Download Problem Set 2 - Class Web Sites

Problem Set 2
1. Imagine you are the manager of the public transit system in your town. Your finance officer
has just advised you that the system faces a deficit. Your board doesn’t want you to cut
service, which means that you can’t cut costs. Your only hope is to increase revenue. You
have to decide whether a fare increase will boost revenue. You consult the economist on
your staff who has researched studies on public transportation elasticities. She reports that
the estimated price elasticity of demand for the first few months after a price change is about
–0.5, but that after several years, it will be about –1.5.
a. Explain why the estimated values for price elasticity of demand differ.
The estimated values differ because short-term and long-term price elasticities are not the same.
In the short run, people may choose to walk instead of riding the subway or may choose not to go
somewhere because the price of a subway ride is too high. This will result in a small loss of
ridership for the public transit system. In the long run, however, the elasticity is significantly
higher because people will substitute other modes of transportation (most likely cars) for subway
rides. However, they will only buy a car after the price of a subway ride has been elevated for a
considerable amount of time.
b. Compute what will happen to ridership over the next few months if you decide to raise
fares from $.85 to $.95.
Price elasticity = (% change in quantity demanded)/(% change in price)
-0.5 =
x
(.95  .85)
.85
= x/.1176
Solving for x yields, x=.0588
In the short run, ridership will fall by 6 percent.
c. Compute what will happen to ridership over the next few years if you decide to raise
fares from $.85 to $.95.
Price elasticity = (% change in quantity demanded)/(% change in price)
-1.5 =
x
(.95  .85)
.85
= x/.1176
Solving for x yields, x=.1765
In the long run, ridership will fall by 18 percent.
d. What happens to total revenue now and after several years if you choose to raise fares?
In the short run, total revenue will rise because demand is inelastic. Ridership will fall, but by a
smaller percentage than the rise in price. Total revenue (which equals price times quantity) will
rise. However, in the long run, revenue will fall. Ridership will decline substantially, and the
price hike will not be sufficient to keep revenue from declining.
2. Are there any times when the price elasticity of demand is positive? Consider the following
questions.
a. The advertising slogan of Maker Mark’s Whiskey is: “It tastes expensive … and it is.”
Isn’t the firm foolish to advertise its high price? Or will people buy more if they think
Maker Mark’s is more expensive than other whiskeys? If so, does this contradict the law
of demand?
The law of demand is still valid. An increase in price (ceteris paribus) will lead to a decreased
quantity demanded. However, in this case all else is not equal. Maker Mark’s is using the ad to
change people’s perceptions about the quality of the whiskey. The ad is leading to an actual shift
of the demand curve. The firm wants people to perceive their whiskey as a premium product and
therefore to demand more of it.
b. A waiter at a swank restaurant says, “It is good to be known as expensive. People know
they can impress their guests here.” What does he think people are purchasing when they
go to this restaurant for dinner?
Again, demand for higher priced restaurants should be lower than demand for low priced
restaurants, all else equal. But, of course, eating at a swank restaurant does not give you the same
experience as eating at Pizza Hut. Patrons of the expensive restaurant are purchasing the dinner
itself, but they are also purchasing the prestige that comes from bringing guest to such an
expensive restaurant, the presentation of the food, the surroundings, the service, etc..
In both cases, it is not really that price elasticity is positive. When the whiskey makers or
restaurant owners are charging a higher price, they are producing (and trying to sell you) a
different, higher-quality good as well. Therefore, you are comparing two different markets and
therefore, two different demand curves, rather than moving along one demand curve.
3. During World War II, there was a freeze on wages, and employers found that they could
evade the limit by providing non-salary benefits, particularly employer-paid (and therefore
untaxed) health-care insurance. The IRS has allowed the benefits (with some exceptions) to
remain untaxed ever since. Employer-based health insurance was thus an unintended
consequence of wage controls that were in effect during WWII. Are wage controls and
example of a price ceiling or a price floor? Use the tools of demand and supply to explain
why employers at the time might have begun to offer health insurance to their employees.
Wage controls are an example of a price ceiling. The government was concerned about a sharp
upward movement in wages caused by a reduction in the civilian labor supply (due to the large
numbers of men entering the military) and a significant increase in the demand for labor (due to
the increased demand for many goods, most notably weapons, ammunition, and other goods used
by the military). When the government imposes a price ceiling, there is a shortage in the market,
as the graph shows. Firms, therefore, faced a shortage of labor. In order to attract labor, they had
to offer other, non-wage benefits, including health insurance. These benefits affected the supply
curve, raising the quantity of labor supplied at each level of the wage (shifting supply to the
right). This allowed firms to hire their desired number of workers at the government-controlled
wage.
4. Internet problem: Using the Internet, discuss the current status of minimum wage legislation
in the Congress in a short essay. Who are some of the proponents of minimum wage
increases and who is opposed to such increases? Be sure to tell me which site(s) you used to
answer this question.
I was looking for an answer which addressed the current status of bills in the House or Senate,
specific proponents and opponents of the bill and a bit of detail on why they took these positions
on minimum wage legislation.