C hapter 4 Elasticity © 2002 South-Western. 2 Economic Principles Demand Sensitivity Determinants...

CChapter 4hapter 4

Elasticity

© 2002 South-Western

2

Economic PrinciplesEconomic Principles

• Demand Sensitivity

• Determinants of Demand Sensitivity to Price Changes

• Price Elasticity of Demand

• Cross Elasticity

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Economic PrinciplesEconomic Principles

• Substitute and Complementary Goods

• Normal and Inferior Goods

• Supply Elasticity

• Relationship Between Price Elasticity of Supply and Tax Revenues

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EXHIBIT 1A DEMAND RESPONSE TO PRICE CHANGE

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EXHIBIT 1B DEMAND RESPONSE TO PRICE CHANGE

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EXHIBIT 1C DEMAND RESPONSE TO PRICE CHANGE

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Exhibit 1: Demand Exhibit 1: Demand Response to Price ChangeResponse to Price Change

1. The demand curve in panel a can be described as:

• Vertical.

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The demand curve is vertical in panel a because:

• The demand for penicillin doesn’t change – regardless of what price is charged.

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The demand curve in panel b can be described as:

• Fairly steep.

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The demand curve in panel b compares to the demand curve in panel c:

• The demand curve in panel b is steeper than in panel c.

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This tells us that the demand response for spark plugs versus Coca-Cola:

• When price is cut, the demand response for Coca-Cola is greater than the demand response for spark plugs.

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Demand SensitivityDemand Sensitivity

Demand Sensitivity:

• Demand sensitivity describes how consumer demand reacts to changes in price.

• High sensitivity: a given change in price will result in a large change in quantity demanded. • Low sensitivity, or insensitivity: a given change in price will result in little or no change in quantity demanded.

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EXHIBIT 2 MARKET DEMAND FOR COCA-COLA AND SPARK PLUGS

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Exhibit 2: Market Demand Exhibit 2: Market Demand for Coca-Cola and Spark for Coca-Cola and Spark

PlugsPlugs

In Exhibit 2, which demand curve, Panel a or b, has a steeper slope?

• Panel a, the demand for Coca-Cola, has a steeper slope.

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Exhibit 2: Market Demand Exhibit 2: Market Demand for Coca-Cola and Spark for Coca-Cola and Spark

PlugsPlugs

Which panel depicts high demand sensitivity?

• Panel a depicts high demand sensitivity.

• A decrease in the price of Coca-Cola results in a large increase in quantity demanded.

• The slope of the demand curve is steep.

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What Factors Influence What Factors Influence Demand Sensitivity?Demand Sensitivity?

All else equal, the demand for low-priced goods is less elastic than high-priced goods.

When something is inexpensive people are less price sensitive.

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The elasticity of demand for poor people is larger than for rich people.

• Poor people are more sensitive to price changes than rich people.

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The price elasticity of demand for basic goods (necessities) is not larger than for less essential goods.

•There are fewer substitutes for basic goods (such as bread, electricity, or gasoline) than for less essential goods (such as slices of pizza or specific brands of running shoes).

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A product used as a compliment with an essential good will have the elasticity characteristics of the essential good.

•If something is used in conjunction with an essential good, then consumption will not decline very much if price rises.

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In which of the following situations will the price elasticity of demand be largest:

• When people have a brief period of time to adjust

•When people have a long time period to adjust.

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In which of the following situations will the price elasticity of demand be largest:

• When people have a brief period of time to adjust

•When people have a long time period to adjust.

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From Sensitivity to From Sensitivity to ElasticityElasticity

The price elasticity of demand is not the same thing as the slope of the demand curve.

• The slope of the demand curve will differ based on the units used to measure price and quantity.

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• We want a measure of sensitivity that will be the same regardless of the units used to measure price and quantity.

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• Price elasticity of demand is the percent change in quantity demanded divided by the percentage change in price.

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Formula for computing the price elasticity of demand:

• Ed = (Q2-Q1)/[(Q2+Q1)/2] divided by(P2-P1)/[(P2+P1)/2]

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EXHIBIT 3APRICE ELASTICITIES OF DEMAND FOR FOOTBALL TICKETS AND MILK

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EXHIBIT 3BPRICE ELASTICITIES OF DEMAND FOR FOOTBALL TICKETS AND MILK

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Exhibit 3: Price Elasticities of Exhibit 3: Price Elasticities of Demand for Football Tickets Demand for Football Tickets

and Milkand Milk

In Exhibit 3, elasticity of demand for football tickets within the $4 to $3 price range is 3.5. This means:

• A price elasticity of 3.5 means that a 1 percent change in price generates a 3.5 percent change in quantity demanded.

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and Milkand Milk

In Exhibit 3, elasticity of demand for football tickets within the $4 to $3 price range is 3.5. This means:

• Elasticities greater than 1.0 are price elastic.

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and Milkand Milk

In the $2 to $1 price range, elasticity of demand for football tickets falls to 0.5. This means:

• A 0.5 price elasticity means that a 1 percent change in price generates a 0.5 percent change in quantity demanded.

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and Milkand Milk

In the $2 to $1 price range, elasticity of demand for football tickets falls to 0.5. This means:

• Elasticities less than 1.0 are price inelastic.

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and Milkand MilkWhen the price of football tickets rises from $1 to $2, quantity demanded falls from 700 to 500. The price elasticity of demand is:

• (Q2-Q1)/[(Q2+Q1)/2] =

(700-500)/[(700+500)/2] = 1/3.

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• (P2-P1)/[(P2+P1)/2] =

(2-1)/[(2+1)/2] = 2/3

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• Ed = (1/3)/(2/3) = ½.

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EXHIBIT 4 ELASTICITIES, PRICE, AND REVENUE CHANGES

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Exhibit 4: Elasticities, Price, Exhibit 4: Elasticities, Price, and Revenue Changesand Revenue Changes

If demand is price inelastic and price goes down, total revenue decreases.

• When demand is price inelastic, the increase in quantity is less than proportionate to the decrease in price.

• Price falls more than quantity increases and total revenue decreases.

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Cross ElasticityCross Elasticity

Cross elasticity of demand:

• It is the ratio of a percentage change in quantity demand of one good to a percentage change in the price of another good.

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EXHIBIT 5 PRICE ELASTICITIES OF DEMAND FOR SELECTED GOODS

Source: Edward Mansfield, Microeconomics (New York: W. W. Norton, 1997); Robert Hall and Mark Lieberman, Economics (Cincinnati: South-Western College Publishing, 1998); Gary Brester and Michael Wohlgenant, “Estimating Interrelated Demands for Meat Using New Measures for Ground and Table Cut Beef,” American Journal of Agricultural Economics (November 1991); and Heinz Kohler, Intermediate Economics: Theory and Applications (new York: Scott, Foresman, 1986).

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Exhibit 5: Price Elasticities Exhibit 5: Price Elasticities of Demand for Selected of Demand for Selected

GoodsGoods

Which of the following has the largest price elasticity of demand:

• Corn

• Cigarettes

• Movies

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Exhibit 5: Price Elasticities Exhibit 5: Price Elasticities of Demand for Selected of Demand for Selected

GoodsGoods

Which of the following has the largest price elasticity of demand:

• Corn

• Cigarettes

• Movies

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EXHIBIT 6 PRICE ELASTICITIES OF DEMAND IN THE SHORT RUN AND LONG RUN

Source: H. S. Houthakker and Lester Taylor, Consumer Demand in the United States, 1929–1970 (Cambridge, Mass.: Harvard University Press, 1970); Richard Voith, “The Long-Run Elasticity of Demand for Commuter Rail Transportation,” Journal of Urban Economics (November 1991); and James Griffen and Henry Steele, Energy Economics and Policy (New York: Academic Press, 1980).

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Exhibit 6: Price Elasticities Exhibit 6: Price Elasticities of Demand in the Short Run of Demand in the Short Run

and Long Runand Long Run

Which of the following has the smallest price elasticity of demand in the long run:

• Gasoline

• Jewelry and watches

• Hospital care

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Exhibit 6: Price Elasticities Exhibit 6: Price Elasticities of Demand in the Short Run of Demand in the Short Run

and Long Runand Long Run

Which of the following has the smallest price elasticity of demand in the long run:

• Gasoline

• Jewelry and watches

•Hospital care

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EXHIBIT 7 CROSS ELASTICITIES BETWEEN SUBSTITUTES

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Exhibit 7: Cross Elasticities Exhibit 7: Cross Elasticities Between SubstitutesBetween Substitutes

In Exhibit 7, the demand for Tums increase when the price of Rolaids increased because:

• Tums and Rolaids are substitute goods -- goods that can replace each other.

• When the price of Rolaids increases, some consumers are willing to switch to a cheaper substitute -- Tums.

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Exhibit 7: Cross Elasticities Exhibit 7: Cross Elasticities Between SubstitutesBetween Substitutes

In Exhibit 7, the demand for Tums increase when the price of Rolaids increased because:

• Cross elasticities for substitute goods are positive.

• A decrease (or increase) in the price of one good generates a corresponding decrease (or a corresponding increase) in the quantity demanded of the other.

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EXHIBIT 8 CROSS ELASTICITIES OF DEMAND FOR SUBSTITUTE GOODS

Source: Edwin Mansfield, Microeconomics (New York: W. W. Norton, 1997); F. Gasmi, J. J. Laffont, and Q. Vuong, “Econometric Analysis of Collusive Behavior in a Soft Drink Market,” Journal of Economics and Management Strategy (Summer 1992); and Gary Brester and Michael Wohlgenant, “Estimating Interrelated Demands for Meats Using New Measures for Ground and Table Cut Beef,” American Journal of Agricultural Economics (November 1991).

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Exhibit 8: Cross Elasticities Exhibit 8: Cross Elasticities of Demand for Substitute of Demand for Substitute

GoodsGoods

Which of the following are the closest substitutes, according to Exhibit 8:

• Butter and margarine

• Poultry and ground beef

• Natural gas and electricity

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GoodsGoods

Which of the following are the closest substitutes, according to Exhibit 8:

• Butter and margarine

• Poultry and ground beef

• Natural gas and electricity

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GoodsGoods

Butter and margarine the closest substitutes because:

• They have the largest cross elasticity of demand.

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EXHIBIT 9A CROSS ELASTICITIES BETWEEN COMPLEMENTS

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EXHIBIT 9B CROSS ELASTICITIES BETWEEN COMPLEMENTS

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Exhibit 9: Cross Exhibit 9: Cross Elasticities Between Elasticities Between

ComplementsComplementsWhen the price of flights decreases, the demand for hotel rooms:

• The demand for hotel rooms will increase, because people fly more and need more hotel rooms.

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Income ElasticityIncome Elasticity

Income elasticity:

• It is the ratio of the percentage change in quantity demanded to the percentage change in income.

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Income elasticity:

• A good is considered income elastic when a 1 percent change in income generates a greater than 1 percent change in quantity demanded.

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Income elasticity:

• A good is considered income inelastic when a 1 percent change in income generates a less than 1 percent change in quantity demanded.

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EXHIBIT 10 AIR TRAVEL

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Exhibit 10: Air TravelExhibit 10: Air Travel

The demand curve in Exhibit 10 shift from Dy to D’y even though price remains constant because:

• In Exhibit 10, the demand for air travel is income elastic. As income increases, the demand for flights increases, even though the price of flights remains unchanged.

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EXHIBIT 11 INCOME ELASTICITIES OF DEMAND

Source: Edwin Mansfield, Microeconomics (New York: W. W. Norton, 1997); and F. Chalemaker, “Rational Addictive Behavior and Cigarette Smoking,” Journal of Political Economy (August 1991).

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Exhibit 11: Income Exhibit 11: Income Elasticities of DemandElasticities of Demand

The income elasticity of demand for electricity so much lower than for furniture because:

• Electricity is a necessity, while

furniture is a luxury.

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EXHIBIT 12 COMPARISON OF INCOME ELASTICITIES OF DEMAND FOR FOOD, BY COUNTRY

Source: Ching-Fun and James Peale Jr., “Income and Price Elasticities,” in Advances in Econometrics Supplement, ed. Henri Thell (Greenwich, Conn.: JAI Press, 1989); and Y. Wu, E. Li, and S. N. Samuel, “Food Consumption in Urban China: An Empirical Analysis,” Applied Economics (June 1995).

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Exhibit 12: Comparison of Income Exhibit 12: Comparison of Income Elasticities of Demand for Food, by Elasticities of Demand for Food, by

CountryCountry

The type of countries which tend to have the lowest income elasticity for food are:

• Industrialized countries.

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EXHIBIT 13A ELASTICITIES OF SUPPLY

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EXHIBIT 13B ELASTICITIES OF SUPPLY

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EXHIBIT 13C ELASTICITIES OF SUPPLY

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Exhibit 13: Elasticities of Exhibit 13: Elasticities of SupplySupply

In Exhibit 13, the different supply curves have different price elasticities because:

• Panel a depicts the market-day supply curve.

• At any price suppliers are unable to adjust supply.

• The price elasticity of supply is 0.

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• Panel b depicts the short-run supply curve.

• Suppliers are willing, but not able, to meet all the demand.• Suppliers can only increase production with existing capacity.

• Price elasticity is 0.47.

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• Panel c depicts the long-run supply curve.

• Suppliers encounter no obstacles in adjusting quantity supplied to price.

• The price elasticity is 1.64.

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EXHIBIT 14A WHAT GETS TAXED?

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EXHIBIT 14B WHAT GETS TAXED?

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Exhibit 14: What Gets Exhibit 14: What Gets TaxedTaxed

If government imposes a per unit tax, the type of demand (elastic or inelastic) which will generate the most revenue is:

• Inelastic.

• Quantity will not decline very much when the tax raises the price of the product.

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