HOW MUCH MORE OR LESS? DOES IT MATTER? THE LAW OF DEMAND SAYS... Consumers will buy more when prices go down and less when prices go up 1

Elasticity Elasticity shows how sensitive quantity is to a change in price.

4 Types of Elasticity 1.Elasticity of Demand 2.Elasticity of Supply 3.Cross-Price Elasticity (Substitutes or Complements) 4.Income Elasticity (Normal or Inferior)

1. Elasticity of Demand Elasticity of Demand Measurement of consumers’ responsiveness to a price change. What will happen if price increases? How much will it affect quantity demanded? Who cares? Firms! – can we get away with a big price increase? How many more customers would we get if we lowered our prices? Governments – how much sales tax can we get away with?

Inelastic Demand

If price increases, quantity demanded will fall a little If price decreases, quantity demanded increases a little. In other words, people will continue to buy it. 20% 5% INelastic = Quantity is INsensitive to a change in price. Examples Gasoline Milk Diapers Chewing Gum Medical Care Toilet paper

Inelastic Demand 20% 5% General Characteristics of INelastic Goods: Few Substitutes Necessities Small portion of income Required now, rather than later Elasticity coefficient less than 1 % Change in Quantity % Change in Price

Elastic Demand

If price increases, quantity demanded will fall by a lot If price decreases, quantity demanded increases a lot. The amount people buy is very sensitive to price. Elastic = Quantity is sensitive to a change in price. Examples Soda Beef Cars Boats

Elastic Demand General Characteristics of Elastic Goods: Many Substitutes Luxuries Large portion of income Plenty of time to decide Elasticity coefficient greater than 1 % Change in Quantity % Change in Price

Elastic or Inelastic? Beef- Gasoline- Real Estate- Medical Care- Electricity- Gold- Elastic INelastic -.20 Elastic INelastic -.31 INelastic -.13 Elastic What about the demand for insulin for diabetics? Perfectly INELASTIC (Coefficient = 0) What if % change in quantity demanded equals % change in price? Unit Elastic (Coefficient =1)

12 Warm Up Take a minute to cram for the quiz!

Total Revenue Test Uses elasticity to show how changes in price will affect total revenue (TR). (TR = Price x Quantity) Elastic Demand- Price increase causes TR to decrease Price decrease causes TR to increase Inelastic Demand- Price increase causes TR to increase Price decrease causes TR to decrease Unit Elastic- Price changes and TR remains unchanged Ex: If demand for milk is INelastic, what will happen to expenditures on milk if price increases?

14 Demand Curve and Total Revenue

Moving from left to right along a downward sloping linear demand curve, price elasticity varies in which of the following ways? (A) First unit elastic, then inelastic throughout (B) First unit elastic, then elastic throughout (C) First inelastic, then unit elastic throughout (D) First elastic, then unit elastic, and finally inelastic (E) First inelastic, then unit elastic, and finally elastic

Moving from left to right along a downward sloping linear demand curve, price elasticity varies in which of the following ways? (A) First unit elastic, then inelastic throughout (B) First unit elastic, then elastic throughout (C) First inelastic, then unit elastic throughout (D) First elastic, then unit elastic, and finally inelastic (E) First inelastic, then unit elastic, and finally elastic

17 Assume that demand for bottled water is relatively price elastic. An increase in supply of bottled water will result in which of the following? (A) A decrease in price, leading to an increase in total revenue (B) A decrease in price, leading to a decrease in total revenue (C) An excess supply of bottled water (D) An excess demand for bottled water (E) A relatively small decrease in price and no change in equilibrium quantity

18 Assume that demand for bottled water is relatively price elastic. An increase in supply of bottled water will result in which of the following? (A) A decrease in price, leading to an increase in total revenue (B) A decrease in price, leading to a decrease in total revenue (C) An excess supply of bottled water (D) An excess demand for bottled water (E) A relatively small decrease in price and no change in equilibrium quantity

Is the range between A and B, elastic, inelastic, or unit elastic? A B 10 x 100 =$1000 Total Revenue 5 x 225 = $1125 Total Revenue Price decreased and TR increased, so… Demand is ELASTIC 125% 50% % Change in Quantity % Change in Price

2. Price Elasticity of Supply Elasticity of Supply- Elasticity of supply shows how sensitive producers are to a change in price. Elasticity of supply is based on time limitations. Producers need time to produce more. INelastic = Insensitive to a change in price (Steep curve) Most goods have INelastic supply in the short-run Elastic = Sensitive to a change in price (Flat curve) Most goods have elastic supply in the long-run Perfectly Inelastic = Q doesn’t change (Vertical line) Set quantity supplied % Change in Quantity % Change in Price

3. Cross-Price Elasticity of Demand Cross-Price elasticity shows how sensitive a product is to a change in price of another good It shows if two goods are substitutes or complements % change in price of product “a” % change in quantity of product “b” If coefficient is negative (shows inverse relationship) then the goods are complements If coefficient is positive (shows direct relationship) then the goods are substitutes P increases 20%Q decreases 15%

22 The cross-price elasticity of demand between good X and good Z measures the percentage change in the quantity demanded of good X in response to a percentage change in (A) the price of good X (B) income (C) the price of good Z (D) the supply of good Z (E) total expenditures on good Z

23 The cross-price elasticity of demand between good X and good Z measures the percentage change in the quantity demanded of good X in response to a percentage change in (A) the price of good X (B) income (C) the price of good Z (D) the supply of good Z (E) total expenditures on good Z

Income elasticity shows how sensitive a product is to a change in INCOME It shows if goods are normal or inferior % change in income % change in quantity If coefficient is negative (shows inverse relationship) then the good is inferior If coefficient is positive (shows direct relationship) then the good is normal Ex: If income falls 10% and quantity falls 20%… If income increases 20% and quantity decreases 15% then the good is… 4. Income-Elasticity of Demand AN INFERIOR GOOD

25 If the income elasticity of demand for good X is negative and the cross-price elasticity of demand between good X and good Y is negative, which of the following must be true of good X? (A) X is a normal good and is a substitute for Y. (B) X is a normal good and is a complement to Y. (C) X is an inferior good and is a substitute for Y. (D) X is an inferior good and is a complement to Y. (E) X is a normal good and Y is an inferior good

26 If the income elasticity of demand for good X is negative and the cross-price elasticity of demand between good X and good Y is negative, which of the following must be true of good X? (A) X is a normal good and is a substitute for Y. (B) X is a normal good and is a complement to Y. (C) X is an inferior good and is a substitute for Y. (D) X is an inferior good and is a complement to Y. (E) X is a normal good and Y is an inferior good

27 Warm Up 1. Describe the elasticity of demand for each of the following: a. Quantity demanded increases from 1,000 to 1,800 when price decreases from $20 to $19 b. Quantity demanded decreases from 1,000 to 950 when price increases from $10 to $15 2. When the government imposes a tax on producers, some say that businesses simply “pass the tax onto consumers.” What does this mean? Is it true?

Elasticity and Excise Taxes Who really ends up paying for an excise tax? 28

S P Q D Suppose gov’t enacts $2 excise tax PS Demand - Inelastic Supply - Unit elastic EXCISE TAX ON CIGARETTES CS

S P Q D 109 S with tax $6.50 = Price Consumers Pay New CS EXCISE TAX ON CIGARETTES $4.50 = Price Sellers Get New PS Tax Revenue

S P Q D Suppose gov’t enacts $2 excise tax PS Demand - Inelastic Supply - Unit elastic EXCISE TAX ON CIGARETTES CS

S P Q D 109 S with tax $6.50 = Price Consumers Pay New CS EXCISE TAX ON CIGARETTES $4.50 = Price Sellers Get New PS Producers’ share Consumers’ share Tax incidence falls more on consumers because demand is less elastic than supply

S P Q D Demand - Elastic Supply- Unit Elastic EXCISE TAX ON YACHTS $2 TAX on Producers

S P Q D $2 TAX on Producers 10 7 S1S1 PcPc PpPp EXCISE TAX ON YACHTS

S P Q D 1.Tax per unit 2.Total Tax Revenue 3.Tax paid by consumers 4.Tax paid by producers 5.Total spending by consumers 6.Total after-tax revenue for producers 7.Deadweight loss 3020 S1S1 P consumers = $7 P producers = $4 New CS EXCISE TAX ON CIGARETTES Calculate:

S P Q D 1.Tax per Unit = $3 2.Total Tax Revenue = $60 3.Tax Paid by Consumers = $40 4.Tax Paid by Producers = $20 5.Total Spending = $140 6.After-tax revenue for producers =$80 7.DWL = $ S1S1 P consumers = $7 P producers = $4 CS After EXCISE TAX ON CIGARETTES

37 If the demand for a good is perfectly price inelastic and the supply curve is upward sloping, imposing a sales tax on the good will (A) leave the price paid by consumers unchanged (B) decrease the after-tax revenues received by suppliers (C) increase the after-tax revenues received by suppliers (D) not change the after-tax revenues received by suppliers (E) not change the total expenditures by consumers on the good

38 If the demand for a good is perfectly price inelastic and the supply curve is upward sloping, imposing a sales tax on the good will (A) leave the price paid by consumers unchanged (B) decrease the after-tax revenues received by suppliers (C) increase the after-tax revenues received by suppliers (D) not change the after-tax revenues received by suppliers (E) not change the total expenditures by consumers on the good