3.4 In some countries, such as Saudi Arabia, the sale of alcohol is prohibited.

Which of the
following is correct? It can be concluded that

A. in those countries no individual has any demand for alcohol.

B. law makers in those countries believe that the consumption of alcohol is

harmful to society.

C. there are no benefits from drinking alcohol.

D. individuals collectively in those countries have no demand for alcohol.

. The existence of laws prohibiting the purchase of goods does not imply that there is no demand for
such goods; indeed, the underworld flourishes on illegal markets. Demand theory assumes that
individuals know their own interests best and that if a good is bought – legally or illegally – it is because
the marginal benefit to the individual exceeds the marginal cost. Economics is not concerned with
making moral judgements on what is good or bad for a rational person.

A well-known football club is considering allowing old-age pensioners (people over 65 years of age) to attend home
games for $20 instead of the normal ticket price of $100. If total ticket receipts were to increase as a result of
adopting such a policy, which of the following is correct? It follows that

A. old-age pensioners, as a group, will have more income remaining to spend on

other goods and services.

B. the demand for tickets by old-age pensioners is more price-elastic than the

demand for tickets by all other age groups taken together.

C. total revenue from ticket sales would increase if all ticket prices were reduced

to $20.

D. the increase in ticket revenue from new fans more than offsets the loss in

revenue from old-age pensioners, who always attended games but now pay $20

instead of $100.

D. Because total receipts increase when the price is lowered from $100 to $20, it means that ticket sales
increase proportionally more than the price decrease, e.g. 100 × $20 > 8 × $100. Thus, in price range
$20–$100, the demand for tickets by old-age pensioners is price-elastic. However, we have no
corresponding data for spectators of other ages and consequently can make no elasticity comparison.
Nevertheless, the increase in gate receipts means that, as a group, old people will have less to spend on
other goods and services; the increase in gate receipts also means that the loss in revenue from original
older fans (now paying $20 instead of $100) has been more than compensated for by new fans each
paying $20.
On a desert island, only two foods are available, fish and coconuts. On some days a castaway eats well; on other
days he goes hungry. On any given day

I. the higher the marginal utilities of fish and coconuts the hungrier he is.

II. the lower the marginal utilities of fish and coconuts the hungrier he is.

III. when the marginal utilities are zero, his total utility is zero.

Which of the following is correct?

A. I only.

B. II only.

C. I and III only.

D. II and III only.

The correct answer is A. The more an individual consumes of a good, the higher will be total utility and
the lower will be marginal utility of that good. Law OF diminishing return.

A consumer’s typical demand curve is downward sloping to the quantity axis because

I. at lower prices the consumer buys more of the good in question in place of other

goods that are now relatively more expensive.

II. at lower prices the consumer can buy all she bought of the good at the higher price,

and with the money left over she can still buy more. Which of the following is correct?

A. I only

B. II only

C. Both I and II

D. Neither I nor II

Correct answer is C. SUBSTITUTION AND INCOME EFFECT

An individual’s demand curve for beer could shift because of

I. a change in the price of beer.

II. a change in the price of wine.

III. a change in the individual’s income.

Which of the following is correct?

A. I only.

B. I and III only.

C. II and III only.

D. I, II and III.

The correct answer is C. A shift in a demand curve is caused by a change in any of the factors
determining the position of the curve – income, prices of other goods, etc. A movement along a demand
curve is caused by a change in price.

Case Study 3.1: The Price of Potatoes

This case is an application of demand theory. Before you tackle it you should understand:

a. linear demand curves

b. total revenue

c. elasticity of demand

d. ceteris paribus

e. movements along a demand curve

f. shifts of a demand curve

g. what is meant by ‘estimating a demand curve’.

The case demonstrates:

why it is important to have information about the shape of a demand curve when

setting the price of a good;

the consequences of price changes for demand curves of different elasticities; and

that many issues in economics are resolved only when theories/hypotheses are

subjected to empirical tests.

The Subsidy to Farmers

In a certain country, agriculture is subsidised by the government. The market for potatoes is run by its Potato
Marketing Board, which acts as a buffer between potato growers and the free market. The Board advises each
farmer on how much acreage he should allocate to potatoes and guarantees a price for all potatoes produced. If a
farmer does not like the price offered, he can grow some other crop; the Board will then recommend to some other
farmer that he increase potato acreage. In this way the

Board has a fairly accurate idea of what the overall potato yield will be for each year, subject to variations in
weather.
Each farmer must sell his potatoes to the Board. The Board in turn sells the potatoes to wholesalers, who in turn sell
them to retailers, who in turn sell them to the public. Most farmers are in favour of this method of setting price and
acreage because it protects them from free-market price fluctuations.

Last Year’s Performance

Last year the Board had two million bags of potatoes that were produced on the basis of the recommendations and
price offered the year before. It sold these potatoes to wholesalers for €2 per bag. The Board was rather pleased with
its performance; its revenue of €4 million from the sale of potatoes more than covered its payments to farmers and
its own running costs. In addition, no potatoes remained unsold and wholesalers did not come back asking for more
potatoes. It appeared that the supply of, and demand for, potatoes was in balance.

How the Potato Marketing Board Got into Trouble

In planning this year’s output, the Board increased both acreage and price offered to farmers. The result was that this
year the Board will have three million bags of potatoes to sell. The Board decided to put the three million bags up
for sale at the same price as last year. However, the Chief Economic Adviser to the Cabinet heard about this and
pointed out that this would lead to one million bags of potatoes being unsold if demand conditions were similar to
last year. Furthermore, the Chief Adviser recommended that, since the potatoes had now been produced, the Board
should sell them at the price that maximised revenue from sales. The Cabinet agreed with his reasoning and
instructed the Chairman of the Board to set the price this year to maximise the revenue from the sale of potatoes.

In some panic, the Chairman employed two teams of economists to find out how, if at all, the price should be altered
this year to maximise revenue. The two teams were instructed to estimate the national demand curve for potatoes
and to recommend what action should be taken on the price. On reading the reports of the two groups, the Chairman
found to his surprise that they had come up with different answers. Group A recommended that the price should be
lowered to €1.50 per bag; Group B recommended that the price be raised to €3 per bag. On examining the reports in
more detail, the Chairman discovered that the critical difference between them was the

demand curves that they had estimated. These two demand curves are shown in Fig BELOW

The Chairman realised immediately that any price change he put into effect could be disastrous if he followed one
team’s advice and that team’s demand curve was the wrong one. Furthermore, he noted that while the recommended
price of €1.50 would result in all 3 million bags of potatoes being sold, the recommendation of Group B would
result in only 1.5 million bags being sold.

1 Consider the following:

1. If Group A were correct, what would be the effect on revenue of their recommended reduction in the price?

2. If Group B were correct, what would be the effect on revenue of their recommended increase in the price?
3. What is the difference between Demand Curve A and Demand Curve B?

4. What would be the effect of reducing the price to €1.50 if Group A is wrong and

Group B is right?

5. What would be the effect of increasing the price to €3 if Group B is wrong and

Group A is right?