Chapter 4: Individual and Market Demand

CHAPTER 4
INDIVIDUAL AND MARKET DEMAND

QUESTIONS FOR REVIEW

1. Explain the difference between each of the following terms:
a. a price consumption curve and a demand curve;
A price consumption curve identifies the utility maximizing combinations of two goods as the
price of one of the goods changes. When the price of one of the goods declines, the budget line
will pivot outwards, and a new utility maximizing bundle will be chosen. The price consumption
curve connects all such bundles. A demand curve is a graphical relationship between the price of
a good and the (utility maximizing) quantity demanded of a good, all else the same. Price is
plotted on the vertical axis and quantity demanded on the horizontal axis.
b. an individual demand curve and a market demand curve;
An individual demand curve identifies the (utility maximizing) quantity demanded by one person
at any given price of the good. A market demand curve is the sum of the individual demand
curves for any given product. At any given price, the market demand curve identifies the quantity
demanded by all individuals, all else the same.
c. an Engel curve and a demand curve;
A demand curve identifies the quantity demanded of a good for any given price, holding income
and all else the same. An Engel curve identifies the quantity demanded of a good for any given
income, holding prices and all else the same.
d. an income effect and a substitution effect;
The substitution effect measures the effect of a change in the price of a good on the consumption
of the good, utility held constant. This change in price changes the slope of the budget line and
causes the consumer to rotate along the current indifference curve. The income effect measures
the effect of a change in purchasing power (caused by a change in the price of a good) on the
consumption of the good, relative prices held constant. For example, an increase in the price of
good 1 (on the horizontal axis) will rotate the budget line down along the indifference curve as
the slope of the budget line (the relative price ratio) changes. This is the substitution effect. This
new budget line will then shift inwards to reflect the decline in purchasing power caused by the
increase in the price of the good. This is the income effect.
2. Suppose that an individual allocates his or her entire budget between two goods, food and clothing. Can
both goods be inferior? Explain.
If an individual consumes only food and clothing, then any increase in income must be spent on
either food or clothing (recall, we assume there are no savings). If food is an inferior good, then, as
income increases, consumption falls. With constant prices, the extra income not spent on food must
be spent on clothing. Therefore, as income increases, more is spent on clothing, i.e. clothing is a
normal good. For both types of goods, normal and inferior, we still assume that more is preferred to
less.
3. Explain whether the following statements are true or false.
a. The marginal rate of substitution diminishes as an individual moves downward along the
demand curve.
This is true. The consumer will maximize his utility by choosing the bundle on his budget line
where the price ratio is equal to the MRS. Suppose the consumer chooses the quantity of goods 1

and 2 such that As the price of good 1 falls, the price ratio becomes a smaller

number and hence the MRS becomes a smaller number. This means that as the price of good 1

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falls, the consumer is willing to give up fewer units of good 2 in exchange for another unit of good
1.
b. The level of utility increases as an individual moves downward along the demand curve.
This is true. As the price of a good falls, the budget line pivots outwards and the consumer is able
to move to a higher indifference curve.
c. Engel curves always slope upwards.
This is false. The Engel curve identifies the relationship between the quantity demanded of a good
and income, all else the same. If the good is inferior, then as income increases, quantity demanded
will decrease, and the Engel curve will slope downwards.
4. Tickets to a rock concert sell for $10. But at that price, the demand is substantially greater than the
available number of tickets. Is the value or marginal benefit of an additional ticket greater than, less than, or
equal to $10? How might you determine that value?
If demand exceeds supply at a price of $10, then consumers are willing to bid up the market price to
a level where the quantity demanded is equal to the quantity supplied. Since utility-maximizing
consumers are willing to pay more than $10, the marginal increase in satisfaction (value) is greater
than $10. One way to determine the value of an additional ticket would be to auction it off. The
highest bid would equal the marginal benefit of that ticket. If a bid was higher than the marginal
benefit, then it would not make sense for the consumer to buy it. If a bid was lower than the
marginal benefit, another consumer would bid exactly the marginal benefit, win the ticket, and still
be maximizing satisfaction.
5. Which of the following combinations of goods are complements and which are substitutes? Could they be
either in different circumstances? Discuss.
a. a mathematics class and an economics class
If the math class and the economics class do not conflict in scheduling, then the classes could be
either complements or substitutes. The math class may illuminate economics, and the economics
class can motivate mathematics. If the classes conflict, they are substitutes.
b. tennis balls and a tennis racket
Tennis balls and a tennis racket are both needed to play a game of tennis, thus they are complements.
c. steak and lobster
Foods can both complement and substitute for each other. Steak and lobster can compete, i.e., be
substitutes, when they are listed as separate items on a menu. However, they can also function as
complements because they are often served together.
d. a plane trip and a train trip to the same destination
Two modes of transportation between the same two points are substitutes for one another.
e. bacon and eggs
Bacon and eggs are often eaten together and are, therefore, complementary goods. By considering
them in relation to something else, such as pancakes, bacon and eggs can function as substitutes.

6. Suppose that a consumer spends a fixed amount of income per month on the following pairs of goods:
a. tortilla chips and salsa;
b. tortilla chips and potato chips;
c. movie tickets and gourmet coffee;
d. travel by bus and travel by subway.
If the price of one of the goods increases, explain the effect on the quantity demanded of each of the goods. In
each pair, which are likely to be complements and which are likely to be substitutes?
a. If the price of tortilla chips increases, the demand for both goods will fall, assuming they are
complements. The demand curve for salsa will shift to the left.

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b. If the price of tortilla chips increases, the demand for tortilla chips will fall and the demand for
potato chips will rise, assuming they are substitutes. The demand curve for potato chips will shift
to the right.
c. If the price of movie tickets increases, the demand for movie tickets will fall. The demand for
coffee is unchanged assuming the goods are unrelated. The demand curve for coffee is
unchanged.
d. If the price of bus travel increases then the demand for bus tickets will fall and the demand for
subway tickets will rise, assuming they are substitutes. The demand curve for subway tickets will
shift to the right.
7. Which of the following events would cause a movement along the demand curve for U.S.-produced
clothing, and which would cause a shift in the demand curve?
a. the removal of quotas on the importation of foreign clothes
The removal of quotas will shift the demand curve inward for domestically-produced clothes,
because foreign-produced goods are substitutes for domestically-produced goods. Both the
equilibrium price and quantity will fall as foreign clothes are traded in a free market environment.
b. an increase in the income of U.S. citizens
When income rises, expenditures on normal goods such as clothing increase, causing the demand
curve to shift out. The equilibrium quantity and price will increase.
c. a cut in the industry’s costs of producing domestic clothes that is passed on to the market in the form of
lower clothing prices
A cut in an industry’s costs will shift the supply curve out. The equilibrium price will fall and
quantity will increase. There is a movement along the demand curve.
8. For which of the following goods is a price increase likely to lead to a substantial income (as well as
substitution) effect?
a. salt
Small income effect, small substitution effect: The amount of income that is spent on salt is relatively
small, but since there are few substitutes for salt, consumers will not readily substitute away from it.
As the price of salt rises, real income will fall only slightly, thus leading to a small decline in
consumption.
b. housing
Large income effect, no substitution effect: The amount of income spent on housing is relatively
large for most consumers. If the price of housing were to rise, real income would be reduced
substantially, thereby reducing the consumption of all other goods. However, consumers would find
it impossible to substitute for housing, in general.

c. theater tickets
Small income effect, large substitution effect: The amount of income that is spent on theater tickets is
relatively small, but consumers can substitute away from the theater tickets by choosing other forms
of entertainment (e.g., television and movies). As the price of theater tickets rises, real income will
fall only slightly, but the substitution effect can be large enough to reduce consumption by a large
amount.
d. food
Large income effect, no substitution effect: As with housing, the amount of income spent on food is
relatively large for most consumers. Price increases for food will reduce real income substantially,
thereby reducing the consumption of all other commodities. Although consumers can substitute out
of particular foods, they cannot substitute out of food in general.
9. Suppose that the average household in a state consumes 800 gallons of gasoline per year. A 20-cent
gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better
or worse off under the new program?
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If the household does not change its consumption of gasoline, it will be unaffected by the tax-rebate
program, because in this case the household pays 0.20*800=$160 in taxes and receives $160 as an
annual tax rebate. The two effects would cancel each other out. To the extent that the household
reduces its gas consumption through substitution, it must be better off. The new budget line (price
change plus rebate) will pass through the old consumption point of 800 gallons of gasoline, and any
now affordable bundle that contains less gasoline must be on a higher indifference curve. The
household will not choose any bundle with more gasoline because these bundles are all inside the old
budget line, and hence are inferior to the bundle with 800 gallons of gas.
10. Which of the following three groups is likely to have the most, and which the least, price-elastic demand
for membership in the Association of Business Economists?
a. students
The major difference among the groups is the level of income. We know that if the consumption of
a good constitutes a large percentage of an individual’s income, then the demand for the good will be
relatively elastic. If we assume that a membership in the Association of Business Economists is
likely to be a large expenditure for students, we may conclude that the demand will be relatively
elastic for this group.
b. junior executives
The level of income for junior executives will be larger than that of students, but smaller than that of
senior executives. Therefore, the demand for a membership for this group will be less elastic than
that of the students but more elastic than that of the senior executives.
c. senior executives
The high earnings among senior executives will result in a relatively inelastic demand for
membership.
11. Explain which of the following items in each pair is more price elastic.
a. The demand for a specific brand of toothpaste and the demand for toothpaste in general.
The demand for a specific brand is more elastic since the consumer can easily switch to another
brand if the price goes up.

b. The demand for gasoline in the short run and the demand for gasoline in the long run.
Demand in the long run is more elastic since consumers have had more time to adjust to the
change in price.
13. Explain the difference between a positive and a negative network externality, and give an example of
each.
A positive network externality exists if the quantity demanded of a good by one individual
increases in response to the purchase of the good by other consumers. Fads are an example of a
positive network externality. For example, each individuals demand for baggy pants increases as
more other individuals begin to wear baggy pants. This is also called a bandwagon effect. A
negative network externality exists if the quantity demanded of a good by one individual decreases
in response to the purchase of the good by other consumers. In this case the individual prefers to
be different from other individuals. As more people adopt a particular style or purchase a
particular type of good, this individual will reduce his demand for the good. Goods like designer
clothing can have negative network externalities as some people would not want to wear the same
clothes that many other people are wearing.

EXERCISES
1. An individual sets aside a certain amount of his income per month to spend on his two hobbies, collecting
wine and collecting books. Given the information below, illustrate both the price consumption curve
associated with changes in the price of wine, and the demand curve for wine.

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Price Price Quantity Quantity Budget

Wine Book Wine Book
$10 $10 7 8 $150
$12 $10 5 9 $150
$15 $10 4 9 $150
$20 $10 2 11 $150

The price consumption curve connects each of the four optimal bundles given in the table above.
As the price of wine increases, the budget line will pivot inwards and the optimal bundle will
change.
2. An individual consumes two goods, clothing and food. Given the information below, illustrate the income
consumption curve, and the Engel curves for clothing and food.

Price Price Quantity Quantity Income

Clothing Food Clothing Food
$10 $2 6 20 $100
$10 $2 8 35 $150
$10 $2 11 45 $200
$10 $2 15 50 $250

The income consumption curve connects each of the four optimal bundles given in the table
above. As the individual’s income increases, the budget line will shift out and the optimal bundle
will change. The Engel curves for each good illustrate the relationship between the quantity
consumed and income (on the vertical axis). Both Engel curves are upward sloping.

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3. Jane always gets twice as much utility from an extra ballet ticket as she does from an extra basketball
ticket, regardless of how many tickets of either type she has. Draw Jane’s income consumption curve and her
Engel curve for ballet tickets.
Jane will consume either all ballet tickets or all basketball tickets, depending on the two prices.
As long as ballet tickets are less than twice the price of basketball tickets, she will choose all
ballet. If ballet tickets are more than twice the price of basketball tickets then she will choose all
basketball. This can be determined by comparing the marginal utility per dollar for each type of
ticket, where her marginal utility of another ballet ticket is 2 and her marginal utility of another
basketball ticket is 1. Her income consumption curve will then lie along the axis of the good that
she chooses. As income increases, and the budget line shifts out, she will stick with the chosen
good. The Engel curve is a linear, upward-sloping line. For any given increase in income, she
will be able to purchase a fixed amount of extra tickets.

4. a. Orange juice and apple juice are known to be perfect substitutes. Draw the appropriate price-
consumption (for a variable price of orange juice) and income-consumption curves.
We know that the indifference curves for perfect substitutes will be straight lines. In this case, the
consumer will always purchase the cheaper of the two goods. If the price of orange juice is less than
that of apple juice, the consumer will purchase only orange juice and the price consumption curve
will be on the “orange juice axis” of the graph (point F). If apple juice is cheaper, the consumer will
purchase only apple juice and the price consumption curve will be on the “apple juice axis” (point
E). If the two goods have the same price, the consumer will be indifferent between the two; the price
consumption curve will coincide with the indifference curve (between E and F). See the figure
below.

Apple J u ice

PA < PO

PA = PO
E

PA > PO

U
F
Or a n ge J u ice

Assuming that the price of orange juice is less than the price of apple juice, the consumer will
maximize her utility by consuming only orange juice. As the level of income varies, only the

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amount of orange juice varies. Thus, the income consumption curve will be the “orange juice axis”
in the figure below.

Apple J u ice

Bu dget
Con st r a in t
In com e
Con su mpt ion
Cu rve

U3
U2
U1

Or a n ge J u ice

4.b. Left shoes and right shoes are perfect complements. Draw the appropriate price-consumption and income-
consumption curves.
For goods that are perfect complements, such as right shoes and left shoes, we know that the
indifference curves are L-shaped. The point of utility maximization occurs when the budget
constraints, L1 and L2 touch the kink of U1 and U2. See the following figure.

Righ t
Sh oes

P r ice
Consu mpt ion
Cur ve

U2

U1
L1 L2

Left Shoes

In the case of perfect complements, the income consumption curve is also a line through the corners
of the L-shaped indifference curves. See the figure below.

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 Chapter 4: Individual and Market Demand

Righ t
Sh oes

In come
Consu mpt ion
Cur ve

U2

U1
L1 L2

Left Shoes

5. Each week, Bill, Mary, and Jane select the quantity of two goods, , that they will consume in
order to maximize their respective utilities. They each spend their entire weekly income on these two goods.
a. Suppose you are given the following information about the choices that Bill makes over a three-week
period:

I
Week 1 10 20 2 1 40
Week 2 7 19 3 1 40
Week 3 8 31 3 1 55

Did Bill’s utility increase or decrease between week 1 and week 2? Between week 1 and week 3?
Explain using a graph to support your answer.
Bill’s utility fell between weeks 1 and 2 since he ended up with less of both goods. In week 2, the
price of good 1 rose and his income remained constant. The budget line will pivot inwards and he
will have to move to a lower indifference curve. Between week 1 and week 3 his utility rose. The
increase in income more than compensated him for the rise in the price of good 1. Since the price
of good 1 rose by $1, he would need an extra $10 to afford the same bundle of goods that he chose
in week 1. This can be found by multiplying week 1 quantities times week 2 prices. However, his
income went up by $15, so his budget line shifted out beyond his week 1 bundle. Therefore, his
original bundle lies within his new budget set, and his new week 3 bundle is on a higher
indifference curve.
b. Now consider the following information about the choices that Mary makes:

I
Week 1 10 20 2 1 40
Week 2 6 14 2 2 40
Week 3 20 10 2 2 60

Did Mary’s utility increase or decrease between week 1 and week 3? Does Mary consider both goods
to be normal goods? Explain.
Mary’s utility went up. To afford the week 1 bundle at the new prices, she would need an extra
$20, which is exactly what happened to her income. However, since she could have chosen the
original bundle at the new prices and income but chose not to, she must have found a bundle that
left her slightly better off. In the graph below, the week 1 bundle is at the intersection of the week

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1 and week 3 budget lines. The week 3 bundle is somewhere on the line segment that lies above
the week 1 indifference curve. This bundle will be on a higher indifference curve. A good is
normal if more is chosen when income increases. Good 2 is not normal because when her income
went up from week 2 to week 3, she consumed less of the good (holding prices the same).

c. Finally, examine the following information about Jane’s choices:

I
Week 1 12 24 2 1 48
Week 2 16 32 1 1 48
Week 3 12 24 1 1 36

Draw a budget line, indifference curve graph that illustrates Jane’s three chosen bundles. What can
you say about Jane’s preferences in this case? Identify the income and substitution effects that result
from a change in the price of good 1.
In week 2, the price of good 1 goes down and Jane consumes more of both goods. Her budget line
pivots outwards. In week 3 the prices remain at the new level, but Jane’s income is reduced. This
will shift her budget line inwards, and cause her to consume less of both goods. Notice that Jane
always consumes the two goods in a fixed 1:2 ratio. This means that Jane views the two goods as
perfect complements, and her indifference curves are L-shaped. Intuitively if the two goods are
complements, there is no reason to substitute one for the other during a price change because they
have to be consumed in a set ratio. Thus the substitution effect will be zero. When the price ratio
changes and utility is kept at the same level, Jane will choose the same point (12,24). The income
effect causes her to buy 4 more units of good 1 and 8 more units of good 2.

6. Two individuals, Sam and Barb, derive utility from the hours of leisure (L) they consume and from the
amount of goods (G) they consume. In order to maximize utility they need to allocate the 24 hours in the day
between leisure hours and work hours. Assume that all hours not spent working are leisure hours. The price
of a good is equal to $1 and the price of leisure is equal to the hourly wage. We observe the following
information about the choices that the two individuals make:
Sam Barb Sam Barb

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Price of G Price of L L(hours) L(hours) G($) G($)

1 8 16 14 64 80
1 9 15 14 81 90
1 10 14 15 100 90
1 11 14 16 110 88

Graphically illustrate Sam’s leisure demand curve and Barb’s leisure demand curve. Place price on the
vertical axis and leisure on the horizontal axis. Given that they both maximize utility, how can you explain
the difference in their leisure demand curves?
It is important to remember that less leisure implies more hours spent working at the higher wage.
Sam’s leisure demand curve is downward sloping. As the price of leisure (the wage) rises, he
chooses to consume less leisure to spend more time working at a higher wage to buy more goods.
Barb’s leisure demand curve is upward sloping. As the price of leisure rises, she chooses to
consume more leisure since her working hours are generating more income. This difference in
demand can be explained by examining the income and substitution effects for the two
individuals. The substitution effect measures the effect of the change in the price of leisure,
keeping utility constant (the budget line will rotate around the current indifference curve). Since
the substitution effect is always negative, a rise in the price of leisure will cause both individuals
to consume less leisure. The income effect measures the change in purchasing power caused by
the change in the price of leisure. Here, when the price of leisure (the wage) rises, there is an
increase in purchasing power (the new budget line will shift outwards). Assuming both
individuals consider leisure to be a normal good (this is not a necessary assumption for Sam), then
the increase in purchasing power will increase demand for leisure. For Sam, the reduction in
leisure demand caused by the substitution effect outweighs the increase in demand for leisure
caused by the income effect. For Barb, her income effect is larger than her substitution effect.
7. The director of a theatre company in a small college town is considering changing the way he prices
tickets. He has hired an economic consulting firm to estimate the demand for tickets. The firm has classified
people who go the theatre into two groups, and has come up with two demand functions. The demand curves
for the general public ( ) and students ( ) are given below.

a. Graph the two demand curves on one graph, with P on the vertical axis and Q on the horizontal axis.
If the current price of tickets is $35, identify the quantity demanded by each group.
Both demand curves are downward sloping and linear. For the general public, the vertical
intercept is 100 and the horizontal intercept is 500. For the students, the vertical intercept is 50
and the horizontal intercept is 200. The general public demands
tickets and the students demand tickets.
b. Find the price elasticity of demand for each group at the current price and quantity.
The elasticity for the general public is and the elasticity for the students

is . If the price of tickets increases by one percent then the general

public will demand .54% fewer tickets and the students will demand 2.33% fewer tickets.
c. Is the director maximizing the revenue he collects from ticket sales by charging $35 for each ticket?
Explain.
No he is not maximizing revenue since neither one of the calculated elasticities is equal to –1.
Since demand by the general public is inelastic at the current price, the director could increase the
price and quantity demanded would fall by a smaller amount in percentage terms, causing revenue
to increase. Since demand by the students is elastic at the current price, the director could

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decrease the price and quantity demanded would increase by a larger amount in percentage terms,
causing revenue to increase.
d. What price should he charge each group if he wants to maximize revenue collected from ticket sales?
To figure this out, find the formula for elasticity, set it equal to –1, and solve for price and
quantity. For the general public:

For the students:

8. Judy has decided to allocate exactly $500 to textbooks at college every year, even though she knows that
the prices are likely to increase by 5 to 10 percent per year and that she will be getting a substantial monetary
gift from her grandparents next year. What is Judy’s price elasticity of demand for textbooks? Income
elasticity?
Price elasticity of demand is percentage change in quantity for a given percentage change in price.
Judy knows that prices will go up in the future. Given she is going to spend a fixed amount on
books, this must mean that her quantity demanded will decrease as price increases. Since
expenditure is constant the percentage change in quantity demanded must be equal to the
percentage change in price, and price elasticity is -1. Income elasticity must be zero because
although she expects a large monetary gift, she has no plans to purchase more books. Recall that
income elasticity is defined as the percentage change in quantity demanded for a given percentage
change in income, all else the same.
9. The ACME Corporation determines that at current prices the demand for its computer chips has a price
elasticity of -2 in the short run, while the price elasticity for its disk drives is -1.
a. If the corporation decides to raise the price of both products by 10 percent, what will happen to its
sales? To its sales revenue?
We know the formula for the elasticity of demand is:

For computer chips, EP = -2, so a 10 percent increase in price will reduce the quantity sold by 20
percent. For disk drives, EP = -1, so a 10 percent increase in price will reduce sales by 10 percent.
Sales revenue is equal to price times quantity sold. Let TR1 = P1Q1 be revenue before the price
change and TR2 = P2Q2 be revenue after the price change.
For computer chips:
TRcc = P2Q2 - P1Q1
TRcc = (1.1P1 )(0.8Q1 ) - P1Q1 = -0.12P1Q1, or a 12 percent decline.
For disk drives:

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TRdd = P2Q2 - P1Q1

TRdd = (1.1P1 )(0.9Q1 ) - P1Q1 = -0.01P1Q1, or a 1 percent decline.
Therefore, sales revenue from computer chips decreases substantially, -12 percent, while the sales
revenue from disk drives is almost unchanged, -1 percent. Note that at the point on the demand
curve where demand is unit elastic, total revenue is maximized.
b. Can you tell from the available information which product will generate the most revenue for the firm?
If yes, why? If not, what additional information do you need?
No. Although we know the responsiveness of demand to changes in price, we need to know both
quantities and prices of the products to determine total sales revenue.
10. By observing an individual’s behavior in the situations outlined below, determine the relevant income
elasticities of demand for each good (i.e., whether the good is normal or inferior). If you cannot determine
the income elasticity, what additional information might you need?
a. Bill spends all his income on books and coffee. He finds $20 while rummaging through a used
paperback bin at the bookstore. He immediately buys a new hardcover book of poetry.
Books are a normal good since his consumption of books increases with income. Coffee is a normal
or neutral good since consumption of coffee did not fall when income increased.
b. Bill loses $10 he was going to use to buy a double espresso. He decides to sell his new book at a
discount to his friend and use the money to buy coffee.
Coffee is clearly a normal good.
c. Being bohemian becomes the latest teen fad. As a result, coffee and book prices rise by 25 percent.
Bill lowers his consumption of both goods by the same percentage.
Books and coffee are both normal goods since his response to a decline in real income is to decrease
consumption of both goods.
d. Bill drops out of art school and gets an M.B.A. instead. He stops reading books and drinking coffee.
Now he reads The Wall Street Journal and drinks bottled mineral water.
His tastes have changed completely, and we do not know exactly how he would respond to price and
income changes. We need more information regarding his new level of income, and relative prices
of the goods to determine the income elasticities.
11. Suppose the income elasticity of demand for food is 0.5, and the price elasticity of demand is –1.0.
Suppose also that Felicia spends $10,000 a year on food, the price of food is $2, and her income is $25,000.
a. If a sales tax on food were to cause the price of food to increase to $2.50, what would happen to her
consumption of food? (Hint: Since a large price change is involved, you should assume that the price
elasticity measures an arc elasticity, rather than a point elasticity.)
The price of food increases from $2 to $2.50, so arc elasticity should be used:

 P1  P2 
Q  
EP   Q 2 Q .
P  1 2

 2 
We know that EP = -1, P = 2, P = 0.5, and Q=5000. We also know that Q 2, the new quantity, is
Q  Q. Thus, if there is no change in income, we may solve for Q:

By cross-multiplying and rearranging terms, we find that Q = -1,000. This means that she
decreases her consumption of food from 5,000 to 4,000 units.

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b. Suppose that she is given a tax rebate of $2,500 to ease the effect of the sales tax. What would her
consumption of food be now?
A tax rebate of $2,500 implies an income increase of $2,500. To calculate the response of demand to
the tax rebate, use the definition of the arc elasticity of income.

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.
We know that EI = 0.5, I = 25,000, I = 2,500, Q = 4,000 (from the answer to 11.a). Assuming no
change in price, we solve for Q.

By cross-multiplying and rearranging terms, we find that Q = 195 (approximately). This means
that she increases her consumption of food from 4,000 to 4,195 units.
c. Is she better or worse off when given a rebate equal to the sales tax payments? Draw a graph and
explain.
Felicia is likely to be better off after the rebate. The amount of the rebate is enough to allow her to
purchase her original bundle of food and other goods. Recall that originally she consumed 5000
units of food. When the price went up by fifty cents per unit, she needed an extra
5000*$0.50=$2,500 to afford the same quantity of food without reducing the quantity of the other
goods consumed. This is the exact amount of the rebate. However, she did not choose to return to
her original bundle. We can therefore infer that she found a better bundle that gave her a higher
level of utility. In the graph below, when the price of food increases, the budget line will pivot
inwards. When the rebate is given, this new budget line will shift outwards. The bundle after the
rebate is on that part of the new budget line that was previously unaffordable, and that lies above
the original indifference curve.

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12. You run a small business and would like to predict what will happen to the quantity demanded for your
product if you raise your price. While you do not know the exact demand curve for your product, you do
know that in the first year you charged a price of $45 and sold 1200 units and in the second year you charged
a price of $30 and sold 1800 units.
a. If you plan to raise your price by 10% what would be a reasonable estimate of what might happen to
quantity demanded in percentage terms?
To answer this question, you need to find the elasticity. You can estimate the slope of the demand
curve in the following way:

You can now use the elasticity formula and calculate elasticity at each data point, as well as the
average point. The elasticities are:

P=45 and Q=1200 elasticity=

P=30 and Q=1800 elasticity==

P=37.5 and Q=1500 elasticity==

Given you are coming up with an estimate based on only two data points, it may be best to go with
the average point. If elasticity is -1 then a 10% increase in price will cause quantity demanded to
fall by 10%.
b. If you raise your price by 10%, will revenue increase or decrease?
If elasticity is really -1 then revenue will fall if price is increased. If elasticity is actually closer to
-0.67 (inelastic) then revenue will rise because the effect of the increase in price will outweigh the
effect of the decrease in quantity. If elasticity is closer to -1.5 (elastic) then revenue will fall when
price is increased.
13. Suppose you are in charge of a toll bridge that costs essentially nothing to operate. The demand for
bridge crossings Q is given by .

a. Draw the demand curve for bridge crossings.

The demand curve is linear and downward sloping. The vertical intercept is 15 and the horizontal
intercept is 30.
b. How many people would cross the bridge if there were no toll?
At a price of zero, the quantity demanded would be 30.
c. What is the loss of consumer surplus associated with a bridge toll of $5?
If the toll is $5 then the quantity demanded is 20. The lost consumer surplus is the area below the
price line of $5 and to the left of the demand curve. The lost consumer surplus can be calculated
as (5*20)+0.5(5*10)=$125.
d. The toll bridge operator is considering an increase in the toll to $7. At this new higher price,
how many people would cross the bridge? Would the toll bridge revenue increase or decrease?
What does your answer tell you about the elasticity of demand?
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 Chapter 4: Individual and Market Demand

At a toll of $7, the quantity demanded would be 16. The initial toll revenue was $5*20=$100.
The new toll revenue is $7*16=$112. Since the revenue went up when the toll was increased,
demand is inelastic (the increase in price (40%) outweighed the decline in quantity demanded
(20%)).
e. Find the lost consumer surplus associated with the increase in the price of the toll from $5 to
$7.
The lost consumer surplus is (7-5)*16+0.5(7-5)(20-16)=$36.
14. Vera has decided to upgrade the operating system on her new PC. She hears that the new Linux
operating system is technologically superior to the Windows operating system and substantially lower in
price. However, when she asks her friends it turns out they all use PCs with Windows. They agree that
Linux is more appealing but add that they see relatively few copies of Linux on sale at the local retail software
stores. Based on what she learns and observes, Vera chooses to upgrade her PC with Windows. Can you
explain her decision?
Vera is consuming under the influence of a positive network externality (not a bandwagon effect).
When she hears that there are limited software choices that are compatible with the Linux operating
system, she decides to go with Windows. If she had not been interested in acquiring much software,
she may have gone with Linux. See Example 4.6 in the text. In the future, however, there may be a
bandwagon effect, i.e., the purchase of Linux because almost everyone else has it. As more people
use Linux, manufacturers might introduce more software that is compatible with the Linux operating
system. As the Linux based software section at the local computer store gets larger and larger, this
prompts more consumers to purchase Linux. Eventually, the Windows section shrinks as the Linux
section becomes larger and larger.
16. Suppose that you are the consultant to an agricultural cooperative that is deciding whether members
should cut their production of cotton in half next year. The cooperative wants your advice as to whether this
will increase the farmers’ revenues. Knowing that cotton (C) and watermelons (W) both compete for
agricultural land in the South, you estimate the demand for cotton to be C=3.5-1.0P C+0.25PW+0.50I, where PC
is the price of cotton, P W the price of watermelon, and I income. Should you support or oppose the plan? Is
there any additional information that would help you to provide a definitive answer?
If production of cotton is cut in half, then the price of cotton will increase, given that we see from the
equation above that demand is downward sloping. With price increasing and quantity demanded
decreasing, revenue could go either way. It depends on whether demand is inelastic or elastic at the
current price. If demand is inelastic then a decrease in production and an increase in price could
increase revenue. If demand is elastic then a decrease in production and an increase in price will
clearly decrease revenue. You need to know the current price and/or quantity demanded to figure
out the current level of elasticity.

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