ECONOMICS

1
ECONOMICS
What Does It Mean To Me?
Part VI Elasticity of Demand Elasticity of
Supply Supply, Demand, and Taxation
READ Krugman Section 9, Modules 46, 47,
48 Mankiw Ch 5 DO Morton Unit 2
2
The Income Effect, Substitution Effect, and
Elasticity
Module
10
Micro Econ
46

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
3
What you will learnin 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

4
The Law of Demand

• The substitution effect
• The income effect

I
5
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
6
The law of demand tells us that consumers will
respond to a decline in a products price by
buying more of that product. But how much more of
it will they purchase? That amount can vary
considerably by product and over different price
ranges for the same product.
7
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
DEMAND.
8
Demand for some products is such that consumers
are highly responsive to price changes modest
price changes lead to very large changes in the
quantity purchased, for example restaurant
meals, steak, cars. The demand for such products
is said to be relatively elastic, or simply
ELASTIC.
9
For other products, consumers are quite
unresponsive to price changes substantial price
changes result in only small changes in the
amount purchased, for example salt, milk,
soap. For such products, demand is relatively
inelastic or simply INELASTIC.
10
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)
11
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

12
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
13
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 ?Qd/?P note we drop the
  negative sign for Ed only.

14
Why use percentages? Economists give two
reasons 1) Choice of Units 2) Comparing
products
15
1) Choice 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).
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2) Comparing 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.
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Elimination 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 negative 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.
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Interpretations of Ed
We can interpret the coefficient of price
elasticity of demand as follows 1) elastic
demand 2) inelastic demand 3) unit elasticity
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Elastic Demand Demand is said to be elastic if a
specific percentage change in price results in a
larger percentage change in quantity demanded.
Then Ed gt 1. Example If a 2 percent decline in
a price results in a 4 percent increase in
quantity demanded, then demand is elastic and
.04 Ed .02 2
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A small percentage change in price leads to a
larger percentage change in quantity demanded.
P1
PRICE
P
P0
D2
Relatively elastic demand
Qd
Ed gt 1
0
Q0
Q1
QUANTITY
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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
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.
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A small percentage change in price will change
quantity demanded by an infinite amount.
P1
PRICE
P
D2
P0
Perfectly elastic demand
Qd
Ed
0
Q0
Q1
QUANTITY
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Inelastic 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 lt 1. Example If a 3
percent decline in price leads to only a 1
percent increase in quantity demanded, demand is
inelastic and .01 Ed .03 .33
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A change in price leads to a smaller percentage
change in quantity demanded.
P1
PRICE
Relatively inelastic demand
P
P0
Ed lt 1
Qd
D1
0
Q0
Q1
QUANTITY
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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 inelastic. Examples include an acute
diabetics demand for insulin or and addicts
demand for heroin.
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The quantity demanded does not change regardless
of the percentage change in price.
D1
P1
PRICE
Perfectly inelastic demand
P
P0
Ed 0
0
Q0
Q1
QUANTITY
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Elastic or Inelastic demand?
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Unit 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 elasticity because Ed 1, or unity.
In this example .01 Ed .01 1
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The percentage change in quantity demanded is the
same as the percentage change in price that
caused it.
P1
PRICE
Unit elastic demand
P
D1
Ed 1
P0
Qd
0
Q0
Q1
QUANTITY
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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.
P1
PRICE
P0
D1
Relatively elastic
D0
Relatively inelastic
0
Q0
Q1
Q2
QUANTITY
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A more accurate way to calculate elasticity
is THE MIDPOINT FORMULA
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The Midpoint Formula

• The problem with calculating percentage changes
• The solution Use the Midpoint formula!
• ?Qd 100(New Quantity Old Quantity)/Average
  Quantity
• ?P 100(New Price Old Price)/Average Price
• Ed ?Qd/?P
• Example

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Using the midpoint formula, calculate the
following
Price Qdemanded Apples A
.90 1,100 Apples B 1.50 900
(1100-900) 200 (1100900)/2 1000 (1.50 -
.90) .60 (1.50 .90)/2 1.20

x
100 100

20 50
.4

x

34
Using the midpoint formula, calculate the
following
Price Qdemanded Apples A
.90 1,500 Apples B 1.10 900
(1500-900) 600 (1500900)/2 1000 (1.10 -
.90) .20 (1.10 .90)/2 1.00

x
100 100

60 20
3

x

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What influences the price elasticity of demand?

• Available substitutes
• Proportion of income
• Luxuries vs necessities
• Time

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• Available Substitutes
• The larger the number of close substitutes, the
  greater the elasticity. If the price increases,
  consumers may select a relatively lower-priced
  substitute instead.
• Examples may include
• Butter gt Margarine
• Pepsi gt Coca Cola
• Texaco gasoline gt Hess gasoline

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• Proportion of Income Spent on the Good
• The smaller the proportion of income spent on a
  good, the lower its elasticity of demand. If the
  amount spent on a good relative to income is
  small, then the change in price on ones 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.

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Luxuries 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

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The Amount of Time Since the Price Change The
more time that people have to adapt to a new
price change, the greater its elasticity of
demand. Immediately after a price change,
consumers may be unable to locate good
alternatives or easily change their consumption
patterns.
40
Total-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.
41
Elastic Demand If demand is elastic, a decrease
in price will increase 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
42
Elastic Demand and Total Revenue
P
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.
A
10 5
Total revenue has increased by 100.
a
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 gt a.
B
c
b
Delastic
Q
0 20 40 60 80 100
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Inelastic Demand If demand is inelastic, a price
decrease will reduce 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
44
Inelastic Demand and Total Revenue
P
At point A, total revenue is 300 (10 x 30), or
area a b.
A
At point B, the total revenue is 200 (5 x 40),
or area b c.
10 5
Total revenue has decreased by 100.
a
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 gt c.
B
c
b
Dinelastic
Q
0 10 20 30 40
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APPLICATIONS OF PRICE ELASTICITY OF DEMAND
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1) Bumper Crops Increases in the output of most
farm products arising from a good growing season
or increase in productivity will cause to
decrease both the farm products and the total
revenues (or incomes) of farmers.
47
2) Automation The impact of technological
advances on employment depends in part on the
elasticity of demand for the product or service
that is involved. If a firm installs technology
that replaces 1000 workers, who are then laid
off, the savings from the cost reduction could be
passed on to consumers. The effect of the price
reduction on sales will depend on the elasticity
of the product. An elastic demand could increase
sales to a point where some of the workers might
be rehired. An inelastic demand will result in
only minimal increase in sales.
48
3) Airline Deregulation In the 1970s,
deregulating the airlines caused increased
profits for the carriers in the short term,
because it increased price competition among the
airlines, thus lowering airfares. Lower fares,
and an elastic demand for air travel, increased
revenues. Filling the airplanes to capacity
increased revenues more than the costs and
increased profits. Profits did not last, however,
because of rising fuel prices, persistent fare
wars, and the entry of competitors on profitable
routes.
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4) Excise Taxes The government selects certain
goods and services with which to levy excise
taxes by paying attention to elasticity of
demand. If a 1 tax is levied on a product and
10,000 units are sold, tax revenue will be
10,000. If government then raises the tax to
1.50 and the consequent higher price reduces
sales to 5000, tax revenue will decline to 7500.
A higher tax on a product with an elastic demand
will reduce revenue, therefore, governments seek
products with inelastic demands, such as liquor,
gasoline and cigarettes.
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5) Drugs and Street Crime Is an addicts 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.
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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
S2
P2
S1
P1
D
Quantity of Drugs
Q1
Q2
Quantity of Drugs
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Another option is drug education, which reduces
demand,
which lowers the price,
and reduces quantity supplied.
Price of Drugs
S
Price of Drugs
S2
P1
P2
S1
P2
P1
D
D1
D2
Quantity of Drugs
Q1
Q2
Q1
Q2
Quantity of Drugs
53
6) Minimum Wage Critics 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.
54
When the government mandates a the minimum price
of something, it is called a PRICE FLOOR and it
keeps the market from reaching equilibrium.
S
The demand for labor diminishes
5 4 3 2 1
while the supply of labor increases
E
D
causing a surplus.
Labor
0 1 2 3 4 5 6 7 8 9 10
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Elasticity of Supply
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The PRICE ELASTICITY OF SUPPLY measures how much
the quantity supplied responds to changes in
price.
57
Supply is said to be elastic if the quantity
supplied responds substantially to changes in
price.
A small percentage change in price leads to a
larger percentage change in quantity supplied.
PRICE
S2
P0
P
P1
Relatively elastic supply
Qd
Ed gt 1
0
Q0
Q1
QUANTITY
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Supply is said to be inelastic if the quantity
supplied responds slightly to changes in price.
A small percentage change in price leads to a
smaller percentage change in quantity supplied.
S2
PRICE
P0
P
P1
Relatively inelastic supply
Qd
Ed lt 1
0
Q0
Q1
QUANTITY
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Elasticity of Supply is dependant upon the
sellers flexibility in changing the amount they
produce.
For example Beachfront property in Florida has
an inelastic supply because we cannot produce
more of it. Manufactured goods such as microwave
ovens, televisions, and cars are elastic because
the producers can easily adjust production of a
good more or less.
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How do government policies (taxes) affect market
outcomes?
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When a tax on tea is levied on consumers, the
sellers will share part of the tax burden.
P0 is the equilibrium price WITHOUT the tax. P1
is the price sellers will receive. P2 is the
price consumers will pay.
PRICE
S
P2
(2.50)
E w/o tax
P0
(2.20)
(.50)
P1
(2.00)
D0
(.50)
D1
0
Q0
Q1
QUANTITY
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A payroll tax puts a wedge between the price that
workers receive and the amount producers pay.
Plabor
Slabor
5 4 3 2 1
E
Dlabor
Qlabor
0 1 2 3 4 5 6 7 8 9 10
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When supply is more elastic than demand, the
burden of the tax falls primarily on consumers.
P
S
Pconsumers pay
5 4 3 2 1
Pw/o tax
E
Pproducers receive
D
Q
0 1 2 3 4 5 6 7 8 9 10
64
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??
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When demand is more elastic than supply, the
burden of the tax falls primarily on producers.
S
P
Pconsumers pay
5 4 3 2 1
Pw/o tax
E
D
Pproducers receive
Q
0 1 2 3 4 5 6 7 8 9 10
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Project by Virginia H. Meachum Coral Springs
High School Sources Principles, Problems, and
Policies, by Campbell McConnell Stanley
Brue Principles of Economics, 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
Center for Economic Education Notes by Foundation
for Teaching Economics