Microeconomics Exam 1; Chapter 4

How Do We Decrease Illegal Drug Use?

Do you think the demand for illegal drugs is relatively elastic or inelastic? Why? Relatively inelastic. No substitutes. May make up a small percent of income. Addiction may increase willingness to pay. Purchases may be made in the immediate or short run. Suppose that we wanted to enact a policy with the following goals: Greatly decrease drug consumption Make drug-dealing a less attractive business Should we try to: Decrease the supply of drugs? Decrease the demand for drugs? Let's start with a decrease in supply: Only a small decrease in drug transactions. Increase in drug prices. Increase in drug revenues. This may actually make drug-dealing more lucrative (and dangerous). Let's try a decrease in demand: Larger decrease in drug transactions. Decrease in drug prices. Decrease in drug revenues. Drug dealing is now less attractive. If we want to accomplish our two goals . . . Policy of decreasing drug demand will be better than trying to decrease drug supply. Better to use resources on education and offering legal substitutes rather than increasing penalties and police enforcement.

The Price Elasticity of Demand Formula

% change in quantity demanded / % change in price ED = %(change)QD / %(change)P

Slope and elasticity

Elasticity and the slope of the demand curve are related but are NOT the same. In fact, with a linear demand curve: The slope will be the same at all points. Elasticity will be different at all points. Elasticity decreases (gets more inelastic) as we move down and right along a linear demand curve.

Conclusion

Elasticity is a measure of sensitivity (responsiveness) between two variables. The ability to determine whether demand and supply are elastic or inelastic allows economists to calculate the effects of personal, business, and policy decisions. Understanding elasticity helps our economic model say much more about the world.

Determinants of the Price Elasticity of Supply

Flexibility of producers: More production flexibility implies firms are more able to respond to changes in price. A firm will have more production flexibility if it is able to: have spare capacity maintain inventory relocate easily. Time and adjustment process: Immediate run: Suppliers are stuck with what they have on hand; no adjustment. Short run, long run: Over time, the firm is able to adjust to market conditions. Supply becomes more elastic.

Price Elasticity of Demand and Total Revenue

Graphically, we can also show trade-offs when a firm changes the price of its good. Increase price: Good news: Receive higher price per unit. Bad news: Sell fewer units. Reduce price: Good news: Sell more units. Bad news: Receive lower price per unit.

Graphing price elasticity

If demand is relatively elastic we are relatively sensitive to price changes. the demand curve is relatively flatter. If demand is relatively inelastic we are relatively insensitive to price changes. the demand curve is relatively steeper.

Income Elasticity

Inferior and normal Cross-price elasticity Substitute and compliment Price elasticity of demand Determinants: The flexibility Time adjustment

Midpoint method

One issue with using the percent change formula: Price decreases from $100 to $80: A 20% change. Price increases from $80 to $100: A 25% change. We would get different answers in calculating elasticity. The midpoint method is a way to calculate elasticity that corrects this problem. ED = ((change)QD) / (average of QD) / ((change)P) / (average of P) ED = (Q2 - Q1) / (Q1 + Q2) / 2) / (p2 - p1) / (p1 + p2) / 2 Example: "Old" price = P1 = $6; Q1 = 15 "New" price = P2 = $4; Q2 = 25 ED = (Q2 - Q1) / [(Q1 + Q2) / 2] / (p2 - p1) / [(p1 + p2) / 2] ED = (25 -15) / [(15 + 25) /2] / (4-6) / [(6 + 4) / 2] ED = 10/20 / -2/5 = -1.25

Price elasticity

Price elasticity of demand: A measure of the responsiveness of quantity demanded to a change in price. This gives us the sensitivity of the relationship between these two variables.

Price Elasticity of Supply

Producers also respond to changes in price. Price elasticity of supply: Measures the responsiveness of the quantity supplied to a change in price.

Price Elasticity of Demand Determinants:

The existence of substitutes The share of the budget spent on the good Definition of the good Time adjustment Common formula vs. midpoint formula Elastic (ED < -1) vs. inelastic (ED > -1)

Calculating the Price Elasticity of Supply

This ratio will be positive. Law of supply: Positive relationship between price and quantity supplied. price elasticity of supply = Es = %change in quantity supplied / %change in price ES = %(change)QS / %(change)P

Determinants of price Elasticity of Demand

1. Existence of substitutes: Determines the options consumers have when the price changes. Many substitutes 🡺 elastic demand Few substitutes 🡺 inelastic demand 2. Share of the budget spent on the good: Determines how much the price change affects the consumer. "Big-ticket items" 🡺 elastic demand Inexpensive items 🡺 inelastic demand 3. Necessities versus luxuries: Affects the options the consumer faces. Luxuries 🡺 elastic demand Necessities 🡺 inelastic demand 4. Whether the market is broadly or narrowly defined: Affects the options the consumer faces. Narrowly defined 🡺 elastic demand Broadly defined 🡺 inelastic demand 5. Time and adjustment process: Affects the ability of consumers to respond to changes in prices. Long time horizon 🡺 elastic demand Short time horizon 🡺 inelastic demand

Elasicity

A measure of the responsiveness of buyers and sellers to changes in price or income. Why is it useful? When price or income changes, we can determine how much buyers and sellers change their behavior.

Economists have studied that when the price of chicken increases, people purchase less rice. With these two goods, which of the following is true? A) EC < 0, chicken and rice are complements. B) EC > 0, chicken and rice are complements. C) EC < 0, chicken and rice are substitutes. D) EC > 0, chicken and rice are substitutes.

A) EC < 0, chicken and rice are complements.

Price Elasticity of Demand and Total Revenue

Total revenue: The amount that a firm receives from the sale of goods and services. Calculated as: Price of the good × Quantity sold Elasticity is related to total revenue. Firms want to know how changing their prices affects their total revenue.

Example: Calculating ED—1

University parking pass prices increase by 50 percent. As a result, 25 percent fewer people purchase a parking pass. Plug the numbers into the equation: ED = %(change)QD / %(change)P = -25% / +50% = -0.5

Combining Supply and Demand

We've previously drawn shifts in demand and supply, and studied the changes in equilibrium price and quantity. How will the magnitude of the price and quantity changes be affected if we alter the demand or supply elasticity?

Example: Calculating ED—2

What does the numerical result mean? If the price of parking rises by 1 percent, the quantity demanded will fall by only 0.5 percent. The demand for parking is not very price elastic. ED = %(change)QD / %(change)P = -25% / +50% = -0.5 Why is it negative? Inverse relationship between price and quantity demanded.

State whether you think the following goods are inferior, necessity, or luxury goods:

steak toothpaste fast food pedicures new vehicles used vehicles laptop computers lawn-care service milk gasoline cigarettes lottery tickets

In terms of price elasticity of demand, which of the following goods do you think is the least elastic (most inelastic)? A) new house B) electricity to power your home C) a specific brand of breakfast cereal D) new vehicle

B) electricity to power your home

Suppose that the price of candy bars increases by 100 percent. As a result of this, you decide to purchase 50 percent fewer candy bars. How would you describe your demand for candy bars? A) Demand is elastic. B) Demand is unit elastic. C) Demand is inelastic. D) Demand is perfectly inelastic.

C) Demand is inelastic.

Income elasticity

Changes in income shift the demand curve But, by how much? Income elasticity of demand: Measures how a change in income affects spending. EI can be positive or negative. Normal good: EI > 0. Necessities: 1 > EI > 0. Luxuries: EI > 1. Inferior good: EI < 0. income elasticity of demand = E1 = %change in quantity demanded / % change in income E1 = %(change)QD / %(change)I

Cross Price Elasticity

Changes in the prices of complements and substitutes also affect demand. Cross-price elasticity of demand (EC): Measures the percentage change in the quantity demanded of one good to the percentage change in the price of a related good. EC can be positive or negative. Substitute goods: EC > 0. Complementary goods: EC < 0. cross price elasticity of demand = EC = %change in quantity demanded of one good / %change in price of related good EC = %(change)QA / %(change)PB

Suppose a firm is selling a product at a price on the inelastic portion of the demand line. This firm could increase revenue by doing what? A) Lowering the price, selling more units. B) Lowering the price, selling fewer units. C) Increasing the price, selling more units. D) Increasing the price, selling fewer units.

D) Increasing the price, selling fewer units.

Suppose that Doug receives a pay increase at work, and his income increases by 20 percent. As a result, Doug decides to buy 12 percent less ground beef. For Doug, ground beef is a(n) ________________. A) luxury good B) necessity good C) normal good D) inferior good

D) inferior good

Demand is elastic if

Demand is elastic if: quantity demanded changes significantly as the result of a price change. Elastic = "sensitive" or "responsive."

Demand is inelastic if

Demand is inelastic if quantity demanded changes a small amount as the result of a price change. Inelastic = "insensitive" or "unresponsive."