(Unit 3) Chapter 5 - Elasticity

The federal government decides to require that automobile manufacturers install new anti-pollution equipment that costs $2,000 per car. Under what conditions can carmakers pass almost all of this cost along to car buyers? Under what conditions can carmakers pass very little of this cost along to car buyers?

Carmakers can pass this cost along to consumers if the demand for these cars is inelastic. If the demand for these cars is elastic, then the manufacturer must pay for the equipment.

Elasticity in Areas Other Than Price

Elasticity is a general term, referring to percentage change of one variable divided by percentage change of a related variable that can be applied to many economic connections. For instance, the income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. The cross-price elasticity of demand is the percentage change in the quantity demanded of a good divided by the percentage change in the price of another good. Elasticity applies in labor markets and financial capital markets just as it does in markets for goods and services. The wage elasticity of labor supply is the percentage change in the quantity of hours supplied divided by the percentage change in the wage. The elasticity of savings with respect to interest rates is the percentage change in the quantity of savings divided by the percentage change in interest rates.

From the data shown in Table 5.5 about demand for smart phones, calculate the price elasticity of demand from: point B to point C, point D to point E, and point G to point H. Classify the elasticity at each point as elastic, inelastic, or unit elastic. Points P Q A 60 3,000 B 70 2,800 C 80 2,600 D 90 2,400 E 100 2,200 F 110 2,000 G 120 1,800 H 130 1,600 Table 5.5

From point B to point C, price rises from $70 to $80, and Qd decreases from 2,800 to 2,600. So: % change in quantity = 2600 - 2800 (2600 + 2800) ÷ 2× 100 = -200 2700× 100 = -7.41 % change in price = 80 - 70 (80 + 70) ÷ 2× 100 = 10 75× 100 = 13.33 Elasticity of Demand = -7.41% 13.33% = 0.56 The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point D to point E: % change in quantity = 2200 - 2400 (2200 + 2400) ÷ 2× 100 = -200 2300× 100 = -8.7 % change in price = 100 - 90 (100 + 90) ÷ 2× 100 = 10 95× 100 = 10.53 Elasticity of Demand = -8.7% 10.53% = 0.83 The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point G to point H: % change in quantity = 1600 - 1800 1700 × 100 = -200 1700× 100 = -11.76 % change in price = 130 - 120 125 × 100 = 10 125× 100 = 7.81 Elasticity of Demand = -11.76% 7.81% = -1.51 The demand curve is elastic in this interval.

From the data shown in Table 5.6 about supply of alarm clocks, calculate the price elasticity of supply from: point J to point K, point L to point M, and point N to point P. Classify the elasticity at each point as elastic, inelastic, or unit elastic. Point Price Quantity Supplied J $8 50 K $9 70 L $10 80 M $11 88 N $12 95 P $13 100

From point J to point K, price rises from $8 to $9, and quantity rises from 50 to 70. So: % change in quantity = 70 - 50 (70 + 50) ÷ 2× 100 = 20 60× 100 = 33.33 % change in price = $9 - $8 ($9 + $8) ÷ 2× 100 = 1 8.5× 100 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83 The supply curve is elastic in this area; that is, its elasticity value is greater than one. From point L to point M, the price rises from $10 to $11, while the Qs rises from 80 to 88: % change in quantity = 88 - 80 (88 + 80) ÷ 2× 100 = 8 84× 100 = 9.52 %change in price = $11 - $10 ($11 + $10) ÷ 2× 100 = 1 10.5× 100 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0 The supply curve has unitary elasticity in this area. From point N to point P, the price rises from $12 to $13, and Qs rises from 95 to 100: % change in quantity = 100 - 95 (100 + 95) ÷ 2×100 = 5 97.5×100 = 5.13 % change in price = $13 - $12 ($13 + $12) ÷ 2× 100 = 1 12.5× 100 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64 The supply curve is inelastic in this region of the supply curve.

Suppose you are in charge of sales at a pharmaceutical company, and your firm has a new drug that causes bald men to grow hair. Assume that the company wants to earn as much revenue as possible from this drug. If the elasticity of demand for your company's product at the current price is 1.4, would you advise the company to raise the price, lower the price, or to keep the price the same? What if the elasticity were 0.6? What if it were 1? Explain your answer.

If the elasticity is 1.4 at current prices, you would advise the company to lower its price on the product, since a decrease in price will be offset by the increase in the amount of the drug sold. If the elasticity were 0.6, then you would advise the company to increase its price. Increases in price will offset the decrease in number of units sold, but increase your total revenue. If elasticity is 1, the total revenue is already maximized, and you would advise that the company maintain its current price level.

Elasticity and Pricing

In the market for goods and services, quantity supplied and quantity demanded are often relatively slow to react to changes in price in the short run, but react more substantially in the long run. As a result, demand and supply often (but not always) tend to be relatively inelastic in the short run and relatively elastic in the long run. The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden, and when demand is more elastic than supply, producers bear most of the cost of the tax. Tax revenue is larger the more inelastic the demand and supply are.

Polar Cases of Elasticity and Constant Elasticity

Infinite or perfect elasticity refers to the extreme case where either the quantity demanded or supplied changes by an infinite amount in response to any change in price at all. Zero elasticity refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. Constant unitary elasticity in either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.

The average annual income rises from $25,000 to $38,000, and the quantity of bread consumed in a year by the average person falls from 30 loaves to 22 loaves. What is the income elasticity of bread consumption? Is bread a normal or an inferior good?

Percentage change in quantity demanded = [(change in quantity)/(original quantity)] × 100 = [22 - 30]/[(22 + 30)/2] × 100 = -8/26 × 100 = -30.77 Percentage change in income = [(change in income)/(original income)] × 100 = [38,000 - 25,000]/[(38,000 + 25,000)/2] × 100 = 13/31.5 × 100 = 41.27 In this example, bread is an inferior good because its consumption falls as income rises.

price elasticity

Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price.

Price Elasticity of Demand and Price Elasticity of Supply

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. Elasticity can be described as elastic (or very responsive), unit elastic, or inelastic (not very responsive). Elastic demand or supply curves indicate that quantity demanded or supplied respond to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

Why is the supply curve with constant unitary elasticity a straight line?

The constant unitary elasticity is a straight line because the curve slopes upward and both price and quantity are increasing proportionally.

Why is the demand curve with constant unitary elasticity concave?

The demand curve with constant unitary elasticity is concave because at high prices, a one percent decrease in price results in more than a one percent increase in quantity. As we move down the demand curve, price drops and the one percent decrease in price causes less than a one percent increase in quantity.

Suppose the cross-price elasticity of apples with respect to the price of oranges is 0.4, and the price of oranges falls by 3%. What will happen to the demand for apples?

The formula for cross-price elasticity is % change in Qd for apples / % change in P of oranges. Multiplying both sides by % change in P of oranges yields: % change in Qd for apples = cross-price elasticity X% change in P of oranges = 0.4 × (-3%) = -1.2%, or a 1.2 % decrease in demand for apples.

What would the gasoline price elasticity of supply mean to UPS or FedEx?

The percentage change in quantity supplied as a result of a given percentage change in the price of gasoline.

Restaurant meals are generally more elastic than gasoline. Select one: True False

True

Positive Income Elasticity of a good indicates that the good is __________. Select one: a. A normal good b. An inferior good c. A substitute d. A compliment e. None of the above

a. A normal good

Which of the following goods are more likely to have producers shoulder the burden of a tax increase on their good or service? Select one: a. Cable television providers b. Electricity providers c. Cigarette producers d. Insulin producers e. Wine makers

a. Cable television providers

Given that total revenue = price x quantity, a reduction in price will lead to an increase in total revenue when demand is: Select one: a. Elastic b. Inelastic c. Unit Elastic d. In equilibrium e. Discontinuous

a. Elastic

Elasticities are often _____ in the short run than in the long run. Select one: a. lower b. higher c. the same d. unmeasurable e. inflated

a. lower

Complete the following statement. We can expect the cross price elasticity of demand between online and traditional classes to be: Select one: a. positive, indicating substitute goods. b. positive, indicating inferior goods. c. positive, indicating normal goods. d. negative, indicating substitute goods. e. zero, indicating normal goods.

a. positive, indicating substitute goods.

elasticity

an economics concept that measures responsiveness of one variable to changes in another variable

Using the mid-point formula, which describes the price elasticity of demand for a Starbucks latte whose price increases from $3 a cup to $5 a cup with the resulting change in quantity demanded from 15 cups an hour to 5 cups an hour? Select one: a. Inelastic b. Elastic c. Unitary elastic d. Perfectly elastic e. Perfectly inelastic

b. Elastic

The % change in quantity of financial savings divided by % change in interest rate is defined as: Select one: a. Elasticity of labor supply b. Elasticity of savings c. Cross-price elasticity of demand d. Elasticity of interest e. Elasticity of banking

b. Elasticity of savings

Using the mid-point formula, what is the price elasticity of demand for a Starbucks latte whose price increases from $3 a cup to $5 a cup with the resulting change in quantity demanded from 15 cups an hour to 5 cups an hour? Select one: a. 1/3 b. 3 c. 2 d. ½ e. 1

c. 2

Negative Cross Price Elasticity of Demand between two goods indicates that the two goods are ________. Select one: a. Substitutes b. Inferior goods c. Compliments d. Normal goods e. None of the above

c. Compliments

If demand is more inelastic than supply, then who pays most of the taxes on a good? Select one: a. Suppliers b. Producers c. Consumers d. The government e. The deadweight loss

c. Consumers

When an increase in income means that one might purchase less of the good, that good is known as: Select one: a. Normal b. Unusual c. Inferior d. Superior e. Unreal

c. Inferior

A perfectly inelastic supply curve would be ___________. Select one: a. Horizontal b. Downward-sloping c. Upward-sloping d. Vertical e. None of the above

d. Vertical

A higher level of income for a normal good causes a demand curve to shift to the _____ for a normal good, which means that the income elasticity of demand is ______. Select one: a. right, negative b. left, negative c. left, positive d. right, positive e. left, unitary

d. right, positive

An example of a perfectly elastic demand curve would be at: Select one: a. A lawyer's office b. A supermarket c. A clothing store d. A pharmacy e. A grain auction

e. A grain auction

constant unitary elasticity

either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.

Inferior goods are

goods that consumers demand less of when their incomes increase

tax incidence

manner in which the tax burden is divided between buyers and sellers

price elasticity of demand

percentage change in the quantity demanded of a good or service divided the percentage change in price

price elasticity of supply

percentage change in the quantity supplied divided by the percentage change in price

perfect elasticity

see infinite elasticity

perfect inelasticity

see zero elasticity

infinite elasticity

the extremely elastic situation of demand or supply where quantity changes by an infinite amount in response to any change in price; horizontal in appearance

zero inelasticity

the highly inelastic case of demand or supply in which a percentage change in price, no matter how large, results in zero change in the quantity; vertical in appearance

wage elasticity of labor supply

the percentage change in hours worked divided by the percentage change in wages

cross-price elasticity of demand

the percentage change in the quantity of good A that is demanded as a result of a percentage change in good B

elasticity of savings

the percentage change in the quantity of savings divided by the percentage change in interest rates

unitary elasticity

when the calculated elasticity is equal to one indicating that a change in the price of the good or service results in a proportional change in the quantity demanded or supplied

elastic demand

when the elasticity of demand is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price

inelastic demand

when the elasticity of demand is less than one, indicating that a 1 percent increase in price paid by the consumer leads to less than a 1 percent change in purchases (and vice versa); this indicates a low responsiveness by consumers to price changes

elastic supply

when the elasticity of either supply is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price

inelastic supply

when the elasticity of supply is less than one, indicating that a 1 percent increase in price paid to the firm will result in a less than 1 percent increase in production by the firm; this indicates a low responsiveness of the firm to price increases (and vice versa if prices drop)