USING EYE ONTHE GLOBAL ECONOMY

nPrice Elasticities of Demand

Often the relatively theoretical nature of economicstakes students by surprise. They expect a typical business course in which only“practical, real-world” issues are studied. Elasticity is precisely the sort of“practical, real-world” concept that can appeal to this set of students. Theprice elasticities of demand in this “Eye on the Global Economy” can be used intest questions, to make the questions more realistic. You also can use them ina class discussion by asking your students about a few of the goods. For instance,you could ask them what they guess is more elastic, the demand for motorvehicles or clothing? The demand for furniture or food? The demand for metalsor oil? Ask the students to explain their answers and then present them withthe actual rankings from this Eye on the Global Economy.

USING EYE ONTHE price of gas

nWhat Do You Do When the Price of Gasoline Rises?

As consumerswith automobiles and very limited budgets (typically), the demand for gasolineis perhaps the first example that students think of when the price elasticityof demand is introduced. Most will identify their demand is highly inelastic. Indeed,some might assert it is perfectly inelastic. You can use the data provided inthis Eye to give students practice calculating the price elasticity of demandand use these calculations to compare to the price elasticity of demand forother goods (as given in the Eye on the Global Economy on page 121). Althoughthe time elapsed is not given for these other calculations so it is not quite ceteris paribus, the extremely inelasticdemand for gasoline seen in this Eye can help illustrate how Americans havemade gasoline such a necessity that it rivals the elasticity of demand for otherlife “essentials,” such as food, beverages, housing services, and clothing. Askstudents to speculate about the price elasticity of demand for gasoline acrossdifferent regions of the U.S. – why might it vary? Also, why might it varyaround the world? Why might demand be more inelastic in theU.S.than in Europe,China,Canada, orMexico? Is thehighly inelastic demand for gasoline in theU.S.inevitable? Have studentsbrainstorm a list of what changes could take place (both shorter term andlonger term) that would make the demand for gasoline in theU.S.moreelastic. Also, you can have students think about the impact that gas taxes haveon gasoline consumption in the U.S. (though this will be more formallyaddressed in Chapter 8, introducing this concept now can get students thinkingabout the important role that elasticities play in market outcomes).

USING EYE ONYOUR LIFE

nYour Price Elasticities of Demand

This Eye presents an interesting discussionexplaining how the students can determine if their demand for a good or serviceis elastic, inelastic, or unit elastic. You can point out to your students thatthis information is useful when they are thinking about public policies such astaxation. In particular, would they rather see a tax imposed on a product forwhich their demand is elastic or inelastic? Though this topic is handled moreformally in a future chapter, you can point out to your students that almostsurely they would prefer that the product with the more elastic demand be taxed.Why? When their demand is elastic, there are other goods which are closesubstitutes. As a result, if the price of the taxed product rises as a resultof the tax, the students can readily find other products to take its place andthereby avoid paying most of the tax. On the other hand, if their demand forthe good or service is inelastic, there are no close substitutes for thespecific product. In this case, if the price of the product rises when the taxis imposed, the students will wind up buying some of it anyway and thereby areunable to escape the effect of the tax. By presenting this sort of intuitive,“real-world” discussion in this chapter you can be extremely helpful inconveying to students the basic intuition about tax incidence, which is studiedmore formally in an up-coming chapter.

 

 

ADDITIONALEXERCISEs FOR ASSIGNMENT

n  Questions

n   Checkpoint  5.1:  ThePrice Elasticity of Demand

1.     Theprice of spring water rises from $1.90 to $2.10 a bottle, and the quantitydemanded decreases from 11 million to 9 million bottles a week.

1a.  Calculatethe percentage change in the price of spring water.

1b.  Calculatethe percentage change in the quantity demanded of spring water.

1c.   Is thedemand for spring water elastic or inelastic?

1d.  Wouldthe demand for Pepsi be more elastic or less elastic than the demand for springwater? Why?

1e.   Calculatethe price elasticity of demand for spring water.

1f.   Atwhat price is the price elasticity of demand for spring water equal to youranswer in part (e)?

1g.  What isthe change in the total revenue of sellers of spring water?

1h.  If thedemand curve for spring water is a straight-line demand curve, is the price atwhich the demand for spring water is unit elastic a higher price or a lowerprice than your answer to part (f)? Why?

2.     Drawa straight-line demand curve and note three points on the curve. Point A shouldhave an elasticity greater than 1, point B should have an elasticity equal to1, and point C should have an elasticity less than 1.

3.     Whatrole does the presence or absence of substitutes play in determining the sizeof the price elasticity of demand?

4.     Isthe demand for a luxury likely to be more or less price elastic than the demandfor a necessity? Why?

n   Checkpoint  5.2:  ThePrice Elasticity of Supply

5.     Theprice of U.S.-produced long grain rice fell by 40 percent from January 1999 toJanuary 2000. In response to the price fall, growers ofU.S.long grainrice planted 17 percent less acreage in 2000. If the harvest also decreases by17 percent:

5a.  Howwould you describe the supply ofU.S.long grain rice?

5b.  How doyou think production possibilities and storage possibilities influence theprice elasticity of supply of long grain rice?

5c.   Calculatethe price elasticity of supply of U.S.-produced long grain rice.

5d. If the price of long grain rice remains thesame, do you think the elasticity of supply will change over the coming years?Explain your answer.

6a.  Supposethat Podunk University wins the 2002 collegebasketball championship. As a result, Podunk U’s fans increase their demand fortickets for the 2003 season. Podunk U. plays in an arena thatseats 7,000 people. Describe the supply of basketballtickets at Podunk U. and draw a supplycurve for tickets.

6b.  Podunk U.’seconomist has calculated the priceelasticity of demand for tickets to be 0.50. Podunk U.’spresident is committed to increasing the total revenue collected by theuniversity. To do so, should Podunk raise or lower its ticket prices?

7.     Once harvested, rice isstorable but strawberries are not. As a result, which will be more elastic: Thesupply of rice or the supply of strawberries?

n   Checkpoint  5.3: Cross Elasticity and Income Elasticity

8.     Suppose that when the priceof a burger decreases from $2.00 to $1.75 and other things remain the same, thequantity demanded of burgers increases from 200 an hour to 400 an hour and thequantity demanded of pizza decreases from 400 an hour to 200 an hour. At thesame time, the quantity demanded of soda increases from 150 an hour to 300 anhour.

8a.  Calculate the cross elasticityof demand for soda with respect to burgers.

8b.  Are soda and burgerssubstitutes or complements? Why?

8c.   Calculate the cross elasticityof demand for pizza with respect to burgers.

8d.  Are pizza and burgerssubstitutes or complements? Why?

8e.   Describehow the demand for soda and the demand for pizza have changed.

9.     When Jody's income increasesby 10 percent and other things remain the same, Jody decreases the quantitydemanded of macaroni and cheese by 20 percent and increases the quantitydemanded of chicken by 5 percent.

9a.  Calculate the income elasticityof demand for macaroni and cheese.

9b.  Is macaroni and cheese a normalgood or an inferior good? Why?

9c.   Calculate the incomeelasticity of demand for chicken.

9d.  Is chicken a normal good or aninferior good? Why?

9e.   Is the demand for chickenincome elastic or income inelastic?

nAnswers

n   Checkpoint  5.1:  ThePrice Elasticity of Demand

1a.  The percentage change in price is 10 percent.The midpoint method shows the percentage change is  which is 10 percent.

1b.  The percentage change in quantity is 20percent. The midpoint method shows the percentage change is  which is 20 percent.

1c.   The demand for spring water is elasticbecause the percentage change in quantity demanded is greater than thepercentage change in price.

1d.  The demand for Pepsi is probably less elasticthan the demand for spring water because fewer close substitutes exist forPepsi. Coke and perhaps R.C. Cola are very close substitutes, but other sodas,such as Mountain Dew, are less close substitutes. Any brand of water, forexample Aquafina or Polar, or even plain tap water are substitutes for spring water.

1e.   The price elasticity of demand equals 20percent ¸ 10 percent,which is 2.0.

1f.   The price at which the elasticity of 2.0applies is the average price of $2.00 a bottle. 

1g.  The change in total revenue = -$2,000,000. This amount is the difference between the initial totalrevenue of $20,900,000 ($1.90 ´ 11million bottles) and the new total revenue of $18,900,000 ($2.10 ´ 9 million bottles). So, the seller’s total revenue decreases by $2million.

1h.  Thedemand for spring water is unit elastic at a price lower than $2.00 a bottle.At $2.00 a bottle, the elasticity equals 2.00. Moving down along a lineardemand curve, the elasticity falls in value. As we move down the demand curve,we will eventually reach the quantity at which the elasticity of demand isequal to 1.

2.     Although your students’ demand curves willbe different from the demand curve in Figure 5.1, there are certain featuresthat must be the same. First, point B,the point with the unit elasticity, must be at the midpoint of the demandcurve. Second, point A, the point atwhich the elasticity exceeds 1.0, must lie above point B on the demand curve. And third, point C, the point at which the elasticity is less than 1, must lie belowpoint B on the demand curve.

 

 

 

 

 

 

3.     Themore substitutes there are for a good or service, the more elastic is thedemand for the good or service. So, the more substitutes, the larger is theprice elasticity of demand.

4.     The demand for a luxury is generally moreprice elastic than the demand for a necessity. There are many substitutes for aluxury, including going without. There are not as many substitutes for anecessity.

n   Checkpoint 5.2:  The Price Elasticity of Supply

5a.  The supply of long grain rice is inelastic.The percentage change in the quantity supplied is less than the percentagechange in the price.

5b.  Once the seed has been planted, the supply ofrice becomes fixed for that period making supply inelastic unless the pricedrops so low that farmers decide not to harvest the rice. Once harvested, riceis a storable good which makes supply more elastic.

5c.   The price elasticity of supply equals 17percent ¸ 40 percent,which is 0.425.

5d.  Ifprice remains low, fewer farmers raise rice. As the price stays low, somefarmers leave the market. So, as more time passes, the quantity supplieddecreases by more and supply becomes more elastic.

6a.  The supply is perfectly inelastic because the number of seats canonly be supplied in a fixed quantity. Figure 5.2 illustrates the supply curve.

6b.  Ifthe university wants to increase its total revenue, it should increase ticketprices. The elasticity of demand for tickets equals 0.5, so demand isinelastic. If ticket prices increase, the percentage decrease in the quantityof tickets demanded is less than the percentage increase in the price. AssumingPodunk U.’s economist is correct, raisingticket prices increase totals revenue.

 

 

 

 

7.     The supply of rice is more elastic than thesupply of strawberries. Suppose the price of each falls. Because rice can bestored, a fall in the price of rice leads to a large quantity being stored, sothere is a large decrease in the quantity supplied. But strawberries cannot bestored, so a fall in the price of strawberries does not change the quantitysupplied because the strawberries must be sold. So the fall in priceresults in only a small decrease in the quantity supplied.

n   Checkpoint 5.3:  Cross Elasticity and Income Elasticity

8a.  The cross elasticity of demand of soda withrespect to burgers is equal to (67 percent) ¸ (-13 percent),which is -5.15. Thepercentage changes are calculated using the midpoint method.

8b.  Soda and burgers are complements because theyare goods that are consumed together. The cross elasticity of demand for acomplement is negative.

8c.   The cross elasticity of demand of pizza withrespect to burgers is equal to (-67percent) ¸ (-13 percent), which is 5.15. The percentages changes are calculatedusing the midpoint method.

8d.  Pizza and burgers are substitutes because theyare foods that can be consumed in place of each other. The cross elasticity ofdemand for a substitute is positive.

8e.   Thedemand for soda has increased and the demand curve has shifted rightward. Thedemand for pizza has decreased and the demand curve has shifted leftward.

9a.  The income elasticity of demand for macaroniand cheese is equal to (-20 percent)¸ (10 percent), which is -2.00.

9b.  Macaroni and cheese is an inferior goodbecause as Jody’s income increases, she consumes less of it. The incomeelasticity of demand for an inferior good is negative.

9c.   The income elasticity of demand for chickenis equal to (5 percent) ¸ (10percent), which is 0.50.

9d.  Chicken is a normal good because as Jody’sincome increases, she consumes more of it. The income elasticity of demand fora normal good is positive.

9e.   The demand for chicken is income inelasticthe percentage change in the quantity of chicken demanded is less than thepercentage change in income.

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