Price Elasticity = (% Change in Quantity Demanded)/(% Change in Price)

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) x -0.5 = (.95  .85) = x/.1176 .85 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) x -1.5 = (.95  .85) = x/.1176 .85 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.