Chapter 3 Part 2

2 truths – 1 Lie Two of my cousins are teachers (I’m serious!) I love Pho (Vietnamese noodle soup.. yummy!) I’ve been to an Olympic game before (Very Believable isn’t it?)

Learning Objectives Review Elasticity of Demand Comprehend Income Elasticity, Cross-Price Elasticity

Price Elasticity of Demand Price elasticity of demand shows how sensitive consumers are to price changes. “How does change in price impact quantity demanded?” ed = ΔQd ÷ average Qd Δprice ÷ average price

Price Elasticity of Demand From what we learned in the previous class, Ed value was always negative. In economics, if we take the absolute, we will get the same answer From negative to positive Ie: if Ed is -6.0 would become +6.0 …

Value of ped Classification Meaning +∞ +1 < Ed<+∞ Ed = +1 Perfectly Elastic. Horizontal Demand Curve Any increase in price results in quantity demanded decreasing to zero and any decrease in price results in quantity demanded increasing to infinity +1 < Ed<+∞ Elastic Demand Price change causes total revenue to change in the opposite direction Ed = +1 Unitary (Unit) Elastic Demand Price does not affect total revenue Percent increase in quantity demanded is equal to percentage decrease in price +1 ‹ Ed‹ 0 Inelastic Demand Quantity demanded is relatively insensitive to price Ed= 0 Perfectly inelastic demand Quantity demanded is completely insensitive to price

Total Revenue and the Price Elasticity of Demand Demand Elasticity and Changes in Total Revenue Elastic Demand Inelastic Demand Unit-Elastic Demand Price Change up down Change in Total Revenue down up unchanged

Consumer Surplus Consumer surplus is a measure of the economic welfare that people gain from purchasing and then consuming goods and services Consumer surplus is the difference between the total amount that consumers are willing to pay and able to pay for a good or service and the total amount that they actually pay Consumer surplus is indicated by the area under the demand curve and above the market price In a nutshell.. amount of money by which consumers value a good or service over and above its purchase price It is the satisfaction (utility) consumers receive for which they do not have to pay for.

Link it back to Elasticity of Demand What happens if Demand becomes more Elastic? What would the graph look like?

In a nutshell… Consumer Surplus is.. The amount of money by which consumers value a good or service over and above its purchase price It is the satisfaction (utility) consumers receive for which they do not have to pay for.

Activity - Sun Chips Hints: How much would 10% price increase for the good affect a consumer’s total budget? What substitutes are available for the good? Do consumers think of this good as a necessity or a luxury?

How does availability of substitutes affect Ed? The more substitutes = More elastic demand will be If a cup of coffee went up by $0.25, consumers would replace their morning caffeine with a cup of tea which means that coffee is an elastic good because a raise in price will cause a decrease in demand What will happen if the price of caffeine as a whole goes up? We would see little change in the consumption of coffee or tea because there are few substitutes for caffeine Thus, we consider this an inelastic product because of its lack of substitutes What can we say about the industry? Inelastic What can we say about the products within the industry? Elastic

How does consumer income affect Ed? If the price of a can of coke goes up from $0.50 to $1 and income of consumers stay the same, the income that is available to spend on coke (ie: $2) is now enough for only two vs four. Consumer is forced to reduce their demand for coke Increase in price / no change in the amount if income = increase in elasticity Demand for big purchases tends to be more elastic than the demand for smaller purchases

How does time affect Ed? Demand tends to become elastic over time Example The price of cigarettes goes up by $2 per pack, the smokers does not have many substitutes and will most likely continue buying their cigarettes. Tobacco is inelastic because the change in price will not have a significant change on the quantity demanded What is the kicker? If that smoker CANNOT afford it, the smoker is forced to break the habit over a period of time thus the price elasticity of cigarettes for the consumer becomes elastic in the long run

Income Elasticity Income elasticity (ei) is the responsiveness of a product’s quantity demanded to changes in consumer income. In mathematical terms: eincome = ei = ΔQd ÷ average Qd ΔI ÷ average I = ΔQd x I ΔI Q

Income Elasticity Ratio of % change in Q demanded to the % change of income (holding the other determinants of demand constant) Example In an economic recession, household income dropped by 7% but household money spent on eating out dropped by 12%. The Income elasticity of demand would then be 12%/7% = 1.7 In this case, a drop in income produces a greater drop in demand What if it was a 7% drop in household income produced a 3% drop in baby formula milk sales? 3/7 = 0.43 telling us that the demand is relatively essential and demand will still PERSIST even when income drops Conclusion: Eating out in restaurants is not an essential economic activity, but buying baby formula is

Income Elasticity Ei>1 then the good is a Luxury Good and is Income Elastic If 0<Ei<1 then the good is a Normal Good and Income Inelastic If Ei<0 then the good is an Inferior Good and Negative Income Inelastic The higher the income elasticity, the more sensitive demand for good to income changes A very high Ei suggests that when consumer income goes up, consumers will buy MORE of that good A very high Ei also suggests that when consumers income goes down, consumers will buy LESS of that good

Example John’s income rises from $20,000 to $22,000 and the quantity of hamburger he buys each week falls from 2 pounds to 1 pound. Calculate Ei and draw a conclusion % change in quantity demanded = (1-2)/1.5 = -0.6667 = -66.67% % change in income = (22,000-20,000)/21,000 = 0.0952 = 9.52% income elasticity = 66.67%/9.52% = -7.00 Hamburger is an inferior good for John

So… in a nutshell Necessities tend to have small income elasticities, while luxuries tend to have large income elasticities

Assignment 1

Cross-Price Elasticity of Demand Cross-price elasticity (ei) is the responsiveness of the quantity demanded of one product (a) to a change in price of another (b). Measures the change in demand for one good in response to a change in price of another good In mathematical terms: eAB= ΔQa ÷ average Qa ΔPb ÷ average Pb eAB = % Change in Quantity Demanded for Good A % Change in Price of Good B

Cross-Price Elasticity of Demand If EAB>0, a higher price for good A increases the quantity of good B demanded => Demand Substitutes Example: apples and peaches are demand substitutes: As the price of peaches increases, the quantity of apples demanded increases If EAB<0, a higher price for good A decreases the quantity of good B demanded => Demand Complements Example: apples and bananas are demand complements: As the price of bananas increases, the quantity of apples demanded decreases

Example  The quantity demanded or product A has increased by 12% in response to a 15% increase in price of product B. Calculate the cross elasticity of demand and tell whether the product pair is (a) apples and oranges, or (b) cars and gas. Cross elasticity of demand = % change in quantity demanded of A % change in price of B = 12%/15% = 0.67 Since the cross elasticity of demand is positive, product A and B are substitute goods. They are most likely apples and oranges.

Example The price of apples rises from $1.00 per pound to $1.50 per pound. As a result, the quantity of oranges demanded rises from 8,000 per week to 9,500. % change in quantity of oranges demanded = (9,500-8,000)/8,750 = 0.1714 = 17.14% % change in price of apples = (1.50-1.00)/1.25 = 0.40 = 40% cross-price elasticity = 17.14%/40% = 0.43 Because the cross-price elasticity is positive, the two goods are substitutes.

Problem The government of Selgina is very serious about drugs. Possession of drugs is illegal and is severely penalized. However, a black market exists which the government has failed to dismantle despite serious attempts. Khusenichho Chamling, the health minister, is worried about the situation. In early 2009, a consultant working with health ministry suggested that the government should increase the price of a pack of cigarettes from 200 Selgina dollars (S$) to S$600. A survey conducted in December 2009 suggested that over the year, the quantity demanded of marijuana decreased from 2,000 kgs per day to just 800 kgs. Calculate the cross elasticity of demand and tell why has the policy proved so effective.

Percentage increase in price of cigarettes = (600-200) ÷ {(600+200) ÷ 2} = 100% Percentage increase in quantity demanded of marijuana = (800-2,000) ÷ {(800+2000) ÷ 2} = -85.71% Cross elasticity of demand = % change in quantity demanded/% change in price = -85.71%/100% = -0.86 Cigarettes and marijuana have negative cross elasticity of demand which tells that they are complimentary goods. The policy has proved effective because cigarettes and marijuana are consumed together. Increase in price of cigarettes increased the price of the whole bundle and reduced the purchasing power of people and resulted in a drop in consumption of marijuana.

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