Download Micro Lecture 5: Elasticity Basics

Micro Lecture 5: Elasticity Basics
Review: Market Demand and Market Supply Curves
P
Market
Market demand curve: How many cans of beer would consumers purchase (the
quantity demanded), if the price of beer were _____, given that everything else
relevant to the demand for beer remains the same?
Market supply curve: How many cans of beer would firms produce (the quantity
supplied), if the price of beer were _____, given that everything else relevant to the
supply of beer remains the same?
Equilibrium (see Figure 5.1)
In equilibrium

Quantity Demanded = Quantity Supplied
S
P*
D
Demand and supply are equal
partners in determining the
equilibrium price and quantity.
Q*
Figure 5.1: Market Equilibrium
Market Forces, the Equilibrium Price, and the Actual Price
Figure 5.2 summarizes market forces:
If Actual Price < Equilibrium Price
If Actual Price > Equilibrium Price


Quantity Demanded > Quantity Supplied
Quantity Demanded < Quantity Supplied


Shortage exists
Surplus exists


Actual Price rises
Actual Price falls
until the equilibrium is reached
until the equilibrium is reached
P
surplus
S
Market forces push the actual price
toward its equilibrium level.
P*
shortage
Assuming that the actual price is free to
move, the actual price will equal the
equilibrium price in short order.
D
Q*
Q
Q
Figure 5.2: Market forces
Shifts versus Movements Along the Demand and Supply Curves
Table 4.1 summarizes the distinction between shifts versus movements along a curve:
Shifts
Movements Along


Change in something OTHER
Change in the price of beer ITSELF
THAN the price of beer ITSELF

ã
é
The slopes of the demand and supply
The demand curve for beer
The supply curve of beer
curves for beer capture the effect
can SHIFT ONLY if
can SHIFT ONLY if
of a change in the BEER PRICE itself;
something that affects
something that affects
a change in the price of beer leads
demand OTHER THAN
supply OTHER THAN
to a MOVEMENT ALONG the
the BEER PRICE changes.
the BEER PRICE changes.
demand and supply curves for beer.
Table 5.1: Shifts versus movements along a curve
2
Project: Advice for the AMTRAK
The Vermonter is an AMTRAK train that travels from
Washington, D.C. to St. Albans, VT, with continuing bus
service to Montreal, Quebec. Presently, the price of a ticket
from Amherst to St. Albans is $39 as illustrated in figure 5.3.
The following two individuals are suggesting ways to increase
the revenues generated from Vermonter ticket sales.
Mr. A:
Ms. B:
“The Vermonter is operating with empty
seats. To increase revenues, AMTRAK
should fill the empty seats by lowering
ticket prices.”
“That would be disastrous! Lower ticket
prices will lead to lower, not higher,
revenues. Your policy would make a
bad situation worse.”
Demand for the Vermonter
Price ($/ticket)
39.00
D
Quantity
(tickets)
Figure 5.3: Demand curve for Vermonter
tickets
Let us now evaluate these statements. What do we know? We
know that the demand curve is downward sloping. Consequently, Mr. A is correct in asserting that a lower price
would increase the number of tickets purchased, the quantity of tickets demanded. That is, lowering the ticket
price would fill some of the empty seats. But how would the total revenue collected by AMTRAK from the
Vermonter be affected? Total revenue equals the ticket price times the number of tickets purchased, the quantity
of tickets demanded:
Total Revenues
=
Price


Quantity Demanded

If AMTRAK followed Mr. A’s advice, the price would fall and quantity demanded would rise. What would
happen to total revenue, the product of the price and quantity demanded? In fact, total revenue could rise, fall,
or remain the same.
To determine how total revenue would be affected, we need some additional information. Specifically, we need
to know the price elasticity of demand for Vermonter tickets.
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Price Elasticity of Demand
We begin with the intuitive notion of the price elasticity of demand and then make it more rigorous. We know
that typically the quantity demanded decreases when the price increases and vice versa; that is, the market
demand curve slopes downward. When a good becomes more expensive we purchase less of it; when a good
becomes cheaper, we buy more. How sensitive is the quantity demanded, however? When the price decreases,
do we buy just a little more or much more? The price elasticity of demand answers this question; it indicates
how sensitive the quantity demanded is to the price. If the quantity demanded is very sensitive to the price,
demand is said to be elastic; if the quantity demanded is not very sensitive, inelastic. We simply ask how
sensitive is the quantity demanded to the price?
If the quantity demanded is
very sensitive to the price

Demand Is Elastic
If the quantity demanded is
not very sensitive to the price

Demand Is Inelastic
More formally, the price elasticity of demand equals the percent change in quantity demanded caused by a one
percent change in the price:
Price Elasticity of Demand
=
Percent change in the quantity demanded resulting from
a 1 percent change in the price
If the price elasticity of demand equals 1, a 1 percent change in the price results in a 1 percent change in the
quantity demanded; in this case, demand is said to be unit elastic. (Note that economists are not very creative
when it comes to definitions.) Unit elastic is the “dividing line” between elastic and inelastic demand. If the
price elasticity of demand is greater than 1, then demand is elastic, the quantity demanded is very sensitive to
the price; more specifically, a 1 percent change in the price results in a more than 1 percent change in the
quantity demanded. If the price elasticity of demand is less than 1, demand is inelastic, the quantity demanded
is not very sensitive to the price; more specifically, a 1 percent change in the price results in a less than 1
percent change in the quantity demanded.
If the quantity demanded is
very sensitive to the price

Demand is Elastic

Price elasticity of
demand greater than 1

1 percent change in
price causes the quantity
demanded to change by
more than 1 percent
Unit Elastic

Price elasticity of
demand equals 1

1 percent change in
price causes the quantity
demanded to change by
exactly 1 percent
If the quantity demanded is
not very sensitive to the price

Demand is Inelastic

Price elasticity of
demand less than 1

1 percent change in
price causes the quantity
demanded to change by
less than 1 percent
Now a warning: When we say demand is inelastic we do not mean that the quantity demanded is not at all
sensitive to the price; instead, we mean that the quantity demanded is not very sensitive to the price. In all but
the most extreme cases, the demand curve is downward sloping; consequently, an increase in the price causes a
decrease in the quantity demanded. When demand is inelastic, an increase in the price causes only a “small”
decrease in the quantity demanded.
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Elasticity and Total Revenues Collected by Firms
The total revenues collected by firms equals the good’s price times the
number of units consumers buy, the quantity demanded:
Total Revenues
=

Price
P
Quantity Demanded
Question: What happens to the total revenues collected when the price of a
good falls? Since the demand curve is downward sloping, a decrease in the
price increases the quantity demanded; when a good becomes less expensive,
we buy more of it (see figure 5.4). Consequently, we cannot tell in general
whether total revenue will rise or fall when the price increases:
Total Revenues
=
Price
Quantity
Demanded



D
Q
Figure 5.4: Demand curve price
response
Claim: To determine what happens to total revenue we need to know the price elasticity of demand.
To justify this claim consider the following table:
If the quantity demanded is
very sensitive to the price

Demand is Elastic

Price elasticity of
demand greater than 1

1 percent change in
price causes the quantity
demanded to change by
more than 1 percent


P1% Q >1%
PQ rises

Elastic demand
When the price increases and
demand is elastic total
expenditures rises. In this case,
the quantity demanded is very
sensitive to the price. A 1
percent decrease in the price
results in a more than 1 percent
increase in the quantity
demanded. Consequently, total
revenues, the product of price
and quantity demanded, rises.
Unit Elastic

Price elasticity of
demand equals 1

1 percent change in
price causes the quantity
demanded to change by
exactly 1 percent

If the quantity demanded is
not very sensitive to the price

Demand is Inelastic

Price elasticity of
demand less than 1

1 percent change in
price causes the quantity
demanded to change by
less than 1 percent

P1% Q1%
P1% Q<1%
PQ constant

Unit elastic
When the price increases and
demand is unit elastic total
expenditures are constant. In
this case, a 1 percent
decrease in the price results
in a 1 percent increase in the
quantity demanded.
Consequently, total revenue,
the product of price and
quantity demanded, remains
constant.
PQ falls

Inelastic demand
When the price decreases and
demand is inelastic total
expenditures fall. In this case,
the quantity demanded is not
very sensitive to the price. A 1
percent decrease in the price
results in a less than 1 percent
increase in the quantity
demanded. Consequently, total
revenues, the product of price
and quantity demanded, falls.
5
Ticket Prices for the Vermonter
The Vermonter is an AMTRAK train that travels from
Washington, D.C. to St. Albans, VT. with continuing bus
service to Montreal, Quebec. Presently, the price of a ticket is
$39.00 as shown in figure 5.5. The following two individuals
are consider ways to increase the revenues generated from
Vermonter ticket sales:
Mr. A: “The Vermonter is operating with empty
seats. To increase revenues, To increase
revenues, AMTRAK should fill the
empty seats by lowering ticket prices.”
Ms. B:
Demand for the Vermonter
Price ($/ticket)
39.00
D
“That would be disastrous! Lower ticket
prices will lead to lower, not higher,
revenues. Your policy would make a
bad situation worse.”
Quantity
(tickets)
Figure 5.5: Demand curve for Vermonter
tickets
To evaluate these statements, recall that the revenues
AMTRAK collects from the Vermonter equal the total expenditures made by consumers:
Total Revenues
=
Price
Quantity Demanded



If AMTRAK follows Mr. A’s advice and lowers ticket prices, more consumers will ride the train, the quantity
demanded decreases. In general, we cannot tell what happens to total revenue, however. It depends on the
elasticity of demand.
If demand were elastic

If demand were inelastic

P Q
PQ rises
P Q 

PQ falls
On the one hand, if demand were elastic, the quantity demanded would be very sensitive to the price. The
lower price would result in a large increase in the quantity demanded; AMTRAK’s total revenues would rise.
On the other hand, demand were inelastic, the lower price would result in a small increase in the quantity
demanded; total revenues would fall. So, if demand is elastic, Mr. A is correct; if demand is inelastic, Ms. B is
correct. If you were a policy maker at AMTRAK, it would be vital for you to obtain information about the
price elasticity of demand. It would determine whether you recommend a decrease in ticket prices. This
example shows that elasticity is not a concept that sadistic economics professors have dreamed up to make life
difficult for introductory economics students. It can be critical when making real world decisions.
6
The Farming “Paradox”
Consider the following statements
Mr. A: “Good farming weather and bountiful
harvests are bad for the farming
community. Poor weather and low
harvests are good.”
Ms. B:
P
S’
S
P**
“You can't be serious. Have you gone
crazy?"
P*
To evaluate these statements, suppose that farmers experience unusually
bad weather. Figure 4.5 illustrates the effect of bad weather. The market
supply curve shifts left. The price of food would rise from P* to P** and
the quantity of food would fall from Q* to Q**.
D
Q
Q** Q*
Figure 5.6: Farming paradox
What happens to the total revenues collected by farmers?
Total Revenues
=
Price
Quantity Demanded



In general, we cannot tell; the price has increased while the quantity decreased. The answer to the question
depends on the elasticity of demand:
If demand were elastic
If demand were inelastic



P Q
PQ falls
P Q 
PQ rises
In fact, the demand for food is inelastic. Consequently, the bad weather will increase the total revenues
collected by the farming community. This explains the apparent paradox.
What influences the price elasticity of demand?
We have just studied two cases in which the price elasticity of demand
plays an important role. Therefore, we will now consider what determines a
good’s elasticity of demand. While many factors play a role perhaps the
most crucial is the availability of substitutes. To make this point, we will
consider insulin, a good that has no substitutes. If you were a diabetic who
needed to use insulin, you would have to take a specific amount of the drug
every day.
Question: What would happen to the quantity of insulin demanded if the
drug companies suddenly decided to reduce the price of insulin by 50
percent? Answer: Nothing as shown in figure 4.6.
P
D
Q
Figure 5.7: Perfectly inelastic
demand
Those individuals who need insulin would not consume any more. They
need a prescribed amount. Taking more or less than this amount could
result in a coma. The demand for insulin is perfectly inelastic; the quantity demanded is constant, unaffected by
the price. Beware, however, that goods whose demand is perfectly inelastic are very rare. On the other hand,
the demand for many goods is inelastic; that is, for many goods, a change in the price will decrease the quantity
demanded, but only by a small amount. Often, introductory students incorrectly assume that when demand is
inelastic, the quantity demand is completely insensitive to the price; be careful not to fall into this trap.
Next, let us consider luxuries and necessities. By definition, necessities have few substitutes; consequently, the
demand for necessities is inelastic. Luxuries, on the other hand, tend to have many substitutes. This winter one
might vacation in Tahiti or St. Bart’s or Vale or … Consequently, the demand for luxuries tends to be elastic.
7
Also, the “scope” of the good is important. For example, the demand for food in general is inelastic because
there are few substitutes for food. On the other hand, the demand for one particular type of food, lima beans for
example, would be elastic; there are many substitutes for lima beans: green beans, peas, etc.
Income Elasticity of Demand
The income elasticity of demand indicates how sensitive the quantity demanded is to income. More formally,
the income elasticity of demand equals the percent change in quantity demanded resulting from a 1 percent
change in income:
Income Elasticity of Demand
=
Percent change in the quantity demanded
resulting from a 1 percent change in income
The income elasticity for most goods is positive; an increase in income results in a greater quantity demanded.
There are some exceptions, however. For example, the quantity of Old Milwaukee Beer an individual
purchases typically falls as income rises. As income rises, people typically purchase switch from Old
Milwaukee to another brand: Budweiser, Coors, Heineken, etc. The income elasticity of demand for Old
Milwaukee is negative; as income rises, the quantity of Old Milwaukee demanded decreases. Old Milwaukee is
an example of an inferior good. Most goods are normal; for a normal good, the quantity demand rises whenever
income increases:
Normal good

An increase in income
leads to an increase
in quantity demanded.

Income elasticity of
demand is positive.
Inferior Good

An increase in income
leads to an decrease
in quantity demanded.

Income elasticity of
demand is negative.
By convention, when we use the term elasticity of demand without the word price of income preceding it, the
word price is understood. In other words, when you see the term “elasticity of demand,” it is shorthand for the
term the “price elasticity of demand.”
(Price) Elasticity of Supply
Just as we did with demand, we will begin with the verbal notion of the price elasticity of supply and then
make it more formal. We know that typically the quantity supplied increases when the price increases and vice
versa; that is, the market supply curve is upward sloping. How sensitive is the quantity supplied to the price,
however. When the price increases, do firms produce just a little more or much more? The price elasticity of
supply answers this question; it indicates how sensitive the quantity supplied is to the price. If the quantity
supplied is very sensitive to the price, supply is said to be elastic; if the quantity supplied is not very sensitive,
inelastic. We simply ask how sensitive is the quantity supplied to the price?
If the quantity supplied is
very sensitive to the price

Elastic Supply
If the quantity supplied is
not very sensitive

Inelastic Supply
More formally, the price elasticity of supply is the percent change in quantity supplied caused by a one percent
change in the price:
Price Elasticity of Supply
=
Percent change in the quantity supplied resulting
from a 1 percent change in the price