Chapter 5 Price Elasticity of Demand and Supply Key Concepts Summary Practice Quiz Internet Exercises ©2002 South-Western College Publishing

How is the percent increase or decrease of two numbers calculated? Percent change is the difference between the two numbers divided by the original number

Suppose the price of a rock concert increases by 10%, what effect will this have on sales? That all depends on the price elasticity of demand for this rock concert

What is elasticity? A term economists use to describe responsiveness, or sensitivity, to a change in price

What is price elasticity of demand? The ratio of the percentage change in the quantity demanded of a product to a percentage change in its price

Price Elasticity of Demand %  in Q demanded %  in price Ed =

Supposing a university’s enrollment drops by 20% because tuition rises by 10%, what is the price elasticity of demand?

-20% +10% -.20 +.10 Ed = = = 2

Why is elasticity 2 in the previous example and not -2? Economists drop the negative sign because we know from the law of demand that quantity demanded and price are inversely related

If there is an increase from 3 units to 5, what is the percentage increase? 2/3 = 66%

If there is a decrease from 5 units to 3, what is the percentage decrease? 2/5 = 40%

Problem - When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve

P A 2 B D 3 Q

Economists can solve this problem of different base points by using the midpoints as the base points of changes in prices and quantity demanded

divided by Price elasticity equals the  in quantity demanded sum of quantities/2 divided by  in price sum of prices/2

What is elastic demand? A condition in which the percentage change in quantity demanded is greater than the percentage change in price

P Elastic Demand Ed > 1 $40 A $30 B $20 $10 Q 10 20 30 40

Why is the demand curve in the previous slide elastic? The percentage change in the quantity demanded is greater than the percentage change in price

Increase in total revenue Elastic Demand Increase in total revenue Price decrease

10 15 % change in Q = .66 = 10 25 .40 % change in P = = % change in Q % change in P .66 .40 Ed = = Ed = 1.65

Inelastic Demand Ed < 1 $40 A $30 B $20 $10 10 20 30 40

Why is the demand curve in the previous slide inelastic? The percentage change in the quantity demanded is less than the percentage change in price

Decrease in total revenue Inelastic Demand Decrease in total revenue Price decrease

5 13 % change in Q = = .38 10 25 % change in P = .40 = % change in Q % change in P .38 .40 Ed = =

What is a unitary elastic demand curve? The percentage change in the quantity demanded is equal to the percentage change in price

Unitary Elastic Demand Ed = 1 $40 E $30 F D $20 $10 10 20 30 40

Unitary Elastic Demand No change in total revenue Price decrease

What is a perfectly elastic demand curve? A condition in which a small percentage change in price brings about an infinite percentage change in the quantity demanded

$40 $30 $20 8 Perfectly Elastic Demand Ed = $10 10 20 30 40

Perfectly Elastic Demand Infinite change in quantity demanded Price change

What is a perfectly inelastic demand curve? A condition in which the quantity demanded does not change as the price changes

Perfectly Inelastic Demand Ed = 0 $40 $30 $20 $10 10 20 30 40

Perfectly Inelastic Demand Zero change in quantity demanded Price change

If a college raises tuition, what happens to revenue? If demand is elastic - total revenue goes down If demand is inelastic - total revenue goes up

If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1

If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1

If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1

Price Elasticity of Demand Ranges $40 $35 Elastic $30 $25 $20 $15 Inelastic Unitary elastic $10 $5 5 10 15 20 25 30 35 40 45

Elastic Inelastic Unitary Elastic 5 10 20 25 30 35 40 45 Total Revenue Curve $400 $350 Elastic $300 Inelastic $250 $200 Unitary Elastic $150 $100 $50 5 10 15 20 25 30 35 40 45

What factors influence demand sensitivity? Availability of substitutes Share of budget on the product Adjustment to a price change over time

What do substitutes have to do with a price change? The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve

A B D D Which demand curve is for a vital medicine and which is for candy?

Why is A the demand curve for medicine? Because medicine is a necessity with few substitutes, and the price can change with little effect on the quantity demanded

Why is B the demand curve for candy? Because candy has many substitutes, a price change can bring about a big change in the quantity demanded

What does the share of one’s budget have to do with a price change? The larger the purchase is to one’s budget, the more sensitive consumers are to a price change, and the more elastic the demand curve

What does time have to do with sensitivity? The longer consumers have to adjust, the more sensitive they are to a price change, and the more elastic the demand curve

What are other elasticity measures? Income elasticity of demand Cross-elasticity of demand

What is Income elasticity of demand? The ratio of the percentage change in the quantity demanded of a good to a given percentage change in income

Income Elasticity of Demand %  in Q demanded %  in income Ed =

What is cross-elasticity of demand? The ratio of the percentage change in quantity demanded of a good to a given percentage change in price of another good

Cross-elasticity of Demand %  Q demanded of good A %  price of good B Ec =

What is the price elasticity of supply? The ratio of the percentage change in the quantity supplied of a product to the percentage change in its price

Price Elasticity of Supply %  in Q supplied %  in price Es =

$40 $30 $20 8 Perfectly Elastic Supply = $10 10 20 30 40

$40 Perfectly Inelastic Supply Es = 0 $30 $20 $10 10 20 30 40

Unit Elastic Supply Es = 1 $40 S $30 .5% $20 .5% $10 10 20 30 40

Who pays the tax levied on sellers of goods such as gasoline, cigarettes, and alcoholic beverages? It all depends; the corporation pays all, some, or very little of the tax

What decides who pays what part of the tax increase? The more elastic the demand, the more the corporation pays; the less elastic the demand, the more the consumer pays

Partially shifted tax to buyers $2.00 s2 $1.75 $1.50 s1 $1.25 Buyers $1.00 Sellers $.75 $.50 D $.25 5 10 15 20 25 30 35 40 45

Consumers and suppliers share burden of tax Decrease in supply Increase in gasoline tax

Fully shifted tax to buyers $2.00 s2 $1.75 $1.50 s1 Buyers $1.25 $1.00 $.75 $.50 D $.25 5 10 15 20 25 30 35 40 45

Consumers bear full burden of tax Decrease in supply Increase in gasoline tax

Key Concepts

Key Concepts What is elasticity? What is price elasticity of demand? What is elastic demand? What is a unitary elastic demand curve? What is a perfectly elastic demand curve? What is a perfectly inelastic demand curve?

Key Concepts cont. What factors influence demand sensitivity? What are other elasticity measures? What is Income elasticity of demand? What is cross-elasticity of demand? What is the price elasticity of supply?

Summary

Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in price. Specifically, price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price.

Price Elasticity of Demand %  in Q demanded %  in price Ed =

What is the midpoint formula for the price elasticity of demand?

divided by Price elasticity equals the  in quantity demanded sum of quantities/2 divided by  in price sum of prices/2

Elastic demand is a change of more than one percent in quantity demanded in response to a one percent change in price. Demand is elastic when the elasticity coefficient is greater than one and total revenue (price time quantity) varies inversely with the direction of the price change.

Elastic Demand $40 $30 $20 $10 10 20 30 40

Inelastic demand is a change of less than one percent in quantity demanded in response to a one percent change in price. Demand is inelastic when the elasticity coefficient is less than one and total revenue varies directly with the direction of the price change.

Inelastic Demand $40 $30 $20 $10 10 20 30 40

Unitary elastic demand is a one percent change in quantity demanded in response to a one percent change in price. Demand is unitary elastic when the elasticity coefficient equals one and total revenue remains constant as the price changes.

Unitary elastic Demand $40 $30 $20 $10 10 20 30 40

Perfectly elastic demand is a decline in quantity demanded to zero for even the slightest rise or fall in price. This is an extreme case in which the demand curve is horizontal and the elasticity coefficient equals infinity.

$40 $30 $20 8 Perfectly Elastic Supply = $10 10 20 30 40

Perfectly inelastic demand is no change quantity demanded in response to price changes. This is an extreme case in which the the demand curve is vertical and the elasticity coefficient equals zero.

$40 Perfectly Inelastic Supply Es = 0 $30 $20 $10 10 20 30 40

Determinants of price elasticity of demand include (a) the availability of substitutes, (b) the percentage of budget spent on the product, and (c) the length of time allowed for adjustment. Each of these factors is directly related to the elasticity coefficient.

Income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. For a normal good or service, income elasticity of demand is positive. For an inferior good or service, income elasticity of demand is negative.

Cross elasticity of demand is the percentage change in the quantity demanded of one product caused by a change in the price of another product. When the cross-elasticity of demand is negative, the two products are complements.

Price elasticity of supply is a measure of the responsiveness of the quantity demanded to a change in price. Price elasticity of supply is the ratio of the percentage change in quantity supplied to the percentage change in price.

Tax incidence is the share of a tax ultimately paid by buyers and sellers. Facing a downward-sloping demand curve and an upward-sloping supply curve, sellers cannot raise the price by the full amount of the tax. If the demand curve is vertical, sellers will raise the price by the full amount of a tax.

Fully shifted tax to buyers $2.00 s2 $1.75 $1.50 s1 Buyers $1.25 $1.00 $.75 $.50 D $.25 5 10 15 20 25 30 35 40 45

Partially shifted tax to buyers $2.00 s2 $1.75 $1.50 s1 $1.25 Buyers $1.00 Sellers $.75 $.50 D $.25 5 10 15 20 25 30 35 40 45

©2002 South-Western College Publishing Chapter 5 Quiz ©2002 South-Western College Publishing

1. If an increase in bus fares in Charlotte, North Carolina, reduces total revenue of the public transit system, this is evidence that demand is a. price elastic. b. price inelastic c. unitary elastic A. When price increases and the total revenue decreases, by definition, this represents an elastic demand curve. The revenue lost from selling fewer units is not offset by the revenue gained by charging a higher price.

2. Which of the following results in an increase in total revenue? a. Price increases when demand is elastic. b. Price decreases when demand is elastic. c. Price increases when demand is unitary elastic. d. Price decreases when demand is inelastic. B. When price decreases and the total revenue increases, the revenue gained by the increase in sales more than offsets the revenue lost from the lower price. By definition, this represents an elastic demand curve.

3. You are on a committee that is considering ways to raise money for your city’s symphony program. You would recommend increasing the price of symphony tickets only if you thought the demand curve for these tickets was a. inelastic. b. elastic. c. unitary elastic. d. perfectly elastic. A. When the demand curve is inelastic, the revenue gained from the higher price more than offsets the revenue lost from the decline in sales.

4. The price elasticity of demand for a horizontal demand curve is a. perfectly elastic. b. perfectly inelastic. c. unitary elastic. d. inelastic. A. A perfectly elastic demand curve exists when any increase in price leads to zero sales. The only curve that would illustrate this would be a horizontal line at the beginning price.

5. Suppose the quantity of steak purchased by the Jones family is 110 pounds per year when the price is $3.90 per pound and 90 pounds per year when the price is $2.10 per pound. The price elasticity of demand coefficient for this family is a. 0.33. b. 0.50. c. 1.00. d. 2.00. A. 20/100 divided by $1.80/$3.00 = .33

6. If a 5 percent reduction in the price of a good produces a 3 percent increase in the quantity demanded, the price elasticity of demand over this range of the demand curve is a. elastic. b. perfectly elastic. c. unitary elastic. d. inelastic. e. perfectly elastic. D. Since the percentage change in quantity demanded is less than the percentage change in price, this range is defined inelastic

7. A manufacturer of Beanie Babies hires an economist to study the price elasticity of demand for this product. The economist estimates that the price elasticity of demand coefficient for a range of prices close to the selling price is greater than 1. The relationship between changes in price and quantity demanded for this segment of the demand curve is a. elastic. b. inelastic. c. perfectly elastic. d. perfectly inelastic. A. Elasticity > 1 = elastic demand

8. A downward-sloping demand curve will have a a. higher price elasticity of demand coefficient along the top of the demand curve. b. lower price elasticity coefficient along the top of the demand curve. c. constant price elasticity of demand coefficient throughout the length of the demand curve. d. positive slope. A. The quantity demanded by consumers is more sensitive to a price change at higher prices than at lower prices.

9. The price elasticity of demand coefficient for a good will be less a. if there are few or no substitutes available. b. if a small portion of the budget will be spent on it. c. in the short run than in the long run. d. all of the above cases. D. A low elasticity of demand means that there is a low sensitivity to a change in price. When the good has few substitutes, or the purchase represents a small portion of one’s budget, or they do not have much time to adjust to the price change, price elasticity of demand is inelastic.

10. The income elasticity of demand for shoes is estimated to be 1. 50 10. The income elasticity of demand for shoes is estimated to be 1.50. We can conclude that shoes a. have a relatively steep demand curve. b. have a relatively flat demand curve. c. are a normal good. d. are an inferior good. B. A flat demand curve would illustrate that when the price changes the quantity demanded changes a lot. This would be represented by a relatively flat demand curve.

11. To determine whether two goods are substitutes or complements, an economist would estimate the a. price elasticity of demand. b. income elasticity of demand. c. cross-elasticity of demand. d. price elasticity of demand. C. Cross-elasticity of demand shows what will happen to the demand for one good if the price of a complementary good, or a good that is a substitute, changes.

12. If the government wanted to raise tax revenue and shift most of the tax burden to the sellers, it would impose a tax on a good with a a. steep (inelastic) demand curve and a steep (inelastic) supply curve. b. steep (inelastic) demand curve and a flat (elastic) supply curve. c. flat (elastic) demand curve and a steep (inelastic) supply curve. d. flat (elastic) demand curve and a flat (elastic) supply curve. C. A steep supply curve would mean that higher taxes will shift the supply curve to the left, but will have a small effect on the quantity supplied. A flat demand curve would mean that higher prices would not effect the quantity demanded very much.

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