Test 2 Prep: Elasticity and Consumer Choices

The questions come from the whole chapter

Test questions for this textbook are written from every part of each chapter: the main text, but also the worked "Work It Out" boxes, the "Clear It Up" boxes, the tables of real figures, the named examples (Netflix, the coffee market, the UK child allowance) and the "Bring It Home" endings. A student who studies only the big ideas meets questions about these details and feels she has never seen them. Tab 5 covers every one of those details for Chapters 5 and 6.

The second reason is disguise. Multiple-choice questions take a familiar idea and wrap it in a story about a product she has never thought about. The idea underneath is almost always one of the twelve below. When a question looks strange, she should name which of the twelve it is testing before she reads the options.

Twelve ideas behind almost every Test 2 question

The plan from tonight to the test

Test 2 covers two chapters while the other tests cover three, yet every test is worth the same 15%. That makes each of Chapters 5 and 6 worth about 9.8% of her final grade, against about 7.3% for every other chapter. With roughly 50 questions, an A (93) allows only three or four misses.

What every symbol means

Economics writes long ideas in short symbols. Learn this key first and every formula on the page becomes a sentence you can read aloud.

Change and percent

Δ

The Greek letter delta. Read it as "change in". Always new value minus old value. ΔP = change in price.

%Δ

Percentage change. %ΔP = the percentage change in price.

The variables

P

Price of the good.

Q

Quantity: how many units.

Qd

Quantity demanded: how many units buyers want to buy at a given price.

Qs

Quantity supplied: how many units sellers want to sell at a given price.

I

Income: the money a consumer has to spend.

TR

Total revenue: the money sellers take in, P × Q.

The little numbers (subscripts)

Q₁, Q₂

A small number below a letter is a label, not a power. In elasticity, 1 means before (old) and 2 means after (new).

MU₁, P₁

In utility the same labels mean something different: good 1 and good 2. Read the setting before reading the label.

Px, Py

Price of the good drawn on the x-axis (horizontal) and on the y-axis (vertical).

S₀ → S₁

A curve before (0) and after (1) it shifts. D₀ → D₁ for demand.

Elasticity names

Ed

Price elasticity of demand.

Es

Price elasticity of supply.

| −0.90 |

Absolute value: the number without its sign, so | −0.90 | = 0.90. Price elasticity of demand is reported this way.

Utility

TU

Total utility: all the satisfaction from the units consumed.

MU

Marginal utility: the extra satisfaction from one more unit.

utils

Made-up units for counting satisfaction. Personal to each person.

Tax graphs

Pe, Qe

Equilibrium price and quantity before the tax (where D and S cross).

Pc

Price consumers pay once the tax is in place.

Pp

Price producers keep after handing the tax to the government.

Qt

Quantity bought and sold once the tax is in place.

Signs and words

> <

Greater than, less than. Ed > 1 reads "elasticity of demand is greater than one".

÷ ×

Divided by, times.

ceteris paribus

Latin for "other things equal": only the one thing named is changing.

Elasticity formulas, read in plain words

The one idea: elasticity measures how strongly one thing reacts when another thing changes. Big reaction, elastic. Small reaction, inelastic.

Utility and budget formulas, read in plain words

The one idea: a consumer with limited money spreads it across goods so that the last dollar spent on each good brings the same extra satisfaction.

• Substitution effect: the good that became relatively more expensive is replaced with the relatively cheaper one.
• Income effect: a higher price cuts the buying power of income. Actual income I has not changed.
• Loss aversion: a $1 loss hurts about 2.25 times as much as a $1 gain helps (Kahneman and Tversky, 1979).
• Mental accounting: treating dollars differently by where they came from. Standard economics treats money as fungible: every dollar is worth the same.

Price elasticity of demand, every step shown

The idea: elasticity measures how strongly buyers react when the price changes. A big reaction is elastic; a small one is inelastic.

A campus coffee shop raises a latte from $4.00 to $5.00. Daily sales fall from 220 cups to 180 cups. Find the price elasticity of demand.

Your turn, with the first half done

A band cuts ticket prices from $40 to $30. Tickets sold rise from 800 to 1,200.

Price elasticity of supply

A bakery's price for a loaf rises from $2.00 to $2.50, and the bakery increases the quantity it offers from 300 to 400 loaves a day. The method is identical; only the quantity is now quantity supplied.

When the question gives the elasticity

Many test questions hand over the elasticity and ask for the effect. Rearrange the same formula.

Unit elastic: revenue does not move

A food truck raises a wrap from $8 to $12, and daily sales drop from 60 to 40.

Here the sign is the answer

For price elasticity of demand we drop the minus sign. For income and cross-price elasticity we keep it, because the sign tells you what kind of good it is.

Total utility, marginal utility, and why it diminishes

• Utility is satisfaction. Economists count it in imaginary units called utils.
• Total utility (TU) is all the satisfaction from a quantity. It is the sum of the marginal utilities.
• Marginal utility (MU) is the extra satisfaction from one more unit.
• Diminishing marginal utility: each extra unit adds less than the one before. The first smoothie on a hot day is wonderful; the fifth is just liquid. The book links this to the law of diminishing returns from Chapter 2.

Finding the best choice with MU per dollar

Amara has $40. Smoothies cost $4. Movie tickets cost $8. Her marginal utilities:

Check by brute force, every affordable combination that spends the full $40:

Kofi's lunch budget

Kofi has $27. Juice costs $3, sandwiches cost $6.

The budget constraint, and its link to the PPF

Put smoothies on the horizontal axis and movies on the vertical axis.

Substitution effect and income effect

Suppose movie tickets rise from $8 to $10 and Amara still has $40.

• Substitution effect: movies are now expensive relative to smoothies, so she swaps some movies for smoothies.
• Income effect: her $40 now buys less in total. She has not lost a cent of actual income, but her buying power fell, so she buys fewer movies (a normal good).
• For a normal good both effects push the same way: fewer movies. That is why demand curves slope down.

Each card covers one section of the textbook, including the side boxes and named examples. These are the details that make a question feel unfamiliar. Read each card, then answer its check before opening it.

Price elasticity of demand and supply

• Elastic means highly responsive; inelastic means weakly responsive; unitary means proportional.
• The book's "Clear It Up" box: elasticity is not the slope. Its example demand line has the same slope everywhere, yet elasticity is 0.45 near the bottom and 1.47 near the top.
• Elasticity has no units, and demand elasticity is read as a positive number.
• The book's supply example is apartment rentals; an elasticity of 3.5 means a 1% rise in rent brings 3.5% more apartments onto the market.

Polar cases and constant elasticity

• Highly elastic supply: goods with easy-to-get inputs that can expand quickly (pizza, bread, books, pencils).
• Highly elastic demand: luxuries, items taking a large share of income, goods with many substitutes (Caribbean cruises, sports vehicles).
• Highly inelastic supply: goods with limited inputs (diamond rings, apartments facing Central Park).
• Highly inelastic demand: necessities with no close substitutes (life-saving drugs, gasoline).
• A unit-elastic demand curve is not a straight line with slope −1. It is curved, because equal percentage steps mean the dollar drops shrink as price falls.

Elasticity and pricing

• Real elasticities table: housing and economy-class transatlantic flights are lowest (0.12); restaurant meals are highest (2.27). Necessities are inelastic, non-necessities elastic. Rush-hour rail (0.15) is less elastic than off-peak rail (1.00), because commuters must travel.
• The band and the arena: elastic demand, cut ticket prices; inelastic demand, raise them. Very famous bands could earn more by pricing so high the arena is not full.
• Passing on cost savings: a breakthrough shifts supply right. With inelastic demand the price falls a lot and quantity barely moves, so consumers gain most, and producers' revenue can fall (the aspirin example).
• Farmers: food demand is inelastic, so a bumper harvest can lower farm revenue and a bad year can raise it.
• Coffee "Clear It Up": coffee demand elasticity is about 0.3. Inelastic demand plus supply shocks (a Brazilian frost, Vietnam entering the market) make prices swing wildly.
• Cigarettes: elasticity about 0.3 for adults. A tax mostly raises the price, so it raises revenue but cuts smoking little. To cut smoking, shift demand left (anti-smoking campaigns). Youth smoking is more elastic than adult smoking.
• Long run versus short run: elasticities are larger in the long run, when people can buy efficient cars or insulate homes. The 1973 OPEC oil cut shows it. In the short run prices swing more; in the long run quantities adjust more.

Elasticity beyond price

• Income elasticity and cross-price elasticity (Tab 3, Chunk 6). A higher income elasticity means a bigger shift of the demand curve when income rises.
• Wage elasticity of labor supply: teenagers are fairly elastic; adults in their thirties and forties are fairly inelastic.
• Elasticity of savings: a tax break that raises the return on saving boosts saving a lot only if savings are elastic. Short-run evidence suggests fairly inelastic, so such policies have a small effect.
• Expanding the concept: elasticity can link any two variables, such as the percentage change in tax collected for a percentage change in spending on tax enforcement.
• "Elasticity of demand" with no qualifier always means price elasticity of demand.
• Netflix (Bring It Home): in 2011 Netflix raised prices about 60% and expected to lose roughly 600,000 subscribers, an implied elasticity near 0.05. About 810,000 cancelled. It misjudged elasticity by ignoring close substitutes (Redbox, Hulu, Amazon Prime).

Consumption choices

• Opens with the US Consumer Expenditure Survey: about a third of spending goes on housing, another third on food and vehicles.
• José example: $56 budget, $14 T-shirts, $7 movies. Intercepts 4 T-shirts and 8 movies; slope −2. Best choice is 1 T-shirt and 6 movies (total utility 103).
• The step-by-step method (give up one unit, buy what the money now affords, compare utils lost and gained) reaches the same answer from any starting point.
• Utils cannot be compared between people. The key assumption is only that people can rank options, not that anyone owns a "utility meter".
• Equivalent form of the rule: P₁ ÷ P₂ = MU₁ ÷ MU₂.

How income and prices change choices

• Kimberly ($50 concerts, $200 overnight getaways): income rises from $1,000 to $2,000. Most likely she buys more of both (normal goods); if she buys less of one, that good is inferior.
• Sergei (baseball bats and cameras): a higher bat price rotates the budget line inward on its hinge at the camera axis. He might buy fewer bats and more cameras, or fewer of both. The book rules out buying more bats as theoretically possible but unlikely.
• A price change for one good can change spending on other goods, because all come out of one budget.
• Foundations of demand: rotating the budget line again and again as price rises traces out the demand curve. Utils cannot be measured, but price and quantity can.
• "Everything else" can be put on the vertical axis when the focus is one good, such as housing.
• Applications: after the 2005 hurricanes raised heating costs, households cut whatever they valued least on the margin, such as dinners out. A tax on alcohol can also reduce spending on bar snacks.
• UK child allowance (Clear It Up): in the 1970s the payment moved from the father's paycheck to cash for the mother. Spending shifted toward child care, restaurant meals and women's clothing and away from alcohol and tobacco, and children's health improved. Lesson: who controls income matters, which the basic model assumes away.

Behavioral economics

• Traditional models assume rationality: people use all information and choose consistently in their own interest. Behavioral economists bring in psychology and state of mind.
• Loss aversion: lose $10 and gain $10 and many people still feel worse. A $1 loss hurts about 2.25 times as much as a $1 gain helps (Kahneman and Tversky, 1979, Econometrica).
• Self-control: people buy cigarettes by the pack instead of the cheaper carton, lock fridges, or overpay taxes to force saving. They pay a price to protect themselves from temptation.
• Nudges: automatic enrolment in a retirement plan with an opt-out. Up to 20% of new employees otherwise delay enrolling; almost no one opts out.
• Mental accounting: $25 found on the street is spent more loosely than $25 earned in three hours of work. Standard economics says money is fungible: every dollar is worth the same.
• Debt and savings example: keeping credit card debt at a high rate while holding low-interest savings loses money every year, yet people do it because they treat the savings account as untouchable.
• Bring It Home: during the Great Recession people worldwide spent more on higher education. Unemployed people have a low opportunity cost of time, and more education brings higher earnings and lower unemployment.

Mock test

Answer in one sitting. Options are shuffled each time. Only the first click on each question counts toward the score. After answering, read why every option is right or wrong, not just the correct one.