Economics

(BUS700)

TRIMESTER 2, 2015
BUS700 MICROECONOMICS, TUTORIAL SEMINAR 2_Answer Guide
1.
2.

Briefly explain the concept of own price elasticity of demand, naming the various types of
elasticity that can be encountered.

A price elasticity of demand of 4 means that a 10% increase in price will result in a:
a)
b)
c)
d)

3.

The price of plums falls by 7% and the quantity of plums demanded increases by 6.75%. We
conclude that the demand for plums is:
a)
b)
c)
d)

4.

5.

4% increase in the quantity demanded

40% decrease in the quantity demanded
2.5% decrease in the quantity demanded
40% decrease in the quantity demanded

Inelastic
Elastic
Perfectly elastic
Perfectly inelastic

If an airline were to increase domestic fares for business and holiday travellers by the same
percentage, why might revenue from sale of business tickets increase whilst revenue from sale
holiday tickets fall? Use the demand curve for business and holiday tickets to illustrate your
answer.

The price elasticity of demand for holiday travellers is higher than the elasticity for
business travellers because holiday travellers can more easily choose a different
mode of transport (like driving or taking the train). Business travellers are less
likely to do so since time is important to them and their schedules are less
adaptable.
Calculate the cross-price elasticity for the following goods. Are they substitutes or complements?

a. The price of movie theatre tickets goes up by 10 percent, causing the quantity demanded for
video rentals to up by 4 percent.

b. Computer price fall by 20 percent, causing the quantity demanded of software to increase by 15
percent.

c. The price of apples falls by 5 percent, causing the quantity demanded of pears to fall by 5 percent.
Answers
a. Cross-price elasticity is 0.40. The two goods are substitutes.
b. Cross-price elasticity is 0.75. The two goods are complements.
c. Cross-price elasticity is 1. The two goods are substitutes.

BUS700 Economics

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Economics (BUS700)
6.

In response to the increasing death of teenagers from illicit drug overdose, the government has
introduced a new get tough on drugs policy in which it will target the importers and dealers of
illicit drugs. There are two types of illicit drugs drug A and drug B. Drug A has an elastic demand
in the relevant range. Drug B has an inelastic demand in the relevant range.

Analyse the effect of the new drug policy in the market for both drugs. What would be the effect
on total expenditure on each of the drugs? Are your answers consistent with economic theory?
Use demand and supply diagram (s) to explain and illustrate your answer.

Answer
Use a D-S diagram. With a policy targeting suppliers, the quantity supplied will be lower at every
price supply will shift to the left (for both drugs).
Drug A is elastic in the relevant range in the new equilibrium, quantity demanded will fall, and
this fall will be proportionally larger than the price rise. Total expenditure would fall.
Drug B is inelastic in the relevant range in the new equilibrium, quantity demanded will fall, and
this fall will be proportionally smaller than the price rise. Total expenditure on Drug B will
increase.

7.

Define the following concepts in relation to economic efficiency: price ceiling, price floor, and
deadweight loss. Use the demand and supply model to illustrate your answer.

8.

Define the term incidence of tax. What does the incidence of tax depend on?

Tax incidence: The actual division of the burden of a tax between buyers and sellers in a
market.

Who actually pays a tax? The answer depends on:

Slope of the demand curve and the price elasticity of demand.

Slope of the supply curve and the price elasticity of supply.

BUS700 Economics

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Economics (BUS700)
9.

Consider a market in which demand for and supply of the good conform to the laws of demand
and supply. The government imposes a tax t on the good to be paid for by the suppliers of the
good. Use the demand and supply diagram to analyse the effect of this tax on the market. Your
answer should include a discussion of the effect of on quantity sold, price in the market and the
incidence (who bears the tax burden) of the tax. What determines the incidence of the tax? Is the
tax efficient?

P

ST



A
S



Pb

P*
C
S

s

P
B


D




P
b

Qt Q* Quantity of X



*
*
*
PThe
the cost of

original equilibrium is (Q P ). A tax to be paid by sellers increases
t
production and, therefore, shifts the supply curve upwards from S to S . The size of the
shift is exactly equal to the tax t.

s
PThe
new equilibrium quantity is Qt, which results from the intersection of St and D.

Consumers pay Pb and sellers receive Ps.
Since Pb > P* and Ps < P*, the tax incidence is shared by both consumer and seller

The incidence of tax depends on the relative elasticity of demand and supply. The less
elastic side bears a larger share of the tax.

BUS700 Economics

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