Elasticity:
A.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.
B.Price elasticity is a concept that also relates to supply.
C.The chapter explores both elasticity of supply and demand and applications of the concept.
Price Elasticity of Demand
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.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.
C.Price elasticity 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.
4.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.
5.Emphasis: What is being compared are the percentages changes, 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.The best formula for elasticity is:
Ed = [(change in Q)/(sum of Q’s/2)] divided by [(change in P)/(sum of P’s/2)]
1.Have the students calculate each of the percentage changes separately using 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.
E.Graphical analysis:
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.
F.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 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.
G.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.
I.There are many practical applications of elasticity.
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.
Price Elasticity of Supply
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
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 shortrun 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 longrun 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. The producer has time to build a new plant.
Cross and income elasticity of demand:
A.Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Numerically, the formula is shown for products X and Y.
Exy = (percentage change in quantity of X) / (percentage change in price of Y)
1.If cross elasticity is positive, then X and Y are substitutes.
2.If cross elasticity is negative, then X and Y are complements.
3.Note: if cross elasticity is zero, then X and Y are unrelated, independent products.
B.Income elasticity of demand refers to the percentage change in quantity demanded that results from some percentage change in consumer incomes.
Ei = (percentage change in quantity demanded) / (percentage change in income)
1.A positive income elasticity indicates a normal or superior good.
2.A negative income elasticity indicates an inferior good.
Consumer Choice
Every consumer must face two facts of economic life:
- They have to pay prices for the goods and services they buy.
- They have limited funds to spend.
- These two facts are summarized by the consumer’s budget constraint.
Definition: A consumer’s budget constraint identifies which combinations of goods and services the consumer can afford with a limited budget, at given prices.
Definition: Budget Line: The graphical representation of a budget constraint.
It is very important to see the relationship between the prices of two goods and the opportunity cost of having more of one or the other. The prices Max faces tell us how many dollars he must give up to get another unit of each good. If, however, we divide one money price by another money price, we get what is called a relative price—the price of one good relative to the other.
Definition: Relative Price: The price of one good relative to the price of another.
The slope of the budget line indicates the spending trade-off between one good and another—the amount of one good that must be sacrificed in order to buy more of another good. If Py is the price of the good on the vertical axis and Px is the price of a good on the horizontal axis, then the slope of the budget line is: .
An increase in income will shift the budget line upward and (rightward).
A decrease in income will shift the budget line downward (and leftward).
These shifts are parallel - changes in income do not affect the budget line’s slope.
Changes in Price:
What happens to the budget line when a price changes?
•When the price of a movie falls, the budget line rotates outward—the vertical intercept moves higher.
Keep in mind:
When the price of a good changes, the budget line rotates: Both its slope and one of its intercepts will change.
Question: What would be the effect of a lower price of “Product x” {in this example “Px”}?
Due to the lower price, the graph will “rotate” only on the side of the graph corresponding to where the price lowered; we know that the lower price will allow the consumer to purchase more of a product, thus we can extend the “budget constraint line” on the x axis to represent an increase in the “ability” to be able to buy more total units of “x.”
If, suppose, the price of product “x” decreases. We would “rotate” only the x intercept (the x intercept is the point on the graph where the graph touches the x axis).
Income /Price of Good = Quantity the consumer can purchase
The Consumer’s Goal
- What is Utility?
Definition: Pleasure or satisfaction obtained from consuming goods and services.
- Pleasure or satisfaction obtained from consuming and services.
- The satisfaction that a consumer gets from consuming goods or services.
- What is Marginal Utility?
- Marginal utility is the increment change in utility (pleasure) an individual “gets” from an additional unit of a good. The marginal utility of a thing to anyone diminishes with every increase in the amount of it he already has.
- How to calculate Marginal Utility?
MU = (Change) in Total Utility / (Change) in Consumption
- Note: “Utility” is a subjective (or normative) notion in economics.
Total and Marginal Utility
Lisa’s Total and Marginal Utility from Consuming Ice Cream Cones
Number of Cones / Total Utility / Marginal Utility0 / 0 Utils
1 / 30 Utils / 30 Utils
2 / 50 Utils / 20 Utils
3 / 60 Utils / 10 Utils
4 / 65 Utils / 5 Utils
5 / 68 Utils / 3 Utils
6 / 68 Utils / 0 Utils
Panel (a) shows Lisa’s total utility from her consumption of ice cream cones. As her consumption of ice cream rises, so does her total utility. Panel (b) shows the corresponding marginal utility. MU falls as ice cream consumption rises, indicating that each additional ice cream cone per week provides less additional utility than the previous one did.
# of plates of pasta / Total utility / Marginal utility0 / 0 / -
1 / 15 / 15
2 / 17 / 2
3 / 18 / 1
4 / 18 / 0
5 / 17 / -1
6 / 14 / -3
Total utility increases as each additional plate of pasta is consumed, but TU (total utility) rises at a diminishing rate, since each plate adds less and less to the consumer’s satisfaction.
At some point, MU (marginal utility) becomes zero, and then negative, which means that after that point, TU (total utility) begins to fall. This is called the law of diminishing returns.
The economic theory of choice is based on the concept of utility. Utility is defined as the level of happiness or satisfaction associated with alternative choices. Economists assume that when individuals are faced with a choice of feasible alternatives, they will always select the alternative that provides the highest level of utility.
Total and marginal utility
The total utility associated with a good is the level of happiness derived from consuming the good. Marginal utility is a measure of the additional utility that is received when an additional unit of the good is consumed.
The Utility Maximum Rule: a consumer will maximize utility by choosing a point on the budget line where MU per dollar is the same for both goods.
In algebraic form, this may be expressed as:
As long as one good provides more utility per dollar than another, the consumer will buy more of that good. As more of that product is consumed, its MU diminishes until the amount of utility per dollar equals (MU/p) that of the other product.
Consumer Decision Making:
- Rationality: if product “a” is preferred to product “b,” and “b” is preferred to “c,” then (product) “a” should be preferred to (product) “c.”
When a consumer makes comparisons, s/he tries to maximize his/her utility. In other words, the consumer’s preferences are said to be rational.
- MU (marginal utility) is positive.
- MU (marginal utility) diminishes as more of a good is consumed (The law of diminishing marginal utility).
The consumer will always choose a point on the budget line, rather than a point below it.
Concerts at $30 eachMovies at $10 each
(1) Point on the Budget line / (2) Number of Concerts per Month / (3) Marginal Utility from last concert / (4) Marginal Utility per Dollar spent on Last Concert / (5) Number of Movies per Month / (6) Marginal Utility from Last Movie / (7) Marginal Utility per Dollar Spent on Last MovieA / 0 / - / - / 15 / 50 / 5
B / 1 / 1,500 / 50 / 12 / 100 / 10
C / 2 / 1,200 / 40 / 9 / 150 / 15
D / 3 / 600 / 20 / 6 / 200 / 20
E / 4 / 390 / 13 / 3 / 350 / 35
F / 5 / 300 / 10 / 0 / - / -
The budget line shows the maximum number of movies Max could attend for each number of concerts he attends. He would never choose an interior point like G because there are more affordable points—on the line—that make him better off. Max will choose a point on the budget line. More specifically, he will choose the point at which the marginal utilities per dollar spent on movies and concerts are equal. This occurs at point D.
Marginal decision making: the process of making decisions based on their incremental or marginal effects.
To understand and predict the behavior of individual decision makers, we focus on the incremental or marginal effects of their actions.
A utility maximizing consumer will choose the point on the budget line where marginal utility per dollar is the same for both goods (). At that point, there is no further gain from reallocating expenditures in either direction.
Changes in Income, Price, and Demand
In a market economy things change. How can changes in income, price, or demand affect the budget line?
Recall: Normal vs. Inferior Goods: Has nothing to do with quality, but with choices based on income.
Normal goods:goods that people demand as their income rises; chosen when the marginal utilities per dollar are equal after an increase in income.
Inferior goods:goodsthat people demand less of as their income rises.
Recall: The Law of Demand: A rise in the price of a good reduces the quantity demanded, and a fall in price increases quantity demanded.
Definition: The individual demand curve: A curve showing the quantity of a good or service demanded by a particular individual at each different price.
Combining Substitutions and Income Effects:
- The Substitution Effect:
The substitution effect of a price change arises from a change in the relative price of a good, and it always moves quantity demanded in the opposite direction to the price change. When price decreases, the substitution effect works to increase quantity demanded; when price increases, the substitution effect works to decrease quantity demanded.
- The Income Effect:
The income effect of a price change is the impact on quantity demanded that arises from a change in purchasing power over both goods. A drop in price increases purchasing power, while a rise in price decreases purchasing power.
- Combining Substitution and Income Effects:
For normal goods, the substitution and income effects work together, causing quantity demanded to move in the opposite direction of the price. Normal goods, therefore, must always obey the law of demand.
- Normal Goods: Substitution and income effects worktogether
demand moves in the opposite direction of the price
normal goods must always obey the law of demand
- Inferior Goods: Substitution and income effects workagainst each other.
substitution effect moves quantity demanded in the opposite direction of the price
income effect moves quantity demanded in the same direction as the price