© 2005 thomson c hapter 4 elasticity. © 2005 thomson 2 gottheil - principles of economics, 4e...

© 2005 Thomson

CChapter 4hapter 4

ElasticityElasticity

2

© 2005 Thomson

Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

Demand sensitivity

Determinants of demand Sensitivity to price changes

Price elasticity of demand

Cross elasticity

3

© 2005 Thomson


Economic PrinciplesEconomic Principles

Substitute and complementarygoods

Normal and inferior goods

Supply elasticity

Relationship between price Elasticity of supply and tax revenues

4

© 2005 Thomson

EXHIBIT 1A DEMAND RESPONSE TO PRICE CHANGE

5

© 2005 Thomson

EXHIBIT 1B DEMAND RESPONSE TO PRICE CHANGE

6

© 2005 Thomson

EXHIBIT 1C DEMAND RESPONSE TO PRICE CHANGE

7

© 2005 Thomson


Exhibit 1: Demand Exhibit 1: Demand Response to Price Response to Price

ChangeChange1. The demand curve in panel a can be described as:

• Vertical

8

© 2005 Thomson



ChangeChangeThe demand curve is vertical in panel a because:

• The demand for penicillin doesn’t change –regardless of what price is charged.

9

© 2005 Thomson



ChangeChangeThe demand curve in panel b can be described as:

• Fairly steep

10

© 2005 Thomson



ChangeChangeThe demand curve in panel b compares to the demand curve in panel c:• The demand curve in panel b is steeper than in panel c.

11

© 2005 Thomson



ChangeChangeThis tells us that the demand response for spark plugs versus Coca-Cola:• When price is cut, the demand response for Coca-Cola is greater than the demand response for spark plugs.

12

© 2005 Thomson


Demand SensitivityDemand Sensitivity

Demand Sensitivity

• Demand sensitivity describes how consumer demand reacts to changes in price.

• High sensitivity: a given change in price will result in a large change in quantity demanded.

• Low sensitivity, or insensitivity: a given change in price will result in little or no change in quantity demanded.

13

© 2005 Thomson


EXHIBIT 2 MARKET DEMAND FOR COCA-COLA AND SPARK PLUGS

14

© 2005 Thomson


Exhibit 2: Market Exhibit 2: Market Demand for Coca-Demand for Coca-

Cola and Spark PlugsCola and Spark PlugsIn Exhibit 2, which demand curve, Panel a or b, has a steeper slope?• Panel a, the demand for Coca-Cola, has a steeper slope.

15

© 2005 Thomson


Exhibit 2: Market Exhibit 2: Market Demand for Coca-Demand for Coca-

Cola and Spark PlugsCola and Spark PlugsWhich panel depicts high demand sensitivity?• Panel a depicts high demand sensitivity.

• A decrease in the price of Coca-Cola results in a large increase in quantity demanded.• The slope of the demand curve is steep.

16

© 2005 Thomson


What Factors What Factors Influence Demand Influence Demand

Sensitivity?Sensitivity?All else equal, the demand for low-priced goods is less elastic than high-priced goods.• When something is inexpensive people are less price sensitive.

17

© 2005 Thomson



Sensitivity?Sensitivity?The elasticity of demand for poor people is larger than for rich people.• Poor people are more sensitive to price changes than rich people.

18

© 2005 Thomson



Sensitivity?Sensitivity?The price elasticity of demand for basic goods (necessities) is not larger than for less essential goods.

• There are fewer substitutes for basic goods (such as bread, electricity, or gasoline) than for less essential goods (such as slices of pizza or specific brands of running shoes).

19

© 2005 Thomson



Sensitivity?Sensitivity?A product used as a compliment with an essential good will have the elasticity characteristics of the essential good.• If something is used in conjunction with an essential good, then consumption will not decline very much if price rises.

20

© 2005 Thomson



Sensitivity?Sensitivity?In which of the following situations will the price elasticity of demand be largest:• When people have a brief period of time to adjust

• When people have a long time period to adjust.

21

© 2005 Thomson



Sensitivity?Sensitivity?In which of the following situations will the price elasticity of demand be largest:• When people have a brief period of time to adjust

•When people have a long time period to adjust.

22

© 2005 Thomson


From Sensitivity to From Sensitivity to ElasticityElasticity

The price elasticity of demand is not the same thing as the slope of the demand curve.• The slope of the demand curve will differ based on the units used to measure price and quantity.

23

© 2005 Thomson



The price elasticity of demand is not the same thing as the slope of the demand curve.• We want a measure of sensitivity that will be the same regardless of the units used to measure price and quantity.

24

© 2005 Thomson



The price elasticity of demand is not the same thing as the slope of the demand curve.• Price elasticity of demand is the percent change in quantity demanded divided by the percentage change in price.

25

© 2005 Thomson



Formula for computing the price elasticity of demand:

• ed = (Q2 - Q1)/[(Q2 + Q1)/2] divided by(P2 - P1)/[(P2 + P1)/2]

EXHIBIT 3APRICE ELASTICITIES OF DEMAND FOR FOOTBALL TICKETS AND MILK

26

© 2005 Thomson

EXHIBIT 3BPRICE ELASTICITIES OF DEMAND FOR FOOTBALL TICKETS AND MILK

27

© 2005 Thomson

28

© 2005 Thomson


Exhibit 3: Price Elasticities Exhibit 3: Price Elasticities of Demand for Football of Demand for Football

Tickets and MilkTickets and Milk

In Exhibit 3, elasticity of demand for football tickets within the $4 to $3 price range is 3.5. This means:• A price elasticity of 3.5 means that a 1 percent change in price generates a 3.5 percent change in quantity demanded.

29

© 2005 Thomson




• Elasticities greater than 1.0 are price elastic.

In Exhibit 3, elasticity of demand for football tickets within the $4 to $3 price range is 3.5. This means:

30

© 2005 Thomson




In the $2 to $1 price range, elasticity of demand for football tickets falls to 0.5. This means:• A 0.5 price elasticity means that a 1 percent change in price generates a 0.5 percent change in quantity demanded.

31

© 2005 Thomson




In the $2 to $1 price range, elasticity of demand for football tickets falls to 0.5. This means:• Elasticities less than 1.0 are price inelastic.

32

© 2005 Thomson




When the price of football tickets rises from $1 to $2, quantity demanded falls from 700 to 500. The price elasticity of demand is:

• (Q2 - Q1)/[(Q2 + Q1)/2] = (700 - 500)/[(700 + 500)/2] = 1/3.

33

© 2005 Thomson





• (P2 - P1)/[(P2 + P1)/2] = (2 - 1)/[(2 + 1)/2] = 2/3

34

© 2005 Thomson





• ed = (1/3)/(2/3) = 1/2.

35

© 2005 Thomson


EXHIBIT 4 ELASTICITIES, PRICE, AND REVENUE CHANGES

36

© 2005 Thomson


Exhibit 4: Elasticities, Exhibit 4: Elasticities, Price, and Revenue Price, and Revenue

ChangesChangesIf demand is price inelastic and price goes down, total revenue decreases.• When demand is price inelastic, the increase in quantity is less than proportionate to the decrease in price.

• Price falls more than quantity increases and total revenue decreases.

37

© 2005 Thomson


Cross ElasticityCross Elasticity

Cross elasticity of demand

• It is the ratio of a percentage change in quantity demand of one good to a percentage change in the price of another good.

38

© 2005 Thomson


EXHIBIT 5 PRICE ELASTICITIES OF DEMAND FOR SELECTED GOODS

Source: Edward Mansfield, Microeconomics (New York: W. W. Norton, 1997); Robert Hall and Mark Lieberman, Economics (Cincinnati: South-Western College Publishing, 1998); Gary Brester and Michael Wohlgenant, “Estimating Interrelated Demands for Meat Using New Measures for Ground and Table Cut Beef,” American Journal of Agricultural Economics (November 1991); and Heinz Kohler, Intermediate Economics: Theory and Applications (new York: Scott, Foresman, 1986).

39

© 2005 Thomson


Exhibit 5: Price Exhibit 5: Price Elasticities of Demand for Elasticities of Demand for

Selected GoodsSelected GoodsWhich of the following has the largest price elasticity of demand?

• Corn

• Cigarettes

• Movies

40

© 2005 Thomson


Exhibit 5: Price Exhibit 5: Price Elasticities of Demand for Elasticities of Demand for

Selected GoodsSelected GoodsWhich of the following has the largest price elasticity of demand?

• Corn

• Cigarettes

• Movies

41

© 2005 Thomson


EXHIBIT 6 PRICE ELASTICITIES OF DEMAND IN THE SHORT RUN AND LONG RUN

Source: H. S. Houthakker and Lester Taylor, Consumer Demand in the United States, 1929–1970 (Cambridge, Mass.: Harvard University Press, 1970); Richard Voith, “The Long-Run Elasticity of Demand for Commuter Rail Transportation,” Journal of Urban Economics (November 1991); and James Griffen and Henry Steele, Energy Economics and Policy (New York: Academic Press, 1980).

42

© 2005 Thomson


Exhibit 6: Price Elasticities Exhibit 6: Price Elasticities of Demand in the Short Run of Demand in the Short Run

and Long Runand Long Run

Which of the following has the smallest price elasticity of demand in the long run?• Gasoline

• Jewelry and watches

• Hospital care

43

© 2005 Thomson


Exhibit 6: Price Elasticities Exhibit 6: Price Elasticities of Demand in the Short Run of Demand in the Short Run

and Long Runand Long Run

Which of the following has the smallest price elasticity of demand in the long run?

• Gasoline

• Jewelry and watches

•Hospital care

44

© 2005 Thomson


EXHIBIT 7 CROSS ELASTICITIES BETWEEN SUBSTITUTES

45

© 2005 Thomson


Exhibit 7: Cross Exhibit 7: Cross Elasticities Between Elasticities Between

SubstitutesSubstitutesIn Exhibit 7, the demand for Tums increase when the price of Rolaids increased because:• Tums and Rolaids are substitute goods— goods that can replace each other.

• When the price of Rolaids increases, some consumers are willing to switch to a cheaper substitute—Tums.

46

© 2005 Thomson


SubstitutesSubstitutes

• Cross elasticities for substitute goods are positive.

• A decrease (or increase) in the price of one good generates a corresponding decrease (or a corresponding increase) in the quantity demanded of the other.

In Exhibit 7, the demand for Tums increase when the price of Rolaids increased because:

47

© 2005 Thomson


EXHIBIT 8 CROSS ELASTICITIES OF DEMAND FOR SUBSTITUTE GOODS

Source: Edwin Mansfield, Microeconomics (New York: W. W. Norton, 1997); F. Gasmi, J. J. Laffont, and Q. Vuong, “Econometric Analysis of Collusive Behavior in a Soft Drink Market,” Journal of Economics and Management Strategy (Summer 1992); and Gary Brester and Michael Wohlgenant, “Estimating Interrelated Demands for Meats Using New Measures for Ground and Table Cut Beef,” American Journal of Agricultural Economics (November 1991).

48

© 2005 Thomson


Exhibit 8: Cross Exhibit 8: Cross Elasticities of Demand for Elasticities of Demand for

Substitute GoodsSubstitute GoodsWhich of the following are the closest substitutes, according to Exhibit 8:• Butter and margarine

• Poultry and ground beef

• Natural gas and electricity

49

© 2005 Thomson



Substitute GoodsSubstitute GoodsWhich of the following are the closest substitutes, according to Exhibit 8:• Butter and margarine

• Poultry and ground beef

• Natural gas and electricity

50

© 2005 Thomson



Substitute GoodsSubstitute GoodsButter and margarine the closest substitutes because:• They have the largest cross elasticity of demand.

53

© 2005 Thomson



ComplementsComplementsWhen the price of flights decreases, the demand for hotel rooms:

• The demand for hotel rooms will increase, because people fly more and need more hotel rooms.

54

© 2005 Thomson


Income ElasticityIncome Elasticity

Income elasticity

• It is the ratio of the percentage change in quantity demanded to the percentage change in income.

55

© 2005 Thomson


Income elasticity

• A good is considered income elastic when a 1 percent change in income generates a greater than 1 percent change in quantity demanded.


56

© 2005 Thomson



Income elasticity

• A good is considered income inelastic when a 1 percent change in income generates a less than 1 percent change in quantity demanded.

58

© 2005 Thomson


Exhibit 10: Air TravelExhibit 10: Air TravelThe demand curve in Exhibit 10 shift from Dy to D′y even though price remains constant because:

• In Exhibit 10, the demand for air travel is income elastic. As income increases, the demand for flights increases, even though the price of flights remains unchanged.

59

© 2005 Thomson


EXHIBIT 11 INCOME ELASTICITIES OF DEMAND

Source: Edwin Mansfield, Microeconomics (New York: W. W. Norton, 1997); and F. Chalemaker, “Rational Addictive Behavior and Cigarette Smoking,” Journal of Political Economy (August 1991).

60

© 2005 Thomson


Exhibit 11: Income Exhibit 11: Income Elasticities Elasticities of Demandof Demand

The income elasticity of demand for electricity so much lower than for furniture because: • Electricity is a necessity, while furniture is a luxury.

61

© 2005 Thomson


EXHIBIT 12 COMPARISON OF INCOME ELASTICITIES OF DEMAND FOR FOOD, BY COUNTRY

Source: Ching-Fun and James Peale Jr., “Income and Price Elasticities,” in Advances in Econometrics Supplement, ed. Henri Thell (Greenwich, Conn.: JAI Press, 1989); and Y. Wu, E. Li, and S. N. Samuel, “Food Consumption in Urban China: An Empirical Analysis,” Applied Economics (June 1995).

62

© 2005 Thomson


Exhibit 12: Comparison of Exhibit 12: Comparison of Income Elasticities of Demand Income Elasticities of Demand

for Food, by Countryfor Food, by CountryThe type of countries which tend to have the lowest income elasticity for food are:

• Industrialized countries

66

© 2005 Thomson


Exhibit 13: Elasticities Exhibit 13: Elasticities of Supplyof Supply

• Panel a depicts the market-day supply curve.• At any price suppliers are unable to adjust supply.• The price elasticity of supply is 0.

In Exhibit 13, the different supply curves have different price elasticities because:

67

© 2005 Thomson

• Panel b depicts the short-run supply curve.

• Suppliers are willing, but not able, to meet all the demand.• Suppliers can only increase production with existing capacity.

• Price elasticity is 0.47.



68

© 2005 Thomson


• Panel c depicts the long-run supply curve.

• Suppliers encounter no obstacles in adjusting quantity supplied to price.

• The price elasticity is 1.64.



71

© 2005 Thomson


Exhibit 14: What Gets Exhibit 14: What Gets TaxedTaxed

• Inelastic.

• Quantity will not decline very much when the tax raises the price of the product.

If government imposes a per unit tax, the type of demand (elastic or inelastic) which will generate the most revenue is:

© 2005 thomson c hapter 4 elasticity. © 2005 thomson 2 gottheil - principles of economics, 4e...

Documents

demand curve

market demand

consumer demand

price change slide

high demand sensitivity

gottheil principles

e exhibit

price sensitive