# ELASTICITY AND ITS APPLICATION

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1 5 ELASTICITY AND ITS APPLICATION Questions for Review 1. If demand is elastic, an increase in price reduces total revenue. With elastic demand, the quantity demanded falls by a greater percentage than the price rises. As a result, total revenue declines. 2. Because the demand for drugs is likely to be inelastic, an increase in price will lead to a rise in total expenditure. Therefore, drug users may resort to theft or burglary to support their habits. 3. Figure 1 presents a supply-and-demand diagram, showing the equilibrium price, the equilibrium quantity, and the total revenue received by producers. Total revenue equals the equilibrium price times the equilibrium quantity, which is the area of the rectangle shown in the figure. Figure 1 4. The price elasticity of supply is usually larger in the long run than it is in the short run. Over short periods of time, firms cannot easily change the sizes of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price. 5. An elasticity greater than one means that demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in 87

2 88 Chapter 5/Elasticity and Its Application price. When the elasticity equals zero, demand is perfectly inelastic. There is no change in quantity demanded when there is a change in price. 6. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. It measures how much quantity supplied responds to changes in price. 7. The main advantage of using the mid-point formula is that it uses a constant base whether the change in price or quantity demanded is an increase or a decrease. 8. The price elasticity of supply of Picasso paintings is zero, because no matter how high price rises, no more can ever be produced. 9. The determinants of the price elasticity of demand include how available close substitutes are, whether the good is a necessity or a luxury, how broadly defined the market is, and the time horizon. Luxury goods have greater price elasticities than necessities, goods with close substitutes have greater elasticities, goods in more narrowly defined markets have greater elasticities, and the elasticity of demand is greater the longer the time horizon. 10. A good with income elasticity less than zero is called an inferior good because as income rises, the quantity demanded declines. 11. The price elasticity of demand measures how much quantity demanded responds to a change in price. The income elasticity of demand measures how much quantity demanded responds to changes in consumer income. Problems and Applications 1. a. If Maria always spends one-third of her income on clothing, then her income elasticity of demand is one, because maintaining her clothing expenditures as a constant fraction of her income means the percentage change in her quantity of clothing must equal her percentage change in income. b. Maria's price elasticity of clothing demand is also one, because every percentage point increase in the price of clothing would lead her to reduce her quantity purchased by the same percentage. c. Because Maria spends a smaller proportion of her income on clothing, then for any given price, her quantity demanded will be lower. Thus, her demand curve has shifted to the left. Because she will again spend a constant fraction of her income on clothing, her 2. If quantity demanded fell, price must have risen. If total revenue rose, then the percentage increase in the price must be greater than the percentage decline in quantity demanded. Therefore, demand is inelastic. 3. Yes, an increase in income would decrease the demand for good X because the income elasticity is less than zero, indicating that good X is an inferior good. A decrease in the price of good Y will decrease the demand for good X because the two goods are substitutes (as indicated by a cross-price elasticity that is greater than zero). income and price elasticities of demand remain one.

4 90 Chapter 5/Elasticity and Its Application c. Subway rides during the next five years have more elastic demand than subway rides during the next six months. Goods have a more elastic demand over longer time horizons. If the fare for a subway ride was to rise temporarily, consumers could not switch to other forms of transportation without great expense or great inconvenience. But if the fare for a subway ride was to remain high for a long time, people would gradually switch to alternative forms of transportation. As a result, the quantity demanded of subway rides during the next six months will be less responsive to changes in the price than the quantity demanded of subway rides during the next five years. d. Root beer has more elastic demand than water. Root beer is a luxury with close substitutes, while water is a necessity with no close substitutes. If the price of water were to rise, consumers have little choice but to pay the higher price. But if the price of root beer were to rise, consumers could easily switch to other sodas. So the quantity demanded of root beer is more responsive to changes in price than the quantity demanded of water. 9. a. If quantity demanded falls by 4.3% when price rises by 20%, the price elasticity of demand is 4.3/20 = 0.215, which is fairly inelastic. b. Because the demand is inelastic, the Transit Authority's revenue rises when the fare rises. c. The elasticity estimate might be unreliable because it is only the first month after the fare increase. As time goes by, people may switch to other means of transportation in response to the price increase. So the elasticity may be larger in the long run than it is in the short run. 10. Tom's price elasticity of demand is zero, because he wants the same quantity regardless of the price. Jerry's price elasticity of demand is one, because he spends the same amount on gas, no matter what the price, which means his percentage change in quantity is equal to the percentage change in price. 11. a. With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20% requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes currently \$2, this would require an increase in the price to \$3.33 a pack using the midpoint method (note that (\$3.33 \$2)/\$2.67 =.50). b. The policy will have a larger effect five years from now than it does one year from now. The elasticity is larger in the long run, because it may take some time for people to reduce their cigarette usage. The habit of smoking is hard to break in the short run. c. Because teenagers do not have as much income as adults, they are likely to have a higher price elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult to reduce their quantity demanded in response to a higher price. 12. In order to determine whether you should raise or lower the price of admissions, you need to know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of admissions will increase total revenue. If demand is inelastic, an increase in the price of admissions will cause total revenue to rise. 13. a. As Figure 2 shows, the increase in supply reduces the equilibrium price and increases the equilibrium quantity in both markets.

5 Chapter 5/Elasticity and Its Application 91 b. In the market for pharmaceutical drugs (with inelastic demand), the increase in supply leads to a relatively large decline in the equilibrium price and a small increase in the equilibrium quantity. Figure 2 c. In the market for computers (with elastic demand), the increase in supply leads to a relatively large increase in the equilibrium quantity and a small decline in the equilibrium price. d. Because demand is inelastic in the market for pharmaceutical drugs, the percentage increase in quantity will be lower than the percentage decrease in price; thus, total consumer spending will decline. Because demand is elastic in the market for computers, the percentage increase in quantity will be greater than the percentage decrease in price, so total consumer spending will increase. 14. a. As Figure 3 shows, the increase in demand increases both the equilibrium price and the equilibrium quantity in both markets. b. In the market for beachfront resorts (with inelastic supply), the increase in demand leads to a relatively large increase in the equilibrium price and a small increase in the equilibrium quantity. c. In the market for automobiles (with elastic supply), the increase in demand leads to a relatively large increase in the equilibrium quantity and a small increase in equilibrium price. d. In both markets, total consumer spending rises, because both equilibrium price and equilibrium quantity rise.

6 92 Chapter 5/Elasticity and Its Application Figure a. Farmers whose crops were not destroyed benefited because the destruction of some of the crops reduced the supply, causing the equilibrium price to rise. b. To tell whether farmers as a group were hurt or helped by the floods, you would need to know the price elasticity of demand. It could be that the total revenue received by all farmers as a group actually rose. 16. A worldwide drought could increase the total revenue of farmers if the price elasticity of demand for grain is inelastic. The drought reduces the supply of grain, but if demand is inelastic, the reduction of supply causes a large increase in price. Total farm revenue would rise as a result. If there is only a drought in Kansas, Kansas production is not a large enough proportion of the total farm product to have much impact on the price. As a result, price does not change (or changes by only a slight amount), while the output by Kansas farmers declines, thus reducing their income. 17. The quantity demanded at various prices is shown in the table below: Price Quantity Demanded

7 Chapter 5/Elasticity and Its Application 93 Figure 4 The demand curve is shown in Figure 4. When price rises from \$1 to \$2 (a % increase), quantity demanded falls from 60 to 30 (a 66.67% decrease). Therefore, the price elasticity of demand is equal to one. When price rises from \$5 to \$6 (an 18.18% increase), quantity demanded falls from 12 to 10 (an 18.18% decline). Again the price elasticity is equal to one. A linear demand curve has a price elasticity that declines in absolute value as price falls. This demand curve has a constant elasticity equal to one.

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