chapter: 6 >> Krugman/Wells Economics ©2009  Worth Publishers Elasticity

Warm-up – October 6, 2015 Scenario: You own a restaurant that is fully booked during the weekends. In mid-week, however, you rarely have enough bookings to stay open. To make more money during this slow period, you decide to cut dinner prices from $15 to $10 on Wednesdays and Thursdays. This results in an increase in quantity demanded from 100 to 140 dinners per day. Was the price cut a good idea? Why or why not?

The Concept of Elasticity Elasticity of demand: if price changes, how drastic will the change be to quantity demanded?

(b) Inelastic Demand: Price Elasticity of Demand = ,050 B A 0 $ D 2 Price of salt A 20% increase in the price generates a 10% decrease in the quantity of salt demanded. Quantity of salt (in lbs) Inelastic Demand

(c) Elastic Demand: Price Elasticity of Demand = 2 … generates a 40% decrease in the quantity of broccoli demanded. 8001,200 B A 0 $ Quantity of broccoli (in lbs) D 3 Price of broccoli (per pound) A 20% increase in the price... Elastic Demand

(a) Unit-Elastic Demand: Price Elasticity of Demand = ,100 B A 0 $ Price of coffee (per cup) A 20% increase in the price... D 1... generates a 20% decrease in the quantity of cups of coffee demanded. Quantity of cups of coffee (in cups) Unit Elasticity of Demand

Two Extreme Cases of Price Elasticity of Demand 10 Quantity of shoelaces (billions of pairs per year) (a)Perfectly Inelastic Demand: Price Elasticity of Demand = 0 $3 $2 Price of shoelaces (per pair) … leaves the quantity demanded unchanged. An increase in price… D 1 Perfectly inelastic: any change in price has no effect on quantity demanded

Two Extreme Cases of Price Elasticity of Demand At any price above $5, quantity demanded is zero At exactly $5, consumers will buy any quantity At any price below $5, quantity demanded is infinite 0 (b)Price Elastic Demand: Price Elasticity of Demand = ∞ $5 Price of pink tennis balls (per dozen) D 2 Quantity of tennis balls (dozens per year) Perfectly elastic: price increase causes quantity demanded to drop to zero

What Factors Determine the Price Elasticity of Demand? Price Elasticity of Demand is determined by:  Whether Close Substitutes Are Available:  Whether the Good Is a Necessity or a Luxury:  Share of Income Spent on the Good:  Time:

Defining and Measuring Elasticity  The price elasticity of demand is the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (dropping the minus sign).

The Price Elasticity of Demand

Interpreting the Price Elasticity of Demand  Demand is elastic if the price elasticity of demand is greater than 1.  Demand is inelastic if the price elasticity of demand is less than 1.  Demand is unit-elastic if the price elasticity of demand is exactly 1.

Practice: Calculate the following price elasticities. Based on the coefficient of elasticity, which product is elastic, inelastic, and unit-elastic? 1.As the price of cheese increases by 30%, the quantity demanded decreases by 15%. 2. As the price of airfare decreases by 10%, the quantity of tickets demanded increases by 40%. 3. As the price of sunglasses increases by 25%, the quantity demanded decreases by 25%.

Using the Midpoint Method  The midpoint method is a technique for calculating the percent change.  In this approach, we calculate changes in a variable compared with the average, or midpoint, of the starting and final values.  MOST OF THE HOMEWORK/PRACTICE PROBLEMS WILL USE THE MIDPOINT METHOD!!

Using the Midpoint Method

Another way to determine elasticity – the total revenue test  The total revenue is defined as the total value of sales of a good or service – money coming in  Total Revenue = Price × Quantity Sold  Revenue does NOT mean profit!

Three businesses in town are losing revenue, and each have decided to increase their prices in order to make more money. Business #1 increased the price of its product from $10 to $20. After that price increase, the business went from selling 100 units to 80 units. Business #2 also increased the price of its product from $10 to $20. After that price increase, the business went from selling 500 units to 200 units. Business #3 also increased the price of its product from $10 to $20. After that price increase, the business went from selling 500 units to 250 units. 1.For each business: Determine the relative price elasticities of demand for each business’ product (which one has elastic, inelastic, unit elastic demand) by calculating the coefficient AND doing the total revenue test. 2.Which business made the correct call in increasing prices in order to make more revenue?

Elasticity and Total Revenue  When a seller raises the price of a good, there are two countervailing effects in action (except in the rare case of a good with perfectly elastic or perfectly inelastic demand):  A price effect: After a price increase, each unit sold sells at a higher price, which tends to raise revenue.  A quantity effect: After a price increase, fewer units are sold, which tends to lower revenue.

Elasticity and Total Revenue  If demand for a good is elastic (the price elasticity of demand is greater than 1), an increase in price reduces total revenue.  In this case, the quantity effect is stronger than the price effect.  If demand for a good is inelastic (the price elasticity of demand is less than 1), a higher price increases total revenue.  In this case, the price effect is stronger than the quantity effect.  If demand for a good is unit-elastic (the price elasticity of demand is 1), an increase in price does not change total revenue.  In this case, the sales effect and the price effect exactly offset each other.

Consider these two product pairs: Butter and margarine Coffee and tea We know that if the price of one product decreases, demand for the substitute product will decrease. Let’s say the prices of butter and coffee have both decreased. Which product do you think will experience the largest decrease in demand – margarine, or tea?

Other Demand Elasticities: Cross-Price Elasticity  The cross-price elasticity of demand between two goods measures the effect of the change in one good’s price on the quantity demanded of the other good.  It is equal to the percent change in the quantity demanded of one good divided by the percent change in the other good’s price. The Cross-Price Elasticity of Demand between Goods A and B

Cross-Price Elasticity  Goods are substitutes when the cross-price elasticity of demand is positive.  Larger # = better substitutes  Goods are complements when the cross-price elasticity of demand is negative.  Very negative # = stronger complements

Practice: 1. As the price of Coke rises by 20%, consumers increase their Pepsi consumption by 5%. Calculate the cross-price elasticity of demand between Coke and Pepsi. As the price of broccoli decreases by 10%, consumers decrease their cauliflower consumption by 50%. Calculate the cross-price elasticity of demand between broccoli and cauliflower. Which are closer substitutes? Coke and Pepsi, or broccoli and cauliflower? 2. As the price of peanut butter decreases by 10%, consumers increase their jelly consumption by 5%. Calculate the cross-price elasticity of demand between peanut butter and jelly. As the price of hot dogs increase by 30%, consumers decrease their hot dog bun consumption by 90%. Calculate the cross-price elasticity of demand between hot dogs and buns. Which are stronger complements? Peanut butter and jelly, or hot dogs and buns?

The Income Elasticity of Demand  The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in the consumer’s income.

Normal Goods and Inferior Goods  When the income elasticity of demand is positive, the good is a normal good - that is, the quantity demanded at any given price increases as income increases.  The larger the coefficient = the more income elastic it is  When the income elasticity of demand is negative, the good is an inferior good - that is, the quantity demanded at any given price decreases as income increases.  The more negative the coefficient = the…lamer the product?

1. Calculating income elasticity: a.When income increased by 20%, demand for Good A decreased by 10%. b.When income decreased by 30%, demand for Good B decreased by 15%. c.Which product is a normal good, and which is inferior? 2. After Chelsea’s income increased from $12,000 to $18,000 per year, her purchases of CDs increased from 10 to 40 a year. Calculate Chelsea’s income elasticity of demand for CDs using the midpoint method.

Measuring the Price Elasticity of Supply  The price elasticity of supply is a measure of the responsiveness of the quantity of a good supplied to the price of that good. It is the ratio of the percent change in the quantity supplied to the percent change in the price as we move along the supply curve.

Two Extreme Cases of Price Elasticity of Supply (a) Perfectly Inelastic Supply: Price Elasticity of Supply = Quantity of cell phone frequencies $3,000 2,000 Price of cell phone frequency S 1 … leaves the quantity supplied unchanged An increase in price… (b) Perfectly Elastic Supply: Price Elasticity of Supply = ∞ 0 Quantity of pizzas $12 Price of pizza S 2 At any price above $12, quantity supplied is infinite. At exactly $12, producers will produce any quantity At any price below $12, quantity supplied is zero.

Two Extreme Cases of Price Elasticity of Supply  There is perfectly inelastic supply when the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied. A perfectly inelastic supply curve is a vertical line.  There is perfectly elastic supply when even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite. A perfectly elastic supply curve is a horizontal line.

What Factors Determine the Price Elasticity of Supply?  The Availability of Inputs: If inputs are readily available and easy to employ = more price elastic Which would then be more price elastic: clothing or aircraft?  Time: Producers have more time to respond to price change = more price elastic

1. Using the midpoint method, calculate the price elasticity of supply for web-design services when the price per hour rises from $100 to $150 and the number of hours transacted increases from 300,000 to 500,000. Is supply elastic, inelastic, or unit-elastic? 2. As the price of Good A increases by 40%, the quantity of Good B demanded decreases by 20%. Which of the following must be true? a. Good A and B are substitute goods. b. The demand for Goods A and B are price inelastic. c. Good A and B are complementary goods. d. The cross-price elasticity of demand for Goods A and B is positive. 3. Average incomes have risen 25% in the past 20 years. As a result, Spam sales have been cut in half over that same span of time. Calculate the income elasticity of demand. Is Spam a normal or inferior good? 4. Calculate the coefficient of price elasticity of demand for a product that is (a) perfectly elastic, and (b) perfectly inelastic in demand.

Using the midpoint method, calculate the price elasticity of supply for web-design services when the price per hour rises from $100 to $150 and the number of hours transacted increases from 300,000 to 500,000. Is supply elastic, inelastic, or unit-elastic? True or false? If the demand for milk rose, then, in the long run, milk-drinkers would be better off if supply was elastic rather than inelastic. True or false? Long-run price elasticities of supply are generally larger than short-run price elasticities of supply. As a result, the short-run supply curves are generally flatter than the long-run supply curves. True or false? When supply is perfectly elastic, changes in demand have no effect on price.

Demand Schedule and Total Revenue D $ Quantity Total revenue $ Quantity Price Demand is elastic: a higher price reduces total revenue Elastic Inelastic Unit- elastic Demand is inelastic: a higher price increases total revenue $ $ Total Revenue Quantity demanded Demand Schedule and Total Revenue for a Linear Demand Curve Price The price elasticity of demand changes along the demand curve

In each of the following cases, do you think the price elasticity of supply is (i) perfectly elastic; (ii) perfectly inelastic; (iii) elastic, but not perfectly so; or (iv) inelastic, but not perfectly so? 1. An increase in demand this summer for luxury cruises leads to an even larger jump in the sales price of a cabin on the Queen Mary The price of a kilowatt of electricity is the same during periods of high electricity demand as during periods of low demand. 3. Fewer people want to fly during February than during any other month. The airlines cancel about 10% of their flights as ticket prices fall about 20% during this month. 4. Owners of vacation homes in Maine rent them out during the summer. Due to the soft economy this year, a 30% decline in the price of a vacation rental leads more than half of homeowners to occupy their vacation homes themselves during the summer.

An Elasticity Menagerie

Elasticity is a general measure of responsiveness that can be used to answer such questions. The price elasticity of demand—the percent change in the quantity demanded divided by the percent change in the price (dropping the minus sign)—is a measure of the responsiveness of the quantity demanded to changes in the price. The responsiveness of the quantity demanded to price can range from perfectly inelastic demand, where the quantity demanded is unaffected by the price, to perfectly elastic demand, where there is a unique price at which consumers will buy as much or as little as they are offered. When demand is perfectly inelastic, the demand curve is a vertical line; when it is perfectly elastic, the demand curve is a horizontal line.

The price elasticity of demand is classified according to whether it is more or less than 1. If it is greater than 1, demand is elastic; if it is less than 1, demand is inelastic; if it is exactly 1, demand is unit-elastic. This classification determines how total revenue, the total value of sales, changes when the price changes. The price elasticity of demand depends on whether there are close substitutes for the good, whether the good is a necessity or a luxury, the share of income spent on the good, and the length of time that has elapsed since the price change. The cross-price elasticity of demand measures the effect of a change in one good’s price on the quantity of another good demanded.

The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in income. If the income elasticity is greater than 1, a good is income elastic; if it is positive and less than 1, the good is income- inelastic. The price elasticity of supply is the percent change in the quantity of a good supplied divided by the percent change in the price. If the quantity supplied does not change at all, we have an instance of perfectly inelastic supply; the supply curve is a vertical line. If the quantity supplied is zero below some price but infinite above that price, we have an instance of perfectly elastic supply; the supply curve is a horizontal line.

The price elasticity of supply depends on the availability of resources to expand production and on time. It is higher when inputs are available at relatively low cost and the longer the time elapsed since the price change.