Chapter 3
DEMAND AND SUPPLY APPLICATIONS
Chapter in a Nutshell
1. The price elasticity of demand measures how sensitive buyers are to a change in price.
Depending on the response of buyers to a change in price, demand is characterized as elastic,
inelastic, or unit elastic.
2. Demand tends to be more elastic for some products and less elastic for others. Among the
major determinants of the price elasticity demand are the availability of substitutes, the
proportion of buyer income spent on a product, and the time period under consideration.
3. If a firm’s price and total revenue move in opposite directions, demand is elastic. If the
firm’s price and total revenue move in the same direction, demand is inelastic. If the firm’s
total revenue does not respond to a change in price, demand is unit elastic.
4. Occasionally, the government will impose price controls on individual markets in which
prices are considered unfairly high to buyers or unfairly low to sellers. When government
imposes a price ceiling on a product, it establishes the maximum legal price a seller may
charge for that product. Conversely, government establishes a price floor to prevent prices
from falling below the legally mandated level.
5. Although price controls on individual markets attempt to make prices more “fair” for buyers
and sellers, they interfere with the market’s allocation of resources. Price ceilings that are set
below the equilibrium price level result in market shortages of a product. Price floors that are
set above the equilibrium level entail market surpluses.
Chapter Objectives
After reading this chapter, you should be able to:
1. Explain the relationship between the responsiveness of quantity demanded to a change in
price and the manner in which a firm’s total revenue is influenced by price changes.
2. Describe the nature and operation of the price elasticity of supply.
3. Assess the advantages and disadvantages of governmental price ceilings and price supports
on individual markets.
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Chapter 3: Demand and Supply Applications
21
Knowledge Check
Key Concept Quiz
1. price elasticity of demand
2. elastic demand
3. inelastic demand
4. unit elastic demand
5. total revenue
_____ a. percentage change in quantity demanded is
greater than the percentage change in price
_____ b. measures how sensitive buyers are to a change
in price
_____ c.
=PxQ
6. price elasticity of supply
_____ d. the maximum legal price a seller may charge
for the product
7. price ceiling
_____ e. a type of price ceiling
8. price floor
_____ f. percentage change in quantity demanded is less
than the percentage change in price
9. rent control
_____ g. percentage change in quantity demanded equals
the percentage change in price
10. usury
11. usury law
12. agricultural price floor
_____ h. measures how quantity supplied responds to a
change in the price
_____ i. the minimum legal price a seller may charge for
the product
_____ j. all payments for the use of money
_____ k. a legally mandated minimum price
_____ l. interest-rate ceiling
Multiple Choice Questions
1. Price elasticity of demand measures
a.
b.
c.
d.
the responsiveness of quantity demanded to a change in the price
the responsiveness of demand to a change in the price
the responsiveness of price to changes in quantity demanded
the responsiveness of price to changes in demand
2. Price elasticity of supply measures
a.
b.
c.
d.
the percentage change in supply due to a percentage change in price
the percentage change in price due to a percentage change in supply
the percentage change in quantity supplied due to a percentage change in the price
the percentage change in price due to a percentage change in the quantity supplied
3. Price elasticity of demand is always
a.
b.
c.
d.
positive
negative
non-zero
zero or negative
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Chapter 3: Demand and Supply Applications
4. The supply curve must always assume
a.
b.
c.
d.
non-negative values
negative values
non-positive values
values close to infinity
5. Demand is relatively inelastic when
a.
b.
c.
d.
Ed
Ed
Ed
Ed
=1
>1
<1
=0
6. Demand is relatively elastic when
a.
b.
c.
d.
Ed = 1
Ed > 1
Ed < 1
Ed = 
7. When the price of a product rises and Ed = 1, the total revenue
a.
b.
c.
d.
remains unchanged
increases
decreases
cannot be determined
8. When the Seattle Mariners decide to increase the price of their tickets to baseball games
hoping to increase total revenues earned, they are working on the assumption that
a.
b.
c.
d.
Ed = 1
Ed > 1
Ed < 1
Ed = 0
9. If Gateway cuts prices on all of its desktop computers on the prediction that total revenues
will rise, then Gateway is assuming that
a.
b.
c.
d.
Ed = 1
Ed > 1
Ed < 1
Ed = 0
10. All the following factors affect the price elasticity of demand except the
a.
b.
c.
d.
availability of substitutes
proportion of income spent on the product
time to adjust to a change in the price
change in the consumer’s income
Chapter 3: Demand and Supply Applications
23
11. If a tax is placed on a life-saving drug that happens to be the only drug on the market
a.
b.
c.
d.
consumers will pay most of the tax
drug companies will pay most of the tax
the drug companies will stop producing the drug
the consumers will boycott the drug
12. If steel producers are successful in lobbying Congress for subsidies, we may expect all of the
following except
a.
b.
c.
d.
increase in the quantity supplied
increase in the price of steel
decrease in the price of steel
reallocation of government funds
13. A gas tax is more effective for collecting revenues in the short run rather than the long run
since
a.
b.
c.
d.
governments usually realize their mistakes over the long run
demand is more elastic in the long run
consumers always get used to the idea of a tax over the long run
producers are very responsive to a tax in the short run but not the long run
14. If cigarettes are subject to price ceilings, all of the following may happen, except
a.
b.
c.
d.
the price of cigarettes falls
an underground market for cigarettes develops
a surplus develops in the market for cigarettes
the quality of the product may deteriorate
15. If a tax is imposed on handguns and the demand and supply for handguns are both elastic
a. the tax will be shared by the sellers and buyers, and the quantity of handguns sold will
decrease
b. the tax will be borne entirely by the buyers
c. the tax will be borne entirely by the sellers
d. the tax will have no effect on the market for handguns
16. When the price of oil is $20 a barrel, 25 million barrels are demanded each day, but when the
price of oil is $30 a barrel, only 20 million barrels are demanded. We can conclude that the
demand for oil is
a.
b.
c.
d.
perfectly inelastic
relatively inelastic
relatively elastic
perfectly elastic
17. The supply of wheat will be more inelastic the
a.
b.
c.
d.
shorter the time period under consideration
greater the number of farmers growing wheat
easier it is to substitute capital for labor in farming
greater the number of buyers in the wheat market
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Chapter 3: Demand and Supply Applications
18. The burden of a tax on gasoline is born entirely by consumers if the demand for gasoline is
a.
b.
c.
d.
perfectly elastic
relatively elastic
relatively inelastic
perfectly inelastic
Interest
Rate
Quantity of
Money
Supplied
Quantity of
Money
Demanded
4%
$1million
$5 million
8%
$2 million
$4 million
12%
$3 million
$3 million
16%
$4 million
$2 million
20%
$5 million
$1 million
19. The table above shows the market for mortgage loans. If the government imposes a ceiling
on interest rates at 8 percent, the ceiling:
a.
b.
c.
d.
does not protect borrowers from the interest rate set by the market
results in borrowers paying an interest rate higher than the market equilibrium rate
leads to an excess demand for mortgage funds
increases profits that lenders make on mortgage loans
20. If the federal government levied an effective ceiling on interest rates charged by MasterCard
and Visa, we would anticipate a decrease in the:
a.
b.
c.
e.
annual credit card fees paid by households
prices charged by merchants who accept credit cards for payment
amount of credit made available by banks issuing credit cards
fee that banks charge merchants for processing credit card sales
21. If the University of Wisconsin increases tuition which results in rising total tuition revenue,
student demand for education at the university is
a.
b.
c.
d.
inelastic
elastic
unit elastic
all of the above
22. In 1997, the U.S. government levied a 10-percent excise tax on the sale of domestic airline
tickets, yet airlines increased fares by 4 percent. Apparently, the demand for tickets was
a. perfectly inelastic
b. perfectly elastic
c. somewhat elastic
d. all of the above
Chapter 3: Demand and Supply Applications
25
23. In 2002, the Pittsburgh Pirates increased season ticket prices to generate additional revenue.
However, fan attendance at baseball games fell more than that anticipated by the team’s
management, resulting in decreases in revenue. Apparently, the demand for tickets was
a.
b.
c.
d.
relatively inelastic
relatively elastic
perfectly inelastic
perfectly elastic
24. Health care would become more expensive if
a.
b.
c.
d.
the increase in the demand curve for health care is more than the increase in supply
the increase in the demand curve for health care is less than the increase in supply
the decrease in the demand curve for health care is more than the decrease in supply
the decrease in the demand curve for health care is the same amount as the decrease in
supply.
25. Below-equilibrium rent controls are plagued by all of the following problems except:
a.
b.
c.
e.
discrimination may occur in the rationing of apartments
rent controls encourage the production of more apartments
the quality of apartments may deteriorate
landlords my develop under-the-table markets to collect extra income
26. If federal ceilings were imposed on the interest rate you pay on your Master Card, the bank
that issued your credit card would have the incentive to
a.
b.
c.
d.
lengthen your interest-free grace period
reduce the annual fee that you pay on your credit card
raise the fee they charge merchants for processing credit card sales
provide more services with your credit card, such as discounts on motels
True-False Questions
1.
T
F
Elasticity of supply decreases when price increases.
2.
T
F
If demand is elastic, the demand curve shifts to the right when price
increases.
3.
T
F
Elasticity of demand and total revenue are unrelated.
4.
T
F
Unit elasticity implies that total revenue is unresponsive to changes in
price.
5.
T
F
If a firm increases total revenue by raising prices, it must be experiencing
inelastic demand.
6.
T
F
When a product has many substitutes, its elasticity is relatively high.
7.
T
F
The price elasticity of demand is insensitive to time.
8.
T
F
Buyers and sellers will always share a gas tax equally.
9.
T
F
When the demand curve is vertical and the supply curve is positively
sloped, a new tax will be borne entirely by the sellers.
26
Chapter 3: Demand and Supply Applications
10.
T
F
Price ceilings are always higher than the equilibrium price.
11.
T
F
Price floors are always lower than the equilibrium price.
12.
T
F
Farm subsidies provide an example of price floors.
13.
T
F
A price ceiling on gas will always benefit consumers.
14.
T
F
Imposition of interest rate ceilings amounts to market interference.
15.
T
F
A price floor typically causes a shortage.
16.
T
F
A price ceiling may lead to improvement of the quality of the product or
service.
17.
T
F
When demand increases in a market experiencing a price ceiling, a
shortage develops in the market.
18.
T
F
When demand is elastic and a firm raises the price of its product, it does
so because it correctly predicts an increase in total revenue.
19.
T
F
Inelastic supply curves may become elastic given enough time.
20.
T
F
Unit elasticity implies that a rise in price leads to a one-unit decline in
the quantity demanded.
21.
T
F
Rent controls and minimum wage laws provide examples of price floors.
22.
T
F
If the price elasticity of demand for first-class letters is 0.3, an increase in
price will result in additional revenues for the U.S. Postal Service.
23.
T
F
24.
T
F
The rising significance of email results in the demand for letter mail
delivered by the U.S. Postal Service becoming more elastic.
If the demand for airline tickets is perfectly elastic, a 10 percent increase
in the excise tax on tickets will entirely be absorbed by passengers in the
form of a higher price.
25.
T
F
If the increase in the supply of health care exceeds the increase in
demand, health care becomes more expensive.
26.
T
F
If the federal government imposes a ceiling on the interest rate that banks
could charge users of VISA, a bank would have the incentive to tighten
credit standards so as to decrease collection costs and write-offs of bad
debt.
27.
T
F
An increase in the minimum wage will result in an increase in total
wages paid to workers if the demand for labor is inelastic.
Chapter 3: Demand and Supply Applications
27
Application Questions
1. The following table shows Homer Simpson’s demand for comedy show tickets.
Price
($/ticket)
Quantity
Demanded
$10
20
$20
15
$30
10
$40
5
$50
0
Use the following midpoint formula to calculate the price elasticities of demand.
P2  P1
Ed  %Q  Q2  Q1 P2  P1  Q2  Q1
Qaverage Paverage (Q1  Q2) 2 (P1  P2) 2
%P
a. Calculate the price elasticity of demand between the prices of $10 and $20.
b. Calculate the price elasticity of demand between the prices of $20 and $40.
c. Calculate the price elasticity of demand between the prices of $40 and $50.
d. Is Homer Simpson more sensitive to price increases when the price is $10 than when it
is $40?
e. Let’s assume that the price of a comedy show ticket is $40 and everyone in the
community has a demand schedule that is identical to Homer Simpson’s. If the
organizers raise the ticket prices, will they succeed in increasing their revenues?
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Chapter 3: Demand and Supply Applications
2. The following table shows the demand and supply for comedy show tickets in the Simpson
neighborhood.
Price
($/ticket)
Quantity
Demanded
Quantity
Supplied
$10
40
20
$20
30
30
$30
20
40
$40
10
50
$50
0
60
a. What is the equilibrium price? What is the equilibrium quantity? Draw the supply and
demand curves for comedy show tickets.
b. Assume that a $10 tax is imposed on each ticket. Draw the new supply curve.
c. What is the new equilibrium price? What is the new equilibrium quantity?
Chapter 3: Demand and Supply Applications
3. The following table represents a new demand schedule for the suburb of Consistent, which
borders the Simpson’s neighborhood.
Price
($10/ticket)
Quantity
Demanded
$10
40
$20
40
$30
40
$40
40
$50
40
Assume that the supply schedule of tickets is identical to the one described in question 2.
a. Draw demand and supply curves of tickets and identify the equilibrium.
b. What is the equilibrium price and quantity?
c. Assume that a tax of $10/ticket is imposed. Draw a new supply curve of tickets.
d. Who pays for the tax?
e. Are the effects of the tax in this market different from the effects in the market
described in question 2? Why?
Answers to Knowledge Check Questions
29
30
Chapter 3: Demand and Supply Applications
Key Concept Answers
1. b
7. d
2. a
8. i
3. f
9. e
4. g
10. j
5. c
11. l
6. h
12. k
Multiple Choice Answers
1. a
6. b
2. c
7. a
3. d
8. c
4. a
9. b
5. c
10. d
11.
12.
13.
14.
15.
a
c
b
c
a
16.
17.
18.
19.
20.
b
a
d
c
c
21.
22.
23.
24.
25.
a
c
b
a
b
26. c
True-False Answers
1. F
6.
2. F
7.
3. F
8.
4. T
9.
5. T
10.
11.
12.
13.
14.
15.
F
T
F
T
F
16.
17.
18.
19.
20.
F
T
F
T
F
21.
22.
23.
24.
25.
F
T
T
F
F
26. T
27. T
T
F
F
F
F
Application Question Answers
1. a. Ed = 0.43
b.
Ed = 1.5
c.
Ed = 9
d.
No. Homer is less sensitive to price increases when the price is $10 than when it is $40.
e.
No. Because the price elasticity of demand is greater than one, total revenue will
decrease when price is increased.
Chapter 3: Demand and Supply Applications
Market for Comedy Show Tickets
Price of
Ticket 60
($)
50
40
S´

Post-tax
Supply Curve





30


S



20

10

10
2. a.
c.
20

Pre-tax
Supply Curve

D
30
40
Equilibrium price = $20
Equilibrium quantity = 30 tickets
New equilibrium price = $25
New equilibrium quantity = 25 tickets
50
60
Quantity
31
32
Chapter 3: Demand and Supply Applications
Market for Comedy Show Tickets
Price of
Ticket 60
($)
D
Post-tax
Supply Curve
50

40


30
20

10

0
3. a.
10
20
S´

S



30

Pre-tax
Supply Curve
40
50
60
Quantity
The new demand curve is vertical.
b.
Equilibrium price = $30
Equilibrium quantity = 40 tickets
c.
Yes. In this market suppliers do not share the tax burden. Also, the same quantity of
tickets (40 tickets) is bought and sold in this market before and after the imposition of the
tax. In the neighborhood in which the Simpsons reside, the suppliers share part of the tax
and less is bought and sold after the tax is imposed.