Do People Respond to Changes in the Price of Gasoline? During May 2010, the average price of gasoline had been $2.79 per gallon. During May 2011, the average price of gasoline was $3.76, U.S. consumers bought about 5 percent less gasoline than they had bought. Consumers found ways to cut back the quantity of gasoline they purchased.

Price Elasticity of demand % Change in quantity demanded the responsiveness of the amount purchased to a change in price. Price Elasticity of demand = % Change in quantity demanded % Change in Price = % Q % P - or put more simply - ( Q - Q ) ( P - P ) ( Q - Q ) P = 1 1 = 1 X Q P - Q ( P P ) 1 PED > 1 Elastic < 1 Inelastic = 1 Unit Elastic

Different Elasticities Price Quantity/ time Perfectly inelastic: An increase in Price results in no change in Quantity Mythical demand curve (b) Price Quantity/ time Relatively inelastic: A percent increase in Price results in a smaller % reduction in Quantity Demand for Cigarettes

(c) Price Quantity/ time Unitary elasticity: The percent change in quantity demanded due to an increase in price is equal to the % change in price. Demand curve of unitary elasticity = 1

Elasticity of Demand (d) Price Quantity/ time Relatively elastic: A % increase in Price leads to a larger % reduction in Quantity. Demand for Granny Smith Apples (e) Price Quantity/ time Perfectly elastic: Consumers will buy all of Farmer Hollings’s wheat at the market price, but none will be sold above the market price. Demand for Farmer Hollings’s wheat

Price Elasticity of demand % Change in quantity demanded Mid Points Formula Price Elasticity of demand = % Change in quantity demanded % Change in Price = % Q % P - But use average Q and average P - = =

For Example: ___ Quan 1 100 20 12 150 45 32 Price 1 5 8 3 12 6 24 (P1+P2)/2 Ch in P ___ Quan 1 100 20 12 150 45 32 Price 1 5 8 3 12 6 24 Quan 2 120 25 16 200 45 40 Price 2 3 7 10 8 2 Ch in Q (Q1+Q2)/2 ___ X ___ 20/110 4/2 = 4/11 5/22.5 7.5/1 5/3 4/14 1.5/3 1/7 50/175 11/2 11/7 0/45 7/2 8/36 13/22 13/99

2. Necessity vs Luxury 4. Time to shop around Elasticity What affects Elasticity??? 1. Available Substitutes 2. Necessity vs Luxury 3. Proportion of Income 4. Time to shop around

Some Estimated Price Elasticities of Demand Product Estimated Elasticity Books (Barnes & Noble) −4.00 Bread −0.40 Books (Amazon) −0.60 Water (residential use) −0.38 DVDs (Amazon) −3.10 Chicken −0.37 Post Raisin Bran −2.50 Cocaine −0.28 Automobiles −1.95 Cigarettes −0.25 Tide (liquid detergent) −3.92 Beer −0.23 Coca-Cola −1.22 Residential natural gas −0.09 Grapes −1.18 Gasoline −0.06 Restaurant meals −0.67 Milk −0.04 Health insurance (low-income households) −0.65 Sugar

More Estimated Price Elasticities of Demand Goods and Services Elasticity Housing 0.12 Transatlantic air travel (economy class) 0.12 Rail transit (rush hour) 0.15 Electricity 0.20 Taxi cabs 0.22 Gasoline 0.35 Transatlantic air travel (first class) 0.40 Wine 0.55 Beef 0.59 Transatlantic air travel (business class) 0.62 Kitchen and household appliances 0.63

More Estimated Price Elasticities of Demand Goods and Services Elasticity Cable TV (basic rural) 0.69 Chicken 0.64 Soft drinks 0.70 Beer 0.80 New vehicle 0.87 Rail transit (off-peak) 1.00 Computer 1.44 Cable TV (basic urban) 1.51 Cable TV (premium) 1.77 Restaurant meals 2.27

The Price Elasticity of Demand for Breakfast Cereal Post Raisin Bran −2.5 All family breakfast cereals −1.8 All types of breakfast cereals −0.9 The price elasticity for a particular brand of raisin bran was larger in absolute value than the elasticity for all family cereals, and the elasticity for all family cereals was larger than the elasticity for all types of breakfast cereals. MIT economist Jerry Hausman

The Relationship between Price Elasticity and Total Revenue When demand is inelastic, a cut in price will decrease total revenue. At point A total revenue = $4,000. At point B, total revenue falls to $3.70 × 1,050 gallons, or $3,885.

If demand is ... then ... elastic P↑ TR↓ P↓ TR↑ inelastic P↑TR↑ P↓TR↓ unit elastic P↑TR→ P↓TR→

Elasticity and Revenue with a Linear Demand Curve Elasticity Is Not Constant along a Linear Demand Curve

Elasticity and Total Revenue ___ Quan 1 2 3 4 5 6 7 8 Price 8 7 6 5 4 X =

Elasticity and 3D TVs 3D televisions were introduced in the U.S. in early 2010, Sony believed that sales would be strong despite prices being several hundred dollars higher than for other high-end ultra-thin televisions. Demand turned out to be more elastic than expected, and by December firms were cutting prices 40 percent or more in an effort to increase revenue. The price elasticity of demand for 3D televisions was higher than Sony had expected.

Time and the Elasticity of Demand for Resources Resource price With time, the demand for a resource becomes more elastic (Dsr Dlr): Dlr the easier it is to switch to substitute inputs, and/or, the more elastic the demand for the products the resource helps to produce. C B P2 The long-run demand for a resource is almost always more elastic than demand in the short-run. A P1 Dsr Q3 Q2 Q1 Quantity

Income Elasticity of demand % Change in quantity demanded the responsiveness of a product’s demand to a change in income. Income Elasticity of demand = % Change in quantity demanded % Change in Income A normal good has a positive income elasticity of demand. As income increases, the demand for normal goods increases. Goods with a negative income elasticity are inferior goods. As income expands, the demand for inferior goods will decline.

Income Elasticity of Demand Low Income Elasticity - 0.20 0.38 Fuel 0.20 Electricity 0.46 Fish (haddock) 0.51 Food 0.64 Tobacco 0.69 Hospital care Margarine High Income Elasticity 2.46 Private education 2.45 New Cars 1.57 Recreation and amusements 1.54 Alcohol

Cross Price Elasticity the responsiveness of a product’s demand to a change in the price of another good. Cross Price Elasticity = % Change in Qx % Change in Py A complement has a negative cross price elasticity. As Py increases, the demand for Y decreases, and demand for goods that are consumed with Y also decreases. A substitute has a positive cross price elasticity As Py increases, the demand for Y decreases, and demand for goods that can be consumed instead of Y also decreases.

Price Elasticity, Cross-Price Elasticity, and Income Elasticity in the Market for Alcoholic Beverages Price elasticity of demand for beer −0.23 Cross-price elasticity of demand between beer and wine 0.31 Cross-price elasticity of demand between beer and spirits 0.15 Income elasticity of demand for beer −0.09 Income elasticity of demand for wine 5.03 Income elasticity of demand for spirits 1.21 The demand for beer, an inferior good, is inelastic. Both wine and spirits are categorized as luxuries because their income elasticities are greater than 1.

a. Market Period c. Long Run Elasticity What affects Supply Elasticity??? 1. Time a. Market Period b. Short Run c. Long Run

Supply Elasticities

Supply Elasticities

Supply Elasticities

Time and Resource Supply Elasticity The supply of CPA services for example Resource price Quantity S If CPA wages increase from P1 to P2, the short-run response will be an increase in CPA services from Q1 to Q2. Some CPAs work more and some come out of retirement. Slr B C P2 Given time, supply of the resource (CPAs) becomes more elastic. (Ssr Slr) as more individuals choose this field of training. A P1 At the higher wage P2, Q3 CPA services are supplied to the market. The long-run supply of a resource is almost always more elastic than short-run supply. Q1 Q2 Q3

Price Elasticity of Demand Table 6.7 Summary of Elasticities Price Elasticity of Demand Absolute Value of Price Elasticity Effect on Total Revenue of an Increase in Price Elastic Greater than 1 Total revenue falls Inelastic Less than 1 Total revenue rises Unit elastic Equal to 1 Total revenue unchanged

Cross-Price Elasticity of Demand Table 6.7 Summary of Elasticities Cross-Price Elasticity of Demand Types of Products Value of Cross-Price Elasticity Substitutes Positive Complements Negative Unrelated Zero Income Elasticity of Demand Types of Products Value of Income Elasticity Normal and a necessity Positive but less than 1 Normal and a luxury Positive and greater than 1 Inferior Negative

Price Elasticity of Supply Table 6.7 Summary of Elasticities Price Elasticity of Supply Value of Price Elasticity Elastic Greater than 1 Inelastic Less than 1 Unit elastic Equal to 1

Elasticity and Incidence of a Tax The actual burden of a tax depends on the elasticity of supply and demand. As supply becomes more inelastic, then more of the burden will fall on sellers. As demand becomes more inelastic, then more of the burden will fall on buyers.

Tax Burden and Elasticity Consider the market for Gasoline and Luxury Boats individually. Price Gasoline market S plus tax $1.65 We begin in equilibrium. S $1.60 If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week. $1.55 $1.50 $1.45 D Quantity (millions of gallons) If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units. 194 200 Price (thousand $) S plus tax Luxury boat market 110 S In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax. 100 90 D In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden. 80 Quantity (thousands of boats) 5 10 15 20

And the Drug Problem Elasticity Inelastic Demand - necessity Price Supply P1 Demand Q1 Quantity

Change supply: Q then P or Q then P Elasticity Price Supply P2 P1 P3 eradication decrease P2 increase P1 legalization P3 Inelastic Demand Q2 Q1 Q3 Quantity

If Sarah’s income rises by 20 percent, and, as a result, she purchases 40 percent more designer clothing, her income elasticity for designer clothing is a. 0.5. b. 1.0. c. 2.0. d. seriously distorted. Suppose the state of New York imposes a one dollar per pack tax on cigarettes, which increases their price by 30 percent, and as a result, the quantity sold declines by 20 percent. The price elasticity of demand for cigarettes is equal to a. –0.20. b. –0.67. c. –1.50. d. –3.00.

b. of unitary elasticity. c. inelastic. d. equal to 0.5. Studies indicate that the demand for fresh tomatoes is much more elastic than the demand for salt. These findings reflect that a. tomatoes are a necessity while salt is a luxury. b. it takes longer for consumers to adjust to a change in the price of salt than to a change in the price of tomatoes. c. salt will not spoil as easily as fresh tomatoes. d. more good substitutes exist for fresh tomatoes than for salt. If a Krispy Kreme doughnut shop near campus increases its prices by 5 %, but revenues from its sales are unchanged, the price elasticity of demand for the services offered by the doughnut shop must be a. elastic. b. of unitary elasticity. c. inelastic. d. equal to 0.5.

If the price of gasoline goes up, and Dan now buys fewer candy bars because he has to spend more on gas, this would best be explained by a. the substitution effect. b. the income effect. c. the highly elastic demand for gasoline. d. weight watchers effect.

Which of the following is true for this demand curve? a. An increase in price from $2 to $3 will reduce total expenditures on the product. b. In the $2 to $3 range, the price elasticity of the demand curve is approximately unitary. c. At a price of $2, the price elasticity of the demand curve equals approximately –2.5. d. In the $2 to $3 range, the demand curve is inelastic.