GS ECO 2302 CH 6 Elasticity: The Responsiveness of Demand and Supply

An Example of Calculating Price Elasticities (continued) @ price cut down from $1.50 to $1.35 (Δ) Demanded = [(1200 - 1000) / 1000] x 100 = 20% (Δ) Price Change = [(1.35 - 1.50) / 1.50] x 100 = -10% = 20% / -10% = -2 or | 2 | = elastic

@ price increase up from $1.35 to $1.50 (Δ) Demanded = [(1000 - 1200) / 1200] x 100 = -16.7% (Δ) Price Change = [(1.50 - 1.35) / 1.35] x 100 = 11.1% = -16.7% / 11.1% = -1.5 or | 1.5 | = elastic BUT different value

Inelastic Demand the percentage change in quantity demanded will be less than the percentage change in price, and the price elasticity of demand will be less than 1 in absolute value.

A situation in which an increase or a decrease in price will not significantly affect demand for the product ex. 5% (Δ) Quantity Demanded / -10% (Δ) Price Change = -.5 or | .5 | absolute value = inelastic

3 of 5 Determinants of the Price Elasticity of Demand : Luxuries versus Necessities

The demand curve for a luxury is more elastic than the demand curve for a necessity. Goods that are luxuries usually have more elastic demand curves than goods that are necessities. For example, the demand for milk is inelastic because milk is a necessity, and the quantity that people buy is not very dependent on its price. Tickets to a concert are a luxury, so the demand for concert tickets is much more elastic than the demand for bread.

The combination of a low price elasticity of demand and a low price elasticity of supply means that

even relatively small increases or decreases in the demand or supply of oil can result in large swings in its equilibrium price.

A less common possibility than those shown in Figure 6.2 is that demand is unit elastic. In that case, a small change in price is

exactly offset by a proportional change in the quantity demanded, leaving revenue unaffected. Therefore, when demand is unit elastic, neither a decrease nor an increase in price affects revenue. Table 6.3 summarizes the relationship between price elasticity and revenue.

• When demand is inelastic, price and total revenue move in the same direction: An increase in price raises total revenue, and a decrease in price reduces total revenue.

example is panel A Change in revenue from price cut is (-$150) vs. Change in Revenue in increased (minor) demand ($67.50) It means you are better off at charging the higher price even if demanded volume is lower (to a point).

• When demand is elastic, price and total revenue move inversely: An increase in price reduces total revenue, and a decrease in price raises total revenue.

example is panel B A price cut generated additional revenue over a price increase. ($150 lost at lower price point vs. $270 gained in higher demand)

elasticity

measure how one economic variable—such as the quantity demanded—responds to changes in another economic variable—such as the price

price elasticity of supply

the responsiveness of the quantity supplied of a good to changes in its price

Unfortunately for U.S. farmers, this increase in wheat production resulted in a substantial decline in wheat prices. Two key factors explain this decline:

(1) The demand for wheat is inelastic, and (2) the income elasticity of demand for wheat is low. Even though the U.S. population has increased greatly since 1950 and the income of the average American is much higher than it was in 1950, the demand for wheat has increased only moderately. For all of the additional wheat to be sold, the price has had to decline. Because the demand for wheat is inelastic, the price decline has been substantial. Figure 6.4 illustrates these points. A large shift in supply, a small shift in demand, and an inelastic demand curve combined to drive down the price of wheat from $19.23 per bushel in 1950 to $3.85 in 2017. (We measure the price in 1950 in terms of prices in 2017 to adjust for the general increase in prices since 1950.) With low prices, only the most efficiently run farms have been able to remain profitable. Small family-run farms have found it difficult to survive, and many of these farms have disappeared.

Formula for a Percentage Change

(Value in second period - Value in first period) / Value in first period x 100

To avoid this confusion over units, economists use

percentage changes when measuring the price elasticity of demand. Percentage changes are not dependent on units of measurement Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price

Measuring the Price Elasticity of Supply As we did with the price elasticity of demand, we calculate the price elasticity of supply by using

percentage changes: Δ% in quantity supplied Δ% in price or [[(Q2-Q1) / Q1] x 100] / [[(P2-P1) / P1] x 100]

Cross-price elasticity of demand (XED)

the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good Suppose you work at Apple, and you need to predict the effect of an increase in the price of Samsung's Galaxy smartphone on the quantity of Apple iPhones demanded, holding other factors constant.

Because most goods are normal goods, during periods of economic expansion when consumer income is rising, most firms can expect—holding other factors constant—that

the quantity demanded of their products will increase. Sellers of luxuries can expect particularly large increases. During recessions, falling consumer income can cause firms to experience increases in demand for inferior goods. For example, the demand for bus trips increases as consumers cut back on air travel, and supermarkets find that the demand for canned tuna increases relative to the demand for fresh salmon. Table 6.5 summarizes the key points about the income elasticity of demand.

price elasticity of demand

the responsiveness of the quantity demanded of a good to changes in its price In addition to a good's price, consumer income and the prices of related goods also affect the quantity of the good that consumers demand.

unit elastic In the special case where the percentage change in quantity demanded is equal to the percentage change in price, the price elasticity of demand equals −1 (or 1 in absolute value)

when the percentage change in price and quantity demanded are the same

6.4 Other Demand Elasticities Elasticity is an important concept in economics because it allows us to quantify the responsiveness of one economic variable to changes in another economic variable. In addition to price elasticity, two other demand elasticities are important:

1. Cross-price elasticity of demand 2. Income elasticity of demand

The cross-price elasticity of demand is positive or negative, depending on whether the two products are substitutes or complements.

1. Recall that substitutes are products that can be used for the same purpose, such as two brands of smartphones. An increase in the price of a substitute will lead to an increase in the quantity demanded, so the cross-price elasticity of demand will be positive. 2. Complements are products that are used together, such as iPhones and applications that can be downloaded from online stores. An increase in the price of a complement will lead to a decrease in the quantity demanded, so the cross-price elasticity of demand will be negative. 3. Of course, if the two products are unrelated—such as iPhones and peanut butter—the cross-price elasticity of demand will be zero.

When Demand Curves Intersect, the Flatter Curve Is More Elastic Remember that elasticity is not the same thing as slope. While slope is calculated using changes in quantity and price, elasticity is calculated using percentage changes.

But it is true that if two demand curves intersect: • The demand curve with the smaller slope (in absolute value)—the flatter demand curve—is more elastic. • The demand curve with the larger slope (in absolute value)—the steeper demand curve—is less elastic.

Elastic Demand If the quantity demanded is very responsive to changes in price, the percentage change in quantity demanded will be greater than the percentage change in price, and the price elasticity of demand will be greater than 1 in absolute value. In this case, demand is elastic.

If (Δ) Quantity Demanded is > than (Δ) Price Change i.e. greater than 1 Then demand is elastic ex. 20% (Δ) Quantity Demanded / -10% (Δ) Price Change = -2 or | 2 | absolute value = elastic

Polar Cases of Perfectly Elastic and Perfectly Inelastic Demand Although they do not occur frequently, you should be aware of the extreme, or polar, cases of price elasticity. (continued)

If a demand curve is a horizontal line, it is perfectly elastic. In this case, the quantity demanded is infinitely responsive to price, and the price elasticity of demand equals infinity. If a demand curve is perfectly elastic, an increase in price causes the quantity demanded to fall to zero. Once again, perfectly elastic demand curves are rare, and it is important not to confuse elastic with perfectly elastic.

Table 6.3 The Relationship between Price Elasticity and Revenue

If demand is...then...because....

Using Price Elasticity of Supply to Predict Changes in Price Figure 6.5 illustrates the important point that when demand increases, the amount by which price increases depends on the price elasticity of supply. Knowing the price elasticity of supply makes it possible to predict more accurately how much price will change following an increase or a decrease in demand.

If resource is limited (inelastic) then a small increase in supply results in higher change in price In panel (a), DemandTypical represents the typical demand for parking spaces on a summer weekend at a beach resort. DemandJuly4 represents demand on July 4. Because supply is inelastic, the shift in equilibrium from point A to point B results in a large increase in price—from $2.00 per hour to $4.00—but only a small increase in the quantity of spaces supplied—from 1,200 to 1,400. If resource is able to be increased easily (elastic) then change in price is small. In panel (b), supply is elastic. As a result, the change in equilibrium from point A to point B results in a smaller increase in price and a larger increase in the quantity supplied. An increase in price from $2.00 per hour to $2.50 is sufficient to increase the quantity of parking supplied from 1,200 to 2,100.

It's important to remember that the price elasticity of demand is not the same as the slope of the demand curve.

If we calculate the price elasticity of demand for a price cut, the percentage change in price will be negative, and the percentage change in quantity demanded will be positive. Similarly, if we calculate the price elasticity of demand for a price increase, the percentage change in price will be positive, and the percentage change in quantity demanded will be negative. Therefore, the price elasticity of demand is always negative because the SLOPE is NEGATIVE (because one of the values is always negative...i.e. -1 / 2 = -.5 1 / -2 = -.5 So, we often drop the minus sign and compare their absolute values. For example, although −3 is actually a smaller number than −2, we say that a price elasticity of −3 is larger than a price elasticity of −2.

5 of 5 Determinants of the Price Elasticity of Demand : Share of a Good in a Consumer's Budget

In general, the demand for a good will be more elastic the larger the share of the good in the average consumer's budget. [larger the cost portion = more decision thinking time vs. small cost portion = meh] For example, most people buy table salt infrequently and in relatively small quantities. The share of an average consumer's budget that is spent on salt is very low. So, even a doubling of the price of salt is likely to result in only a small decline in the quantity of salt demanded. "Big-ticket items," such as houses, cars, and furniture, take up a larger share in the average consumer's budget. Increases in the prices of these goods are likely to result in significant declines in the quantity demanded.

An Example of Calculating Price Elasticities Suppose you own a grocery, and you are trying to decide whether to cut the price of a 2-liter bottle of Coca-Cola. You are currently at point A in Figure 6.1, selling 1,000 bottles per day at a price of $1.50 per bottle. How many more bottles you will sell by cutting the price to $1.35 depends on the price elasticity of demand for Coca-Cola at your grocery store.

Let's consider two possibilities: If D1 is the demand curve for Coca-Cola at your grocery, your sales will increase to 1,200 bottles per day, point B. But if D2 is your demand curve, your sales will increase only to 1,050 bottles per day, point C. We might expect—correctly, as we will see—that between these points, demand curve D1 is elastic (>1) and demand curve D2 is inelastic (<1).

6.5 Using Elasticity to Analyze the Disappearing Family Farm The concepts of price elasticity and income elasticity can help us understand many economic issues. For example, some people are concerned that the family farm is becoming an endangered species in the United States. Although food production has been growing steadily, the number of farms and farmers continue to dwindle. In 1950, the United States had more than 5 million farms, and more than 23 million people lived on farms. By 2017, only about 2 million farms remained, and fewer than 3 million people lived on them. The federal government has several programs that are intended to aid farmers (see Chapter 4, Section 4.3). Many of these programs have been aimed at helping small, family-operated farms, but growth in farm production, combined with low price and income elasticities for most food products, have made it difficult for owners of family farms to earn a profit.

Productivity measures the ability of firms to produce goods and services with a given amount of economic inputs, such as workers, machines, and land. Productivity has grown very rapidly in U.S. agriculture. In 1950, the average U.S. wheat farmer harvested about 17 bushels from each acre of wheat planted. By 2017, because of the development of superior strains of wheat and improvements in farming techniques, the average American wheat farmer harvested 53 bushels per acre. So, even though the total number of acres devoted to growing wheat declined from about 62 million to about 44 million, total wheat production rose from about 1.0 billion bushels to about 2.3 billion.

1 of 5 Determinants of the Price Elasticity of Demand : Availability of Close Substitutes How consumers react to a change in the price of a product depends on whether there are alternative products.

So the availability of substitutes is the most important determinant of the price elasticity of demand. In fact, a key constraint on a firm's pricing policies is how many close substitutes exist for its product. In general, if a product has more substitutes available, it will have a more elastic demand. If a product has fewer substitutes available, it will have a less elastic demand.

Table of Price Elasticity of Supply

Table 6.6 summarizes the different price elasticities of supply.

Elasticity and Revenue with a Linear Demand Curve Along most demand curves, elasticity is not constant at every point.

The demand curve shows that when the price drops by $1 per movie, consumers always respond by renting 2 more movies per month. When the price is high and the quantity demanded is low, demand is elastic. Demand is elastic because a $1 drop in price is a smaller percentage change when the price is high, and an increase of 2 movies is a larger percentage change when the quantity of movies rented is low. By similar reasoning, we can see why demand is inelastic when the price is low and the quantity demanded is high.

The Midpoint Formula We can use the midpoint formula to ensure that we have only one value of the price elasticity of demand between the same two points on a demand curve.

The midpoint formula uses the average of the initial and final quantities and the initial and final prices. If Q1 and P1 are the initial quantity and price, and Q2 and P2 are the final quantity and price, the midpoint formula is: Price Elasticity of Demand = = Δ Quantity / Δ Price Avg Quantity Avg Price The midpoint formula will give us the same value whether we are moving from the higher price to the lower price or from the lower price to the higher price.

4 of 5 Determinants of the Price Elasticity of Demand : Definition of the Market

The more narrowly we define a market, the more elastic demand will be. [many competitors for same product] For example, if you own a service station and raise the price you charge for gasoline, many of your customers will switch to buying from a competitor. So, the demand for gasoline at one particular station is likely to be elastic. The demand for gasoline as a product, in contrast, is inelastic because consumers have few alternatives (in the short run) to buying it.

2 of 5 Determinants of the Price Elasticity of Demand : Passage of Time It usually takes consumers some time to adjust their buying habits when prices change.

The more time that passes, the more elastic the demand for a product becomes. It usually takes consumers some time to adjust their buying habits when prices change. If the price of chicken falls, for example, it takes a while before consumers decide to change from eating chicken for dinner once a week to eating it twice a week. If the price of gasoline increases, it also takes a while for consumers to decide to begin taking public transportation, to buy more fuel-efficient cars, or to find new jobs closer to where they live.

Many public policy issues are related to the consumption of alcoholic beverages. These issues include underage drinking, drunk driving, and the possible beneficial effects of red wine in lowering the risk of heart disease. Knowing how responsive the demand for alcohol is to changes in price provides insight into these policy issues. Christopher Ruhm of the University of Virginia and colleagues estimated statistically the following elasticities. (Spirits refers to all beverages, other than beer and wine, that contain alcohol.)

These results indicate that the demand for beer is inelastic. A 10 percent increase in the price of beer will result in a 3 percent decline in the quantity of beer demanded. Somewhat surprisingly, both wine and spirits are complements for beer rather than substitutes. A 10 percent increase in the price of wine will result in an 8.3 percent decrease in the quantity of beer demanded. The results in the table also show that a 10 percent increase in income will result in a 0.9 percent increase in the quantity of beer demanded. So, beer is a normal good. According to the definitions given earlier, beer would be classified as a necessity because it has an income elasticity that is positive but less than 1.

The Price Elasticity of Supply and Its Measurement We can use the concept of elasticity to measure the responsiveness of firms to a change in price, just as we used it to measure the responsiveness of consumers.

We know from the law of supply that when the price of a product increases, the quantity supplied increases. To measure how much the quantity supplied increases when price increases, we use the price elasticity of supply.

Determinants of the Price Elasticity of Supply Whether supply is elastic or inelastic depends on

ability and willingness of firms to alter the quantity they produce as price increases. Often, firms have difficulty increasing the quantity of the product they supply during any short period of time. As a result, the supply curve for pizza and most other products will be inelastic if we measure it over a short period of time, but the supply curve will be increasingly elastic the longer the period of time over which we measure it. Products that require resources that are themselves in fixed supply are an exception to this rule. If all the land on which that grape can be grown is already planted in vineyards, then the supply of that wine will be inelastic even over a long period.

Income elasticity of demand (YED)

measures the responsiveness of the quantity demanded to changes in income. It is calculated as follows: We know that if the quantity demanded of a good increases as income increases, the good is a normal good (see Chapter 3, Section 3.1). Normal goods are often further subdivided into luxuries and necessities. A good is a luxury if the quantity demanded is very responsive to changes in income so that a 10 percent increase in income results in more than a 10 percent increase in the quantity demanded. Expensive jewelry and vacation homes are examples of luxuries. A good is a necessity if the quantity demanded is not very responsive to changes in income so that a 10 percent increase in income results in less than a 10 percent increase in the quantity demanded.Food and clothing are examples of necessities. A good is inferior if the quantity demanded falls when income increases. Ground beef with a high fat content is an example of an inferior good.

The Relationship between Price Elasticity of Demand and Total Revenue Knowing the price elasticity of demand allows a firm to calculate how changes in price will affect its total revenue

which is the total amount of funds it receives from selling a good or service. Total revenue is calculated by multiplying price per unit by the number of units sold. • When demand is inelastic, price and total revenue move in the same direction: An increase in price raises total revenue, and a decrease in price reduces total revenue. • When demand is elastic, price and total revenue move inversely: An increase in price reduces total revenue, and a decrease in price raises total revenue.

Table of Elasticities

• Elastic > 1 • Inelastic < 1 • Unit Elastic = 1 Rare • Perfectly Elastic = horizontal (infinite) • Perfectly Inelastic = vertical (0)

Polar Cases of Perfectly Elastic and Perfectly Inelastic Demand Although they do not occur frequently, you should be aware of the extreme, or polar, cases of price elasticity.

• If a demand curve is a vertical line, it is perfectly inelastic. In this case, the quantity demanded is completely unresponsive to price, and the price elasticity of demand equals zero. No matter how much price may increase or decrease, the quantity remains the same. (not quite perfect but) The drug insulin is an example. Some diabetics must take a certain amount of insulin each day. If the price of insulin declines, it will not affect the required dose and therefore will not increase the quantity demanded.

Polar Cases of Perfectly Elastic and Perfectly Inelastic Supply Although it occurs infrequently, supply can fall into one of the polar cases of price elasticity.

• If a supply curve is a vertical line, it is perfectly inelastic. In this case, the quantity supplied is completely unresponsive to price, and the price elasticity of supply equals zero. Regardless of how much price may increase or decrease, the quantity remains the same. For example, a parking lot may have only a fixed number of parking spaces. If demand increases, the price to park in the lot may rise, but no more spaces will become available. • If a supply curve is a horizontal line, it is perfectly elastic. In this case, the quantity supplied is infinitely responsive to price, and the price elasticity of supply equals infinity.

Notice that because supply curves are upward sloping, the price elasticity of supply will be a positive number. We categorize the price elasticity of supply the same way we categorize the price elasticity of demand:

• If the price elasticity of supply is less than 1, then supply is inelastic. For example, economists have estimated that over a period of a year, the price elasticity of supply of gasoline from U.S. oil refineries is about 0.20. So, gasoline supply is inelastic: A 10 percent increase in the price of gasoline will result in only a 2 percent increase in the quantity supplied. • If the price elasticity of supply is greater than 1, then supply is elastic. • If the price elasticity of supply is equal to 1, the supply is unit elastic. For example, if the price of bottled water increases by 10 percent and the quantity of bottled water that firms supply increases by 10 percent, the price elasticity of supply equals 1

The Determinants of the Price Elasticity of Demand In this section, we examine why price elasticities differ among products. The key determinants of the price elasticity of demand are:

• The availability of close substitutes for the good • The passage of time • Whether the good is a luxury or a necessity • The definition of the market • The share of the good in the consumer's budget