F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications

FERNANDO QUIJANO, YVONN QUIJANO,

KYLE THIEL & APARNA SUBRAMANIAN

PREPARED BY:

© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez

Elasticity: A Measure of Responsiveness

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THE PRICE ELASTICITY OF DEMAND 4.1

• price elasticity of demand (Ed)A measure of the responsiveness ofthe quantity demanded to changes inprice; equal to the absolute value ofthe percentage change in quantitydemanded divided by the percentagechange in price.

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Computing Percentage Changes and Elasticities

Table 4.1COMPUTING PRICE ELASTICITY WITH INITIAL VALUES AND MIDPOINTS

Price Quantity

Data Initial $20 100

New 22 80

Price Quantity

Computation with Initial-value method

Percentage change

Price elasticity of demand

Price Quantity

Computation with Midpoint method

Percentage change

Price elasticity of demand

100 x $20

$2 %10

%100.2

20%-

100 x 100

20 %20

100 x $21

$2 %52.9 100 x

90

20 %22.22

%52.933.2

22.22%-

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Price Elasticity and the Demand Curve

Figure 4.1 shows five different demand curves, each with a different elasticity. We can divide products into five types, depending on their price elasticities of demand.

► FIGURE 4.1Elasticity and Demand Curves

• elastic demandThe price elasticity of demand is greater than one.

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► FIGURE 4.1 (cont’d.)Elasticity and Demand Curves

• inelastic demandThe price elasticity of demand is less than one.

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• unit elastic demandThe price elasticity of demand is one.

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• perfectly inelastic demandThe price elasticity of demand is zero.

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• perfectly elastic demandThe price elasticity of demand is infinite.

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THE PRICE ELASTICITY OF DEMAND 4.1Elasticity and the Availability of Substitutes

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THE PRICE ELASTICITY OF DEMAND 4.1Other Determinants of the Price Elasticity of Demand

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USING PRICE ELASTICITY TO PREDICTCHANGES IN QUANTITY 4.2

If we have values for two of the three variables in the elasticity formula, we can compute the value of the third. The three variables are:

(1)the price elasticity of demand itself,

(2)the percentage change in quantity, and

(3)the percentage change in price.

Specifically, we can rearrange the elasticity formula:

percentage change in quantity demanded = percentage change in price × Ed

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WHY YOU’LL PAY MORE IN RENT THIS YEAR

The current rental market is extremely hot with the average rent reaching $940 per month for the last quarter of 2005. Some areas such as New York City reported rents averaging $2,400 per month. In spite of these numbers, many analysts believe rent is still low in several regions. In some areas such as Ft. Lauderdale Florida, rent has climbed almost 12% in the recent months as occupancy rates approached 100% and is expected to go higher. Much of the reason for higher rents is supply related due to many apartment units being converted to condominiums. Other regions, particularly along the Gulf Coast, can thank Hurricane Katrina for the rental unit shortage. With apartments being difficult to find vacant, many owners are using the hot market to increase rents a little. Rising home prices and increasing rates also alter the picture and push a number of people back to the rental market. Houses are getting too expensive for some people to own.

A decrease in the supply of rental units will automatically push prices higher. Owners, looking to make a profit, tend to react very quickly to high occupancy rates. However, new units will no doubt soon be constructed to lessen the shortage.

Extra Application 8

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BEER TAXES AND HIGHWAY DEATHS

APPLYING THE CONCEPTS #1: How can we use the price elasticity of demand to predict the effects of taxes?

• The price elasticity of demand for beer among young adults is about 1.30.

• If a state imposes a beer tax that increases the price of beer by 10 percent, how will the price hike affect beer consumption among young adults?

Using the elasticity formula, we predict that beer consumption will decrease by 13 percent:

percentage change in quantity demanded = percentage change in price × Ed

= 10% × 1.30 = 13%

• The number of highway deaths among young adults is roughly proportional to their beer consumption, so the number of deaths will also decrease by 13 percent.

• Larger taxes would decrease beer consumption and highway deaths by larger amounts.

We can use the concept of price elasticity to predict the effects of a change in the price of beer on drinking and highway deaths among young adults.

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SUBSIDIZED MEDICAL CARE IN CÔTE D’IVOIRE AND PERU

APPLYING THE CONCEPTS #2: Does the responsiveness of consumers to changes in price vary by income?

• In Côte d’Ivoire in Africa, the price elasticity of demand for hospital services is 0.47 for poor households and 0.29 for wealthy households. A 10-percent increase in the price of hospital services would cause poor households to cut back their hospital care by:

percentage change in quantity demanded = 10% × 0.47 = 4.7%

In contrast, wealthy households would cut back by:


• In Peru, the price elasticity is 0.67 for poor households but only 0.03 for wealthy households. How would the higher price affect its poor and wealthy households?

• The poor are much more sensitive to price, so when prices increase, they experience much larger reductions in medical care.

Many developing nations subsidize medical care, charging consumers a small fraction of the cost of providing the services. If a nation were to cut its subsidies and thus increase the price of medical care for consumers, how would the higher price affect its poor and wealthy households?

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PRICE ELASTICITY AND TOTAL REVENUE 4.3

• total revenueThe money a firm generates from selling its product.

total revenue = price per unit × quantity sold

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HOW TO CUT TEEN SMOKING BY 60 PERCENT

APPLYING THE CONCEPTS #3: How can we use the price elasticity of demand to predict the effects of public policies?

• The demand for cigarettes by teenagers is elastic, with an elasticity of 1.3. Therefore, a 25-percent price hike will reduce teen smoking by only 32.5 percent, far short of the target reduction:


• About half of the decrease in consumption occurs because fewer teenagers will become smokers, and the other half occurs because each teenage smoker will smoke fewer cigarettes. To meet the target reduction of teenage smoking, the price of cigarette prices must increase by about 46 percent:

percentage change in quantity demanded = 46% × 1.3 = 60%

Under the 1997 federal tobacco settlement, if smoking by teenagers does not decline by 60 percent by the year 2007, cigarette makers will be fined $2 billion. The settlement increased cigarette prices by about 62 cents per pack, a percentage increase of about 25 percent. Will the price hike be large enough to meet the target reduction of 60 percent?

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PRICE ELASTICITY AND TOTAL REVENUE 4.3Elastic Versus Inelastic Demand

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PRICE ELASTICITY AND TOTAL REVENUE 4.3Elastic Versus Inelastic Demand

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A BUMPER CROP IS BAD NEWS FOR FARMERS

APPLYING THE CONCEPTS #4: If demand is inelastic, how does an increase in supply affect total expenditures?

The good news is that farmers will sell more bushels of soybeans. The bad news is that the increase in supply will decrease the equilibrium price of soybeans, so they will get less money per bushel. Which will be larger, the increase in quantity or the decrease in price?

• The demand for soybeans and many other agricultural products is inelastic.

• To increase the quantity demanded by 30 percent to meet the higher supply, the price must decrease by more than 30 percent.

• Consumers need a large price reduction to buy more of the product.

Suppose that favorable weather generates a “bumper crop” for soybeans that is 30 percent larger than last year’s harvest.

If the price elasticity of demand is 0.75, the price must decrease by 40 percent to increase the quantity demanded by 30 percent. To show this, we can rearrange the elasticity formula:

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ELASTICITY AND TOTAL REVENUE FORA LINEAR DEMAND CURVE 4.4

Price Elasticity Along a Linear Demand Curve

► FIGURE 4.2Elasticity and Total Revenue Along a Linear Demand Curve

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ELASTICITY AND TOTAL REVENUE FORA LINEAR DEMAND CURVE 4.4

Price Elasticity Along a Linear Demand Curve

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OTHER ELASTICITIES OF DEMAND 4.5

Income Elasticity of Demand

• income elasticity of demandA measure of the responsiveness ofdemand to changes in consumer income; equal to the percentage change in the quantity demanded divided by the percentage change in income.

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OTHER ELASTICITIES OF DEMAND 4.5

Cross-Price Elasticity of Demand

• cross-price elasticity of demandA measure of the responsiveness of demand to changes in the price of another good; equal to the percentage change in the quantity demanded of one good (X) divided by the percentage change in the price of another good (Y).

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HIGH FUEL PRICES IMPACT VACATION PLANS

Memorial Day vacation travel by automobile will be up by only 0.7 percent this year, the smallest increase in several years. A 34 percent year-to-year increase in the price of gasoline is the culprit. The AAA Travel survey also indicated that many vacationers would alter their plans to take advantage of cheaper motels, closer destinations, and/or shorter stays.

The substitution effect helps explain why the demand curve is downward sloping and to the right. As the price of gasoline increases people will alter their behavior by buying less gasoline. Part of this behavior can be explained by consumers substituting a portion of gasoline purchases. Vacation and entertainment travel happens to be a substitutable component of gasoline consumption.

Extra Application 9

• Air, bus, and train travel all expect similar slight increases in people traveling, or stable numbers.

• Airplane ticket prices are up about 10 percent and hotels have increased rates by about 5 percent.

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THE PRICE ELASTICITY OF SUPPLY 4.6

• price elasticity of supplyA measure of the responsiveness of the quantity supplied to changes in price; equal to the percentage change in quantity supplied divided by the percentage change in price.

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▼ FIGURE 4.3The Slope of the Supply Curve and Supply Elasticity

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What Determines the Price Elasticity of Supply?

The price elasticity of supply is determined by how rapidly production costs increase as the total output of the industry increases. If the marginal cost increases rapidly, the supply curve is relatively steep and the price elasticity is relatively low.

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The Role of Time: Short-Run Versus Long-Run Supply Elasticity

Time is an important factor in determining the price elasticity of supply for a product. The market supply curve is positively sloped because of two responses to an increase in price:

• Short run. A higher price encourages existing firms to increase their output by purchasing more materials and hiring more workers.

• Long run. New firms enter the market and existing firms expand their production facilities to produce more output.

The short-run response is limited because of the principle of diminishing returns.

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Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply

▼ FIGURE 4.4Perfectly Inelastic Supply and Perfectly Elastic Supply

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THE MARKET FOR RARE GUITARS

The price of rare guitars is escalating faster than most corporate stocks. A sunburst Les Paul Standard that originally sold for $265 in 1960 can now command $300,000 in pristine condition. Les Paul’s are not alone in this market. Pre-war Martin acoustic guitars and pre-1966 Fender Stratocasters have seen similar run-ups. Much of the recent price appreciation has been driven by non-musician investors attempting to cash in on the gains. However, scarcity is also to blame. For example, there were only approximately 1,700 sunburst Les Pauls ever manufactured. Many experts caution buyer beware since the astronomical prices have stimulated a heavy trade in fakes. The current estimated count of 2,200 sunburst Les Pauls illustrates this point. Where did the other 500 come from?

The known supply of rare guitars is virtually fixed. Therefore, increasing demand by collectors pushes the price rapidly higher. Even a very small shift in demand due to an increase in the number of collectors/investors results in a substantial change in the price. The opposite is also true. If investor/collectors suddenly became concerned about this market and moved into other investments (i.e. decrease in the number of potential buyers) the price could fall just as rapidly.

Extra Application 11

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Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply

• perfectly inelastic supplyThe price elasticity of supply equalszero.

• perfectly elastic supplyThe price elasticity of supply is equal to infinity.

Predicting Changes in Quantity Supplied

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OPEC’S OIL STRANGLEHOLD

The Organization of Petroleum Exporting Countries (OPEC) is considering production cutbacks to halt the falling world price of oil. However, OPEC members are also cognizant of the fact that high oil prices spur development of alternative fuel sources. Many analysts point out that this fact forces OPEC to allow prices to fall periodically so that alternative fuel projects do not become viable. However, as oil demand continues to increase, OPEC may not be able to periodically lower prices.

Since oil has a relatively inelastic short run demand, a cutback in supply results in only a very small reduction in the number of units sold but a substantial increase in price. Since the production and distribution costs will remain constant the price increase means a significant increase in profits for oil producers.

Extra Application 10

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USING ELASTICITIES TO PREDICTCHANGES IN EQUILIBRIUM PRICE 4.7

The Price Effects of a Change in Demand

► FIGURE 4.5An Increase in Demand Increases the Equilibrium Price

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The Price Effects of a Change in Demand

Under what conditions will an increase in demand cause a relatively small increase in price?

• Small increase in demand.

• Highly elastic demand.

• Highly elastic supply.

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The Price Effects of a Change in Supply

► FIGURE 4.6A Decrease in Supply Increases the Equilibrium Price

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The Price Effects of a Change in Supply

Under what conditions will a decrease in supply cause a relatively small increase in price?

• Small decrease in supply.

• Highly elastic demand.

• Highly elastic supply.

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AN IMPORT BAN AND SHOE PRICES

APPLYING THE CONCEPTS #7: How do import restrictions affect prices?

We can use the supply version of the price-change formulato predict the effects of import restrictions on equilibrium prices.Consider a nation that limits shoe imports.

• Suppose the import restrictions decrease the supply of shoes by 30 percent.

To use the price-change formula, we need the price elasticities of supply and demand.

• Suppose the supply elasticity is 2.3 and, as shown in Table 20.2, the demand elasticityis 0.70.

• Plugging these numbers into the price-change formula, we predict a 10-percent increase in price:

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F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications