ECONOMICS

1. ECONOMICS What Does It Mean To Me? Part VI: Elasticity of Demand Elasticity of Supply Supply, Demand, and Taxation READ Krugman Section 9, Modules 46, 47, 48 Mankiw Ch 5 DO Morton Unit 2

2. Module The Income Effect, Substitution Effect, and Elasticity 10 Micro: Econ: • KRUGMAN'S • MICROECONOMICS for AP* 46 Margaret Ray and David Anderson

3. What you will learnin thisModule: • How the income and substitution effects explain the law of demand • The definition of elasticity, a measure of responsiveness to changes in prices or incomes • The importance of the price elasticity of demand, which measures the responsiveness of the quantity demanded to changes in price • How to calculate the price elasticity of demand

4. The Law of Demand • The substitution effect • The income effect I

5. “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.” --Alfred Marshall, Principles of Economics

6. The law of demand tells us that consumers will respond to a decline in a product’s price by buying more of that product. But how much more of it will they purchase? That amount can vary considerably by product and over different price ranges for the same product.

7. The responsiveness, or sensitivity, of quantity demanded to a change in the price of a product is measured by the concept of PRICE ELASTICITY OF DEMAND.

8. Demand for some products is such that consumers are highly responsive to price changes; modest price changes lead to very large changes in the quantity purchased, for example: restaurant meals, steak, cars. The demand for such products is said to be relatively elastic, or simply ELASTIC.

9. For other products, consumers are quite unresponsive to price changes; substantial price changes result in only small changes in the amount purchased, for example: salt, milk, soap. For such products, demand is relatively inelastic or simply INELASTIC.

10. Economist measure the degree of price elasticity or inelasticity of demand with the coefficient Ed defined as: percentage change in quantity demanded of product X Ed = percentage change in price of product X (Ed = Elasticity of demand)

11. These percentage changes are calculated by dividing the change in price by the original price and the consequent change in quantity demanded by the original quantity demanded. Thus, our definition can be restated as follows: change in quantity demanded of X change in price of X Ed original quantity original price of X demanded of X :

12. Another way to state the equation would be using the Greek letter delta, , meaning change in……. % Qd (Q1 + Q2)/2 % P (P1 + P2)/2 Ed =

13. Calculating Elasticity • Calculating elasticity • Elasticity is the % change in the dependent variable divided by the % change in the independent variable • In symbols, elasticity is %∆dep/%∆ind • Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price. • In symbols: Ed = %ΔQd/ΔP note: we drop the negative sign for Ed only.

14. Why use percentages? Economists give two reasons: 1) Choice of Units 2) Comparing products

15. 1) Choice of Units If we use absolute changes, our impression of buyer responsiveness will be arbitrarily affected by the choice of units. Using percentages avoids this problem. A particular price decline is 33 percent whether measured in terms of dollars ($1/$3) or pennies (100 cents/300 cents).

16. 2) Comparing products By using percentages, we can correctly compare consumer responsiveness to changes in the prices of differentproducts. It makes little sense to compare the effects on quantity demanded of (1) a $1 increase in the price of a $10,000 auto with (2) a $1 increase in the price of a $1 can of cola. Here, the price of an auto is rising by .01 percent while the price of cola is up by 100 percent.

17. Elimination of Minus Sign We know from the downsloping demand curve that price and quantity are inversely related. Thus, the price elasticity coefficient of demand Ed will always be a negative number. As an example, if price declines, then quantity demanded will increase. This means that the numerator in our formula will be positive and the denominator negative, yielding a negative Ed . For an increase in price, the numerator will be negative but the denominator positive, again yielding a negative Ed . Economists usually ignore the minus sign and present the absolute value of the elasticity coefficient to avoid ambiguity.

18. Interpretations of Ed We can interpret the coefficient of price elasticity of demand as follows: 1) elastic demand 2) inelastic demand 3) unit elasticity

19. Elastic Demand Demand is said to be elastic if a specific percentage change in price results in a larger percentage change in quantity demanded. Then Ed > 1. Example: If a 2 percent decline in a price results in a 4 percent increase in quantity demanded, then demand iselastic and .04 Ed = .02 = 2

20. A small percentage change in price leads to a larger percentage change in quantity demanded. P1 PRICE P P0 D2 Relatively elastic demand Qd Ed > 1 0 Q1 Q0 QUANTITY

21. When we say demand is “elastic,” we do not mean that consumers are completely responsive to a price change. In that extreme situation, where a small price reduction would cause buyers to increase their purchases from zero to all they could obtain, economists say demand is perfectly elastic. You will see in later chapters that such a demand applies to a firm, for instance, a blueberry grower, selling its product in a purely competitive market.

22. A small percentage change in price will change quantity demanded by an infinite amount. P1 PRICE P P0 D2 Perfectly elastic demand Qd Ed = 0 Q1 Q0 QUANTITY

23. Inelastic Demand If a specific percentage change in price is accompanied by a smaller percentage change in quantity demanded, demand is said to be inelastic. Then Ed < 1. Example: If a 3 percent decline in price leads to only a 1 percent increase in quantity demanded, demand is inelastic and .01 Ed = .03 = .33

24. A change in price leads to a smaller percentage change in quantity demanded. P1 PRICE Relatively inelastic demand P P0 Ed < 1 Qd D1 0 Q1 Q0 QUANTITY

25. When we say demand is “inelastic,” we do not mean that consumers are completely unresponsive to a price change. In that extreme situtation, where a price change results in no change whatsoever in the quantity demanded, economist say that demand is perfectly inelastic. Examples include an acute diabetic’s demand for insulin or and addict’s demand for heroin.

26. The quantity demanded does not change regardless of the percentage change in price. D1 P1 PRICE Perfectly inelastic demand P P0 Ed = 0 0 Q0 = Q1 QUANTITY

27. Elastic or Inelastic demand?

28. Unit Elasticity The case separating elastic and inelastic demands occurs where a change in price and the accompanying percentage change in quantity demanded are equal. Example: A 1 percent drop in price causes a 1 percent increase in quantity demanded. This special case is termed unit elasticity because Ed = 1, or unity. In this example: .01 Ed = .01 = 1

29. The percentage change in quantity demanded is the same as the percentage change in price that caused it. P1 PRICE Unit elastic demand P D1 Ed = 1 P0 Qd 0 Q1 Q0 QUANTITY

30. When a demand curve is relatively steep, such as D0 in this graph, its price elasticity is relatively inelastic. When a demand curve is relatively flat, such as D1, its price elasticity is relatively elastic. P1 PRICE P0 D1 Relatively elastic D0 Relatively inelastic 0 Q2 Q1 Q0 QUANTITY

31. A more accurate way to calculate elasticity is THE MIDPOINT FORMULA

32. The Midpoint Formula • The problem with calculating percentage changes • The solution: Use the Midpoint formula! • %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity • %ΔP = 100*(New Price – Old Price)/Average Price • Ed = %ΔQd/ΔP • Example

33. Using the midpoint formula, calculate the following: Price Qdemanded Apples A .90 1,100 Apples B 1.50 900 (1100-900) 200 (1100+900)/2 1000 (1.50 - .90) .60 (1.50 + .90)/2 1.20 = x 100 100 = 20 50 .4 = x =

34. Using the midpoint formula, calculate the following: Price Qdemanded Apples A .90 1,500 Apples B 1.10 900 (1500-900) 600 (1500+900)/2 1000 (1.10 - .90) .20 (1.10 + .90)/2 1.00 = x 100 100 = 60 20 3 = x =

35. What influences the price elasticity of demand? • Available substitutes • Proportion of income • Luxuries vs necessities • Time

36. Available Substitutes • The larger the number of close substitutes, the greater the elasticity. If the price increases, consumers may select a relatively lower-priced substitute instead. • Examples may include: • Butter => Margarine • Pepsi => Coca Cola • Texaco gasoline => Hess gasoline

37. Proportion of Income Spent on the Good • The smaller the proportion of income spent on a good, the lower its elasticity of demand. If the amount spent on a good relative to income is small, then the change in price on one’s income will also be small. • Example: • 100% increase in price of salt vs. 100% increase in price of an automobile. • 50% increase in price of private education vs. 50% increase in cost of textbooks.

38. Luxuries vs Necessities The demand for “necessities” tends to be price-inelastic; that for “luxuries” price-elastic. A price increase will not significantly the amount of a necessity consumed. If the price of a luxury rises, an individual need not buy them and will suffer no great hardship without them. • Examples (necessities): • Bread • Electricity • Appendectomy • Examples (Luxuries): • Caribbean cruise • Emerald ring • Lexus

39. The Amount of Time Since the Price Change The more time that people have to adapt to a new price change, the greater its elasticity of demand. Immediately after a price change, consumers may be unable to locate good alternatives or easily change their consumption patterns.

40. Total-Revenue Test Total revenue (TR) is the total amount the seller receives from the sale of a product; it is calculated by multiplying the product price (P) by the quantity demanded and sold (Q). In equation form: TR = P x Q Total revenue and the price elasticity are related. Indeed, perhaps the easiest way to infer whether demand is elastic or inelastic is to employ the total-revenue test, where we observe what happens to total revenue when product price changes.

41. Elastic Demand If demand is elastic, a decrease in price will increase total revenue. Even though a lesser price is received per unit, enough additional units are sold to more than make up for the lower price. TR = P x Q TR = P x Q

42. Elastic Demand and Total Revenue P At point A, total revenue is $400 ($10 x 40), or area a + b. At point B, the total revenue is $500 ($5 x 100), or area b + c. A $10 $5 Total revenue has increased by $100. a We can also see in the graph that total revenue has increased because the area b + c is greater than area a + b, or c > a. B b c Delastic 0 20 40 60 80 100 Q

43. Inelastic Demand If demand is inelastic, a price decrease will reduce total revenue. The modest increase in sales will not offset the decline in revenue per unit, and the net result is that total revenue declines. TR = P x Q TR = P x Q

44. Inelastic Demand and Total Revenue P At point A, total revenue is $300 ($10 x 30), or area a + b. A At point B, the total revenue is $200 ($5 x 40), or area b + c. $10 $5 Total revenue has decreased by $100. a We can also see in the graph that total revenue has decreased because the area a + b is greater than area b + c, or a > c. B b c Dinelastic 0 10 20 30 40 Q

45. APPLICATIONS OF PRICE ELASTICITY OF DEMAND

46. 1) Bumper Crops Increases in the output of most farm products arising from a good growing season or increase in productivity will cause to decrease both the farm products and the total revenues (or incomes) of farmers.

47. 2) Automation The impact of technological advances on employment depends in part on the elasticity of demand for the product or service that is involved. If a firm installs technology that replaces 1000 workers, who are then laid off, the savings from the cost reduction could be passed on to consumers. The effect of the price reduction on sales will depend on the elasticity of the product. An elastic demand could increase sales to a point where some of the workers might be rehired. An inelastic demand will result in only minimal increase in sales.

48. 3) Airline Deregulation In the 1970s, deregulating the airlines caused increased profits for the carriers in the short term, because it increased price competition among the airlines, thus lowering airfares. Lower fares, and an elastic demand for air travel, increased revenues. Filling the airplanes to capacity increased revenues more than the costs and increased profits. Profits did not last, however, because of rising fuel prices, persistent fare wars, and the entry of competitors on profitable routes.

49. 4) Excise Taxes The government selects certain goods and services with which to levy excise taxes by paying attention to elasticity of demand. If a $1 tax is levied on a product and 10,000 units are sold, tax revenue will be $10,000. If government then raises the tax to $1.50 and the consequent higher price reduces sales to 5000, tax revenue will decline to $7500. A higher tax on a product with an elastic demand will reduce revenue, therefore, governments seek products with inelastic demands, such as liquor, gasoline and cigarettes.

50. 5) Drugs and Street Crime Is an addict’s demand for crack cocaine and heroin highly elastic? This belief is typically used by law enforcement to reduce supply by intercepting drug shipments. If this is true, then the street price to addicts will rise sharply while amounts purchased will decrease slightly. This will result in greater revenues for drug dealers. Because the income of the addict comes from crime, it may be true that restricting supply of drugs actually causes crime. Proponents of drug legalization contend that drugs should be treated like alcohol because the war on drugs has been unsuccessful and the associated costs are too great.