EconS 404, Professor Rosenman

Week 2 Exercises

Analysis Questions

1. On November 4, 1988 The Wall Street Journal reported that American Express Company planned to raise its annual fees for green and gold cards by $10. Green card fees jumped from $45.00 to $55.00 while those for Gold cards went to $75.00 from $65.00 per year. John Keefe, a financial analyst for Drexel Burnham Lambert Inc. estimated that American Express would find an increase in its bottom revenues of 60 to 70 million dollars, even though it would lose some customers.

Clearly, American Express must be facing an inelastic demand for its cards. Although price increased, by over 22 percent for Green cards and by over 15 percent for Gold cards, total spending on the cards increased. Our review of the price elasticity of demand indicates that it must be inelastic. Mr. Keefe estimated that American Express had about 13 million Green card holders and 7 million Gold card holders. Can we figure out the price elasticity from the information we have?

First, figure a weighted average percentage increase of 20 percent (actually 19.55), and treat all cards the same so there are 20 million cards. On an annual basis, American Express had earnings of $1,104.8 million. Now if total revenue equals price time quantity, the change in total revenue equals approximately quantity time the change in price plus price times the change in quantity. That is

DTR = [(DP)Q] + [P(DQ)].

Dividing by total revenue (which equals PQ) gives

%DTR = (%DP) + (%DQ)

If we divide both sides by (%DP) we get

(%DTR)/(%DP) = 1 + e_p.

From our data, revenues for American Express increased by about $65 million dollars, which is 5.9 percent. The 10 dollar change is 20 percent of a price of 50 (weighted average price of Gold and Green cards) so we need to divide 5.9 by 20. Thus

5.9/20 = .295 = 1 + e_p

or e_p= -.705.

Question. What would be the change in quantity demanded from the 20 percent increase in the price of American Express Cards? Was the increase a good move on the part of American Express?  Should American Express increase its price more, or decrease the price of cards? Explain.

2.  Local governments that run their own landfills face an interesting tradeoff. Landfills are unpopular, and officials need to worry about filling them up too fast. Once filled, the politically undesirable task of what to do with new garbage (shipping it elsewhere, which angers those who are the recipients, or finding a new local landfill, which will anger those nearby). But at the same time, landfills are usually a revenue generator for the locality. Thus, the officials want to take in enough garbage to at least cover the costs of running the landfill, and perhaps even make a profit to alleviate the need for other revenue sources. In setting prices for tipping fees (the charges for dumping garbage at a landfill), officials in New York City ran into a barrier economics places on unrestrained policy making.

According to the Wall Street Journal (July 9, 1990) it all started in December of 1988 when officials had more than doubled the tipping fees at the Fresh Kills landfill on Staten Island, from $18.50 per ton to $40.00 per ton. In response haulers diverted between 25% to 30% of the garbage collected in the city (about 10000 tons of trash a day) to out of state facilities. Using a higher price, the city lowered the rate at which the landfill would be exhausted. Interestingly, since the percentage change in quantity (30%) was less than the percentage change in price (100%), the demand was inelastic, so revenues must have increased with the price rise.

In 1990, when faced with a fiscal crisis, New York city decided it wanted its garbage back. The sanitation department proposed lowering the tipping fee to $25.00, which would, in their estimation, bring back 3500 tons of the lost garbage a day. Officials claim that an additional $20 million in revenue would result.

Question. If you were in charge of the budget for New York City in 1990, would you lower the tipping fee? Explain. (HINT: What would happen to revenue collected?)

3.  No farmer ever thought peanuts were worth, well peanuts, as long as they were grown under the peanut quota program of the federal government. Essentially, the peanut quota is a government license to sell peanuts in the United States. With a limited number of quotas available for domestic sales (except to the less profitable meal and oil markets), foreign sales restricted only for fresh consumption, and imports virtually nil (only 1.7 million pounds in a market of 1.6 billion pounds in 1989), quota holders are a select group according to the Wall Street Journal (May 1, 1990, page A1).

The quota program is structured so only quota holders can sell their peanuts to the lucrative markets for use in peanut butter (54 percent of the market), salted peanuts (24 percent of the market) and peanut candy (20 percent of the market). Other products account for 2 percent of the market for quota grown peanuts. Besides restricting sales, the government offers a price support program, so peanut growers under the quota are assured of an adequate return.

But the quota is so effective that the subsidies amounted to about only $4 million dollars a year. And the cost to consumers is enormous. One peanut processor estimated the output restrictions cost consumers $369 million dollars per year in higher peanut prices, money that goes to peanut quota holders. The U.S. Department of Agriculture estimates the cost at a lower $190 million per year. Overall, about 40 cents of a $1.79 18 ounce jar of peanut butter is added cost due to the peanut quota.

How do these transfers work? In the figure S_r indicates the supply curve with the quota quantity restricted to Q_r. With this restriction, the demanders (the peanut processors) are willing to pay a price of P_r. Since the federal government offers a support price of $631 per ton, and so little peanuts are sold to the government, P_r must exceed that amount. Moreover, the price that arises from the quota is about fifty percent higher than the price on the unregulated world market. The $369 (or $190) million dollars is just the rectangle P_rabP_e.

Question.  Does the rectangle P_rabP_e measure the total welfare loss?  What other welfare losses are there from the peanut quota?

4. The current high price of gasoline has stilmulated some political advocacy groups to call for price controls.

Question. How do of price controls effect consumer and producer surplus. You might need draw a graph of the market with and without price controls to answer this question.

5.  With lagging sales on its minivans, Chrysler Corporation pledged that any customer who bought one between April 1 and September 30 of 1990 would be eligible for any consumer rebate offered on the vehicle during that time period. Chrysler tendered a dealer rebate in May of that year, and the Wall Street Journal (May 22, 1990, page B1) reported that some customers who had bought their minivans in recent weeks might feel slighted. As the Journal put it, "When is a guaranteed rebate no guaranteed? When the money is paid to the dealer, instead of directly to consumers."

A Chrysler-Plymouth dealer in California claimed that customers had no reason to feel slighted, calling them "... two totally different programs. (The dealer incentive) is not a rebate. This is dealer cash for each unit we sell." But it should have generated resentment on the part of customers anyway, especially those that understand economics. As we saw with taxes, who is legislatively responsible for the tax is immaterial to the burden felt. Instead, the tax incidence is shared by the supply and demand sides of the market. Is same is true with subsidies.

Question.  Why were customers treated unfairly by Chrysler's decision?  After all, is a payment to the seller equivalent to a payment to a buyer?

TECHNICAL PROBLEMS

1.  Suppose you face the  following demand curve for your product:  Q = 1500 - 30P.

a)  Find the elasticity of demand if the price changes from 10 to 11.

b)  Find the elasticity of demand if the price changes from 15 to 16.

c)  What happens to the elasticity of demand as price goes up?  Figure out at what output the price elasticity of demand is unit elastic.
 

2. Suppose the demand for gasoline is given by Qd = 50 - 0.5P and the supply by Qs = 0.2P - 6.  If a 20 cents per gallon tax increase is imposed on gasoline, answer the following:

a)  What is the equilibrium quantity and price before the tax increase (pretend the initial tax is zero)?

b)  What is the consumer surplus before the tax?  What about the producer surplus?

c)  What is the equilibrium quantity, consumer surplus, producer surplus and tax collections if the tax is imposed?