CHAPTER 7
Deciding How Much -- Elasticity
[return]

I. Introduction

A. Examples of Elasticity

1. Elasticity affects total revenue (TR)
   example: MCC library fees or Harper Tuition increase
   
2. If the P increases what happens to quantity sold of:
   (Remember: HOW MUCH?)
   
   • gasoline?
     
     If price increases we know from chapter 3 that the quantity demanded will go down (the law of demand).
     
     What we are ADDING now to our knowledge is HOW MUCH?
     
     

     If the price of gasoline,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of gasoline ,

     does the quantity :

     a little

     or

     a lot

     ?

     
     
     
     Think about it. I would guess:
     
     
     
     
     
     

     If the price of gasoline,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of gasoline ,

     does the quantity :

     a little

     or

     a lot

     ?

     Do you agree?

      

   • Big Mac?

      

     If the price of a Big Mac,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of a Big Mac ,

     does the quantity :

     a little

     or

     a lot

     ?

     
     
     
     Think about it. I would guess:
     
     
     
     
     
     

     If the price of a Big Mac,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of a Big Mac ,

     does the quantity :

     a little

     or

     a lot

     ?

     Do you agree?

      

   • salt?
     
     

     If the price of salt,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of salt ,

     does the quantity :

     a little

     or

     a lot

     ?

     
     
     
     Think about it. I would guess:
     
     
     
     
     

     If the price of salt,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of salt ,

     does the quantity :

     a little

     or

     a lot

     ?

     Do you agree?

      

   • new car?
     
     

     If the price of a new car,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of a new car ,

     does the quantity :

     a little

     or

     a lot

     ?

     
     
     
     Think about it. I would guess:
     
     
     
     
     

     If the price of a new car,

     does the quantity :

     a little

     or

     a lot

     ?

     
     

     If the price of a new car ,

     does the quantity :

     a little

     or

     a lot

     ?

     Do you agree?

      

B. Definition of Elasticity -- HOW MUCH

C. Types of elasticity

1. price elasticity of demand
(quantity demanded and price)

2. price elasticity of supply
(quantity supplied and price)

3. cross elasticity of demand
(price of one product and the quantity of another)

4. income elasticity of demand
(income and quantity of a product)

II. Price Elasticity of Demand

A. Definition

1. price elasticity of demand vs. the law of demand

Know the difference between:

• the PRICE ELASTICITY OF DEMAND and
• the LAW OF DEMAND.

2. coefficient of the price elasticity of demand (Ed)
3. examples (Table 7-2)

B. The Elasticity Formula

1. Ed =

% D Qd

/

% D P

2. calculating the % D Qd

a. calculating %
b. problems with calculating % D Qd

3. midpoints formula

C. Interpreting the Coefficient of Price Elasticity of Demand

This is important!

1. price elastic demand
2. price inelastic demand
3. unit elastic demand

D. Price Elasticity Changes Along a Single Demand curve (Figure 7-2)

1. elasticity and price range
2. elasticity is not slope

E. Special Cases (Figure 7-1)

Do not confuse an INELASTIC demand with a PERFECTLY INELASTIC demand.

What is the difference?

1. perfectly price elastic demand
2. perfectly price inelastic demand

How do we know if the demand for a product is price elastic or price inelastic?

There are 4 ways:

1. Guess (Gasoline, Big Mac, Salt, New Car)
2. Calculate the Coefficient of Price Elasticity of Demand (Ed)
3. Use the Total Revenue Test
4. Apply the Determinants of Price Elasticity of Demand

III. The Total Revenue Test

A. Calculating Total Revenue (TR)
B. Rules (Table 7-2)

1. when demand is price elastic:

a. and P­ , then TR¯ (because quantity D a lot)
b. and P¯ , then TR­ (because quantity D a lot)

2. when demand is price inelastic:

a. and P ­ , then TR­ (because quantity D a little)
b. and P ¯, then TR¯ (because quantity D a little)

3. when demand is unit elastic: TR does not change if P changes

C. Graphic Portrayal

IV. Determinants of the Price Elasticity of Demand
REVIEW: http://www.hencc.uky.edu/thurmanm/Elastic.html

A. Number of Substitutes (Substitutability)
B. Product Price as a Proportion of Income
C. Luxuries versus Necessities
D. Time

 

Number of Substitutes

if MANY: then demand is MORE price elastic
if FEW then demand is LESS price elastic

EXAMPLE: Big Mac

Proportion of Income

If the price is a LARGE % of your income: demand is MORE elastic

If the price a SMALL % of your income: demand is LESS elastic

EXAMPLE: New Car or Salt

Luxuries versus Necessities

Luxury Goods: demand is MORE elastic

Necessities: demand is LESS elastic

EXAMPLE: Gasoline

Time

MORE time between the price change and when quantity is measured:
demand is MORE elastic

LESS time between the price change and when quantity is measured:
demand is LESS elastic

EXAMPLE: time affects the number of substitutes - with more time consumers can find more substitutes

V. Some Practical Applications

A. Bumper Crops
B. Automation
C. Airline Deregulation
D. Excise Taxes
E. Cocaine and Street Crime
F. Minimum Wage (how much unemployment?)

VI. Price Elasticity of Supply

A. Definition
B. Coefficient of Elasticity (Es)
C. Example
D. Determinants of Price Elasticity of Supply

1. ease of storage (market period)
2. available excess capacity (short run)
3. characteristics of the production process (long run)
4. time

a. market period
b. short run
c. long run

VIII. Excise Tax and Efficiency Loss (pp. 372-377)

A. Definitions

1. tax incidence
2. excise tax

B. Division of burden

1. excise taxes and supply
2. determine the amount of tax
3. tax incidence
4. incidence and the price elasticity of demand "With a specific supply curve, the more inelastic the demand for a product, the larger the portion of the tax shifted to consumers."

5. incidence and the price elasticity of supply

"With a specific demand curve, the more inelastic the supply, the larger the portion of the tax borne by producers."

C. Efficiency Loss of a Tax

1. tax revenue
2. efficiency loss

a. allocative efficiency: MSB=MSC
b. efficiency loss:

1) definition

"the sacrifice of net benefit accruing to society because consumption and production of the taxed product are reduced below their allocatively efficient levels"

2) graphically:smaller quantity

e. role of elasticities
f. qualifications

IX. Cross and Income Elasticity of Demand

A. Cross Elasticity of Demand

1. definition
2. coefficient of cross elasticity of demand (Eab)
3. the sign IS important
4. example

B. Income Elasticity of Demand

1. definition
2. coefficient of income elasticity of demand (Edy)
3. the sign IS important
4. example