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Fundamentals of Economics

Fundamentalsof Economics

  1. Let’s consider two smokers A and B who, following a 20% decrease in the price of cigarettes, increase their smoking by 6% and 30% respectively.

  1. What is the price elasticity of demand for each consumer? Show all the steps of your calculation to get full credit

Letprice be P and quantity Q

Priceelasticity for smoker A

Pricedecrease by 20% = 80% of P

Newprice = 0.8P

Quantityincreases by 6%= 106% of Q

Newquantity = 1.06Q

Priceelasticity of demand = *

= *

=*

=-0.3

Priceelasticity for smoker B

Pricedecrease by 20% = 80% of P

Newprice = 0.8P

Quantityincreases by 30%= 130% of Q

Newquantity = 1.3Q

Priceelasticity of demand = *

= *

=*

=-1.5

b)Are A’s and B’s consumptions of cigarettes elastic or inelastic?Whom you think is the occasional smoker and who is the regular smoker(that is, dependent on smoking)? Explain clearly in 2 or moresentences.

Bothsmoker A and B are price inelastic since their price elasticity ofdemand is below 1.

Sincethe price elasticity of demand of A is higher than that of B, A is aregular smoker since he is not affected too much by fall in prices,whereas B is an occasional smoker and only smokes more when pricesare lower.

c)Supposethat for a consumer C the price elasticity of demand for cigarettesis equal 1.5. How big will the increase in cigarettes consumed befollowing a 16 percent decrease in cigarettes’ prices? Show all thesteps of your calculation to get full credit.

Priceelasticity of demand = 1.5

Priceelasticity of demand = *

Pricedecrease by 16% = 84% of P

Newprice = 0.84P

Letchange in Q be x

1.5 = *

1.5 =*

1.5 =

x =1.5 * -0.16

x =-0.24

Thereforechange in Q = -0.24

Thereforethe consumption of cigarettes will decrease by 24%

d) If you are seller of cigarettes, and you realize that when you loweryour price by 24%, your quantity sold are increased by 8% in onemarket and by 36% in the other market, in which market would yourtotal revenue increase or decrease? Explain, that is, show all thesteps that lead to your conclusion

Firstmarket

Pricedecrease by 24% = 76% of P

Newprice = 0.76P

Quantityincreases by 8%= 108% of Q

Newquantity = 1.08Q

Priceelasticity of demand = *

= *

=*

=-0.3333

Secondmarket

Pricedecrease by 24% = 76% of P

Newprice = 0.76P

Quantityincreases by 36%= 136% of Q

Newquantity = 1.36Q

Priceelasticity of demand = *

= *

=*

=-1.5

Theprice elasticity of demand in the first market is higher than that ofthe second market. That implies that the first market is not highlyaffected by changes in prices, and also they are regular smokerscompared to the second market. In the first market, the seller ismore likely to make more revenue as compared to the second marketwhere the seller will make a large income at first but later makelower levels of revenues.