CHAPTER 7

Elasticity

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# CHAPTER OVERVIEW

This chapter is the first of the chapters in Part Five, “Microeconomics of Product Markets.”  Students will benefit by reviewing Chapter 3’s demand and supply analysis prior to reading this chapter. Depending upon the course outline used in the micro principles course, this chapter could be taught after Chapter 3.

Both the elasticity coefficient and the total receipts test for measuring price elasticity of demand are presented in the chapter.  The text attempts to sharpen students’ ability to estimate price elasticity by discussing its major determinants.  The chapter reviews a number of applications and presents empirical estimates for a variety of products.  Cross and income elasticities of demand and price elasticity of supply are also addressed.

Finally, price ceilings and price floors are discussed as well as the economic consequences on the market of government-set prices.

# LECTURE NOTES

I.          Introduction

A.  Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumers’ income, or change in price of related product.

B.   Price elasticity is a concept that also relates to supply.

C.   The chapter explores both elasticity of supply and demand and applications of the concept.

D.  The chapter also looks at the effects of government-set prices on individual markets.

II.        Price Elasticity of Demand

A.  Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.

B.   The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.

1.   If consumers are relatively responsive to price changes, demand is said to be elastic.

2.   If consumers are relatively unresponsive to price changes, demand is said to be inelastic.

3.   Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness.  A precise definition of what we mean by “responsive” or “unresponsive” follows.

C.   Price elasticity formula:

Quantitative measure of elasticity, Ed = percentage change in quantity/ percentage change in price.

1.   Using two price-quantity combinations of a demand schedule, calculate the percentage change in quantity by dividing the absolute change in quantity by one of the two original quantities. Then calculate the percentage change in price by dividing the absolute change in price by one of the two original prices.

2.   Estimate the elasticity of this region of the demand schedule by comparing the percentage change in quantity and the percentage change in price.  Do not use the ratio formula at this time.  Emphasize that it is the two percentage changes that are being compared when determining elasticity.

4.   Show that if the other original quantity and price were used as the denominator that the percentage changes would be different.  Explain that a way to deal with this problem is to use the average of the two quantities and the average of the two prices.

5.   Emphasis: What is being compared are the percentages changes, not the absolute changes.

a.   Absolute changes depend on choice of units.  For example, a change in the price of a \$10,000 car by \$1 and is very different than a change in the price a of \$1 can of beer by \$1.  The auto’s price is rising by a fraction of a percent while the beer rice is rising 100 percent.

b.   Percentages also make it possible to compare elasticities of demand for different products.

6.   Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number.  However, we ignore the minus sign and use absolute value of both percentage changes.

7.   If the coefficient of elasticity of demand is a number greater than one, we say demand is elastic; if the coefficient is less than one, we say demand is inelastic. In other words, the quantity demanded is “relatively responsive” when Ed is greater than 1 and “relatively unresponsive” when Ed is less than 1.  A special case is if the coefficient equals one; this is called unit elasticity.

8.   Note: Inelastic demand does not mean that consumers are completely unresponsive.  This extreme situation called perfectly inelastic demand would be very rare, and the demand curve would be vertical.

9.   Likewise, elastic demand does not mean consumers are completely responsive to a price change.  This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal.

D.  The best formula for elasticity is:

E = [(change in Q)/(change in P)]

1.   Calculate each of the percentage changes separately using to determine whether the demand is elastic or inelastic.  After you have determined the type of elasticity, then have them insert the percentage changes into the formula.

2.   Students should practice the exercise in Table 20.1. (Key Question 2)

E.   Graphical analysis:

1.   Illustrate graphically perfectly elastic, relatively elastic, unitary elastic, relative inelastic, and perfectly inelastic.

2.   Using Figure 20.2, explain that elasticity varies over range of prices.

a.   Demand is more elastic in upper left portion of curve (because price is higher, quantity smaller).

b.   Demand is more inelastic in lower right portion of curve (because price is lower, quantity larger).

3.   It is impossible to judge elasticity of a single demand curve by its flatness or steepness, since demand elasticity can measure both elastic and inelastic at different points on the same demand curve.

F.   Total-revenue test is the easiest way to judge whether demand is elastic or inelastic.  This test can be used in place of elasticity formula, unless there is a need to determine the elasticity coefficient.

1.   Elastic demand and the total-revenue test: Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue.  (Price and revenue move in opposite directions).

2.   Inelastic demand and total revenue test: Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue.  (Price and revenue move in same direction).

3.   Unit elasticity and the total revenue test: Demand has unit elasticity if total revenue does not change when the price changes.

4.   The graphical representation of the relationship between total revenue and price elasticity is shown in Figure 20.2.

5.   Table 20.2 provides a summary of the rules and concepts related to elasticity of demand.

G.   There are several determinants of the price elasticity of demand.

1.   Substitutes for the product: Generally, the more substitutes, the more elastic the demand.

2.   The proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.

3.   Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand.

4.   The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

H.  Table 20.3 presents some real‑world price elasticities.  Use the determinants discussed to see if the actual elasticities are equivalent to what one would predict.   (Questions 9 and 10)

I.    There are many practical applications of elasticity.

1.   Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers.

2.   Governments look at elasticity of demand when levying excise taxes.  Excise taxes on products with inelastic demand will raise the most revenue and have the least impact on quantity demanded for those products.

3.   Demand for cocaine is highly inelastic and presents problems for law enforcement.  Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business.  Crime may also increase as buyers have to find more money to buy their drugs.

a.   Opponents of legalization think that occasional users or “dabblers” have a more elastic demand and would increase their use at lower, legal prices.

b.   Removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right.

4.   The impact of minimum-wage laws will be less harmful to employment if the demand for minimum-wage workers is inelastic.

III.       Price Elasticity of Supply

A.  The concept of price elasticity also applies to supply.  The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula.

Es = percentage change in quantity supplied / percentage change in price

As with price elasticity of demand, the midpoints formula is more accurate.

B.   The time period involved is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her resources to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries. (Figure 20.3)

1.   The market period is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical.  In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied.  (Think of adjustments on a farm once the crop has been planted.)

2.   The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change.  Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift.

3.   The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price, as in Figure 20.3c.  The producer has time to build a new plant.

IV.       Cross and income elasticity of demand:

A.  Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product.  Numerically, the formula is shown for products X and Y.

Exy = (percentage change in quantity of X) / (percentage change in price of Y)

1.   If cross elasticity is positive, then X and Y are substitutes.

2.   If cross elasticity is negative, then X and Y are complements.

3.   Note:  if cross elasticity is zero, then X and Y are unrelated, independent products.

B.   Income elasticity of demand refers to the percentage change in quantity demanded that results from some percentage change in consumer incomes.

Ei = (percentage change in quantity demanded) / (percentage change in income)

1.   A positive income elasticity indicates a normal or superior good.

2.   A negative income elasticity indicates an inferior good.

3.   Those industries that are income elastic will expand at a higher rate as the economy grows.

V.         Government-Set  Prices

A.  Price ceilings are maximum legal prices a seller may charge for a product or service; they have been established historically to enable consumers to obtain some “essential” good or service that they could not afford at the market equilibrium price.

1.   Figure 20.4 illustrates the problem that arises when the price is set below the equilibrium price.  Shortages will result, since the quantity demanded will be greater than the quantity supplied at the lower price.  This presents problems to the government.

a.   How should the available supply be apportioned among buyers?  Some possibilities include first‑come, first‑served or ration cards.

b.   Black markets arise as some consumers obtain the item at the fixed price and resell it at the higher price that many consumers are willing and able to pay.

2.   Rent controls also create special problems because they make it less attractive for landlords to offer housing in that market, and so shortages of housing will develop.

3.   Interest ceilings on credit cards have also been proposed but might create problems, according to a Federal Reserve study.

a.   Card issuers might tighten credit standards.

b.   The annual fee would probably rise or transaction fees would emerge.

c.   The interest‑free “grace period” available on most cards might disappear.

d.   Retail stores might raise prices to offset decline in interest income on their credit cards.

B.   Price floors are minimum prices set by government above the equilibrium.  Examples include farm price subsidies and minimum wage laws.

1.   Price floors result in persistent surpluses, since the quantity supplied will be above the quantity demanded (see Figure 20.5).

2.   There are government policies to cope with surpluses.

a.   Government may obtain agreement of the sellers to restrict supplies in exchange for the price floor.

b.   Government may purchase the surplus if efforts to restrict supply are not successful.

C.   Controversial Tradeoffs: Price ceilings or price floors destroy the rationing function of the market‑price system. Price ceilings cause shortages; price floors create surpluses.

1.   Price ceilings or price floors destroy the rationing and guiding functions of the market‑price system.

2.   Government must step in and provide a rationing system for product shortages created by price ceilings, and devise methods to eliminate product surpluses from price floors.

3.   Government interference with market processes imposes administrative costs and unwanted side effects that must be weighed against the alleged benefits.

VI.       LAST WORD:  Luxury on \$8 Day

A.  Rent controls in New York City have allowed long-term residents of some high-priced hotels to continue to live in the hotel for a fraction of the usual room rent.

B.   New York City regulations allow landlords to increase rents on apartments that are vacant, but they cannot increase the rent on an apartment that continues to be occupied by the same tenant.

C.   Some hotels have tried to encourage the permanent residents to move by offering to pay them as much as \$250,000.  Few have taken the offer.