Reading Essentials and Study Guide

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1 Lesson 3 Elasticity of Demand ESSENTIAL QUESTION What are the causes for a change in demand? Reading HELPDESK Academic Vocabulary technical related to a particular subject such as art, science, or trade adequate just enough to satisfy a requirement Content Vocabulary elasticity a measure of responsiveness that tells us how a dependent variable such as quantity responds to a change in an independent variable such as price demand elasticity the extent to which a change in price causes a change in the quantity demanded elastic type of elasticity in which a change in the independent variable (usually price) results in a larger change in the dependent variable (usually quantity demanded or supplied) inelastic type of elasticity where the percentage change in the independent variable (usually price) causes a less than proportionate change in the dependent variable (usually quantity demanded or supplied) unit elastic elasticity where a change in the independent variable (usually price) generates a proportional change of the dependent variable (quantity demanded or supplied) Key Ideas and Details Use the graphic organizer below to compare and contrast elastic and inelastic consumer goods. Demand Type Elastic Demand Inelastic Demand Unit Elastic Demand Description 1

2 Elasticity is the measure of responsiveness that describes the way a dependent variable changes in response to a change in an independent variable. In economics, price is almost always the independent variable, or the variable that causes other things to change. For example, when price changes, the quantity demanded the dependent variable usually changes. If you ve ever gotten a catalog in the mail, or shopped at a store, you know about checking out the price of the goods you want. You ve probably seen a toy or clothing item you wanted to buy until you saw the high price tag. Your willingness or ability to buy that item and hence your demand for it dropped. There are plenty of other reasons that the demand for an item could change, but let s look at price. Conduct a survey of at least five of your friends. Ask them how much music they would buy if each song cost $.01, $1, $5, or $10. Then look at your results. Were they less likely to buy music as the price went up? Three Cases of Demand Elasticity Guiding Question How do we measure the three cases of demand elasticity? Consumers react to a change in price by changing the quantity demanded. For example, in Figure 4.3 we lowered the price of burritos from $5 to $3 and increased the quantity demanded from 24 to 40. This response is known as demand elasticity. It is the extent, or degree, to which a change in price causes a change in the quantity demanded. Elastic Demand Demand is elastic when a change in price causes a relatively larger change in quantity demanded. This is shown in Panel A of Figure 4.5. As we move from point a to point b, we see that price declines (goes down) by one-third, or from $3 to $2. At the same time, the quantity demanded doubles from two to four units. The percentage change in quantity demanded is larger than the percentage change in price. Therefore, demand between those two points is elastic. The demand for products like beans, corn, or other garden vegetables tends to be elastic. If the price goes up, consumers can switch to other vegetables. But if it goes down, they may switch from other vegetables. The key is that consumers have choices. They do not need any one vegetable urgently. Inelastic Demand Demand is inelastic when a given change in price causes a relatively smaller change in quantity demanded. This is shown in Panel B of Figure 4.5. A one-third drop in price from point a to b causes quantity demanded to increase (go up) by 25 percent, or from two to two and one-half units. For example, a price change for a cancer drug may not change the quantity purchased if patients need the medicine and don t have other options. Even if the price were cut in half, the quantity demanded might not increase if patients didn t need more. Unit Elastic Demand Demand is unit elastic when a change in price causes a proportional change, or equal percentage of change, in quantity demanded. For example, Panel C of Figure 4.5 shows that a drop in price from a to b causes an equal percentage increase in quantity demanded. Examples of unit elasticity are hard to find. This is because the demand for most products is either elastic or inelastic. Unit elasticity is more like a middle ground. It falls between elastic demand and inelastic demand. 2

3 To summarize, to measure the elasticity of demand, compare the percentage change in the quantity demanded and the percentage change in the price. Relatively smaller changes in quantity demanded indicate (show) inelastic demand. Relatively larger changes in quantity demanded indicate elastic demand. Changes that are proportional to the change in price are unit elastic. Comparing What is the difference between elastic and inelastic demand? The Total Expenditures Test Guiding Question How does the total expenditures test help determine demand elasticity? To figure elasticity, compare the direction of a price change to the direction of the change in total expenditures (amount spent). This is sometimes called the total expenditures test. Here are a few examples to make the idea easier to understand. Determining Total Expenditures We find total expenditures by multiplying the price of a product by the quantity demanded for a point on the demand curve. What consumers consider spending is the expenditure to the seller. To illustrate, the total expenditure under point a in Panel A of Figure 4.5 is $6 to either the buyer or the seller. Likewise, the total expenditure under point b in Panel A is $8, or four units at $2 each. Estimating Elasticity The relationship between a change in price and the change in total expenditures in each of the three diagrams in Figure 4.5 is shown in Figure 4.6. For example, in Panel A of Figure 4.5, the price decrease is enough to increase total expenditures from $6 to $8. This is an example of elastic demand because price and revenue (income) move in opposite directions. In Panel B of Figure 4.5, the same decrease in price causes a decrease in expenditures an example of inelastic demand. In Panel C of Figure 4.5, the decrease in price neither increases nor decreases total expenditures. This is because at point a, two units are demanded at a price of $3 for a total of $6. At b, three units are demanded at a price of $2 for a total of $6. When total expenditures do not change even though there is a change in price, that called is unit elasticity. Note that the same relationships hold if the price moves in the other direction. If price goes up from $2 to $3 in Panel A of Figure 4.5, then total revenue goes down. The change in price and the change in revenue move in opposite directions. If the price goes up in Panel C, revenue also moves up. 3

4 In summary, the changes among these relationships are: Elastic demand the change in price and the change in revenue move in opposite directions Inelastic demand the change in price and the change in revenue move in the same direction. Unit elastic demand there is no change in revenue regardless of the change in price Business Sales This discussion about elasticity may seem technical. However, knowledge of demand elasticity is very important to most businesses. Suppose that you run your own business and want to do something that will increase how much money people spend on your product. You could try to stay open longer or advertise more. You might also be tempted to raise the price of your product to increase sales. This might actually work in the case of tobacco products or medical services, because the demand for these products is generally inelastic. Also, an increase in price goes with an increase in revenue. However, what would happen if you sold a product with elastic demand? If you raised the price, expenditures, or the amount a consumer spends, would go down instead of up. That s exactly what you don t want! Many businesses experiment with, or try, different prices when they introduce a new product to the market. Knowing the demand elasticity for a new product lets a business set or change the price to raise the most expenditures. Explaining What happens to the total expenditures for a product with elastic demand when its price goes up? Determinants of Demand Elasticity Guiding Question What factors determine a product s demand elasticity? What makes the demand for a specific good elastic or inelastic? To find out, ask the following three questions. Can the Purchase Be Delayed? Sometimes consumers cannot put off buying a certain good. This tends to make demand for that good inelastic. The quantity of that product is not very sensitive to, or dependent on, price changes. For example, people who need to take a medication on a specific schedule will pay higher prices rather than delay buying the product. The demand for tobacco products also tends to be inelastic because the product is addictive. So, a sharp increase in price will lower the quantity purchased by consumers, but not by very much. The change in quantity demanded is also likely to be fairly small when their prices go down instead of up. But if the price of corn, tomatoes, or a computer game rises, consumers can delay buying any of these items without too much trouble. 4

5 Lesson 3 Elasticity of Demand Figure 4.7 summarizes some of these observations. If the answer to the question Can the purchase be delayed? is yes, then the demand for the product is likely to be elastic. If the answer to the question is no, then demand is likely to be inelastic. Are Adequate Substitutes Available? If adequate substitutes are available, consumers can switch between the product and its substitute to get the best price. If the price of beef goes up, buyers can switch to chicken. With enough substitutes, even small changes in the price of a product will cause people to switch, making the demand for the product elastic. However, the fewer the substitutes for a product, the more inelastic the demand is for it. Sometimes only a single adequate substitute is needed to make demand elastic. For example, in the past there were few substitutes for mailing a letter. Today, most people use or send instant messages. All the adequate substitutes make it difficult for the U.S. Postal Service to increase total expenditures by raising the price of stamps. The size of the market is also important. For example, the demand for gasoline or tobacco products at one store tends to be elastic. This is because consumers can buy gas or tobacco at another store. If we ask about the demand for gasoline or tobacco in general, however, demand is much more inelastic because there are few adequate substitutes for either. Does the Purchase Use a Large Portion of Income? The third factor is the amount of income required for you to make the purchase. If the amount is large, then demand tends to be elastic. If the amount of income is small, demand tends to be inelastic. Finally, you may have noticed that the answers to our three questions are not always yes or no for each product shown in Figure 4.7. Some products are easy to classify, because each of the answers is no. However, we have to think about others, or use judgment on them. For example, the demand for the services of doctors tends to be inelastic even though they tend to require a large portion of people s income. This is because most people want to get medical care right away or from a particular doctor. They don t want to take time to look for acceptable substitutes. Identifying Can you think of other goods with inelastic demand? Why is the demand for those goods inelastic? 5