Micro Lecture 5: Elasticity Basics

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1 Micro Lecture 5: Elasticity Basics Review: Market emand and Market Supply Curves Market demand curve: How many cans of beer would consumers purchase (the Market quantity demanded), if the price of beer were, given that everything else S relevant to the demand for beer remains the same? Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were, given that everything else relevant to the * supply of beer remains the same? Equilibrium (see Figure 5.1) In equilibrium emand and supply are equal * partners in determining the Figure 5.1: Market Equilibrium uantity emanded = uantity Supplied equilibrium price and quantity. Market Forces, the Equilibrium rice, and the Actual rice Figure 5.2 summarizes market forces: If Actual rice < Equilibrium rice If Actual rice > Equilibrium rice uantity emanded > uantity Supplied uantity emanded < uantity Supplied Shortage exists Surplus exists Actual rice rises Actual rice falls until the equilibrium is reached until the equilibrium is reached * surplus S shortage * Figure 5.2: Market forces Market forces push the actual price toward its equilibrium level. Assuming that the actual price is free to move, the actual price will equal the equilibrium price in short order. Shifts versus Movements Along the emand and Supply Curves Table 4.1 summarizes the distinction between shifts versus movements along a curve: Shifts Movements Along Change in something OTHER Change in the price of beer ITSELF THAN the price of beer ITSELF ã é The slopes of the demand and supply The demand curve for beer The supply curve of beer curves for beer capture the effect can SHIFT ONLY if can SHIFT ONLY if of a change in the BEER RICE itself; something that affects something that affects a change in the price of beer leads demand OTHER THAN supply OTHER THAN to a MOVEMENT ALONG the the BEER RICE changes. the BEER RICE changes. demand and supply curves for beer. Table 5.1: Shifts versus movements along a curve

2 2 roject: Advice for the AMTRAK The Vermonter is an AMTRAK train that travels from Washington,.C. to St. Albans, VT, with continuing bus service to Montreal, uebec. resently, the price of a ticket from Amherst to St. Albans is $39 as illustrated in figure 5.3. The following two individuals are suggesting ways to increase the revenues generated from Vermonter ticket sales. emand for the Vermonter rice ($/ticket) Mr. A: The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices Ms. B: That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse. Let us now evaluate these statements. What do we know? We know that the demand curve is downward sloping. Consequently, Mr. A is correct in asserting that a lower price would increase the number of tickets purchased, the quantity of tickets demanded. That is, lowering the ticket price would fill some of the empty seats. But how would the total revenue collected by AMTRAK from the Vermonter be affected? Total revenue equals the ticket price times the number of tickets purchased, the quantity of tickets demanded: Total Revenues = rice uantity emanded uantity (tickets) Figure 5.3: emand curve for Vermonter tickets If AMTRAK followed Mr. A s advice, the price would fall and quantity demanded would rise. What would happen to total revenue, the product of the price and quantity demanded? In fact, total revenue could rise, fall, or remain the same. To determine how total revenue would be affected, we need some additional information. Specifically, we need to know the price elasticity of demand for Vermonter tickets.

3 3 rice Elasticity of emand We begin with the intuitive notion of the price elasticity of demand and then make it more rigorous. We know that typically the quantity demanded decreases when the price increases and vice versa; that is, the market demand curve slopes downward. When a good becomes more expensive we purchase less of it; when a good becomes cheaper, we buy more. How sensitive is the quantity demanded, however? When the price decreases, do we buy just a little more or much more? The price elasticity of demand answers this question; it indicates how sensitive the quantity demanded is to the price., demand is said to be elastic; if the quantity demanded is not very sensitive, inelastic. We simply ask how sensitive is the quantity demanded to the price? emand Is Elastic not emand Is Inelastic More formally, the price elasticity of demand equals the percent change in quantity demanded caused by a one percent change in the price: rice Elasticity of emand = ercent change in the quantity demanded resulting from a 1 percent change in the price If the price elasticity of demand equals 1, a 1 percent change in the price results in a 1 percent change in the quantity demanded; in this case, demand is said to be unit elastic. (Note that economists are not very creative when it comes to definitions.) Unit elastic is the dividing line between elastic and inelastic demand. If the price elasticity of demand is greater than 1, then demand is elastic, the quantity demanded is very sensitive to the price; more specifically, a 1 percent change in the price results in a more than 1 percent change in the quantity demanded. If the price elasticity of demand is less than 1, demand is inelastic, the quantity demanded is not ; more specifically, a 1 percent change in the price results in a less than 1 percent change in the quantity demanded. not emand is Elastic Unit Elastic emand is Inelastic rice elasticity of rice elasticity of rice elasticity of demand greater than 1 demand equals 1 demand less than 1 1 percent change in 1 percent change in 1 percent change in price causes the quantity price causes the quantity price causes the quantity demanded to change by demanded to change by demanded to change by more than 1 percent exactly 1 percent less than 1 percent Now a warning: When we say demand is inelastic we do not mean that the quantity demanded is not at all sensitive to the price; instead, we mean that the quantity demanded is not. In all but the most extreme cases, the demand curve is downward sloping; consequently, an increase in the price causes a decrease in the quantity demanded. When demand is inelastic, an increase in the price causes only a small decrease in the quantity demanded.

4 4 Elasticity and Total Revenues Collected by Firms The total revenues collected by firms equals the good s price times the number of units consumers buy, the quantity demanded: Total Revenues = rice uantity emanded uestion: What happens to the total revenues collected when the price of a good falls? Since the demand curve is downward sloping, a decrease in the price increases the quantity demanded; when a good becomes less expensive, we buy more of it (see figure 5.4). Consequently, we cannot tell in general whether total revenue will rise or fall when the price increases: Total Revenues = rice uantity emanded Figure 5.4: emand curve price response Claim: To determine what happens to total revenue we need to know the price elasticity of demand. To justify this claim consider the following table: not emand is Elastic Unit Elastic emand is Inelastic rice elasticity of rice elasticity of rice elasticity of demand greater than 1 demand equals 1 demand less than 1 1 percent change in 1 percent change in 1 percent change in price causes the quantity price causes the quantity price causes the quantity demanded to change by demanded to change by demanded to change by more than 1 percent exactly 1 percent less than 1 percent 1% >1% 1% 1% 1% <1% rises constant falls Elastic demand When the price increases and demand is elastic total expenditures rises. In this case, the quantity demanded is very sensitive to the price. A 1 percent decrease in the price results in a more than 1 percent increase in the quantity demanded. Consequently, total revenues, the product of price and quantity demanded, rises. Unit elastic When the price increases and demand is unit elastic total expenditures are constant. In this case, a 1 percent decrease in the price results in a 1 percent increase in the quantity demanded. Consequently, total revenue, the product of price and quantity demanded, remains constant. Inelastic demand When the price decreases and demand is inelastic total expenditures fall. In this case, the quantity demanded is not. A 1 percent decrease in the price results in a less than 1 percent increase in the quantity demanded. Consequently, total revenues, the product of price and quantity demanded, falls.

5 5 Ticket rices for the Vermonter The Vermonter is an AMTRAK train that travels from Washington,.C. to St. Albans, VT. with continuing bus service to Montreal, uebec. resently, the price of a ticket is $39.00 as shown in figure 5.5. The following two individuals are consider ways to increase the revenues generated from Vermonter ticket sales: Mr. A: The Vermonter is operating with empty seats. To increase revenues, To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices. emand for the Vermonter rice ($/ticket) Ms. B: That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse. uantity (tickets) Figure 5.5: emand curve for Vermonter tickets To evaluate these statements, recall that the revenues AMTRAK collects from the Vermonter equal the total expenditures made by consumers: Total Revenues = rice uantity emanded If AMTRAK follows Mr. A s advice and lowers ticket prices, more consumers will ride the train, the quantity demanded decreases. In general, we cannot tell what happens to total revenue, however. It depends on the elasticity of demand. If demand were elastic rises If demand were inelastic falls On the one hand, if demand were elastic, the quantity demanded would be. The lower price would result in a large increase in the quantity demanded; AMTRAK s total revenues would rise. On the other hand, demand were inelastic, the lower price would result in a small increase in the quantity demanded; total revenues would fall. So, if demand is elastic, Mr. A is correct; if demand is inelastic, Ms. B is correct. If you were a policy maker at AMTRAK, it would be vital for you to obtain information about the price elasticity of demand. It would determine whether you recommend a decrease in ticket prices. This example shows that elasticity is not a concept that sadistic economics professors have dreamed up to make life difficult for introductory economics students. It can be critical when making real world decisions.

6 6 The Farming aradox Consider the following statements Mr. A: Good farming weather and bountiful harvests are bad for the farming community. oor weather and low harvests are good. ** S S Ms. B: You can't be serious. Have you gone crazy?" To evaluate these statements, suppose that farmers experience unusually bad weather. Figure 4.5 illustrates the effect of bad weather. The market supply curve shifts left. The price of food would rise from * to ** and the quantity of food would fall from * to **. ** * Figure 5.6: Farming paradox What happens to the total revenues collected by farmers? Total Revenues = rice uantity emanded In general, we cannot tell; the price has increased while the quantity decreased. The answer to the question depends on the elasticity of demand: If demand were elastic If demand were inelastic falls rises * In fact, the demand for food is inelastic. Consequently, the bad weather will increase the total revenues collected by the farming community. This explains the apparent paradox. What influences the price elasticity of demand? We have just studied two cases in which the price elasticity of demand plays an important role. Therefore, we will now consider what determines a good s elasticity of demand. While many factors play a role perhaps the most crucial is the availability of substitutes. To make this point, we will consider insulin, a good that has no substitutes. If you were a diabetic who needed to use insulin, you would have to take a specific amount of the drug every day. uestion: What would happen to the quantity of insulin demanded if the drug companies suddenly decided to reduce the price of insulin by 50 percent? Answer: Nothing as shown in figure 4.6. Figure 5.7: erfectly inelastic demand Those individuals who need insulin would not consume any more. They need a prescribed amount. Taking more or less than this amount could result in a coma. The demand for insulin is perfectly inelastic; the quantity demanded is constant, unaffected by the price. Beware, however, that goods whose demand is perfectly inelastic are very rare. On the other hand, the demand for many goods is inelastic; that is, for many goods, a change in the price will decrease the quantity demanded, but only by a small amount. Often, introductory students incorrectly assume that when demand is inelastic, the quantity demand is completely insensitive to the price; be careful not to fall into this trap. Next, let us consider luxuries and necessities. By definition, necessities have few substitutes; consequently, the demand for necessities is inelastic. Luxuries, on the other hand, tend to have many substitutes. This winter one might vacation in Tahiti or St. Bart s or Vale or Consequently, the demand for luxuries tends to be elastic.

7 7 Also, the scope of the good is important. For example, the demand for food in general is inelastic because there are few substitutes for food. On the other hand, the demand for one particular type of food, lima beans for example, would be elastic; there are many substitutes for lima beans: green beans, peas, etc. Income Elasticity of emand The income elasticity of demand indicates how sensitive the quantity demanded is to income. More formally, the income elasticity of demand equals the percent change in quantity demanded resulting from a 1 percent change in income: Income Elasticity of emand = ercent change in the quantity demanded resulting from a 1 percent change in income The income elasticity for most goods is positive; an increase in income results in a greater quantity demanded. There are some exceptions, however. For example, the quantity of Old Milwaukee Beer an individual purchases typically falls as income rises. As income rises, people typically purchase switch from Old Milwaukee to another brand: Budweiser, Coors, Heineken, etc. The income elasticity of demand for Old Milwaukee is negative; as income rises, the quantity of Old Milwaukee demanded decreases. Old Milwaukee is an example of an inferior good. Most goods are normal; for a normal good, the quantity demand rises whenever income increases: Normal good An increase in income leads to an increase in quantity demanded. Income elasticity of demand is positive. Inferior Good An increase in income leads to an decrease in quantity demanded. Income elasticity of demand is negative. By convention, when we use the term elasticity of demand without the word price of income preceding it, the word price is understood. In other words, when you see the term elasticity of demand, it is shorthand for the term the price elasticity of demand. (rice) Elasticity of Supply Just as we did with demand, we will begin with the verbal notion of the price elasticity of supply and then make it more formal. We know that typically the quantity supplied increases when the price increases and vice versa; that is, the market supply curve is upward sloping. How sensitive is the quantity supplied to the price, however. When the price increases, do firms produce just a little more or much more? The price elasticity of supply answers this question; it indicates how sensitive the quantity supplied is to the price. If the quantity supplied is, supply is said to be elastic; if the quantity supplied is not very sensitive, inelastic. We simply ask how sensitive is the quantity supplied to the price? If the quantity supplied is Elastic Supply If the quantity supplied is not very sensitive Inelastic Supply More formally, the price elasticity of supply is the percent change in quantity supplied caused by a one percent change in the price: rice Elasticity of Supply = ercent change in the quantity supplied resulting from a 1 percent change in the price

Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Monday, September 17 Lecture: Elasticity

Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Monday, September 17 Lecture: Elasticity Amherst College epartment of Economics Economics 111 Section 3 Fall 2012 Monday, September 17 Lecture: Elasticity Market emand and Market Supply Curves Market demand curve: How many cans of beer would