Elasticities of Demand and Supply

Elasticitiesof Demand and Supply

Chapter

5CHAPTER OUTLINE

1.Define and calculate the price elasticity of demand, and explain the factors that influence it.

A. Percentage Change in Price1. A Rise in Price2. A Fall in Price3. The Midpoint Method

B. Percentage Change in Quantity DemandedC. Comparing the Percentage Changes in Price and QuantityD.Elastic and Inelastic DemandE. Influences on the Price Elasticity of Demand

1. Availability of Substitutesa. Luxury Versus Necessityb. Narrowness of Definitionc. Time Elapsed Since Price Change

2. Proportion of Income SpentF. Computing the Price Elasticity of DemandG.Interpreting the Price Elasticity of Demand NumberH.Elasticity Along a Linear Demand CurveI. Total Revenue and the Price Elasticity of DemandJ. Applications of the Price Elasticity of Demand

1. Orange Prices and Total Revenue2. Addiction and Elasticity

© 2015 Pearson Education, Inc.

78 Part 2 . A CLOSER LOOK AT MARKETS

2.Define and calculate the price elasticity of supply, and explain the factors that influence it.

A. Elastic and Inelastic SupplyB. Influences on the Price Elasticity of Supply

1. Production Possibilitiesa. Time Elapsed Since Price Change

2. Storage PossibilitiesC. Computing the Price Elasticity of Supply

3.Define the cross price elasticity of demand and the income elasticity of demand, and explain the factors that influence them.

A. Cross Elasticity of DemandB. Income Elasticity of Demand

What’s New in this Edition?Chapter 5 is lightly updated from the sixth edition, with content for “A Rise in Price,” “A Fall in Price,” and “Comparing the Percentage Changes in Prices and Quantities” now separated into subheadings.

Where We AreIn this chapter we examine the price elasticity of de-mand, price elasticity of supply, cross elasticity of demand, and income elasticity of demand. The moti-vation for studying elasticity focuses on how elastic-ity can help make quantitative predictions about price and quantity changes. We study the total rev-enue test, which estimates the price elasticity of de-mand by observing the change in total revenue that results from a price change.

Where We’ve BeenWe have now examined why we study economics and have built basic models, such as the production possibilities frontier and the demand and supply framework.

Where We’re GoingThe next chapter continues to use the supply and de-mand framework to study the efficiency and fairness of markets. Consumer surplus and producer surplus will be introduced. We return to the concept of effi-ciency and study occasions when the market is inef-ficient. We discuss issues of fairness.


Chapter 5 . Elasticities of Demand and Supply 79

IN THE CLASSROOM

Class Time NeededYou can complete this chapter in no more than three sessions. Take the time to explain the idea of percentage changes and explicitly go over each of the calculations in computing the elasticity.

An estimate of the time per checkpoint is: 5.1 The Price Elasticity of Demand—70 to 90 minutes

5.2 The Price Elasticity of Supply—20 to 25 minutes

5.3 Cross Elasticity and Income Elasticity—15 to 20 minutes

Classroom Activity: A Georgia professor begins the discussion of elasticity by pass-ing around the class two rubber exercise bands. The green band is much harder to stretch than the pink band. Everybody has a great time pulling on the exercise bands. Some rubber bands, such as the green exercise band, don’t stretch very much. They are, comparatively, inelastic. And some rubber bands are quite stretchy. When the same amount of pressure is put on the pink exercise band as was placed on the green one, the pink band stretches much more. It, compared to the green band, is relatively elastic. What we’re really describing is how responsive the two exercise bands are to the same amount of force: the relatively elastic band responds a lot, while the relatively inelastic band responds less to the same amount of force. Similarly, when analyzing cause and effect relationships in economics, some causes have a greater effect on some variables than others. The greater the response, the more elastic the relationship. Therefore, if the price of gasoline (force) increases, peo-ple change their behavior only a little (less stretching) because they have few al-ternatives. The demand for gasoline is relatively inelastic. On the other hand, if the price of potatoes (more force) rises, people respond dramatically (more stretching), because there are plenty of alternatives. Demand for potatoes is rel-atively elastic.

Classroom Activity: After introducing the influences on the price elasticity of de-mand, break students into small groups and give them a list of goods. Have stu-dents rank the price elasticities of demand for these goods by considering the various influences (but standardize the time elapsed for them). For example, you can give them salt, an automobile, filet mignon, beef, Grey Poupon Dijon Mus-tard, and a Hawaiian vacation (you can choose your own goods, just make sure they highlight the influences). Ask students to rank the demand for these goods from where demand would be most inelastic to most elastic. While there is a mathematically “correct” ranking, it is not important that you actually know what it is. The important thing is being able to support arguments about the rel-ative price elasticities of demand based upon the influences. The actual correct ranking would be a far more advanced research project than any of your stu-dents (or you, for that matter) should be expected to undertake at this point. Re-mind students to consider all of the influences on the elasticity of demand when thinking about this list – whether the good is more of a luxury or necessity, whether the market is more narrowly or broadly defined, and whether the good would make up a fairly small or large proportion of a budget. Make sure to rein-



force to students that it is the combination of these influences that ultimately de-termine the price elasticity of demand, not just one of the influences. When you bring the class back together, have each group volunteer their rankings and record them on the board. While it is unlikely every group will have the same rankings, there will be remarkable similarities. Use the trends you see in these rankings to review the influences and analyze how discrepancies can be ex-plained by the assumptions made by different groups about how heavily to weigh these different influences. This exercise will get students practice interpreting the various influences on the price elasticity of demand and how the combination af-fects the price elasticity of demand for various goods.



CHAPTER LECTURE

5.1 The Price Elasticity of DemandIn general, elasticity measures responsiveness. The price elasticity of demand mea-sures how responsive demanders are to a change in the price of the good. This infor-mation is often useful for both businesses and governments.

Land Mine: Many students need a refresher and some practice at doing what seems too simple to bother with: calculating per-centages and percentage 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 the price of an economics text from $80 to $100. What is the percentage increase in price? Now suppose the campus book store cuts the price of an econom-ics text from $100 to $80. What is the percentage decrease in price? You’re now set to have the students use the average of the original and new price to calculate percentages that are indepen-dent of the direction of change.

Land Mine: Many students have a hard time remembering whether quantity or price goes in the numerator of the elasticity formulas. Have the students create their own mnemonic. Suggest McDonald’s Quarter Pounder™ hamburgers. It’s silly, but it works, reminding the student that Q (quantity) appears before P (price) in the ratio of percentage changes.

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 influ-ences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of:

Percentage Change in Price and Quantity Demanded One method for calculating the percentage change in the price is:

However this method gives different percentage changes depending if the price rises or falls. For instance, the $2 change from $8 to 10$ is a 25 per-cent change whereas 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 regardless of 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 abso-lute value is used when calculating the percentage changes so that any nega-tive sign is ignored.

Elastic and Inelastic Demand Demand is elastic if the percentage change in the quantity demanded ex-

ceeds the percentage change in price. If the quantity demanded changes by a large percentage in response to a

tiny price change, then the good is said to have perfectly elastic de-mand. The good’s demand curve is a horizontal line.

Demand is unit elastic if the percentage change in the quantity demanded equals the percentage change in price.

Demand is inelastic if the percentage change in the quantity demanded is less than the percentage change in price. If the quantity demanded remains constant when the price changes, so

that the percentage change in the quantity demanded is zero, then the good is said to have perfectly inelastic 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 to know the price elasticity of demand for their product because they want to know how a change in price affects their total revenue. Gov-ernments what to know the price elasticity of demand for various products, such as oil, because they want to predict the effect of a change in price on the quantity de-manded (as this will play a key role in how a tax impacts market outcomes). You should point these facts out to your students because many students are eager to learn when they know what they are learning will have real-life applications. So your discussion of 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 of substitutes: The more and the closer the substitutes for a good or service, the more elastic the demand for it. A luxury good has more substitutes than a necessity, so the demand

for luxuries is more elastic than the demand for necessities. The more narrowly defined a good (for example, a Mountain Dew at 2

PM) has more substitutes than a more broadly defined good (for ex-ample, a soda sometime today).

The longer the time elapsed since the price of the good changed, the more elastic the demand for the good.

The proportion of income spent on the good: The greater the proportion of income spent on a good or service, the more elastic the 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 a significant fraction of their budgets. Because the proportion of their income they spend on salt is large, the price elasticity of demand for these cities is much larger than that of “ordinary” consumers.

To practice applying the influences, have students compare the elasticity of demand for a few goods. Ask them which of the following would have a more elastic demand and why:● Food or whole wheat bread● Alcohol or Gatorade ● Gasoline one month after a price change or gasoline one year after a price change● A yacht or milk● Airfare for business travelers or airfare for leisure travelers

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. The absolute value of the percent

change in quantity demanded is [(500 400) 450] 100 = 22.2 per-cent.

The absolute value of the percentage change in price is [($14 $16) $15] 100 = 13.3 percent.

Between these two points on the demand curve, the price elasticity of de-mand 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 lower-ing the price a bit gains many customers.

Land Mine: Students sometimes wonder why we don’t just measure the slope of the demand curve to measure responsive-ness. Point out to the students that the slope will change when the units change. For instance, you can compute the slope of a demand curve when the price is measured in dollars and then the slope of the exact same demand curve when the price is mea-sured in cents. The slope with the price measured in cents is 100 times as large as the initial slope. Tell the students that it is not


Price(dollars per

pizza)

Quantitydemanded(pizzas per

week)14 50016 400


acceptable for the measure of responsiveness to change when-ever the units of the price (or of the quantity) change. To show the importance of a units-free measure of elasticity, you can cal-culate the slope of a demand curve when the vertical axis is mea-sured in dollars and again when it is measured in cents. Draw a demand curve for tacos, such that when the price rises from $1.00 to $1.05, the quantity demanded decreases from 50 to 45 tacos. The slope of the demand curve with the price measured in dollars is 0.01. Then, draw the identical demand curve, only this time measure the price in cents. When the price rises from 100 cents to 105 cents, the quantity demanded decreases from 50 to 45 units. Now the slope is 1.00. Point out that having the slope of the identical demand curve change simply because the units of the price change is surely not a good feature. In addition, the slope changes when the quantity units change. For this reason, economists do not use the slope as their measure of sensitivity. They use elasticity because elasticity is calculated using units-free percentage changes. Elasticity does not change if the units of the price or the quantity are changed.

Elasticity Along a Linear Demand Curve

With the exception of a vertical de-mand curve and a horizontal de-mand curve (along which the elas-ticity 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 de-mand is elastic while at points be-low the midpoint, the price elastic-ity of demand is inelastic. At the midpoint, the price elasticity of de-mand is unit elastic.

Total Revenue and the Price Elasticity of Demand The total 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. If demand is elastic, a 1 percent price cut increases the quantity sold by

more than 1 percent and total revenue increases. If demand is unit elastic, a 1 percent price cut increases the quantity sold

by 1 percent and total revenue does not change.



If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

The total revenue test is a method of estimating the price elasticity of de-mand by observing the change in total revenue that results from a change in price. If a percent price cut increases total revenue, demand is elastic. And if a

price hike decreases total revenue, demand is elastic. If a percent price cut does not change total revenue, demand is unit elas-

tic. And if a price hike does not change total revenue, demand is unit elas-tic.

If a percent price cut decreases total revenue, demand is inelastic. And if a price 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 con-sumed by much. In addition, the price elasticity of demand shows that the elasticity of demand for cigarettes by young people is larger than for estab-lished smokers. So although a tax will not have much of an effect on estab-lished smokers’ behavior, it will discourage smoking by younger people.

5.2 The Price Elasticity of Supply The price elasticity of supply measures how responsive the quantity sup-

plied is to a change in the price a good when all other influences on sellers’ plans remain unchanged. The price elasticity of supply compares the percent-age change in the quantity supplied to the percentage change in the price.

Elastic and Inelastic Supply Supply is elastic if the percentage change in the quantity supplied exceeds

the percentage change in price. If the quantity supplied changes by a large percentage in response to a

tiny price change, then the good is said to have perfectly elastic sup-ply.

Supply is unit elastic if the percentage change in the quantity supplied equals the percentage change in price.

Supply is inelastic if the percentage change in the quantity supplied is less than the percentage change in price. If the quantity supplied remains constant when the price changes, so

that the percentage change in the quantity supplied is zero, then the good is said to have perfectly inelastic supply.

Influences on the Price Elasticity of Supply The magnitude of the elasticity of supply depends on:

Production possibilities: The more unique or rare are the productive re-sources used to produce the good, the smaller the elasticity of supply.



The more common the productive resources used to produce the good, the larger the elasticity of supply.The time elapsed since the price change: The longer the amount of time

producers have to adjust to a change in price, the more elastic will be the supply.

Storage possibilities: If the good can be stored, its supply will be more elastic.

To practice applying the influences, have students compare the elasticity of supply for a few goods. Ask them which of the following would have a more elastic supply and why:

● Fresh produce or canned produce● Diamond rings or cubic zirconia rings● Crude oil one month after a price change or crude oil one year after a price change● Housing in Hawaii or housing in Kansas

Computing the Price Elasticity of Supply The price elasticity of supply is equal to:

The table to the right has two points on the supply curve for pizza from a pizza parlor. The percentage change in the quantity

supplied is [(400 300) 350] 100 = 28.6 percent.

The percentage change in price is [($16 $14) $15] 100 = 13.3 per-cent.

Between these two points, the elasticity of supply is 28.6% 13.3% = 2.15.

5.3 Cross Elasticity and Income Elasticity

Cross Elasticity of Demand The cross elasticity of demand is a measure of the responsiveness of the

demand for a good to a change in the price of a substitute or compliment, other things remaining the same.

The cross elasticity of demand is equal to:

The cross elasticity of demand is positive for substitutes and negative for complements.


Price(dollars per

pizza)

Quantitysupplied

(pizzas per week)

14 30016 400


Use examples to show the students why the cross elasticity of demand is positive for substitutes and negative for complements. For instance, suppose the price of Coke rises. What effect does this price hike have on the demand for Pepsi? Students will immediately realize that the demand for Pepsi increases. So in this case the cross elasticity of demand for Pepsi with respect to the price of Coke is calculated by di-viding one positive number by another, so the result will be positive. For comple-ments, such as bowling balls and bowling shirts, a price hike for bowling balls de-creases the demand for bowling shirts. So in this case the cross elasticity of demand for bowling shirts with respect to the price of bowling balls is a negative number di-vided by a positive number, so the result will be negative.

Income Elasticity of Demand The income elasticity of demand is a measure of the responsiveness of the

demand for a good to a change in the income, other things remaining the same.

The income elasticity of demand is equal to:

The income elasticity of demand is positive for normal goods and negative for inferior goods.

Land Mine: Elasticity is a subject that can overwhelm students by the many details. Be sure to stress the common features of all the different elasticities. All elasticities measure how strongly people respond to a change in some factor; all elasticities use percentage changes; and all elasticities divide the percentage change in the quantity by the percentage change in the relevant factor. Of these features, the most important is the fact that elas-ticities measure responsiveness. Stress this fact and your stu-dents will find it significantly easier to comprehend all the myriad details.



USING EYE ON THE GLOBAL ECONOMY

Price Elasticities of DemandOften the relatively theoretical nature of economics takes students by surprise. They expect a typical business course in which only “practi-cal, real-world” issues are studied. Elasticity is precisely the sort of “practical, real-world” concept that can appeal to this set of students. The price elasticities of demand in this “Eye on the Global Economy” can be used in test questions, to make the questions more realistic. You also can use them in a 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 motor vehicles or clothing? The demand for furniture or food? The demand for metals or oil? Ask the students to explain their answers and then present them with the ac-tual rankings from this Eye on the Global Economy.

USING EYE ON THE PRICE OF GASOLINE

What Do You Do When the Price of Gasoline Rises?As consumers with automobiles and very limited budgets (typically), the demand for gasoline is perhaps the first example that students think of when the price elasticity of 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 in this Eye to give students practice calculating the price elasticity of demand and use these calculations to compare to the price elasticity of demand for other goods (as given in the Eye on the Global Economy on page 119). Although the time elapsed is not given for these other calculations so it is not quite ceteris paribus, the extremely inelastic demand for gasoline seen in this Eye can help illustrate how Americans have made gasoline such a necessity that it rivals the elasticity of demand for other life “essentials,” such as food, beverages, housing services, and clothing. Ask students to speculate about the price elasticity of demand for gasoline across different regions of the U.S. – why might it vary? Also, why might it vary around the world? Why might demand be more inelastic in the U.S. than in Europe, China, Canada, or Mex-ico? Is the highly inelastic demand for gasoline in the U.S. inevitable? Have students brainstorm a list of what changes could take place (both shorter term and longer term) that would make the demand for gasoline in the U.S. more elastic. Also, you can have students think about the impact that gas taxes have on gasoline consumption in the U.S. (though this will be more formally addressed in Chapter 8, intro-ducing this concept now can get students thinking about the impor-tant role that elasticities play in market outcomes).



USING EYE ON YOUR LIFE

Your Price Elasticities of DemandThis Eye presents an interesting discussion explaining how the stu-dents can determine if their demand for a good or service is elastic, inelastic, or unit elastic. You can point out to your students that this information is useful when they are thinking about public policies such as taxation. In particular, would they rather see a tax imposed on a product for which their demand is elastic or inelastic? Though this topic is handled more formally in a future chapter, you can point out to your students that almost surely 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 close substitutes. As a result, if the price of the taxed product rises as a result of the tax, the stu-dents can readily find other products to take its place and thereby avoid paying most of the tax. On the other hand, if their demand for the good or service is inelastic, there are no close substitutes for the specific product. In this case, if the price of the product rises when the tax is imposed, the students will wind up buying some of it anyway and thereby are unable to escape the effect of the tax. By presenting this sort of intuitive, “real-world” discussion in this chapter you can be extremely helpful in conveying to students the basic intuition about tax incidence, which is studied more formally in an up-coming chap-ter.



ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions Checkpoint 5.1: The Price Elasticity of Demand1. The price of spring water rises from $1.90 to $2.10 a bottle, and

the quantity demanded decreases from 11 million to 9 million bottles a week.

1a. Calculate the percentage change in the price of spring water.1b. Calculate the percentage change in the quantity demanded of

spring water.1c. Is the demand for spring water elastic or inelastic?1d. Would the demand for Pepsi be more elastic or less elastic than

the demand for spring water? Why?1e. Calculate the price elasticity of demand for spring water.1f. At what price is the price elasticity of demand for spring water

equal to your answer in part (e)?1g. What is the change in the total revenue of sellers of spring wa-

ter?1h. If the demand curve for spring water is a straight-line demand

curve, is the price at which the demand for spring water is unit elastic a higher price or a lower price than your answer to part (f)? Why?

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

3. What role does the presence or absence of substitutes play in de-termining the size of the price elasticity of demand?

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

Checkpoint 5.2: The Price Elasticity of Supply5. The price of U.S.-produced long grain rice fell by 40 percent from

January 1999 to January 2000. In response to the price fall, grow-ers of U.S. long grain rice planted 17 percent less acreage in 2000. If the harvest also decreases by 17 percent:

5a. How would you describe the supply of U.S. long grain rice?5b. How do you think production possibilities and storage possibili-

ties influence the price elasticity of supply of long grain rice?5c. Calculate the price elasticity of supply of U.S.-produced long

grain rice.5d. If the price of long grain rice remains the same, do you think the

elasticity of supply will change over the coming years? Explain your answer.

6a. Suppose that Podunk University wins the 2002 college basketball championship. As a result, Podunk U’s fans increase their de-mand for tickets for the 2003 season. Podunk U. plays in an



arena that seats 7,000 people. Describe the supply of basketball tickets at Podunk U. and draw a supply curve for tickets.

6b. Podunk U.’s economist has calculated the price elasticity of de-mand for tickets to be 0.50. Podunk U.’s president is committed to increasing the total revenue collected by the university. To do so, should Podunk raise or lower its ticket prices?

7. Once harvested, rice is storable but strawberries are not. As a re-sult, which will be more elastic: The supply of rice or the supply of strawberries?

Checkpoint 5.3: Cross Elasticity and Income Elasticity8. Suppose that when the price of a burger decreases from $2.00 to

$1.75 and other things remain the same, the quantity demanded of burgers increases from 200 an hour to 400 an hour and the quantity demanded of pizza decreases from 400 an hour to 200 an hour. At the same time, the quantity demanded of soda in-creases from 150 an hour to 300 an hour.

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

8b. Are soda and burgers substitutes or complements? Why?8c. Calculate the cross elasticity of demand for pizza with respect to

burgers.8d. Are pizza and burgers substitutes or complements? Why?8e. Describe how the demand for soda and the demand for pizza have

changed.

9. When Jody's income increases by 10 percent and other things re-main the same, Jody decreases the quantity demanded of maca-roni and cheese by 20 percent and increases the quantity de-manded of chicken by 5 percent.

9a. Calculate the income elasticity of demand for macaroni and cheese.

9b. Is macaroni and cheese a normal good or an inferior good? Why?9c. Calculate the income elasticity of demand for chicken.9d. Is chicken a normal good or an inferior good? Why?9e. Is the demand for chicken income elastic or income inelastic?

Answers Checkpoint 5.1: The Price Elasticity of Demand1a. 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 20 percent. The midpoint method shows the percentage change is

which is 20 percent.



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

1d. The demand for Pepsi is probably less elastic than the demand for spring water because fewer close substitutes exist for Pepsi. 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, for example Aquafina or Polar, or even plain tap water are substitutes for spring water.

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

1f. The price at which the elasticity of 2.0 applies 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 total revenue of $20,900,000 ($1.90 11 million bottles) and the new total revenue of $18,900,000 ($2.10 9 million bottles). So, the seller’s total revenue de-creases by $2 million.

1h. The demand 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. Mov-ing down along a linear demand 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 is equal to 1.

2. Although your students’ demand curves will be different from the demand curve in Figure 5.1, there are certain features that must be the same. First, point B, the point with the unit elasticity, must be at the midpoint of the demand curve. Second, point A, the point at which 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 below point B on the demand curve.

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

4. The demand for a luxury is generally more price elastic than the demand for a necessity. There are many substitutes for a luxury,



including going without. There are not as many substitutes for a necessity.

Checkpoint 5.2: The Price Elasticity of Supply5a. The supply of long grain rice is inelastic. The percentage change

in the quantity supplied is less than the percentage change in the price.

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

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

5d. If price remains low, fewer farmers raise rice. As the price stays low, some farmers leave the market. So, as more time passes, the quantity supplied decreases by more and supply becomes more elastic.

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

6b. If the university wants to increase its to-tal revenue, it should increase ticket prices. The elasticity of demand for tick-ets equals 0.5, so demand is inelastic. If ticket prices increase, the percentage decrease in the quantity of tickets de-manded is less than the percentage in-crease in the price. Assuming Podunk U.’s economist is correct, raising ticket prices increase totals revenue.

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

Checkpoint 5.3: Cross Elasticity and Income Elasticity8a. The cross elasticity of demand of soda with respect to burgers is

equal to (67 percent) (13 percent), which is 5.15. The percent-age changes are calculated using the midpoint method.



8b. Soda and burgers are complements because they are goods that are consumed together. The cross elasticity of demand for a com-plement is negative.

8c. The cross elasticity of demand of pizza with respect to burgers is equal to (67 percent) (13 percent), which is 5.15. The percent-ages changes are calculated using the midpoint method.

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

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

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

9b. Macaroni and cheese is an inferior good because as Jody’s in-come increases, she consumes less of it. The income elasticity of demand for an inferior good is negative.

9c. The income elasticity of demand for chicken is equal to (5 per-cent) (10 percent), which is 0.50.

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

9e. The demand for chicken is income inelastic the percentage change in the quantity of chicken demanded is less than the per-centage change in income.


Elasticities of Demand and Supply

Business

Transcript of Elasticities of Demand and Supply