 Question 5(c)
c. Compare your answers to questions (a) and
(b) above. What conclusion do you draw from
this comparison?
Answer: The impact of a tax collected from
sellers is equivalent to the impact of a tax
collected from buyers.
 Question 5(d)
d. Who bears the greater burden of this tax, the
buyers or the sellers? Why?
Answer: The greater burden of the tax has fallen
on the buyers. The free market equilibrium price
was £500. After the tax, the price the buyers pay
has risen £200 while the price the sellers receive
has fallen £100. This is because demand is less
price elastic than supply at this price.
 Question 6(a)
Suppose the government introduces a tax, t, on some good that is
priced at p. In the after tax equilibrium, D(p) = S(p-t). Note that p is a
function of t, i.e. p(t) . So, in equilibrium, D(p(t))=S(p(t)-t). Some (fairly)
simple geometry can be used to show that the incidence of a (small)
change in t, call this dt where d means “small change in”, on p depends
on the relative slopes of D and S. In particular, one can show that
𝑑𝑝 𝑑𝑆Τ𝑑𝑝
=
𝑑𝑡 𝑑𝑆 − 𝑑𝐷
𝑑𝑝 𝑑𝑝

We know that dD/dp<0 (D slopes downwards) and dS/dp>0 (S slopes

upwards) so the denominator is ambiguous – it could be positive or
negative depending on whether D or S is steeper. Show that this
implies that
𝑑𝑝
= 𝜀 𝑆 /(𝜀 𝑆 − 𝜀 𝐷 )
𝑑𝑡
where ε is the price elasticity and D and S refer to D and S curves.
HINT: multiply numerator and denominator by p/Q where Q is the
quantity demanded and supplied.
 Question 6(a)
𝑑𝑝
Write in terms of 𝜀 𝑆 and 𝜀 𝐷 .
𝑑𝑡
 Question 6(b)
For many years the US government has subsidised
corn which is used in ethanol which is a petrol
substitute – supposedly to reduce US dependence
on imported oil. It also provided a direct subsidy.
The idea was to get consumers to shift away from
regular petrol. In 2010 the government spent $4b
on these two subsidies that amounted to about
$2.60 a gallon.
Just as a tax shifts the S curve up, a subsidy shifts it
down. The price elasticity of D is estimated to be
2.9 and the elasticity of S is estimated to be 0.25.
Using the above equation calculate the incidence of
this tax.
 Question 6(b)
𝑑𝑝
= 𝜀 𝑆 /(𝜖 𝑆 − 𝜀 𝐷 )
𝑑𝑡
𝑑𝑝 .25
= = 0.08
𝑑𝑡 .25 − −2.9
𝑑𝑝
= 0.08
2.6
𝑑𝑝 = 0.08 ∗ 2.6 = .24

Answer: About 0.24. In other words the $2.60

subsidy only reduced price by 24c – the producer
and corn growers pocketed almost all of the subsidy.
And the policy had little effect on oil use.
 Question 6(c)
Do you think the subsidy is a good idea?

http://www.economist.com/node/18867278
Practice Multiple Choice Questions
 An Inferior Good:
a) Is a Giffen good
b) Has a positive income elasticity of demand
c) Has a negative income elasticity of demand
d) Has an upward sloping demand function
Suppose a demand curve is written
D=60-3P. Find the intercept and slope
of the corresponding inverse demand
curve.
a) Slope of -20, intercept of 3
b) Slope of -1/3, intercept of 20
c) Slope of -3, intercept of 20
d) Slope of 1/3, intercept of 60
Suppose D=120-4P. Find the price
elasticity at a price of 10 and at a price
of 20. Use the standard mathematical
method, not the midpoint method.
a) -0.2, -2, respectively
b) -0.5, -2, respectively
c) -0.5, -4, respectively
d) Not possible to say without knowing what
the corresponding level of demand is.
Suppose D=200-2P and S=20+4P.
What is the equilibrium price and
quantity?

a) P*=20, Q*=100
b) P*=30, Q*=140
c) P*=50, Q*=220
d) P*=40, Q*=180