Chapter 4: Elasticity

-University parking pass prices increase by 50 percent. -As a result, 25 percent fewer people purchase a parking pass.

(% CHANGE IN QUANTITY DEMANDED)/(% CHANGE IN PRICE) (-25%)/(+50%) = -0.5

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

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

cross-price elasticity of demand

EC can be positive or negative Substitute goods: EC > 0 Complementary goods: EC < 0

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. The downward-sloping demand gives the elasticity coefficient the negative sign. However, the slope is not the same as the elasticity.

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.

Ask students to suggest some "necessities" in their lives.

Electricity Internet Gasoline Mobile phone service Clean water Medication Toilet paper

Elasticity (cont.)

Emphasize that elasticity can compare the responsiveness of the relationship between any two variables. There are several types of elasticity that detail the sensitivity of the relationship between different pairs of variables. Supply and demand allows us to predict what happens to quantity demanded or quantity supplied in terms of whether it falls or rises; elasticity allows us to be more precise and put a size to that change.

Examples of broadly defined:

Examples of broadly defined:

How do you respond when the price of gasoline rises by 10 percent? Does your answer change if we are talking about a 10 percent rise in the price of a Big Mac meal?

If it's easier, start with an initial price of gasoline = $2.00. After the price increase, the price of a gallon is now $2.20. The price of a Big Mac meal goes from $5.00 to $5.50. Try to get the students to discuss why they would be less responsive to the change in the price of a gasoline. Lack of substitutes More of a necessity

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.

Perfectly inelastic

Numerator is a zero. So, elasticity demanded is a O.

An alternative to using rubber bands is to use a set of "Bounce/No Bounce Balls"

One ball is bouncy, so as you drop it to the floor, it responds by bouncing back (elastic). The other ball does not respond; when you drop it, it remains on the floor (inelastic).

Recall the law of demand:

The demand curve is downward-sloping. This gives us the direction of the relationship between these two variables.

Inelastic

There is no change in quantity demanded

Elasticity

A measure of the responsiveness of buyers and sellers to changes in price or income

If demand is relatively elastic

We are relatively sensitive to price changes The demand curve is relatively flatter

Why is elasticity 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

Examples of narrowly defined:

Breyer's French vanilla ice cream Kellogg's Frosted Flakes Toyota RAV4 Sanyo 46" Smart TV

Underscore why this is important to know:

Businesses know if they raise prices, they will sell fewer units. But how many fewer inputs? That is something they'd like to know.

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 More income leads to less consumption. This is a characteristic of an inferior good.

Determinants of the 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

Determinants of the Price Elasticity of 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

Determinants of the Price Elasticity of Demand—4: Whether the market is broadly or narrowly defined

Affects the options the consumer faces Narrowly defined = elastic demand Broadly defined = inelastic demand

Determinants of the Price Elasticity of Demand—3: Necessities versus luxuries

Affects the options the consumer's faces Luxuries = elastic demand Necessities = inelastic demand When the price of a good rises, the consumer will typically want to buy less.

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 -Houses and vehicles are elastic since they make up a big portion of your budget. -A specific type of cereal is elastic since it has a lot of substitutes. -Electricity has no viable substitutes.

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. Price is "less important" than quantity. Mathematically, the numerator (%QD change) is less than the denominator (%Price change), so the magnitude is smaller than one. This is inelastic (relatively insensitive).

Suppose a firm is selling a product at a price on the inelastic portion of the demand line. This firm could A. increase revenue by doing what? B. lowering the price, selling more units C. lowering the price, selling less units D. increasing the price, selling more units E. increasing the price, selling less units

C. lowering the price, selling less units Why is (C) not correct? The demand curve is downward-sloping. We can't increase the price and sell more, or we would be picking a point that isn't even on the demand line. By increasing the price and selling less units, we are moving toward the unit elastic point in which revenue is maximized.

Example of elastic supply:

De Beers diamonds has raw, uncut diamonds in inventory that aren't put on the market yet. If the price goes up, it is very easy to put these diamonds for sale. Hotdog vendors can adapt easily to changes in demand It is easy to relocate to a higher-demand area (where price is higher).

Determinants of the Price Elasticity of 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

Elasticity is related to total revenue

Firms want to know how changing their prices affects their total revenue

Lecture Note:

First click: Immediate run No change in quantity demanded; QD remains at Q1 No time to adjust at all Second click: Short run Time for a small adjustment QD falls to Q2, a slight decrease Third click: Long run Time for full adjustment Demand is more elastic, and QD falls to Q3

Some examples of relatively elastic goods include:

Fruits, vegetables, and breakfast cereals There are many substitutes for these goods. The substitutes may not be identical, but they are close enough so we will be more sensitive to price changes in these goods. Emphasize the word "relatively" when introducing relatively elastic goods. Technically, we cannot call this an elastic demand curve, since there is actually an elastic and inelastic section on the line. It is, however, "relatively" more elastic than a curve that is steeper.

Some possible examples of determinants include:

Goods with many substitutes: Toiletries (toothpaste, deodorant, shampoo, etc.) Breakfast cereals Fruits and vegetables Fast food Goods with few substitutes: Clean drinking water Electricity Gasoline Medical goods such as insulin

income elasticity of demand tip:

The numerator is the same. The denominator is now a change in income instead of a change in price. Note that we are holding price (and everything besides QD and income) constant here. How much more (or less) do you buy when income changes, all other things equal? Remind students that they learned the definitions for normal and inferior goods in Chapter 3. Ask students to define these terms for as review. The midpoint method can be used for these calculations as well.

If a good is perfectly inelastic, ...

it means you are willing to pay anything to receive the good or service.

Demand is inelastic if

Quantity demanded changes a small amount as the result of a price change Inelastic = "insensitive" or "unresponsive"

Demand is elastic if

Quantity demanded changes significantly as the result of a price change Elastic = "sensitive" or "responsive"

Relatively elastic

"Big" divided by "Small"

Relatively Inelastic

"Small" divided by "Big"

Some examples of perfectly elastic demands include:

$10 bill No one will give you more than $10 for it. Grade A large eggs from one farmer (not the market) Identical across farmers If all farmers are selling for $1.50 per dozen and Farmer John decides he wants to price at $2 per dozen, he will sell no eggs Too many other options for buyers for the same product If there are perfect substitutes for the good, demand will be perfectly elastic

The Price Elasticity of Demand Formula:

(% CHANGE IN QUANTITY DEMANDED)/(% CHANGE IN PRICE)

there are three time periods of interest:

1. Immediate run: -No time to adjust behavior -Perfectly inelastic 2. Short run: -Consumers can partially adjust their behavior 3: Long run: -Consumers can fully adjust to market conditions A good example of when there is little time to make a decision is a medical emergency.

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.

Example: "Old" price = P1 = $6; Q1 = 15 "New" price = P2 = $4; Q2 = 25

Answer is 1.25 ((Write your calculations))

Demand is elastic at high prices and inelastic at low prices.

Ask students to consider a 1 percent change in a large price versus a 1 percent change in a low price.

Perfectly elastic

Denominator is ZERO

The midpoint method is a way to calculate elasticity that corrects this problem.

ED = ((Q2-Q1)/(Q2+Q1/2))/((P2-P1)/(P1+P2/2)) First click: ΔQD = Q2 - Q1 Second click: Average of QD = (sum of the two QDs divided by 2) = (Q1 + Q2)/2 Third click: ΔP = P2 - P1 Fourth click: Average of P = (sum of the two Ps divided by 2) = (P1 + P2)/2

income elasticity of demand

EI can be positive or negative Normal good: EI > 0 Necessities: 1 > EI > 0 Luxuries: EI > 1 Inferior good: EI < 0

The existence of substitutes example:

For example, imagine that an unexpected freeze in Florida reduces the supply of oranges. As a result, the supply of orange juice shifts to the left (picture the supply curves we discussed in Chapter 3). Because demand remains unchanged, the price of orange juice rises. However, the consumer of orange juice can find many good substitutes.

the price elasticity of demand example

For instance, if the price of a sweatshirt with a college logo rises by $10 and the quantity demanded falls by a large amount (say, half), we'd say that the demand for those sweatshirts is elastic. But if the $10 rise in price results in very little or no change in the quantity demanded, the demand for the sweatshirts is inelastic.

Some examples of relatively inelastic goods include:

Gasoline: When the price of gas goes up, people do not change their driving habits very much. Cigarettes: Higher prices (usually in the form of sin taxes) are accompanied by only small decreases in smoking. This actually results in large revenues from cigarette taxes. Emphasize the word "relatively" when introducing relatively inelastic goods. Technically, we cannot call this an inelastic demand curve, since there is actually an elastic and inelastic section on the line. It is, however, "relatively" more inelastic than a curve that is flatter.

If we want to accomplish our two goals . . .

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 Determinants of the Price Elasticity of Supply—2: 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.

Some examples of perfectly inelastic goods include:

Insulin (if you are diabetic) Healthcare for your beloved pet

Why is it negative?

Inverse relationship between price and quantity demanded

We are left with just a number. What does the number mean?

It's a measure of sensitivity. A big negative number means more sensitivity. A small negative number means less sensitivity.

Income elasticity of demand

Measures how a change in income affects spending A different type of elasticity (with different variables now) is income elasticity. Now, we ask how sensitive our consumption is with regard to a change in income.

Cross-price elasticity of demand

Measures the responsiveness of the quantity demanded of one good to a change in the price of a related good -Changes in the prices of complements and substitutes also affect demand

Price elasticity of supply

Measures the responsiveness of the quantity supplied to a change in price -Producers also respond to changes in price.

Over time, consumers are:

More able to find substitutes More able to adjust for price changes in other ways Consuming less of the good You can provide some examples of this, such as gas consumers shifting to more fuel-efficient cars, or using public transportation

Determinants of the Price Elasticity of Supply—1: 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

cross-price elasticity of demand tip:

Notice that the equation above is very similar to the ones we have seen before. The numerator is the same. The denominator is now a change in price of a related good. Note that we are holding price (and everything besides QD of good A and price of good B) constant here.

price elasticity of supply

Notice that the equation is very similar to the one we have seen before. The numerator is the same except we are talking about quantity supplied, not quantity demanded. The denominator is still the change in price.

Review what was discussed about complements and substitutes in Chapter 3.

Review what was discussed about complements and substitutes in Chapter 3. When the price of apples falls, the demand for oranges rises. But by how much? When the price of tennis rackets rises, the demand for tennis balls falls. But by how much?

Changes in income

Shift the demand curve But, by how much?

Examples of inelastic supply:

Sporting events It is not easy to add more stadiums (or even more seats within an existing stadium) if the price goes up. Fresh fish at the dock What is available today is what was caught today; this cannot change easily.

How Do We Decrease Illegal Drug Use?—2

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? To decrease the supply of drugs: Tougher laws for drug dealers More police enforcement To decrease the demand for drugs: Drug education programs Offer (legal) substitute activities to decrease drug demand

Total revenue

The amount that consumers pay and sellers receive for goods and services Calculated as: Price of the good × Quantity Sold

Now, ask them to list true "luxuries."

Vacations Dining out Jewelry Designer clothes Imported beer

If demand is relatively inelastic

We are relatively insensitive to price changes The demand curve is relatively steeper

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?

Five determinants play a crucial role in influencing whether demand will be elastic or inelastic:

the existence of substitutes, the share of the budget spent on a good, whether the good is a necessity or a luxury good, how broadly defined the market is, and time.