price elasticity of demand

price elasticity of demand

SECTION A (5 marks per question)
Answer all questions in this section.
Indicate whether each statement is TRUE, FALSE or UNCERTAIN, giving a brief explanation in the space provided. Use diagrams and/or equations where appropriate. Your marks will depend entirely on the quality of this explanation: e.g., even if it is correct, putting “TRUE” will get no marks unless you explain your answer.

1. “The price elasticity of demand of Ivory brand soap would generally be greater than the price elasticity of demand of all soaps, taken as a category”.
2. “It is bad economic policy for a country to import a good that it can produce more cheaply itself”.
3.“The demand for an inferior good must be upwards-sloping.”
4. “Rising marginal cost tends to raise average costs. Hence, if we graph average and marginal cost, we find that marginal cost crosses average cost at a point where average cost is increasing”.
5. “Diseconomies of scale occur whenever a production function exhibits diminishing marginal returns”.
6. “When all input prices double, marginal cost is unaffected and so remains the same. Similarly, a doubling of all input prices results in no shift in supply for a perfectly competitive market”.
7. “A perfectly competitive firm earns zero profits, so there must be no incentive to enter a perfectly competitive market”.
8. “Monopoly is not favoured by consumer groups because monopoly price is set so as to leave no surplus to consumers. On the other hand, since perfect competition results in no producer’s surplus, firms do not favour it. From the point of view of how markets generate surplus, then, monopolist and consumer interests are completely opposed.”
9. “David had the choice between taking a job that paid £30,000 a year or a job that paid £5,000 as a base wage, but had the potential to earn an additional £45,000 per year if it turned out that David performed well. David thinks that there is a 50% chance that he is a good performer. If David accepts the second job, he is a risk lover.
10. “If the income elasticity of demand of a good is less than one, then increasing income with all prices held constant will result in consumers’ devoting a lower share of income to that good”.
Section B. (25 marks per question)
Answer both questions in this section.

1. Mr. Butler is elderly, and receives only a state pension of £100 per month as income. He spends the entire pension on food and heating, where food is approximately £20 per unit (in this case, per shopping trip) while heating is £1 per unit.

a. Illustrate Mr. Butler’s budget constraint in a careful diagram. If Mr. Butler wishes to remain comfortable during the winter, he must use 40 units of heating. How many shopping trips worth of food can he purchase each month and still remain comfortable?
b. The price of heating is likely to rise due to political unrest in the countries that produce fossil fuels. This year, the predicted price of heating is £1.50 per unit. The government is considering adding a supplement to the pension. How much must the government add to the pension in order to allow Mr. Butler to afford the amount of heating and food that he chose in (a)?
c. The government implements the increase in (b). Will Mr. Butler choose to consume the amount of heating and food he chose in (a)? Has his utility increased, decreased or stayed the same compared to (a)?
d. Consider an alternative policy whereby the government adds a heating allowance to the pension instead of the supplement of (b). This heating allowance must be spent on heating: it cannot be spent on food. How much must the allowance be in order for Mr. Butler to consume the heating and food he purchased in (a)? If the government implements this programme, will Mr. Butler choose to consume the amount of heating and food in (a)? Has his utility increased, decreased, or stayed the same compared to (a)?
e. If you were Mr. Butler, which programme – the supplement to the pension or the heating allowance – would you support and why?
2.
a. The recession has hit a number of industries very hard because consumers have reduced
their demand for goods. Take the market for raw milk in the UK as approximately perfectly competitive. Hence, for the market for raw milk, produced on farms and sold to milk processors, use diagrams to analyse the effect of the recession on the equilibrium price, farm output, industry output, and the number of farms in the short and long run.

b. The unusual summer weather has reduced cow milk yields. How does this reduction in
yields modify the market analysis that you conducted in (a)? Should farmers welcome the
unusual weather or not?

c. The government is concerned with the effect of the recession on dairy farmers and so
proposes that price floors be raised for milk. Show how this affects your answer in (a).
What other policy tools does the government have at its disposal to help farmers? Would
you favour the use of price floors in this case? Explain your reasoning.

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