CHAPTER OUTLINE

1. Define the price elasticity of demand, andexplain the factors that influence it and how to calculate it.

A. PercentageChange in Price

1.  TheMidpoint Method

B.  PercentageChange in Quantity Demanded

C. Elasticand Inelastic Demand

D. Influenceson the Price Elasticity of Demand

1.  Availabilityof Substitutes

a.  LuxuryVersus Necessity

b.  Narrownessof Definition

c.  TimeElapsed Since Price Change

2.  Proportionof Income Spent

E.  Computingthe Price Elasticity of Demand

F.  Interpreting the PriceElasticity of Demand Number

G. ElasticityAlong a Linear Demand Curve

H. TotalRevenue and the Price Elasticity of Demand

I.   Applicationsof the Price Elasticity of Demand

1.  OrangePrices and Total Revenue

2.  Addictionand Elasticity

 

n What’s New in this Edition?

Chapter 5 is a lightly updated version ofChapter 5 from the fifth edition.

n Where We Are

In this chapter we examine the priceelasticity of demand, price elasticity of supply, cross elasticity of demand,and income elasticity of demand. The motivation for studying elasticity focuseson how elasticity can help make quantitative predictions about price andquantity changes. We study the total revenue test, which estimates the priceelasticity of demand by observing the change in total revenue that results froma price change.

n Where We’ve Been

We have now examined why we study economicsand have built basic models, such as the production possibilities frontier andthe demand and supply framework.

n Where We’re Going

The nextchapter continues to use the supply and demand framework to study theefficiency and fairness of markets. Consumer surplus and producer surplus willbe introduced. We return to the concept of efficiency and study occasions whenthe market is inefficient. We discuss issues of fairness.

IN THECLASSROOM

nClass Time Needed

You can complete this chapter in no more thanthree sessions. Take the time to explain the idea of percentage changes andexplicitly go over each of the calculations in computing the elasticity.

           Anestimate of the time per checkpoint is:

·            5.1 The Price Elasticity ofDemand—70 to 90 minutes

·            5.2 The Price Elasticity ofSupply—20 to 25 minutes

·            5.3 Cross Elasticity and IncomeElasticity—15 to 20 minutes

Classroom Activity: AGeorgiaprofessor begins thediscussion of elasticity by passing around the class two rubber exercise bands.The green band is much harder to stretch than the pink band. Everybody has agreat time pulling on the exercise bands. The professor points out to the studentsthat in some parts of the country rubber bands are called “elastics.” Somerubber bands, such as the green exercise band, don’t stretch very much. Theyare, comparatively, inelastic. Andsome rubber bands are quite stretchy. When the same amount of pressure is puton the pink exercise band as was placed on the green one, the pink bandstretches much more. It, compared to the green band, is relatively elastic.

        Whatwe’re really describing is how responsivethe two exercise bands are to the same amount of force: the relatively elasticband responds a lot, while the relatively inelastic band responds less to thesame amount of force. Similarly, when analyzing cause and effect relationshipsin economics, some causes have a greater effect on some variables than others.The greater the response, the more elastic the relationship. Therefore, if theprice of gasoline (force) increases, people change their behavior only a little(less stretching) because they have few alternatives. The demand for gasolineis relatively inelastic. On the other hand, if the price of potatoes (moreforce) rises, people respond dramatically (more stretching), because there areplenty of alternatives. Demand for potatoes is relatively elastic.

Classroom Activity: After introducing the influences on the price elasticity of demand,break students into small groups and give them a list of goods.  Have students rank the price elasticities ofdemand for these goods by considering the various influences (but standardizethe time elapsed for them). For example, you can give them salt, an automobile,filet mignon, beef, Grey Poupon Dijon Mustard, a Hawaiian vacation, and a Chevy1500 Silverado pickup truck (you can choose your own goods, just make sure theyhighlight the influences). Ask students to rank the demand for these goods fromwhere demand would be most inelastic to most elastic. While there is amathematically “correct” ranking, it is not important that you actually knowwhat it is - the important thing is being able to support arguments about therelative price elasticities of demand based upon the influences. The actualcorrect ranking would be a far more advanced research project than any of yourstudents (or you, for that matter) should be expected to undertake at thispoint. Remind students to consider all of the influences on the elasticity ofdemand when thinking about this list – whether the good is more of a luxury ornecessity, whether the market is more narrowly or broadly defined, and whetherthe good would make up a fairly small or large proportion of a budget.  Make sure to reinforce to students that it isthe combination of these influences that ultimately determine the priceelasticity of demand, not just one of the influences. When you bring the classback together, have each group volunteer their rankings and record them on theboard. While it is unlikely every group will have the same rankings, there willbe remarkable similarities.  Use thetrends you see in these rankings to review the influences and analyze howdiscrepancies can be explained by the assumptions made by different groupsabout how heavily to weigh these different influences. This exercise will getstudents practice interpreting the various influences on the price elasticityof demand and how the confluence of these influences makes demand more elasticor inelastic for various goods.

 

CHAPTER LECTURE

n 5.1       The Price Elasticity of Demand

Ingeneral, elasticity measures responsiveness. The price elasticity of demandmeasures how responsive demanders are to a change in the price of the good.This information is often useful for both businesses and governments.

qLand Mine: Many students need a refresher and some practiceat doing what seems too simple to bother with: calculating percentages andpercentage changes. Don’t be afraid to start with this pre-elasticity warm up.Just toss out some numbers. Suppose that the campus book store increases theprice of an economics text from $80 to $100. What is the percentage increase inprice? Now suppose the campus book store cuts the price of an economics textfrom $100 to $80. What is the percentage decrease in price? You’re now set to havethe students use the average of the original and new price to calculatepercentages that are independent of the direction of change.

qLandMine: Many students have a hard time rememberingwhether quantity or price goes in the numerator of the elasticity formulas.Have the students create their own mnemonic. Suggest McDonald’s QuarterPounder™ hamburgers. It’s silly, but it works, reminding the student that Q (quantity) appears before P (price) in the ratio of percentagechanges.

• The price     elasticity of demand     is a measure of the responsiveness of the quantity demanded of a good to a     change in its price when all other influences on a buyer’s plans remain     unchanged. The price elasticity of demand is equal to the absolute value     of:

PercentageChange in Price and Quantity Demanded

• One     method for calculating the percentage change in the price is:

Howeverthis method gives different percentage changes depending if the price rises orfalls. For instance, the $2 change from $8 to 10$ is a 25 percent changewhereas the $2 change from $10 to $8 is only a 20 percent change.

• Economists     use the midpoint method for calculating     the percentage change in the price:

This method gives the same percentage regardlessof whether the price rises or falls. For instance, the $2 change from $8 to 10$is a 22.2 percent change regardless of whether the price rises or falls.

• Economists use the midpoint method for calculating the percentage change in the     quantity:

• When     calculating the price elasticity of demand, only the magnitude or absolute     value is used when calculating the percentage changes so that any negative     sign is ignored.

Elastic and InelasticDemand

• Demand iselastic if the percentage change     in the quantity demanded exceeds the percentage change in price.

·           Ifthe quantity demanded changes by a large percentage in response to a tiny pricechange, then the good is said to have perfectlyelastic demand.The good’s demand curve is a horizontal line.

• Demand isunit elastic if the percentage change     in the quantity demanded equals the percentage change in price.

• Demandis inelasticif the percentage change     in the quantity demanded is less than the percentage change in price.

·           Ifthe quantity demanded remains constant when the price changes, so that the percentagechange in the quantity demanded is zero, then the good is said to have perfectlyinelastic demand.The good’s demand curve is a vertical line.

Elasticity is a very practical concept.Businesses and governments are interested in elasticities. Businesses want toknow the price elasticity of demand for their product because they want to knowhow a change in price affects their total revenue. Governments what to know theprice elasticity of demand for various products, such as oil, because they wantto predict the effect of a change in price on the quantity demanded (as thiswill play a key role in how a tax impacts market outcomes). You should pointthese facts out to your students because many students are eager to learn whenthey know what they are learning will have real-life applications. So your discussionof how elasticities are used in the real world can motivate your students.

Influences on the Price Elasticity of Demand

• The magnitude of the price     elasticity of demand depends on:

·        The availability ofsubstitutes:The more and the closer the substitutes for a good or service, the more elasticthe demand for it.

·        Aluxury good has more substitutes than a necessity, so the demand for luxuriesis more elastic than the demand for necessities.

·        Themore narrowly defined a good (for example, a Mountain Dew at 2 PM) has moresubstitutes than a more broadly defined good (for example, a soda sometimetoday).

·        Thelonger the time elapsed since the price of the good changed, the more elasticthe demand for the good.

·        The proportion ofincome spent on the good:The greater the proportion of income spent on a good or service, the more elasticthe demand for it.

Most people’s demand for salt is inelastic,largely because most people spend a miniscule amount of their income on salt.However large Northern cities’ demand for salt is significantly more elastic.These cities use salt to treat their roads after a snow storm. Salt is asignificant fraction of their budgets. Because the proportion of their incomethey spend on salt is large, the price elasticity of demand for these cities ismuch larger than that of “ordinary” consumers.

Computing the Price Elasticity of Demand

• The formula for the price elasticity of demand     is the absolute     value of:

• The table to the right has two points on the     demand curve for pizza from a pizza parlor.

·        Theabsolute value of the percent change in quantity demanded is [(500 - 400) ¸ 450] ´ 100= 22.2 percent.

·        Theabsolute value of the percentage change in price is [($14 - $16) ¸ $15] ´ 100 = 13.3 percent.

·        Betweenthese two points on the demand curve, the price elasticity of demand is 22.2% ¸ 13.3% = 1.67.

• If the price elasticity of demand is greater     than 1, demand is elastic; if it is equal to 1, demand is unit elastic; if     it is less than 1, demand is inelastic.

• If the price elasticity of demand is elastic,     we can presume that the good probably has many substitutes and does not     take up a large proportion of its buyers’ incomes. Pushing up the price a     bit loses many customers but lowering the price a bit gains many customers.

qLand Mine: Studentssometimes wonder why we don’t just measure the slope of the demand curve tomeasure responsiveness. Point out to the students that the slope will changewhen the units change. For instance, you can compute the slope of a demandcurve when the price is measured in dollars and then the slope of the exactsame demand curve when the price is measured in cents. The slope withthe price measured in cents is 100 times as large as the initial slope. Tellthe students that it is not acceptable for the measure of responsiveness tochange whenever the units of the price (or of the quantity) change. To show theimportance of a units-free measure of elasticity, you can calculate the slopeof a demand curve when the vertical axis is measured in dollars and again whenit is measured in cents. Draw a demand curve for tacos, such that when theprice rises from $1.00 to $1.05, the quantity demanded decreases from 50 to 45tacos. The slope of the demand curve with the price measured in dollars is -0.01. Then, draw the identical demand curve, only this time measurethe price in cents. When the price rises from 100 cents to 105 cents, thequantity demanded decreases from 50 to 45 units. Now the slope is -1.00. Point out that having the slope of the identical demandcurve change simply because the units of the price change is surely not a goodfeature. In addition, the slope changes when the quantity units change. Forthis reason, economists do not use the slope as their measure of sensitivity.They use elasticity because elasticity is calculated using units-freepercentage changes. Elasticity does not change if the units of the price or thequantity are changed.

Elasticity Along a Linear Demand Curve

• With the exception of a vertical demand curve     and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively) the price     elasticity of demand changes when moving along a straight-line demand     curve.

• As the figure illustrates, at points on the     demand curve above the midpoint, the price elasticity of demand is elastic     while at points below the midpoint, the price elasticity of demand is     inelastic. At the midpoint, the price elasticity of demand is unit     elastic.

Total Revenue and the Price Elasticity of Demand

• Thetotal revenue is the total amount spent     on a good and received by the seller. It equals the price of the good     multiplied by the quantity sold.

·        Ifdemand is elastic, a 1 percent price cut increases the quantity sold by morethan 1 percent and total revenue increases.

·        Ifdemand is unit elastic, a 1 percent price cut increases the quantity sold by 1percent and total revenue does not change.

·        Ifdemand is inelastic, a 1 percent price cut increases the quantity sold by lessthan 1 percent and total revenue decreases.

• The total revenue test is a method of estimating the price elasticity of demand by observing     the change in total revenue that results from a change in price.

·        Ifa percent price cut increases total revenue, demand is elastic. And if a pricehike decreases total revenue, demand is elastic.

·        Ifa percent price cut does not change total revenue, demand is unit elastic. Andif a price hike does not change total revenue, demand is unit elastic.

·        Ifa percent price cut decreases total revenue, demand is inelastic. And if aprice hike increases total revenue, demand is inelastic.

Applications of the Price Elasticity of Demand

• The price     elasticity of demand can be used to predict the effect on the price of a     change in the quantity. For instance, if the price elasticity of demand     for oranges is 0.4 and the quantity of oranges decrease by 1 percent, then     the price of oranges will rise by (1 percent) ÷ 0.4, which is 2.5 percent.

• The price     elasticity of demand for many illegal drugs is very small, which shows     that even substantial price hikes will not decrease the quantity consumed     by much. In addition, the price elasticity of demand shows that the     elasticity of demand for cigarettes by young people is larger than for     established smokers. So although a tax will not have much of an effect on     established smokers’ behavior, it will discourage smoking by younger     people.