Office Hours: Monday 3:00-4:00 – LUMS C86 ECON 101 Tutorial: Week 2 Shane Murphy s.murphy5@lancaster.ac.uk Office Hours: Monday 3:00-4:00 – LUMS C86

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Exercise Consider the following demand function: QA=100-8PA+0.5PB+2Y, where QA is the quantity demanded of good A, PA is the price of good A, PB is the price of good B and Y is the income. If PA =7, PB=12 and Y=4.5 calculate the price elasticity of demand of good A. Is the demand elastic or inelastic? First, let us solve for QA QA= 100 - 8PA + 0.5PB + 2Y = 100 – 8 (7) + 0.5 (12) + 2 (4.5) = 100 – 56 + 6 + 9 = 59

Exercise Consider the following demand function: QA=100-8PA+0.5PB+2Y, where QA is the quantity demanded of good A, PA is the price of good A, PB is the price of good B and Y is the income. a) If PA =7, PB=12 and Y=4.5 calculate the price elasticity of demand of good A. Is the demand elastic or inelastic?

Exercise If PA =7, PB=12, Y=4.5 and QA= 59, and QA=100-8PA+0.5PB+2Y calculate the price elasticity of demand of good A. Is the demand elastic or inelastic? Ped = dQA/dPA * PA/QA dQA/dPA = -8 ped = dQA/dPA * PA/QA = -8 * 7/59 = -56/59 By convention, we write ped = 56/59 (positive) Elasticity of Demand is Inelastic (ped<1)

Exercise If PA =7, PB=12, Y=4.5 and QA= 59, and QA=100-8PA+0.5PB+2Y calculate the calculate the income elasticity. What kind of good is A? (Normal/Inferior? If normal then necessity or luxury?) ied = dQA/dY * Y/QA dQA/dY = 2 ied = dQA/dY * Y/QA = 2 * 4.5/59 = 9/59 This is a normal good (ied>0) This is a necessity (0<ied<1)

Exercise If PA =7, PB=12, Y=4.5 and QA= 59, and QA=100-8PA+0.5PB+2Y calculate the cross price elasticity. What kind of goods are A and B? (Complements or substitutes?) cped = dQA/dPB * PB/QA dQA/dPB = 0.5 cped = dQA/dPB * PB/QA = 0.5 * 12/59 = 6/59 These goods are substitutes (cped > 0)

Exercise 5 Suppose that your demand Schedule for DVDs is as follows: Price Quantity Demanded (Y = 10,000) Quantity Demanded (Y = 12,000) 8 40 50 10 32 45 12 24 30 14 16 20 Suppose that your demand Schedule for DVDs is as follows: Use the midpoint method to calculate your price elasticity of demand as the price of DVDs increases from 8 to 10 for income of 10,000 and income of 12,000. Income of 10,000: ped = [(QA – QB)/([QA + QB]/2)/[(PA – PB)/([PA + PB]/2) = [(40 – 32)/([40 + 32]/2)/[(8 – 10)/([8 + 10]/2) = (8/36)/(-2/9) = -4/4 = -1

Exercise 5 Suppose that your demand Schedule for DVDs is as follows: Price Quantity Demanded (Y = 10,000) Quantity Demanded (Y = 12,000) 8 40 50 10 32 45 12 24 30 14 16 20 Suppose that your demand Schedule for DVDs is as follows: Use the midpoint method to calculate your price elasticity of demand as the price of DVDs increases from 8 to 10 for income of 10,000 and income of 12,000. Income of 12,000: ped = [(QA – QB)/([QA + QB]/2)/[(PA – PB)/([PA + PB]/2) = [(50 – 45)/([50 + 45]/2)/[(8 – 10)/([8 + 10]/2) = (5/47.5)/(-2/9) = -45/95 = -0.47

Exercise 5 Suppose that your demand Schedule for DVDs is as follows: Price Quantity Demanded (Y = 10,000) Quantity Demanded (Y = 12,000) 8 40 50 10 32 45 12 24 30 14 16 20 Suppose that your demand Schedule for DVDs is as follows: Use the midpoint method to calculate your income elasticity of demand as your income increases from 10,000 to 12,000 for price of 12 and price of 16. Price of 12: ied = [(QA – QB)/([QA + QB]/2)/[(YA – YB)/([YA + YB]/2) = [(24 – 30)/([24 + 30]/2)/ [(10,000 – 12,000)/([10 ,000+ 12,000]/2) = (-6/27)/(-2/11) = 66/54 = 1.22

Exercise 5 Suppose that your demand Schedule for DVDs is as follows: Price Quantity Demanded (Y = 10,000) Quantity Demanded (Y = 12,000) 8 40 50 10 32 45 12 24 30 14 16 20 Suppose that your demand Schedule for DVDs is as follows: Use the midpoint method to calculate your income elasticity of demand as your income increases from 10,000 to 12,000 for price of 12 and price of 16. Price of 16: ied = [(QA – QB)/([QA + QB]/2)/[(YA – YB)/([YA + YB]/2) = [(8 – 12)/([8 + 12]/2)/ [(10,000 – 12,000)/([10 ,000+ 12,000]/2) = (-4/10)/(-2/11) = 44/20 = 2.2

Exercise 7 Consider public policy aimed at smoking Studies indicate the ped for cigarettes is about 0.4. If a packed of cigarettes is currently priced at 6 and the government wants to reduce smoking by 20%, by how much should it increase the price? 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? Studies also find that teenagers have a higher price elasticity of demand for cigarettes than do adults. Why might this be true? a) ped = % change in Q/% change in P 0.4 = -0.2/% change in P % change in P = -0.2/0.4 = -1/2 price should increase by 50 percent (4 using the midpoint method) Goods tend to be more elastic over longer time horizons, so the policy will have a smaller effect in the short run than the long run

Exercise 7 Consider public policy aimed at smoking Studies indicate the ped for cigarettes is about 0.4. If a packed of cigarettes is currently priced at 6 and the government wants to reduce smoking by 20%, by how much should it increase the price? 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? Studies also find that teenagers have a higher price elasticity of demand for cigarettes than do adults. Why might this be true? c) ped might be a function of income as income increases, elasticity falls ped might be a function of age as people get older, they are less flexible, and have more inelastic demand functions ped might be a function of the experiences of the consumer Older smokers might be more addicted and less elastic to price changes Older smokers might have a taste for fewer substitutes for smoking