Question

Economists have estimated the following transportation elasticities. For each pair, explain possible reasons why the elasticities differ.

University of Richmond Professor Erik Craft analyzed the states’ pricing of vanity plates. He found that in California, where vanity plates cost $28.75, the elasticity of demand was 0.52. In Massachusetts, where vanity plates cost $50, the elasticity of demand was 3.52.

a. Assuming vanity plates have zero production cost and his estimates are correct, was each state collecting the maximum revenue it could from vanity plates? Explain your reasoning.

• Neither state is maximizing revenue. Maximum revenue is collected when elasticity is zero.

• Neither state is maximizing revenue. Maximum revenue is collected when elasticity is 1.

• Massachusetts is maximizing revenue but California is not because revenue is only maximized when elasicity is greater than 1.

• California is maximizing revenue but Massachusetts is not because revenue is only maximized when elasicity is less than 1.

b. What recommendation would you have for each state to maximize revenue?

I would recommend that Massachusetts  (Click to select)  lower its price, raise its price, not change its price  and California  (Click to select)  not change its price , raise its price, lower its price  .

c. If these estimates are correct, which state was most likely to be following a politically unpopular policy?

(Click to select)  California, Massachusetts  , because not only is it not collecting maximum revenue but it is also charging a  (Click to select)  higher price , lower price than is optimal. It could simultaneously  (Click to select) lower its price, raise its price and increase revenues, which would please both those who buy vanity plates and the Treasury.

Answer 1

in California, where vanity plates cost $28.75, the elasticity of demand was 0.52.

In Massachusetts, where vanity plates cost $50, the elasticity of demand was 3.52.

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(a) Revenue is maximum at the point on the demand curve where price elasticity of demand is unitary elastic (i.e., the absolute value of price elasticity of demand is 1)

Hence, neither state is maximizing revenue becuase revenue maximize when elasticity is 1.

Answer: Option (B).

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(b) In case of ealstic demand, there is negative relationship between the price change in total revenue change. So, when demand is elastic, then price should be decrease in order to increase the revenue.

In case of inelastic demand, there is positive relationship between change in total revenue change. So, when demand is inelastic, then price should be increase in order to increase the revenue.

In Massachusetts demand is elastic, I would recommend that Massachusetts lowers its price.

In California demand is inelastic, I would recommend that Californua riase its prices.

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(c)

Massachusetts because not only is it not collecting maximum revenue but it is also charging a higher price , than is optimal. It could simultaneously lower its price and increase revenues, which would please both those who buy vanity plates and the Treasury.