ECONOMICSWhat Does It Mean To Me?

Part VI:Part VI:

Elasticity of DemandElasticity of Demand

Elasticity of SupplyElasticity of Supply

Supply, Demand, and Supply, Demand, and TaxationTaxation

READ Krugman Section 9, Modules 46, 47, 48

Mankiw Ch 5DO Morton Unit 2

•KRUGMAN'S•MICROECONOMICS for AP*

The Income Effect, Substitution Effect, and Elasticity

Margaret Ray and David Anderson

46

10Micro:

Econ:

Module

What you will learn

in this Module:• How the income and substitution effects

explain the law of demand

• The definition of elasticity, a measure of responsiveness to changes in prices or incomes

• The importance of the price elasticity of demand, which measures the responsiveness of the quantity demanded to changes in price

• How to calculate the price elasticity of demand

The Law of Demand• The substitution effect

• The income effectI

“The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.”

--Alfred Marshall, Principles of Economics

The law of demand tells us that consumers will respond to a decline in a product’s price by buying more of that

product.

But how much more of it will they But how much more of it will they purchase?purchase?

That amount can vary considerably by product and over different price ranges

for the same product.

The responsiveness, or sensitivity, of quantity demanded to a change in the price of a product is measured by the

concept of

PRICE ELASTICITY OF PRICE ELASTICITY OF DEMAND.DEMAND.

Demand for some products is such that consumers are highly responsive to price

changes; modest price changes lead to modest price changes lead to very large changes in the quantity very large changes in the quantity

purchasedpurchased, for example: restaurant meals, steak, cars.

The demand for such products is said to be

relatively elastic, or simply ELASTICELASTIC.

For other products, consumers are quite unresponsive to price changes;

substantial price changes result in substantial price changes result in only small changes in the amount only small changes in the amount purchasedpurchased, for example: salt, milk,

soap.

For such products, demand is relatively

inelastic or simply INELASTICINELASTIC.

Economist measure the degree of price elasticity or inelasticity of demand with the coefficient Ed defined as:

percentage change in quantity

demanded of product X

Ed = percentage change in price of

product X(Ed = Elasticity of demand)

These percentage changes are calculated by dividing the change in price by the original

price and the consequent change in quantity demanded by the original quantity

demanded. Thus, our definition can be restated as follows:

change in quantity demanded of X change in price

of X Ed

original quantity original price of X

demanded of X

:

Another way to state the equation would be using the Greek letter delta, ,

meaning change in…….

% Qd

(Q1 + Q2)/2

% P

(P1 + P2)/2

Ed =

Calculating Elasticity

• Calculating elasticity

– Elasticity is the % change in the dependent variable divided by the % change in the independent variable

– In symbols, elasticity is %∆dep/%∆ind

– Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price.

– In symbols: Ed = %ΔQd/ΔP note: we drop the negative sign for Ed only.

Why use percentages?Why use percentages?

Economists give two reasons:

1) Choice of Units

2) Comparing products

1) Choice of UnitsChoice of Units

If we use absolute changes, our impression of buyer responsiveness will be arbitrarily

affected by the choice of units. Using percentages avoids this problem. A particular price decline is 33 percent

whether measured in terms of dollars ($1/$3) or pennies (100 cents/300 cents).

2) Comparing productsComparing products

By using percentages, we can correctly compare consumer responsiveness to

changes in the prices of different products. It makes little sense to compare the effects on quantity demanded of (1) a $1 increase in the price of a $10,000 auto with (2) a $1 increase in the price of a $1 can of cola. Here, the price of an auto is rising by .01 percent while the price of

cola is up by 100 percent.

Elimination of Minus SignElimination of Minus Sign

We know from the downsloping demand curve that price and quantity are inversely related.

Thus, the price elasticity coefficient of demand Ed will always be a negativenegative number.

As an example, if price declines, then quantity demanded will increase. This means that the numerator

in our formula will be positive and the denominator negative, yielding a negative Ed . For an increase in

price, the numerator will be negative but the denominator positive, again yielding a negative Ed .

Economists usually ignore the minus sign and present the absolute value of the elasticity

coefficient to avoid ambiguity.

Interpretations of Ed

We can interpret the coefficient of price elasticity of demand as follows:

1) elastic demand

2) inelastic demand

3) unit elasticity

Elastic DemandElastic Demand

Demand is said to be elastic if a specific a specific percentage change in price results in a larger percentage change in price results in a larger

percentage change in quantity demandedpercentage change in quantity demanded. Then Ed > 1.

Example: If a 2 percent decline in a price results in a 4 percent increase in quantity

demanded, then demand is elasticelastic and

.04

Ed = .02 = 2

PRICE

QUANTITY

DD22

Relatively elastic demand

A small percentage change in price leads to a larger percentage change in quantity demanded.

P0

P1P

0 Q0Q1

Qd

Ed > 1

When we say demand is “elastic,” we do not mean that consumers are completely

responsive to a price change. In that extreme situation, where a small price reduction

would cause buyers to increase their purchases from zero to all they could obtain, economists say demand is perfectly elasticperfectly elastic.

You will see in later chapters that such a demand applies to a firm, for instance, a blueberry grower, selling its product in a

purely competitive market.

PRICE

QUANTITY

DD22

Perfectly elastic demand

A small percentage change in price will change quantity demanded by an infinite amount.

P0

P1P

0 Q0Q1

Qd Ed =

Inelastic DemandInelastic Demand

If a specific percentage change in price is accompanied by a smaller percentage change in quantity demanded, demand is said to be

inelastic. Then Ed < 1.

Example: If a 3 percent decline in price leads to only a 1 percent increase in quantity

demanded, demand is inelasticinelastic and

.01

Ed = .03 = .33

PRICE

QUANTITY

DD11

Relatively inelastic demand

P0

P1

P

0 Q0Q1

Qd

A change in price leads to a smaller percentage change in quantity demanded.

Ed < 1

When we say demand is “inelastic,” we do not mean that consumers are completely unresponsive to a price change. In that extreme situtation, where a price change results in no change whatsoever in the quantity demanded, economist say that

demand is perfectly inelasticperfectly inelastic.

Examples include an acute diabetic’s demand for insulin or and addict’s

demand for heroin.

PRICE

QUANTITY

DD11

Perfectly inelastic demand

P0

P1

P

0 Q0 = Q1

The quantity demanded does not change regardless of the percentage change in price.

Ed = 0

Elastic or Inelastic demand?

Unit ElasticityUnit Elasticity

The case separating elastic and inelastic demands occurs where a change in price and

the accompanying percentage change in quantity demanded are equal.

Example: A 1 percent drop in price causes a 1 percent increase in quantity demanded. This special case is termed unit elasticityunit elasticity because

Ed = 1, or unity. In this example:

.01

Ed = .01 = 1

PRICE

QUANTITY

DD11

Unit elastic demand

P0

P1

P

0 Q0Q1

Qd

The percentage change in quantity demanded is the same as the percentage change in price that caused it.

Ed = 1

PRICE

QUANTITY

DD11

P0

P1

0 Q0Q1

DD00

Q2

Relatively Relatively inelasticinelastic

Relatively Relatively elasticelastic

When a demand curve is relatively steep, such as D0 in this graph, its price

elasticity is relatively inelastic.When a demand curve is

relatively flat, such as D1, its price elasticity is relatively

elastic.

A more accurate way to calculate elasticity is

THE MIDPOINT FORMULA

The Midpoint Formula

• The problem with calculating percentage changes

• The solution: Use the Midpoint formula!

– %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity

– %ΔP = 100*(New Price – Old Price)/Average Price

– Ed = %ΔQd/ΔP

• Example

Using the midpoint formula, calculate the following:

Price Qdemanded

Apples A .90 1,100

Apples B 1.50 900

(1100-900) 200(1100+900)/2 1000

(1.50 - .90) .60(1.50 + .90)/2 1.20

=

= x

x 100

100

=

=

20

50

.4

Using the midpoint formula, calculate the following:

Price Qdemanded

Apples A .90 1,500

Apples B 1.10 900

(1500-900) 600(1500+900)/2 1000

(1.10 - .90) .20(1.10 + .90)/2 1.00

=

= x

x 100

100

=

=

60

20

3

•Available substitutes

•Proportion of income

•Luxuries vs necessities

•Time

What influences the price elasticity of demand?

Available SubstitutesAvailable Substitutes

The largerlarger the number of close substitutes, the greater the elasticitygreater the elasticity. If the price increases, consumers may

select a relatively lower-priced substitute instead.

Examples may include:

•Butter => Margarine

•Pepsi => Coca Cola

•Texaco gasoline => Hess gasoline

Proportion of Income Spent on the GoodProportion of Income Spent on the Good

The smallersmaller the proportion of income spent on a good, the lower its elasticity of lower its elasticity of

demanddemand. If the amount spent on a good relative to income is small, then the change in price on one’s income will also be small.

Example:

•100% increase in price of salt vs. 100% increase in price of an automobile.

•50% increase in price of private education vs. 50% increase in cost of textbooks.

Luxuries vs NecessitiesLuxuries vs Necessities

The demand for “necessities” tends to be price-inelastic; that for “luxuries” price-elastic. A price

increase will not significantly the amount of a necessity consumed. If the price of a luxury rises, an individual need not buy them and will suffer no great

hardship without them.

Examples (necessities):

•Bread

•Electricity

•Appendectomy

Examples (Luxuries):

•Caribbean cruise

•Emerald ring

•Lexus

The Amount of Time Since the Price The Amount of Time Since the Price ChangeChange

The moremore time that people have to adapt to a new price change, the greater its greater its

elasticity of demandelasticity of demand. Immediately after a price change, consumers may be unable to locate good alternatives or easily change

their consumption patterns.

Total-Revenue TestTotal-Revenue Test

Total revenue (TR) is the total amount the seller receives from the sale of a product; it is calculated by

multiplying the product price (P) by the quantity demanded and sold (Q). In equation form:

TR = P x Q

Total revenue and the price elasticity are related. Indeed, perhaps the easiest way to infer whether

demand is elastic or inelastic is to employ the total-revenue test, where we observe what

happens to total revenue when product price changes.

Elastic DemandElastic Demand

If demand is elastic, a decreasedecrease in price will increaseincrease total revenue. Even though

a lesser price is received per unit, enough additional units are sold to more

than make up for the lower price.

TR = P x Q

TR = P x Q

Elastic Demand and Total Revenue

P

Q

$10

$5

0 20 40 60 80 100

B

A

cb

a

At point A, total revenue is $400 ($10 x 40), or area a + b.

At point B, the total revenue is $500 ($5 x 100), or area b + c.

Total revenue has increased by $100.

We can also see in the graph that total revenue

has increased because the area b + c is greater than

area a + b, or c > a.Delastic

Inelastic DemandInelastic Demand

If demand is inelastic, a price decreasedecrease will reducereduce total revenue. The modest

increase in sales will not offset the decline in revenue per unit, and the net

result is that total revenue declines.

TR = P x Q

TR = P x Q

Inelastic Demand and Total Revenue

P

Q

$10

$5

0 10 20 30 40

B

A

cb

a

At point A, total revenue is $300 ($10 x 30), or area a + b.

At point B, the total revenue is $200 ($5 x 40), or area b + c.

Total revenue has decreased by $100.

We can also see in the graph that total revenue has decreased because the area a + b is greater than area b + c, or a > c.Dinelastic

APPLICATIONS OF APPLICATIONS OF PRICE ELASTICITY PRICE ELASTICITY

OF DEMANDOF DEMAND

1) Bumper Crops1) Bumper Crops

Increases in the output of most Increases in the output of most farm products arising from a farm products arising from a

good growing season or good growing season or increase in productivity will increase in productivity will

cause to decrease both the farm cause to decrease both the farm products and the total revenues products and the total revenues

(or incomes) of farmers.(or incomes) of farmers.

2) Automation2) Automation

The impact of technological advances on The impact of technological advances on employment depends in part on the elasticity of employment depends in part on the elasticity of

demand for the product or service that is involved. demand for the product or service that is involved. If a firm installs technology that replaces 1000 If a firm installs technology that replaces 1000

workers, who are then laid off, the savings from workers, who are then laid off, the savings from the cost reduction could be passed on to the cost reduction could be passed on to

consumers. The effect of the price reduction on consumers. The effect of the price reduction on sales will depend on the elasticity of the product. sales will depend on the elasticity of the product. An elastic demand could increase sales to a point An elastic demand could increase sales to a point where some of the workers might be rehired. An where some of the workers might be rehired. An

inelastic demand will result in only minimal inelastic demand will result in only minimal increase in sales.increase in sales.

3) Airline Deregulation3) Airline Deregulation

In the 1970s, deregulating the airlines caused In the 1970s, deregulating the airlines caused increased profits for the carriers in the short increased profits for the carriers in the short term, because it increased price competition term, because it increased price competition

among the airlines, thus lowering airfares. Lower among the airlines, thus lowering airfares. Lower fares, and an elastic demand for air travel, fares, and an elastic demand for air travel,

increased revenues. Filling the airplanes to increased revenues. Filling the airplanes to capacity increased revenues more than the costs capacity increased revenues more than the costs

and increased profits.and increased profits.

Profits did not last, however, because of rising Profits did not last, however, because of rising fuel prices, persistent fare wars, and the entry of fuel prices, persistent fare wars, and the entry of

competitors on profitable routes.competitors on profitable routes.

4) Excise Taxes4) Excise Taxes

The government selects certain goods and The government selects certain goods and services with which to levy excise taxes by services with which to levy excise taxes by

paying attention to elasticity of demand. If a $1 paying attention to elasticity of demand. If a $1 tax is levied on a product and 10,000 units are tax is levied on a product and 10,000 units are

sold, tax revenue will be $10,000. If sold, tax revenue will be $10,000. If government then raises the tax to $1.50 and the government then raises the tax to $1.50 and the consequent higher price reduces sales to 5000, consequent higher price reduces sales to 5000, tax revenue will tax revenue will declinedecline to $7500. A higher tax to $7500. A higher tax

on a product with an elastic demand will on a product with an elastic demand will reduce revenue, therefore, governments seek reduce revenue, therefore, governments seek

products with inelastic demands, such as products with inelastic demands, such as liquor, gasoline and cigarettes.liquor, gasoline and cigarettes.

5) Drugs and Street Crime5) Drugs and Street CrimeIs an addict’s demand for crack cocaine and heroin highly elastic? This belief is typically used by law enforcement to reduce supply by intercepting drug

shipments. If this is true, then the street price to addicts will rise sharply while amounts purchased will decrease slightly. This will result in greater revenues for drug dealers. Because the income of the addict

comes from crime, it may be true that restricting supply of drugs actually causes crime.

Proponents of drug legalization contend that drugs should be treated like alcohol because the war on drugs has been unsuccessful and the associated costs are too

great.

Clip

Price of Drugs

Price of Drugs

Quantity of Drugs

Quantity of Drugs

D

S1

S2

Q1Q2

P1

P2

If the demand for drugs is inelastic then drug “busts” reduce the supply of drugs,which raises the price,and reduces quantity supplied.

Price of Drugs

Price of Drugs

Quantity of Drugs

Quantity of Drugs

D

S1

S2

Q1Q2

P1

P2

Another option is drug education, which reduces demand, which lowers the price,and reduces quantity supplied.

S

D1D2

P1

P2

Q1Q2

6) Minimum Wage6) Minimum WageCritics say that a minimum wage, if it is above the

equilibrium market wage, moves employers upward along their downsloping labor demand curves toward lower

quantities of labor demanded, thus causing unemployment--especially among teenage workers.

Conversely, workers who remain employed received higher incomes with a minimum wage than otherwise.

Research suggests that the demand for teenage labor is inelastic, with Ed possibly as low as 0.15 or 0.25. If

correct, this means income gains associated with the minimum wage exceed income losses. The argument

would be stronger if the demand for teenage workers were elastic.

$5

$4

$3

$2

$1

Labor0 1 2 3 4 5 6 7 8 9 10

S

D

E

When the government mandates a the minimum price When the government mandates a the minimum price of something, it is called a of something, it is called a PRICE FLOORPRICE FLOOR and it keeps and it keeps the market from reaching equilibrium.the market from reaching equilibrium.

The demand for labor diminisheswhile the supply of labor increasescausing a surplus.

Elasticity of Supply

The PRICE ELASTICITY OF SUPPLY measures how

much the quantity supplied responds to changes in

price.

PRICE

QUANTITY

SS22

Relatively elastic supply

A small percentage change in price leads to a larger percentage change in quantity supplied.

P0

P1

P

0 Q0Q1

Qd

Ed > 1

Supply is said to be elastic if the quantity supplied responds substantially to changes in price.

PRICE

QUANTITY

SS22

Relatively inelastic supply

A small percentage change in price leads to a

smaller percentage change in quantity

supplied.P0

P1

P

0 Q0Q1

Qd

Ed < 1

Supply is said to be inelastic if the quantity supplied responds slightly to changes in price.

Elasticity of Supply is dependant upon the Elasticity of Supply is dependant upon the sellers’ flexibility in changing the amount they sellers’ flexibility in changing the amount they

produce.produce.

For example: Beachfront property in Florida has an inelasticinelastic supply because we

cannot produce more of it.

Manufactured goods such as microwave ovens, televisions, and cars are elasticelastic

because the producers can easily adjust production of a good more or less.

How do government

policies (taxes) affect

market outcomes?

When a tax on tea is levied on consumers, the sellers will share part of the tax burden.

PRICE

QUANTITY

SS

P0

P1

0 Q0Q1

P2

E w/o tax

D0

D1

P0 is the equilibrium price WITHOUT the tax.

P1 is the price sellers will receive.

P2 is the price consumers will pay.

($2.50)

($2.20)

($2.00)

($.50)

($.50)

$5

$4

$3

$2

$1

Qlabor0 1 2 3 4 5 6 7 8 9 10

Slabo

r

Dlabor

E

Plabor

A payroll tax puts a wedge between the price that workers receive and the amount producers pay.

$5

$4

$3

$2

$1

Q0 1 2 3 4 5 6 7 8 9 10

S

D

E

P

When supply is more elastic than demand, the burden of the tax falls primarily on consumers.

Pw/o tax

Pconsumers pay

Pproducers receive

In the late 1980s, Governor Martinez of Florida placed a tax on

luxury items in the State of Florida. Why was this tax repealed a few

years later??

$5

$4

$3

$2

$1

Q0 1 2 3 4 5 6 7 8 9 10

S

DE

P

When demand is more elastic than supply, the burden of the tax falls primarily on producers.

Pw/o tax

Pconsumers pay

Pproducers receive

Project by:Project by:

Virginia H. MeachumVirginia H. Meachum

Coral Springs High SchoolCoral Springs High School

Sources:Sources:

Principles, Problems, and PoliciesPrinciples, Problems, and Policies, by Campbell McConnell & , by Campbell McConnell & Stanley BrueStanley Brue

Principles of EconomicsPrinciples of Economics, by N. Gregory Mankiw, by N. Gregory Mankiw

Economics For AP, by Paul Krugman, Robin Wells, David Anderson, Margaret Ray

Notes by Florida Council on Economic Education and FAU Notes by Florida Council on Economic Education and FAU Center for Economic EducationCenter for Economic Education

Notes by Foundation for Teaching EconomicsNotes by Foundation for Teaching Economics