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Elasticity, price changes, and changes in total revenue
(TR) (total expenditure, (TE)).
In the market for a particular good:
Total revenue (TR) is the amount of money sellers
take in.
Total expenditure (TE) is the amount of money
buyers pay out.
Assuming no excise taxes:
TR = TE = p x Q (price x quantity)
Question: When p and Q change as the result of
movements along a demand curve, what is the
relationship between changes in price and changes
in TR?
p
p2
TR2 = p2 x Q2
TR1 = p1 x Q1
p1
Demand
Q2
Q1
Q
When p increases,
Q decreases, so it’s
not clear, without
more information,
how TR is affected.
Need info
about elasticity
of demand.
Let’s look at some cases:
Suppose demand is inelastic (%Q < %p) and price
increases (quantity decreases).
(Keep in mind -- we’re talking about movements
along a demand curve.)
TR = TE = p x Q
“big” increase in p
. . . combined with “small”
decrease in Q
TR = TE increases, on balance.
This is easy to remember by visualizing a demand curve
close to the limiting case of perfectly inelastic:
For a demand curve that is
close to perfectly inelastic,
it’s obvious that TR = TE
increases when price
increases.
p
p2
p1
Q2 Q1
Q
Now suppose that demand is elastic (%Q > %p)
and price increases (quantity decreases).
TR = TE = p x Q
“small” increase in p
. . . combined with “big”
decrease in Q
TR = TE decreases, on balance.
Once again, visualizing a demand curve close to the
limiting case -- perfectly elastic this time -- helps us
remember the general result:
p
With a demand curve
that is close to perfectly
elastic, it’s obvious that
the TR = TE rectangle
gets smaller when price
increases.
p2
p1
Q2
Q1
Q
Let’s organize the findings in a table:
When demand
is . . .
. . . and price
increases
decreases
perf. inelastic
TR = TE
TR = TE
inelastic
TR = TE
TR = TE
unit elastic
elastic
perf. elastic
no change in TR = TE
TR = TE
TR = TE
(can’t really talk about
price changes)
Own price elasticity of demand can vary . . .
from one demand curve to another . . .
and even along a given demand curve.
(Text’s discussion of elasticity and linear
demand. (p. 97))
What determines the elasticity of demand?
Availability of substitutes:
A good with close substitutes tends to have more elastic
demand than a good with no close substitutes.
Breadth of definition:
Any one of a group of related goods tends to have more
elastic demand than the group taken as a whole.
Time horizon (period of time allowed for adjustment to
a price change):
The long-run demand for a good will tend to be more
elastic than the short-run demand.
Consider the demand for gasoline:
p
p2
p
1
DLR
DSR
Q3
Q2 Q1
Q
A price increase from p1 to p2 . . .
leads to a smaller quantity response (Q1  Q2)
in the short-run . . . than in the long-run
(Q1  Q3)
Elasticity is a general concept. Whenever we have one
variable (X) that depends on another variable (Y) . . .
. . . we can use elasticity to provide a “unit-free”
measure of the degree of responsiveness of X
to changes in Y.
Elasticities are always ratios of percentage (rather than
absolute) changes.
Some other elasticities in economics:
Income elasticity of demand =
% in Q demanded
% in income
Algebraic sign and normal vs. inferior goods?
Cross-price elasticity of demand =
% in Q demanded of one good (x)
% in price of another good (y)
Algebraic sign and substitutes vs. complements?
Own price elasticity of supply =
% in Q supplied
% in price
Like demand, supply tends to be more elastic in the
long-run than in the short-run.
OPEC (Organization of Petroleum Exporting Countries)
and the price of crude oil.
(http://en.wikipedia.org/wiki/OPEC)
OPEC members include several Persian Gulf region
countries (Saudi Arabia, Egypt, United Arab Emirates,
etc.) plus a few others (Venezuela, Indonesia, etc.)
An example of a cartel : a group of firms (usually, in
this case countries) acting in unison.
Collusion: An agreement among firms (countries) about
quantities to produce or prices to charge.
OPEC’s game: Raise the price of crude oil through a
coordinated reduction in quantity produced.
OPEC’s greatest successes occurred in mid- to late-70s.
Price, to U.S. buyers, of crude oil imports for December
of each year ($/bl.)
(source: http://www.economagic.com/ . . .)
1973
1977
1981
1985
1989
6.34
13.41
34.56
24.23
18.80
1993
1997
2001
2005
2009
11.63
14.21
15.22
50.06
71.24
Inflation-adjusted price, to U.S. buyers, of crude oil
imports for Dec. of each year (1973$/bl.)
1973
1977
1981
1985
1989
6.34
9.97
17.00
10.25
6.89
1993
1997
2001
2005
2009
3.68
4.07
3.97
11.70
15.18
Real (inflation-adjusted) price increases throughout midto-late-70s, peaking around 1981.
Real price decreases though remainder of 80s. Fairly
stable through 90’s until about 2003.
Until 2003, prices comparable, in real terms, to 1973.
Why was OPEC’s success only temporary?
One reason is that both supply and demand are more
elastic in the long-run than in the short-run.
price of
crude
SSR2
SSR1
When supply decreases
in the short-run (with
quite inelastic supply
and demand) . . .
. . . price increases
substantially.
p1973
DSR
Q1973
quantity of
crude
The same supply shift (same horizontal distance
between supply curves) in the long-run (with much more
elastic supply and demand) . . .
. . . results in a more
modest price
increase.
price of
crude
SLR2
SLR1
p1973
DLR
Q1973
quantity of
crude
Other reasons
for OPEC’s shortlived success?
Breakdown in
cartel discipline.
(chapter 16)
Market for illegal drugs and drug-related crime.
Costs to society:
Ruined lives of addicts and their families are main
costs, but . . .
. . . there are additional significant costs because
addicts often turn to crime to support their addiction.
(Drug-related crime: robberies, thefts, muggings.)
Drug-related crime victims’ losses, and law
enforcement costs of fighting drug-related crime are
additional costs of illegal, addictive drugs.
Two strategies for fighting illegal addictive drugs.
Drug interdiction: Law enforcement efforts to reduce
supply . . .
. . . by catching and prosecuting pushers,
intercepting drug shipments, finding and destroying
illegal drug labs, etc.
Drug education: Public educational efforts to decrease
demand . . .
. . . “Just say ‘No!’” “Drug-free zones” etc.
Effects of drug interdiction:
price of
illegal
drugs
S2
S1
Demand -- very! inelastic
quantity of
illegal drugs
Drug interdiction decreases supply . . .
. . . increasing the street price of illegal drugs and,
because demand is inelastic, increasing expenditure
More drug-related crime.
on illegal drugs.
Effects of drug education:
price of
illegal
drugs
D2
S1
Demand -- very! inelastic
quantity of
illegal drugs
Drug education decreases demand . . .
. . . reducing drug consumption, price, and
expenditure.
Less drug-related crime.