A. Law of demand
tells us that consumers will respond to a price decrease by buying
more of a product (other things remaining constant), but it does not
tell us how much more.
B. Elasticity of
demand measures how much the quantity demanded changes with a given
change in price of the item, change in consumers’ income, or change
in price of related product.
C The degree of
responsiveness or sensitivity of consumers to a change in price is
measured by the concept of price elasticity of demand.
1. If consumers
are relatively responsive to price changes, demand is said to be
elastic.
2. If consumers
are relatively unresponsive to price changes, demand is said to
be inelastic.
3. Note that
with both elastic and inelastic demand, consumers behave
according to the law of demand; that is, they are responsive to
price changes. The terms elastic or inelastic describe the
degree of responsiveness. A precise definition of what we mean
by “responsive” or “unresponsive” follows.
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CONSIDER THIS …
A Bit of a Stretch
-
The Ace bandage stretches a lot when
force is applied (elastic); the rubber tie-down (not to
be confused with a rubber band) moves stretches little
when force is applied (inelastic).
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D. Price elasticity
coefficient and formula:
Quantitative
measure of elasticity, Ed
= percentage change in quantity/ percentage change in price.
1. Using two
price-quantity combinations of a demand schedule, calculate the
percentage change in quantity by dividing the absolute change in
quantity by one of the two original quantities. Then calculate
the percentage change in price by dividing the absolute change
in price by one of the two original prices.
2. Estimate the
elasticity of this region of the demand schedule by comparing
the percentage change in quantity and the percentage change in
price. Do not use the ratio formula at this time. Emphasize
that it is the two percentage changes that are being compared
when determining elasticity.
3. Show that if
the other original quantity and price were used as the
denominator that the percentage changes would be different.
Explain that a way to deal with this problem is to use the
average of the two quantities and the average of the two prices.
4. Using
averages – the midpoint formula
a. Using
traditional calculations, the measured elasticity over a
given range of prices is sensitive to whether one starts at
the higher price and goes down, or the lower price and goes
up. The midpoint formula calculates the average elasticity
over a range of prices to alleviate that problem
b. The
midpoint formula for elasticity is:
Ed =
[(change in Q)/(sum of Q’s/2)] divided by [(change in
P)/(sum of P’s/2
c. Have the
students calculate each of the percentage changes separately
to determine whether the demand is elastic or inelastic.
After the students have determined the type of elasticity,
then have them insert the percentage changes into the
formula.
The midpoint formula is ridiculously
complicated and useless. Use the "Good Enough Formula":
Ed =
[(Q2 - Q1/Q1)
divided by (P2 - P1/P1)]
5. Emphasis:
The percentages changes are compared, not the absolute changes.
a. Absolute
changes depend on choice of units. For example, a change in
the price of a $10,000 car by $1 and is very different than
a change in the price a of $1 can of beer by $1. The auto’s
price is rising by a fraction of a percent while the beer
rice is rising 100 percent.
b.
Percentages also make it possible to compare elasticities of
demand for different products.
6. Because of
the inverse relationship between price and quantity demanded,
the actual elasticity of demand will be a negative number.
However, we ignore the minus sign and use absolute value of both
percentage changes.
7. If the
coefficient of elasticity of demand is a number greater than
one, we say demand is elastic; if the coefficient is less than
one, we say demand is inelastic. In other words, the quantity
demanded is “relatively responsive” when Ed is greater than 1
and “relatively unresponsive” when Ed is less than 1. A special
case is if the coefficient equals one; this is called unit
elasticity.
8. Note:
Inelastic demand does not mean that consumers are completely
unresponsive. This extreme situation called perfectly inelastic
demand would be very rare, and the demand curve would be
vertical.
9. Likewise,
elastic demand does not mean consumers are completely responsive
to a price change. This extreme situation, in which a small
price reduction would cause buyers to increase their purchases
from zero to all that it is possible to obtain, is perfectly
elastic demand, and the demand curve would be horizontal.
D. Graphical
analysis
1. Illustrate
graphically perfectly elastic, relatively elastic, unitary
elastic, relative inelastic, and perfectly inelastic. (Figures
18.1 and 18.2)
2. Using Figure
18.2, explain that elasticity varies over range of prices.
a. Demand
is more elastic in upper left portion of curve (because
price is higher, quantity smaller).
b. Demand
is more inelastic in lower right portion of curve (because
price is lower, quantity larger).
3. It is
impossible to judge elasticity of a single demand curve by its
flatness or steepness, since demand elasticity can measure both
elastic and inelastic at different points on the same demand
curve.
E. Total-revenue
test is the easiest way to judge whether demand is elastic or
inelastic. This test can be used in place of elasticity formula,
unless there is a need to determine the elasticity coefficient.
1. Elastic
demand and the total-revenue test: Demand is elastic if a
decrease in price results in a rise in total revenue, or if an
increase in price results in a decline in total revenue. (Price
and revenue move in opposite directions).
2. Inelastic
demand and the total-revenue test: Demand is inelastic if a
decrease in price results in a fall in total revenue, or an
increase in price results in a rise in total revenue. (Price
and revenue move in same direction).
3. Unit elasticity and the total-revenue
test: Demand has unit elasticity if total revenue does not
change when the price changes.
4. The graphical representation of the
relationship between total revenue and price elasticity:
. 
F. There are
several determinants of the price elasticity of demand.
1. Substitutes
for the product: Generally, the more substitutes, the more
elastic the demand.
2. The
proportion of price relative to income: Generally, the larger
the expenditure relative to one’s budget, the more elastic the
demand, because buyers notice the change in price more.
3. Whether the
product is a luxury or a necessity: Generally, the less
necessary the item, the more elastic the demand.
4. The amount
of time involved: Generally, the longer the time period
involved, the more elastic the demand becomes.
G. Table 18.3
presents some real‑world price elasticities. Use the determinants
discussed to see if the actual elasticities are equivalent to what
one would predict.
H. There are many
practical applications of the price elasticity of demand.
1. Inelastic
demand for agricultural products helps to explain why bumper
crops depress the prices and total revenues for farmers.
2. Governments
look at elasticity of demand when levying excise taxes. Excise
taxes on products with inelastic demand will raise the most
revenue and have the least impact on quantity demanded for those
products.
3. Demand for
cocaine is highly inelastic and presents problems for law
enforcement. Stricter enforcement reduces supply, raises prices
and revenues for sellers, and provides more incentives for
sellers to remain in business. Crime may also increase as
buyers have to find more money to buy their drugs.
a.
Opponents of legalization think that occasional users or
“dabblers” have a more elastic demand and would increase
their use at lower, legal prices.
b. Removal
of the legal prohibitions might make drug use more socially
acceptable and shift demand to the right.
A. The concept of
price elasticity also applies to supply. 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.
Es =
percentage change in quantity supplied / percentage change in price
As
with price elasticity of demand, the midpoints formula is more
accurate, but the "Close Enough Formula" works as well.
B. The ease of
shifting resources between alternative uses is very important in
price elasticity of supply because it will determine how much
flexibility a producer has to adjust his/her output to a change in
the price. The degree of flexibility, and therefore the time period,
will be different in different industries. (Figure 18.4)
1. The market
period is so short that elasticity of supply is inelastic; it
could be almost perfectly inelastic or vertical. In this
situation, it is virtually impossible for producers to adjust
their resources and change the quantity supplied. (Think of
adjustments on a farm once the crop has been planted.)
2. The
short‑run supply elasticity is more elastic than the market
period and will depend on the ability of producers to respond to
price change. Industrial producers are able to make some output
changes by having workers work overtime or by bringing on an
extra shift.
3. 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, as in Figure 18.4c. The producer
has time to build a new plant.
C. Applications of the price elasticity of supply.
1. Antiques and other non-reproducible commodities are
inelastic in supply, sometimes the supply is perfectly
inelastic. This makes their prices highly susceptible to
fluctuations in demand
2. Gold prices are volatile because the supply of gold is
highly inelastic, and unstable demand resulting from speculation
causes prices to fluctuate significantly.
A. Consumer Surplus
1. Definition – the difference between the maximum price a
consumer is (or consumers are) willing to pay for
a product and the actual price.
2. The surplus,
measurable in dollar terms, reflects the extra utility
gained from paying a lower price than what is required to
obtain the good.
3. Consumer
surplus can be measured by calculating the difference between
the maximum willingness to pay and the actual price for each
consumer, and then summing those differences.
4. Consumer
surplus is measured and represented graphically by the area
under the demand curve and above the equilibrium price. (Figure
18.5)
5. Consumer
surplus and price are inversely related – all else equal, a
higher price reduces consumer surplus.
B. Producer Surplus
1. Definition
– the difference between the actual price a producer receives (or
producers receive) and the minimum acceptable price.
2. Producer
surplus can be measured by calculating the difference between the
minimum acceptable price and the actual price for each unit sold,
and then summing those differences.
3. Producer
surplus is measured and represented graphically by the area above
the supply curve and below the equilibrium price. (Figure 18.6)
4. Producer
surplus and price are directly related – all else equal, a higher
price increases producer surplus.
VI. Efficiency Revisited
A. Efficiency is attained at equilibrium, where the
combined consumer and producer surplus is maximized. (Figure
18.7)
1. Consumers receive utility up to their maximum
willingness to pay, but only have to pay the equilibrium price.
2. Producers receive the equilibrium price for each
unit, but it only costs the minimum acceptable price to produce.
3. Allocative efficiency occurs at quantity levels
where three conditions exist:
b. Maximum willingness to pay = minimum
acceptable price.
c. Combined consumer and producer surplus is
at a maximum.
A. Sellers often
charge different prices for goods based on differences in price
elasticity of demand.
B. The ability to
charge different prices depends on some market power; that is, some
ability to control price (unlike the competitive model where all
buyers and sellers exchange at exactly the same price).
C. Customers are
grouped according to elasticities. Business travelers have more
inelastic demand for air travel, and thus can be charged a higher
price than the more price elastic tourist. The low budgets of
children make their demand more price elastic, explaining why they
receive discounts for movies or sporting events. In a like manner,
colleges and universities recognize that income differences cause
students to have different elasticities of demand for higher
education, and schools attempt to discount prices (through financial
aid) based on price sensitivity.
D. The above
are examples of price discrimination, a topic covered in more
detail in Chapter 22.
