Chapter 4/5 Elasticity & Market Failures

Elasticity extends our understanding of markets by letting us know the degree to which changes in price affect the quantity supplied and the quantity demanded. Elasticity = Responsiveness

The law of demand tells us that consumers will buy more of a good when its price falls and less when its price rises. But how much more or less? The amount varies from product to product and over different price ranges for the same product. It may also vary over time.

Price elasticity of demand shows how responsive consumers are to a price change and can be broken down into 3 ranges.

1.Elastic Demand- When a given change in price causes a relatively larger change in the quantity demanded. Here consumers are sensitive to a price change.

2.Inelastic Demand- When a given change in price causes a relatively smaller change in the quantity demanded. Now consumers are much less responsive to a price change.

3. Unit Elastic- When a given change in price causes a proportional change in the quantity demanded.

Elasticity Formula Ed= (∆Qd ∕ sum Q ∕2) (∆P ∕ sum P ∕ 2) Ed > 1 demand is elastic Ed = 1 demand is unit elastic Ed < 1 demand is inelastic

The importance of elasticity for business firms relates to the effect of price changes on total revenue, and thus on profits. Total revenue is the amount the seller receives from the sale of his product and is calculated by multiplying the product price (P) by the quantity sold (Q) so TR=P×Q.

Graphically, total revenue is represented by the P×Q rectangle lying below a point on the demand curve. Price Qty. D $10 1 $8 3 $6 5 $4 7 $2 9

Total Revenue Test If total revenue changes in the opposite direction from price, demand is elastic. If total revenue changes in the same direction as price, demand is inelastic. If total revenue does not change when price changes, demand is unit elastic.

Quantity demanded Price Ed TR Total revenue test 1,000 $8 $8,000 2,000 $7 5.0 $14,000 Elastic 3,000 $6 2.6 $18,000 Elastic 4,000 $ $20,000 Elastic 5,000 $4 1.0 $20,000 Unit Elastic 6,000 $3.64 $18,000 Inelastic 7,000 $2.38 $14,000 Inelastic 8,000 $1.20 $8,000 Inelastic

Determinants of Demand Elasticity The following general questions can be helpful in determining the elasticity for a product.

1)Substitutability-The larger the number of substitute goods that are available, the greater the elasticity of demand. Candy bars are elastic Gasoline is inelastic

2) Proportion of Income- The higher the price of a good relative to consumers income, the greater the elasticity of demand. New cars are elastic Chewing gum is inelastic

3) Luxuries vs. Necessities-The more the good is considered a “luxury”, the greater the elasticity of demand. Vacation travel is elastic Electricity is inelastic

4) Time-Generally, product demand is more elastic the longer the time period under consideration. This is true for 2 reasons. Consumers are creatures of habit and often need time to adjust to changes in price. Product durability is another factor.

Applications of Demand Elasticity  Large Crop Yields Inelastic demand, lower total revenue  Excise Taxes Inelastic demand, more total revenue  Decriminalization of Illegal Drugs Inelastic demand, more total revenue

Price Elasticity of Supply This concept is used the same way as it was for demand elasticity. If the quantity supplied is relatively responsive to a price change, then supply is elastic. If the quantity supplied is relatively unresponsive, then supply is inelastic.

The degree of price elasticity of supply depends on how easily or quickly firms can shift resources between alternative uses. The easier and faster resources can be shifted, the greater the elasticity of supply. Economists distinguish between 3 time periods when analyzing supply elasticity.

1.Market Period: is a period that occurs when the time immediately after a change in price is too short for producers to respond with any change in quantity supplied. In this period the quantity of a product, say tomatoes, is fixed.

2. Short Run: is a period of time too short to change plant capacity but long enough to use the fixed plant size more or less intensively. The result is somewhat greater output in response to the higher price.

3. Long Run: is a time period long enough to adjust plant size and for new firms to enter, or existing firms to leave the industry.

There is no total revenue test for supply elasticity. Regardless of the degree of elasticity or inelasticity, price and total revenue always move together.

Applications of Supply Elasticity  Antiques  Reproductions  Gold

Sometimes markets fail because economically desirable goods may not be produced, or in other situations may be under or over produced. When these failures occur resources are no longer allocated efficiently.

Examples include the following inadequate competition inadequate information resource immobility externalities public goods

We will focus on the last two types of failures. In such situations, an economic role for government may be necessary to improve the efficiency with which resources are used.

Public Goods In the case of public goods private markets may fail to produce any of the public goods whatsoever. To explain why let’s start by contrasting public and private goods.

Private goods- are goods offered for sale in stores, shops, and on the internet by businesses.

They have 2 characteristics.  Rivalry- means that when one person buys and consumes a product, it is not available for another person to consume.  Excludability- means that sellers can keep people who do not pay for a product from obtaining its benefits. Only those who are willing and able to pay the market price can obtain the good.

Public Goods- are goods that are consumed collectively and are provided by the government. Their characteristics are the opposite of private goods.

 Nonrivalry- means that one person’s consumption of a good does not preclude consumption of the good by others. Everyone can simultaneously obtain the benefit from a public good such as national defense, street lighting, GPS systems, light-houses and fireworks displays.

 Nonexcludability- means there is no effective way of excluding people from the benefit of the good once it has been produced.

These 2 characteristics create a free-rider problem which basically says that if you can get something for free, why willingly pay for it.

Private goods Ice-cream cones Clothing cars Public goods Tornado sirens National defense Flood control programs

If private firms won’t produce these goods because of the free rider problem, then who has to do it? Government produces these goods and imposes taxes on its citizens to pay for them.

Quasi-Public Goods Government provides many goods that fit the economist’s definition of a public good. However, it also provides other goods and services that could be produced and delivered in such a way that exclusion would be possible.

These items could be priced and provided by private firms through the market system. But, because the benefits of these goods go well beyond the benefit to individual buyers these goods would be under- produced by the market system.

An externality occurs when some of the costs or benefits of a good or service are passed onto or “spill over to” someone other than the immediate buyer or seller. There are both positive as well as negative externalities. Two examples include vaccinations and pollution.

When there are negative externalities, an overproduction of the related good occurs and there is an over-allocation of resources to this product. Conversely, underproduction and under-allocation of resources result when a positive externality is present.

Government Solutions Government solutions might be to tax the polluting firm to make them produce less(decrease supply), or in the case of vaccinations, government might want to subsidize shots(increase supply or demand) to encourage more people to get their shots.