Download Chapter 4

Elasticity: A Measure
of Responsiveness
PREPARED BY:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
chapter
4.1
THE PRICE ELASTICITY OF DEMAND
• price elasticity of demand (Ed)
A measure of the responsiveness of
the quantity demanded to changes in
price; equal to the absolute value of
the percentage change in quantity
demanded divided by the percentage
change in price.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Computing Percentage Changes and Elasticities
Table 4.1
Data
Computation
with Initialvalue method
COMPUTING PRICE ELASTICITY WITH INITIAL VALUES AND
MIDPOINTS
Price
Quantity
Initial
$20
100
New
22
80
Price
Quantity
Percentage change
Price elasticity of demand
10% 
$2
x 100
$20
2.0 
Percentage change
Price elasticity of demand
9.52% 
2.33 
20
x 100
100
- 20%
10%
Price
Computation
with Midpoint
method
 20%  
$2
x 100
$21
Quantity
 22.22%  
20
x 100
90
- 22.22%
9.52%
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Price Elasticity and the Demand Curve
Figure 4.1 shows five different demand curves, each with a different elasticity. We
can divide products into five types, depending on their price elasticities of demand.
► FIGURE 4.1
Elasticity and Demand Curves
• elastic demand
The price elasticity of demand is
greater than one.
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Price Elasticity and the Demand Curve
► FIGURE 4.1 (cont’d.)
Elasticity and Demand Curves
• inelastic demand
The price elasticity of demand is
less than one.
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Price Elasticity and the Demand Curve
► FIGURE 4.1 (cont’d.)
Elasticity and Demand Curves
• unit elastic demand
The price elasticity of demand is
one.
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Price Elasticity and the Demand Curve
► FIGURE 4.1 (cont’d.)
Elasticity and Demand Curves
• perfectly inelastic demand
The price elasticity of demand is
zero.
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7 of 37
chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Price Elasticity and the Demand Curve
► FIGURE 4.1 (cont’d.)
Elasticity and Demand Curves
• perfectly elastic demand
The price elasticity of demand is
infinite.
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Elasticity and the Availability of Substitutes
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chapter
4.1
THE PRICE ELASTICITY OF DEMAND
Other Determinants of the Price Elasticity of Demand
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chapter
4.2
USING PRICE ELASTICITY TO PREDICT
CHANGES IN QUANTITY
If we have values for two of the three variables in the elasticity formula, we
can compute the value of the third. The three variables are:
(1) the price elasticity of demand itself,
(2) the percentage change in quantity, and
(3) the percentage change in price.
Specifically, we can rearrange the elasticity formula:
percentage change in quantity demanded = percentage change in price × Ed
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chapter
Extra Application 8
WHY YOU’LL PAY MORE IN RENT THIS YEAR
The current rental market is extremely hot with the average rent reaching $940 per month
for the last quarter of 2005. Some areas such as New York City reported rents averaging
$2,400 per month. In spite of these numbers, many analysts believe rent is still low in
several regions. In some areas such as Ft. Lauderdale Florida, rent has climbed almost
12% in the recent months as occupancy rates approached 100% and is expected to go
higher. Much of the reason for higher rents is supply related due to many apartment units
being converted to condominiums. Other regions, particularly along the Gulf Coast, can
thank Hurricane Katrina for the rental unit shortage. With apartments being difficult to find
vacant, many owners are using the hot market to increase rents a little. Rising home prices
and increasing rates also alter the picture and push a number of people back to the rental
market. Houses are getting too expensive for some people to own.
A decrease in the supply of rental units will
automatically push prices higher. Owners, looking to
make a profit, tend to react very quickly to high
occupancy rates. However, new units will no doubt
soon be constructed to lessen the shortage.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 12 of 37
chapter
BEER TAXES AND HIGHWAY DEATHS
APPLYING THE CONCEPTS #1: How can we use the price elasticity
of demand to predict the effects of taxes?
We can use the concept of price elasticity to predict the
effects of a change in the price of beer on drinking and
highway deaths among young adults.
• The price elasticity of demand for beer among young adults is about 1.30.
• If a state imposes a beer tax that increases the price of beer by 10 percent, how will
the price hike affect beer consumption among young adults?
Using the elasticity formula, we predict that beer consumption will decrease by 13 percent:
percentage change in quantity demanded = percentage change in price × Ed
= 10% × 1.30 = 13%
• The number of highway deaths among young adults is roughly proportional to their
beer consumption, so the number of deaths will also decrease by 13 percent.
• Larger taxes would decrease beer consumption and highway deaths by larger
amounts.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 13 of 37
chapter
SUBSIDIZED MEDICAL CARE IN CÔTE D’IVOIRE AND PERU
APPLYING THE CONCEPTS #2: Does the responsiveness of
consumers to changes in price vary by income?
Many developing nations subsidize medical care, charging consumers a small
fraction of the cost of providing the services. If a nation were to cut its subsidies
and thus increase the price of medical care for consumers, how would the higher
price affect its poor and wealthy households?
• In Côte d’Ivoire in Africa, the price elasticity of demand for hospital services is 0.47 for
poor households and 0.29 for wealthy households. A 10-percent increase in the price of
hospital services would cause poor households to cut back their hospital care by:
percentage change in quantity demanded = 10% × 0.47 = 4.7%
In contrast, wealthy households would cut back by:
percentage change in quantity demanded = 10% × 0.29 = 2.9%
• In Peru, the price elasticity is 0.67 for poor households but only 0.03 for wealthy
households. How would the higher price affect its poor and wealthy households?
• The poor are much more sensitive to price, so when prices increase, they experience
much larger reductions in medical care.
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chapter
4.3
PRICE ELASTICITY AND TOTAL REVENUE
• total revenue
The money a firm generates from
selling its product.
total revenue = price per unit × quantity sold
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chapter
HOW TO CUT TEEN SMOKING BY 60 PERCENT
APPLYING THE CONCEPTS #3: How can we use the price elasticity of
demand to predict the effects of public policies?
Under the 1997 federal tobacco settlement, if smoking by teenagers does not
decline by 60 percent by the year 2007, cigarette makers will be fined $2 billion.
The settlement increased cigarette prices by about 62 cents per pack, a
percentage increase of about 25 percent. Will the price hike be large enough to
meet the target reduction of 60 percent?
• The demand for cigarettes by teenagers is elastic, with an elasticity of 1.3. Therefore, a
25-percent price hike will reduce teen smoking by only 32.5 percent, far short of the
target reduction:
percentage change in quantity demanded = 25% × 1.30 = 32.5%
• About half of the decrease in consumption occurs because fewer teenagers will become
smokers, and the other half occurs because each teenage smoker will smoke fewer
cigarettes. To meet the target reduction of teenage smoking, the price of cigarette prices
must increase by about 46 percent:
percentage change in quantity demanded = 46% × 1.3 = 60%
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 16 of 37
chapter
4.3
PRICE ELASTICITY AND TOTAL REVENUE
Elastic Versus Inelastic Demand
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chapter
4.3
PRICE ELASTICITY AND TOTAL REVENUE
Elastic Versus Inelastic Demand
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chapter
A BUMPER CROP IS BAD NEWS FOR FARMERS
APPLYING THE CONCEPTS #4: If demand is inelastic, how does an increase
in supply affect total expenditures?
Suppose that favorable weather generates a “bumper crop” for soybeans
that is 30 percent larger than last year’s harvest.
The good news is that farmers will sell more bushels of soybeans. The bad
news is that the increase in supply will decrease the equilibrium price of
soybeans, so they will get less money per bushel. Which will be larger, the
increase in quantity or the decrease in price?
• The demand for soybeans and many other agricultural products is inelastic.
• To increase the quantity demanded by 30 percent to meet the higher supply,
the price must decrease by more than 30 percent.
• Consumers need a large price reduction to buy more of the product.
If the price elasticity of demand is 0.75, the price must decrease by 40 percent to increase
the quantity demanded by 30 percent. To show this, we can rearrange the elasticity formula:
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 19 of 37
chapter
4.4
ELASTICITY AND TOTAL REVENUE FOR
A LINEAR DEMAND CURVE
Price Elasticity Along a Linear Demand Curve
► FIGURE 4.2
Elasticity and Total Revenue
Along a Linear Demand Curve
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chapter
4.4
ELASTICITY AND TOTAL REVENUE FOR
A LINEAR DEMAND CURVE
Price Elasticity Along a Linear Demand Curve
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chapter
4.5
OTHER ELASTICITIES OF DEMAND
Income Elasticity of Demand
• income elasticity of demand
A measure of the responsiveness of
demand to changes in consumer income;
equal to the percentage change in the
quantity demanded divided by the
percentage change in income.
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chapter
4.5
OTHER ELASTICITIES OF DEMAND
Cross-Price Elasticity of Demand
• cross-price elasticity of demand
A measure of the responsiveness of demand to changes
in the price of another good; equal to the percentage
change in the quantity demanded of one good (X) divided
by the percentage change in the price of another good
(Y).
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 23 of 37
chapter
Extra Application 9
HIGH FUEL PRICES IMPACT VACATION PLANS
Memorial Day vacation travel by automobile will be up by only 0.7 percent this year, the
smallest increase in several years. A 34 percent year-to-year increase in the price of
gasoline is the culprit. The AAA Travel survey also indicated that many vacationers would
alter their plans to take advantage of cheaper motels, closer destinations, and/or shorter
stays.
• Air, bus, and train travel all expect similar slight increases in people traveling, or
stable numbers.
• Airplane ticket prices are up about 10 percent and hotels have increased rates by
about 5 percent.
The substitution effect helps explain why the demand
curve is downward sloping and to the right. As the price of
gasoline increases people will alter their behavior by
buying less gasoline. Part of this behavior can be
explained by consumers substituting a portion of gasoline
purchases. Vacation and entertainment travel happens to
be a substitutable component of gasoline consumption.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 24 of 37
chapter
4.6
THE PRICE ELASTICITY OF SUPPLY
• price elasticity of supply
A measure of the responsiveness of the
quantity supplied to changes in price;
equal to the percentage change in
quantity supplied divided by the
percentage change in price.
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chapter
4.6
THE PRICE ELASTICITY OF SUPPLY
▼ FIGURE 4.3
The Slope of the Supply Curve and Supply Elasticity
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chapter
4.6
THE PRICE ELASTICITY OF SUPPLY
What Determines the Price Elasticity of Supply?
The price elasticity of supply is determined by how rapidly
production costs increase as the total output of the
industry increases. If the marginal cost increases rapidly,
the supply curve is relatively steep and the price elasticity
is relatively low.
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chapter
4.6
THE PRICE ELASTICITY OF SUPPLY
The Role of Time: Short-Run Versus Long-Run Supply
Elasticity
Time is an important factor in determining the price elasticity of supply for a product.
The market supply curve is positively sloped because of two responses to an
increase in price:
• Short run. A higher price encourages existing firms to increase their output by
purchasing more materials and hiring more workers.
• Long run. New firms enter the market and existing firms expand their production
facilities to produce more output.
The short-run response is limited because of the principle of diminishing returns.
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chapter
4.6
THE PRICE ELASTICITY OF SUPPLY
Extreme Cases: Perfectly Inelastic Supply and Perfectly
Elastic Supply
▼ FIGURE 4.4
Perfectly Inelastic Supply and Perfectly Elastic Supply
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 29 of 37
chapter
Extra Application 11
THE MARKET FOR RARE GUITARS
The price of rare guitars is escalating faster than most corporate stocks. A sunburst Les
Paul Standard that originally sold for $265 in 1960 can now command $300,000 in pristine
condition. Les Paul’s are not alone in this market. Pre-war Martin acoustic guitars and pre1966 Fender Stratocasters have seen similar run-ups. Much of the recent price
appreciation has been driven by non-musician investors attempting to cash in on the gains.
However, scarcity is also to blame. For example, there were only approximately 1,700
sunburst Les Pauls ever manufactured. Many experts caution buyer beware since the
astronomical prices have stimulated a heavy trade in fakes. The current estimated count of
2,200 sunburst Les Pauls illustrates this point. Where did the other 500 come from?
The known supply of rare guitars is virtually fixed.
Therefore, increasing demand by collectors pushes the
price rapidly higher. Even a very small shift in demand due
to an increase in the number of collectors/investors results
in a substantial change in the price. The opposite is also
true. If investor/collectors suddenly became concerned
about this market and moved into other investments (i.e.
decrease in the number of potential buyers) the price could
fall just as rapidly.
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chapter
4.6
THE PRICE ELASTICITY OF SUPPLY
Extreme Cases: Perfectly Inelastic Supply and Perfectly
Elastic Supply
• perfectly inelastic supply
The price elasticity of supply equals
zero.
• perfectly elastic supply
The price elasticity of supply is equal
to infinity.
Predicting Changes in Quantity Supplied
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 31 of 37
chapter
Extra Application 10
OPEC’S OIL STRANGLEHOLD
The Organization of Petroleum Exporting Countries (OPEC) is considering production
cutbacks to halt the falling world price of oil. However, OPEC members are also cognizant
of the fact that high oil prices spur development of alternative fuel sources. Many analysts
point out that this fact forces OPEC to allow prices to fall periodically so that alternative fuel
projects do not become viable. However, as oil demand continues to increase, OPEC may
not be able to periodically lower prices.
Since oil has a relatively inelastic short run demand, a
cutback in supply results in only a very small reduction
in the number of units sold but a substantial increase
in price. Since the production and distribution costs
will remain constant the price increase means a
significant increase in profits for oil producers.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 32 of 37
chapter
4.7
USING ELASTICITIES TO PREDICT
CHANGES IN EQUILIBRIUM PRICE
The Price Effects of a Change in Demand
► FIGURE 4.5
An Increase in Demand
Increases the Equilibrium
Price
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chapter
4.7
USING ELASTICITIES TO PREDICT
CHANGES IN EQUILIBRIUM PRICE
The Price Effects of a Change in Demand
Under what conditions will an increase in demand
cause a relatively small increase in price?
• Small increase in demand.
• Highly elastic demand.
• Highly elastic supply.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 34 of 37
chapter
4.7
USING ELASTICITIES TO PREDICT
CHANGES IN EQUILIBRIUM PRICE
The Price Effects of a Change in Supply
► FIGURE 4.6
A Decrease in Supply
Increases the Equilibrium
Price
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chapter
4.7
USING ELASTICITIES TO PREDICT
CHANGES IN EQUILIBRIUM PRICE
The Price Effects of a Change in Supply
Under what conditions will a decrease in supply
cause a relatively small increase in price?
• Small decrease in supply.
• Highly elastic demand.
• Highly elastic supply.
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chapter
AN IMPORT BAN AND SHOE PRICES
APPLYING THE CONCEPTS #7: How do import restrictions
affect prices?
We can use the supply version of the price-change formula
to predict the effects of import restrictions on equilibrium prices.
Consider a nation that limits shoe imports.
• Suppose the import restrictions decrease the supply of shoes by 30 percent.
To use the price-change formula, we need the price elasticities of supply and demand.
• Suppose the supply elasticity is 2.3 and, as shown in Table 20.2, the demand elasticity
is 0.70.
• Plugging these numbers into the price-change formula, we predict a 10-percent
increase in price:
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