Other Elasticities Module KRUGMAN'S MICROECONOMICS for AP* 12 48 Margaret Ray and David Anderson

What you will learn in this Module: How can we discover which goods are complements or substitutes? How can we determine the strength of the income effect? How can we calculate normal and inferior goods? How closely does price influence supply? The factors that influence the size of these various elasticities. The purpose of this module is to help students to see that other consumer and producer responses can be measured with elasticities.

Other Elasticities Cross-price elasticity of demand Income elasticity of demand Price elasticity of supply Elasticity is a general concept that can be used to measure the relationship between any two variables. In addition to the price elasticity of demand, economists consider a number of other elasticity measures. Notably, cross-price elasticity, income elasticity, and price elasticity of supply. Economists, governments, and firms are quite interested in how one variable responds to a change in another variable.   For example, suppose the price of gasoline were to increase. The producers of large trucks and SUVs will be very interested to know how this might affect sales of these vehicles. A cross-price elasticity of demand would be used to measure this response. Suppose the economy is suffering a recession and personal incomes are lower. The airline and hotel industries would be interested to know how this would affect the demand for air travel and hotel rooms. An income elasticity of demand would be used in this case. On the supply side of the market, producers would like to increase output if the price of their goods was to rise. A price elasticity of supply would be useful in measuring this response.

Cross-Price Elasticity of Demand Measures the responsiveness of the demand for good “X” to changes in the price of good “Y” Exy = %∆ Qd of X / %∆ P of Y Substitutes (positive) Complements (negative Cross-price elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product.   Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. If cross elasticity is positive, then X and Y are substitutes. Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If cross elasticity is negative, then X and Y are complements. Example: The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = - .25. Note: if cross elasticity is zero, then X and Y are unrelated, independent products. Example: if the price of breakfast cereal increased, there would likely be no impact on the quantity of denim jeans demanded.

Cross-Price Elasticity of Demand For example, suppose the price of gasoline were to increase. The producers of large trucks and SUVs will be very interested to know how this might affect sales of these vehicles. A cross-price elasticity of demand would be used to measure this response. Cross-price elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product.   Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. If cross elasticity is positive, then X and Y are substitutes. Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If cross elasticity is negative, then X and Y are complements. Example: The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = - .25. Note: if cross elasticity is zero, then X and Y are unrelated, independent products. Example: if the price of breakfast cereal increased, there would likely be no impact on the quantity of denim jeans demanded.

Cross-Price Elasticity of Demand Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = - .25. Note: if cross elasticity is zero, then X and Y are unrelated, independent products. Example: if the price of breakfast cereal increased, there would likely be no impact on the quantity of denim jeans demanded. Cross-price elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product.   Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. If cross elasticity is positive, then X and Y are substitutes. Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If cross elasticity is negative, then X and Y are complements. Example: The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = - .25. Note: if cross elasticity is zero, then X and Y are unrelated, independent products. Example: if the price of breakfast cereal increased, there would likely be no impact on the quantity of denim jeans demanded.

Income Elasticity of Demand Measures the responsiveness of demand for a good to changes in income. Ei = %∆ Qd / %∆ I Normal good (positive) Inferior good (negative) Income elasticity of demand refers to the percentage change in quantity demanded which results from some percentage change in consumer incomes.   Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. A positive income elasticity indicates a normal good. Example: American consumer income falls by 2% and quantity of flights to Europe declines by 8%. Ei = 8%/2% = 4 Note: this example demonstrates a very income-elastic response and this is true of most goods that are considered luxuries. Example: Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%. Ei = 1%/4% = .25 Note: this example demonstrates an income-inelastic response that is fairly typical for food and other necessities. A negative income elasticity indicates an inferior good. Example: Consumer income falls by 5% and consumers increase consumption of Spam by 4%. Ei = 4%/(-5%) = -.80 Note: at the height of the most recent economic recession, stronger sales of Spam were responsible for a very profitable quarter for Hormel.

Income Elasticity of Demand Suppose the economy is suffering a recession and personal incomes are lower. The airline and hotel industries would be interested to know how this would affect the demand for air travel and hotel rooms. An income elasticity of demand would be used in this case. Income elasticity of demand refers to the percentage change in quantity demanded which results from some percentage change in consumer incomes.   Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. A positive income elasticity indicates a normal good. Example: American consumer income falls by 2% and quantity of flights to Europe declines by 8%. Ei = 8%/2% = 4 Note: this example demonstrates a very income-elastic response and this is true of most goods that are considered luxuries. Example: Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%. Ei = 1%/4% = .25 Note: this example demonstrates an income-inelastic response that is fairly typical for food and other necessities. A negative income elasticity indicates an inferior good. Example: Consumer income falls by 5% and consumers increase consumption of Spam by 4%. Ei = 4%/(-5%) = -.80 Note: at the height of the most recent economic recession, stronger sales of Spam were responsible for a very profitable quarter for Hormel.

Income Elasticity of Demand Example: American consumer income falls by 2% and quantity of flights to Europe declines by 8%. Ei = 8%/2% = 4 Example: Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%. Ei = 1%/4% = .25 A negative income elasticity indicates an inferior good. Example: Consumer income falls by 5% and consumers increase consumption of Spam by 4%. Ei = 4%/(-5%) = -.80 Income elasticity of demand refers to the percentage change in quantity demanded which results from some percentage change in consumer incomes.   Note: remind the students that the demand for good X shifts when the price of related goods changes. This elasticity measures how much that demand curve shifts. A positive income elasticity indicates a normal good. Example: American consumer income falls by 2% and quantity of flights to Europe declines by 8%. Ei = 8%/2% = 4 Note: this example demonstrates a very income-elastic response and this is true of most goods that are considered luxuries. Example: Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%. Ei = 1%/4% = .25 Note: this example demonstrates an income-inelastic response that is fairly typical for food and other necessities. A negative income elasticity indicates an inferior good. Example: Consumer income falls by 5% and consumers increase consumption of Spam by 4%. Ei = 4%/(-5%) = -.80 Note: at the height of the most recent economic recession, stronger sales of Spam were responsible for a very profitable quarter for Hormel.

Price Elasticity of Supply Measures the responsiveness of quantity supplied to changes in price. Es = %∆ Qs / %∆ P If Es >1, supply is considered elastic. If Es < 1, supply is considered inelastic. If Es = 1, supply is considered unit elastic. The concept of price elasticity also applies to supply. The Law of Supply says that when the price of a good increases, firms will increase quantity supplied. Economists would like to measure how much quantity will increase in response to this higher price. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula. The same elastic and inelastic distinctions are made.   If Es >1, supply is considered elastic. If Es < 1, supply is considered inelastic. If Es = 1, supply is considered unit elastic. The figure below shows an upward sloping supply curve S1, a perfectly elastic (horizontal) supply curve S2 and a perfectly inelastic (vertical) supply curve S3. A vertical supply curve like S3 implies that, even at the highest of prices, there is something that prevents firms from increasing the quantity that they supply. This might be a technological limitation or, in the case of agriculture, a seasonal impossibility. A horizontal supply curve like S2 implies that even the smallest increase in the price would dramatically increase quantity supplied. A small decrease in the price would decrease quantity supplied to zero.

Factors Influencing Price Elasticity of Supply Determinants of Price Elasticity of Supply Availability of inputs Time Other factors also determine the price elasticity of supply Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic.   The time period involved is very important in elasticity of supply The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example: Agriculture is a great example of the importance of time. Suppose it is July 2010 and the price of soybeans is soaring. Farmers would love to supply more soybeans at the higher price, but soybean crops have already been planted. The quantity of soybeans that will be supplied at harvest 2010 was basically determined months ago during the spring planting season. So the immediate soybean supply curve is very inelastic or nearly vertical and farmers are incapable of responding to the higher price. However, if the high prices continue in early 2011, farmers will plant more acres of soybeans next year and will supply more soybeans. So the increase in quantity supplied is greater as more time passes and farmers are able to respond.

Remembering these formula 1) Just memorize them all. We will cover many this year. 2) Remember the independent variable goes on the bottom, the dependent on top. 3) Pay attention to the name! Price elasticity of supply is Supply/Price. Income elasticity of demand is Demand/Income. Do you see the pattern? Other factors also determine the price elasticity of supply Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic.   The time period involved is very important in elasticity of supply The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example: Agriculture is a great example of the importance of time. Suppose it is July 2010 and the price of soybeans is soaring. Farmers would love to supply more soybeans at the higher price, but soybean crops have already been planted. The quantity of soybeans that will be supplied at harvest 2010 was basically determined months ago during the spring planting season. So the immediate soybean supply curve is very inelastic or nearly vertical and farmers are incapable of responding to the higher price. However, if the high prices continue in early 2011, farmers will plant more acres of soybeans next year and will supply more soybeans. So the increase in quantity supplied is greater as more time passes and farmers are able to respond.

Can you use them? In 2008, you work at a manufacturing plant in America that produces goods for home construction. The economy has just crashed. Which formula do you use to estimate your future production? No numbers, just reasons. Now you just heard that the price of steel has gone up by 6%, and you hear your competitor will reduce his manufacturing by 8%. Calculate elasticity and interpret. Because the price of steel went up, consumers preference for brick homes went up by 4%. Calculate elasticity and interpret. Other factors also determine the price elasticity of supply Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic.   The time period involved is very important in elasticity of supply The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example: Agriculture is a great example of the importance of time. Suppose it is July 2010 and the price of soybeans is soaring. Farmers would love to supply more soybeans at the higher price, but soybean crops have already been planted. The quantity of soybeans that will be supplied at harvest 2010 was basically determined months ago during the spring planting season. So the immediate soybean supply curve is very inelastic or nearly vertical and farmers are incapable of responding to the higher price. However, if the high prices continue in early 2011, farmers will plant more acres of soybeans next year and will supply more soybeans. So the increase in quantity supplied is greater as more time passes and farmers are able to respond.