Elasticities of Demand and Supply

5 Elasticities of Demand and Supply CHECKPOINTS

Checkpoint 5.1 Checkpoint 5.2 Checkpoint 5.3 Clicker version Clicker version Problem 1 Problem 1 Problem 1 Problem 2 Clicker version Problem 2 Problem 2 Problem 3 Problem 3 Clicker version Problem 3 Problem 4

Practice Problem 1 When the price of a good increased by 10 percent, the quantity demanded of it decreased 2 percent. Is the demand for this good elastic, unit elastic, or inelastic? CHECKPOINT 5.1

Solution The demand for a good is inelastic if the percentage decrease in the quantity demanded is less than the percentage increase in its price. In this example, a 10 percent price rise brings a 2 percent decrease in the quantity demanded, so demand is inelastic. CHECKPOINT 5.1

Study Plan Problem When the price of a good increased by 10 percent, the quantity demanded of it decreased 2 percent. Demand for this good is __________. A. Inelastic B. Elastic C. unit elastic CHECKPOINT 5.1

Practice Problem 2 When the price of a good increased by 10 percent, the quantity demanded of it decreased 2 percent. Are substitutes for this good easy to find or does it have poor substitutes? Is this good more likely to be a necessity or a luxury? Why? Is the good more likely to be narrowly or broadly defined? Why? CHECKPOINT 5.1

Solution Because the good has an inelastic demand, it most likely has poor substitutes. is a necessity rather than a luxury. is broadly defined. CHECKPOINT 5.1

Study Plan Problem When the price of a good increased by 10 percent, the quantity demanded of it decreased 2 percent. Most likely, this good ___________ and ____________. A. has poor substitutes; is a luxury B. is a necessity; has poor substitutes C. is a luxury; is narrowly defined D. is a necessity; has good substitutes E. is broadly defined; is a luxury CHECKPOINT 5.1

Practice Problem 3 When the price of a good increased by 10 percent, the quantity demanded of it decreased 2 percent. Calculate the price elasticity of demand for this good. Explain how the total revenue from the sale of the good has changed. Explain which of the following goods this good is most likely to be: orange juice, bread, toothpaste, theater tickets, clothing, blue jeans, Super Bowl tickets. CHECKPOINT 5.1

Solution Price elasticity of demand = Percentage change in the quantity demanded ÷ Percentage change in price. Price elasticity of demand = 2 ÷ 10 or 0.2. An elasticity less than 1 means that demand is inelastic. When demand is inelastic, a price rise increases total revenue. This good is most likely a necessity (bread), or has poor substitutes (toothpaste), or is broadly defined (clothing). CHECKPOINT 5.1

Study Plan Problem When the price of a good increased by 10 percent, the quantity demanded of it decreased 2 percent. The price elasticity of demand is ___. A price rise will ____ total revenue. ____ is a good with such a demand. A. 5.0; decrease; Toothpaste B. 0.2; increase; Toothpaste C. 0.2; decrease; Super Bowl tickets D. 5.0; decrease; Blue jeans E. 5.0; increase; Super Bowl tickets CHECKPOINT 5.1

Practice Problem 4 Music giant chops price to combat downloads In 2003, when music downloading first took off, Universal Music slashed the price of a CD from $21 to $15. The company said that it expected the price cut to boost the quantity of CDs sold by 30 percent. Source: Globe and Mail, September 4, 2003 What was Universal Music’s estimate of the price elasticity of demand for CDs and is the demand estimated to be elastic or inelastic? CHECKPOINT 5.1

Solution Price elasticity of demand = Percentage change in the quantity demanded ÷ Percentage change in price. The Percentage change in the price equals [($21 – $15)/($18)] × 100, which is 33.3 percent. The Percentage change in the quantity is 30 percent. So the estimated price elasticity of demand is 30 percent ÷ 33.3 percent, or 0.9. An estimated elasticity of 0.9 means that demand is estimated to be inelastic. CHECKPOINT 5.1

Practice Problem 1 You are told that a 10 percent increase in the price of a good has led to a 1 percent increase in the quantity supplied of the good after one month and a 25 percent increase in the quantity supplied after one year. Is the supply of this good elastic, unit elastic, or inelastic? Is this good likely to be produced using factors of production that are easily obtained? What is the price elasticity of supply of this good? CHECKPOINT 5.2

Solution The supply of a good is inelastic if the percentage increase in the quantitysupplied is less than the percentage increase in price. In this example, a 10 percent price rise brings a 1 percent increase in the quantity supplied, so supply is inelastic. CHECKPOINT 5.2

Because the quantity supplied increases by such a small percentage after one month, the factors of production that are used to produce this good are more likely to be difficult to obtain. The elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. Elasticity of supply = 1 ÷ 10 or 0.1. CHECKPOINT 5.2

Study Plan Problem You are told that a 10 percent increase in the price of a good has led to a 1 percent increase in the quantity supplied of that good after one month. Supply of the good is ____. A. inelastic B. unit elastic C. elastic D. decreasing E. increasing CHECKPOINT 5.2

Practice Problem 2 You are told that a 10 percent increase in the price of a good has led to a 1 percent increase in the quantity supplied of the good after one month and a 25 percent increase in the quantity supplied after one year. What is the elasticity of supply of this good after one year? Has the supply of this good become more elastic or less elastic? Why? CHECKPOINT 5.2

Solution Elasticity of supply = Percentage change in the quantity supplied ÷ Percentage change in the price. After one year, the elasticity of supply = 25 ÷ 10 = 2.5. The supply of the good has become more elastic over the year since the price rise. Possibly other producers have gradually started producing the good and with the passage of time more factors of production can be reallocated. CHECKPOINT 5.2

Practice Problem 3 Weak coal prices hit China's third-largest coal miner The chairman of Yanzhou Coal Mining, Wang Xin, reported that the global financial crisis has decreased the demand for coal, with its sales falling by 11.9 percent to 7.92 million tons from 8.99 million tons a year earlier, despite the price falling by 10.6 percent. Source: Dow Jones, April 27, 2009 Calculate the price elasticity of supply of coal at Yanzhou Coal Mining. Is its supply of coal elastic or inelastic? CHECKPOINT 5.2

Solution Elasticity of supply = Percentage change in the quantity supplied ÷ Percentage change in the price. Yanzhou Coal Mining’s price elasticity of supply equals 11.9 percent divided by 10.6 percent, or 1.12. The quantity supplied fell by a larger percentage than the price, so supply of coal is elastic. That is what an elasticity of supply of 1.12 means. CHECKPOINT 5.2

Practice Problem 1 The quantity demanded of good A increases by 5 percent when the price of good B rises by 10 percent and other things remain the same. Are goods A and B complements or substitutes? Describe how the demand for good A changes. Calculate the cross elasticity of demand. CHECKPOINT 5.3

Solution Goods A and B are substitutes because when the price of good B rises, the quantity demanded of good A increases. As the price of good B rises, people switch from good B to good A. The demand for good A increases. CHECKPOINT 5.3

Cross elasticity of demand = Percentage change in the quantity demanded of good A ÷ Percentage increase in the price of good B. Cross elasticity of demand = 5 ÷ 10 or 0.5. CHECKPOINT 5.3

Practice Problem 2 When income rises by 5 percent and other things remain the same, the quantity demanded of good C increases by 1 percent. Is good C a normal good or an inferior good? Describe how the demand for good C changes. Calculate the income elasticity of demand for good C. CHECKPOINT 5.3

Solution Because the quantity demanded of good C increases when income increases, good C is a normal good. An increase in income increases the demand for good C. CHECKPOINT 5.3

Income elasticity of demand = Percentage change in the quantity demanded of good C ÷ Percentage increase in income. Income elasticity of demand = 1 ÷ 5 or 0.2. CHECKPOINT 5.3

Practice Problem 3 Economy forces many to shorten summer vacation plans Americans are taking fewer exotic holidays and are visiting local scenic places instead. The financial crisis has encouraged many to cut their holiday budgets. Source: USA Today, 22 May, 2009 Given the prices of the two holidays, is the income elasticity of demand for exotic holidays positive or negative? Are exotic holidays a normal good or an inferior good? Are local holidays a normal good or an inferior good? CHECKPOINT 5.3

Solution As income falls, the quantity of exotic holidays decreases. The income elasticity equals the percentage change in the quantity of exotic travel ÷ Percentage change in income. Because both income and the quantity of exotic holidays decreased, the income elasticity of demand is positive. Because the income elasticity of demand is positive, exotic holidays are a normal good. The income elasticity of demand for local holidays is negative, so local holidays are an inferior good. CHECKPOINT 5.3

Practice Problem 4 Economy forces many to shorten summer vacation plans Americans are taking fewer exotic holidays and are visiting local scenic places instead. The financial crisis has encouraged many to cut their holiday budgets. Source: USA Today, 22 May, 2009 Are exotic holidays and local holidays substitutes? Explain your answer. CHECKPOINT 5.3

Solution To know whether exotic and local holidays are substitutes, we need to calculate the cross elasticity of demand. To calculate the cross elasticity of demand, we need to know how the quantity of one of the holidays changes when the price of the other changes. The news clip does not give that information. CHECKPOINT 5.3

Elasticities of Demand and Supply