CHAPTER 6

Extensions of Demand and Supply Analysis - Elasticity

Deciding HOW MUCH -- Elasticity

I. Introduction

A. Examples of Elasticity
1. Elasticity affects total revenue (TR)
example: MCC library fees

What do you think happens to TR if:

  • gasoline price increases
  • the price of black pens increased?

 

2. If the P increases what happens to quantity sold of:
(Remember: HOW MUCH?)

  • gasoline?
  • Big Mac?
  • salt?
  • new car?

B. Definition of Elasticity -- HOW MUCH

HOW MUCH does one variable change in response to a change in another variable
  • Chapter 3: If price increases what happens to the quantity demanded?
  • Chapter 6: If price increases HOW MUCH does the quantity demanded decrease?

C. Types of elasticity

1. price elasticity of demand
( If price changes, how much does quantity demanded change?)

2. price elasticity of supply
(If price changes, how much does quantity supplied change?)

3. cross elasticity of demand
(If the price of one product changes, how much does the quantity of another change?)

4. income elasticity of demand
(If income changes, how much does the quantity of a product change?)

II. Price Elasticity of Demand

A. Definition
The ratio of the percentage change in quantity demanded of a product or resource to the percentage change in its price;

a measure of the responsiveness of buyers to a change in the price of a product or resource

1. price elasticity of demand (ch. 6) vs. the law of demand (Ch. 3)

2. coefficient of the price elasticity of demand (Ed)

3. examples (Table 6.3)

 

B.

4 Ways to Assess the Price Elasticity of Demand:

1. Guess
  • gasoline?
  • Big Mac?
  • salt?
  • new car?

2. Calculate the Coefficient
3. Total Revenue Test
4. Make an informed guess: use the Determinants

 

C. Calculate the Coefficient

1. The Elasticity Formula -
a. Ed =

% Qd
/

% P

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

c. midpoints formula

2. Interpreting the Coefficient of Price Elasticity of Demand

a. price elastic demand
Product or resource demand whose price elasticity is greater than 1;

means the resulting change in quantity demanded is greater than the percentage change in price.

b. price inelastic demand

Product or resource demand for which the price elasticity coefficient is less than 1;

means the resulting percentage change in quantity demanded is less than the percentage change in price.

c. unit elastic demand

Demand or supply for which the elasticity coefficient is equal to 1;

means the percentage change in the quantity demanded or supplied is equal to the percentage change in price.

3. Price Elasticity Changes Along a Single Demand curve (Figure 6.2)
1. elasticity and price range
2. elasticity is not slope

4. Special Cases (Figure 6.1)

a. perfectly price elastic demand
Product or resource demand in which quantity demanded can be of any amount at a particular price;

graphs as a horizontal demand curve

b. perfectly price inelastic demand

Product or resource demand in which price can be of any amount at a particular quantity of the product or resource demanded;

quantity demanded does not respond to a change in price;

graphs as a vertical demand curve.

D. The Total Revenue Test (table 6.1, figure 6.2)

1. Calculating Total Revenue (TR)
a. Definition
  • The total number of dollars received by a firm (or firms) from the sale of a product;
  • equal to the quantity sold (demanded) multiplied by the price at which it is sold.

b. Formula

  • TR = P x Q

2. Total Revenue Test

A test to determine elasticity of demand between any two prices

3. Summary of Total Revenue Test (Figure and Table 6.2)
[http://www.harpercollege.edu/mhealy/eco211/lectures/elas/intgraph/mb_chap_20a.html]

a. when demand is price elastic:
(1) and P , then TR(because quantity a lot)
(2) and P , then TR(because quantity a lot)

Demand is elastic if total revenue moves in the opposite direction as price;

b. when demand is price inelastic:

(1) and P , then TR (because quantity a little)
(2) and P , then TR (because quantity a little)

Demand is inelastic when total revenues move in the same direction as price;

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

Demand is of unitary elasticity when total revenues do not change when price changes.

4. Graphic Portrayal

E. Make an informed guess: use the Determinants of the Price Elasticity of Demand

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

F. Some Practical Applications

1. Large Crop Yields ("Bumper Crops")
  • Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers.
  • 2. Government Excise Taxes
    • Governments look at elasticity of demand when levying excise taxes.
    • Excise taxes on products with inelastic demand will raise the most revenue and have the least impact on quantity demanded for those products.
    • More below (Excise Tax and Efficiency Loss).

    3. Legalization of Illegal Drugs

    • What will happen to price?
    • What will happen to quantity used?
      • Proponents: Demand is inelastic
        • Demand for cocaine is highly inelastic and presents problems for law enforcement.
        • Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business.
        • Crime may also increase as buyers have to find more money to buy their drugs.
      • Opponents: Demand is elastic
        • Opponents of legalization think that occasional users or "dabblers" have a more elastic demand and would increase their use at lower, legal prices.
        • Removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right.

    4. Drug Busts and Street Crime

    5. Minimum Wage (how much unemployment?)

    6. LAST WORD (p. 121):

    • Elasticity and Pricing Power: Why Different Consumers Pay Different Prices
    • Called "Price Discrimination"

      a. Sellers often charge different prices for goods based on differences in price elasticity of demand.

      b. The ability to charge different prices depends on some market power; that is, some ability to control price (unlike the competitive model where all buyers and sellers exchange at exactly the same price).

      c. Customers are grouped according to elasticities.

      • Business travelers have more inelastic demand for air travel, and thus can be charged a higher price than the more price elastic tourist.
      • The low budgets of children make their demand more price elastic, explaining why they receive discounts for movies or sporting events.
      • In a like manner, colleges and universities recognize that income differences cause students to have different elasticities of demand for higher education, and schools attempt to discount prices (through financial aid) based on price sensitivity.

        QUESTIONS:

        • Who pays the higher price:
          A. The person with the more elastic demand, or

          B. The person with the less elastic demand ?

        • What happens to Total revenue?

      d. The above are examples of price discrimination, a topic covered in more detail in Chapter 10.

     

G. Excise Tax and Efficiency Loss (pp. 339-344)

1. Definition:

2. Examples:

3. Excise tax and the supply curve

4. Incidence of Taxes and Price Elasticity of Demand

a. "With a specific supply curve, the more inelastic the demand for a product, the larger the portion of the tax shifted to consumers."

b. Government Revenue and Price Elasticity of Demand

c. Allocative Inefficiency and Price Elasticity of Demand

d. efficiency loss: definition

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

e. graphically: smaller quantity

5. Why DO they tax alcohol, cigarettes, and gasoline?

6. Efficiency loss is one result of an excise or sales tax.

a. Figure 17.5 illustrates the concept of efficiency loss, which occurs as a result of an excise tax or sales tax.
  • The efficiency loss is the reduction of well being that occurs because there will be less produced at the higher price caused by the tax.
  • It is the sacrifice of net benefit accruing to society because consumption and production of the taxed product are reduced below their allocatively efficient levels.

b. Elasticities play a role in determining the extent of the efficiency loss. Other things being equal, the greater the elasticities of supply and demand, the greater the efficiency loss of a particular tax.

c. Qualifications to the analysis relate to the idea that the goals of tax policy may be more important than the goal of minimizing efficiency losses from taxes. Two examples are given.

(1) Redistributive goals-Excise taxes placed on luxury items in 1990 resulted in efficiency losses, but the benefits from redistributing income from the wealthier consumers who buy luxury items may have been worth the loss in efficiency. However, these luxury taxes were unpopular and have been repealed.

(2) Reducing negative externalities-If there is less alcohol and tobacco consumption as a result of excise taxes, the taxes may have socially desirable consequences.

7.

III. Price Elasticity of Supply

A. Definition
The ratio of the percentage change in quantity supplied of a product or resource to the percentage change in its price; the responsiveness of producers to a change in the price of a product or resource.

B. Coefficient of Elasticity (Es) (midpoint formula)

C. Example (yellow page)

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
A period in which producers of a product are unable to change the quantity produced in response to a change in its price;

a period in which there is a perfectly inelastic supply.

b. short run

In microeconomics a period of time in which producers are able to change the quantity of some but not all of the resources they employ;

a period in which some resources (usually plant) are fixed and some are variable.

c. long run

In microeconomics a period of time long enough to enable producers of a product to change the quantities of all the resources they employ;

a period in which all resources and costs are variable and no resources or costs are fixed.

 

IV. Cross and Income Elasticity of Demand

A. Cross Elasticity of Demand
1. definition
The ratio of the percentage change in quantity demanded of one good to the percentage change in the price of some other good.

2. coefficient of cross elasticity of demand (Eab)

3. the sign IS important

a positive coefficient indicates the two products are substitute goods;

a negative coefficient indicates they are complementary goods.

4. example

B. Income Elasticity of Demand

1. definition
The ratio of the percentage change in the quantity demanded of a good to a percentage change in consumer income;

measures the responsiveness of consumer purchases to income changes.

2. coefficient of income elasticity of demand (Edy)

3. the sign IS important

a positive coefficient indicates the product is a normal good;

a negative coefficient indicates the product is an inferior good.

4. example