Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

180 MIDTERM EXAMINATION
Answers
1. (a) One way to reduce gasoline consumption is rationing. Such a policy could cut gasoline consumption by the
required 30% but would also lead to black markets and a huge bureaucracy to enforce rationing. As a result,
rationing was not adopted but was reserved as a policy of last resort only. Another way to reduce gasoline consumption
is by increasing the price of gasoline. The advantage of this policy is that it works through the price
mechanism rather than replacing it (as in the case of rationing). The disadvantage is that because the coefficient
of price elasticity of demand is very low, a huge price increase would be required to achieve the needed 30%
cutback in the quantity of gasoline consumed.
(b) When the amount of gasoline demanded per vehicle dropped 8% in the face of a price increase of 40%, the coefficient
of price elasticity of demand for gasoline was roughly
e ¼
%DQ
%DP ¼ ( 8%)
(þ40%) ¼ 0:2
This is a very rough measure because it assumes that everything else remained constant, which was clearly not the
case. To achieve the 30% reduction in gasoline consumption, the required price increase would have to be roughly
%DP ¼ %DQ
e
¼ 30%
0:2 ¼ 150%
(c)
The Administration in Washington, while stressing conservation, believed that deregulation and the resulting
sharp increase in gasoline prices would stimulate new exploration which would lead to a large increase in domestic
petroleum extraction. Thus the Administration stressed the supply side to attempt to solve this problem while
previous efforts relied mostly on the demand side.
2. In the top panel of Fig. M-1, point A on budget line 1 and indifference curve I is the original consumer equilibrium
point. When P x falls, equilibrium is at point B, where indifference curve II is tangent to budget line 2. The movement
from point A to point B (Q 1 Q 4 ) is the total of the substitution and income effects of the fall in P x and gives
d x (the usual demand curve) in the bottom panel. Because the slope of the price consumption curve is negative
between points A and B, d x is price-elastic.
Fig. M-1