Chapter 4 Macroeconomics Erika Smitten Elasticity I Price Elasticity of Demand a Variation of price ranges matter b The responsiveness or sensitivity of consumers to a price change is measured by a product s price elasticity of demand c For example i Restaurant meals Consumers are highly responsive to price changes and modest changes cause very large changes in quantity purchased 1 Relatively elastic elastic ii Toothpaste consumers pay much less attention to price changes and substantial changes only cause small changes in the amount purchased 1 Relatively inelastic elastic d The Price Elasticity Coefficient and Formula i Degree to which demand is price elastic or inelastic ii Ed change in Qd of Product x change in P of product X iii Percentage changes in the equation are calculated by dividing the change in Qd by the original Qd and by dividing the change in price by the original P 1 Ed change in Qd X Original Qd X Change in P X Original P X iv Using Averages 1 Annoying problem arises in computing the price 2 Simplest solution to problem is to use midpoint formula elasticity coefficient for calculating elasticity a Ed change in Q sum of Q 2 change in v Using Percentages P sum of P 2 1 First using absolute changes the choice of units will arbitrarily affect our impression of buyer responsiveness 2 Second by using percentages correctly compare customer responsiveness to changes in the prices of different products vi Elimination of Minus Sign 1 Price and quantity are inversely related so the price elasticity coefficient of demand Ed will always be a negative number 2 Economist usually ignore minus sign and simply present absolute value 3 All elasticity of supply coefficients are positive numbers because price and quantity are positively related Chapter 4 Macroeconomics Erika Smitten e Interpretations of Ed i Elastic Demand 1 Larger percentage change in price than Qd 2 Greater than 1 3 Price over quantity demanded ii Inelastic Demand 1 Smaller percentage change in price than Qd 2 Less than 1 iii Unit Elastic iv Extreme cases 1 Percentage change in price and Qd the same 2 Exactly 1 1 Perfectly inelastic when a price change results in no change whatsoever in the Qd a Coefficient is 0 because there is no response to a change in price 2 Perfectly elastic when a small price reduction causes buyers to increase their purchases from 0 to all they can obtain a Elasticity coefficient in infinite Perfectly inelastic demand Ed 0 y i n f i n i t D E d e l a s t i c t l y P e r f e c f The Total Revenue Test i Total amount the seller receives from the sale of a product in a particular time period ii Calculated by multiplying P by Q 1 TR P x Q point on a demand curve iv TR and PEoD are related iii Graphically represented by the P x Q rectangle lying below a 1 Easiest way to infer whether demand is elastic or inelastic to employ TR test v TR changes in the opposite direction from P demand is elastic vi TR changes same direction as price demand is inelastic vii TR doesn t change demand is unit elastic viii Elastic Demand 1 Decrease in P will increase TR Chapter 4 Macroeconomics Erika Smitten 2 Price increase will decrease TR 3 Other things equal when P and TR move in opposite directions demand is Elastic 4 Ed is greater than 1 ix Inelastic Demand 1 Price decrease will decrease TR 2 Price increase will increase TR 3 Other things equal P and TR move in the same direction when inelastic 4 Ed less than 1 x Unit Elasticity Increase or decrease in P leaves TR unchanged 1 2 Gain in revenue from a higher unit price is exactly offset by revenue loss associated with accompanying decline in amount demanded 3 Other things equal when price changes and TR remains constant demand is unit elastic unitary 4 Ed 1 a Change in Q change in P xi Price elasticity along a Linear Demand Curve 1 Elasticity typically varies over different price ranges of the same demand curve a Exception is when elasticity is 1 g Price Elasticity and the T R Curve i Comparison of curves D and TR sharply focuses on relationship between elasticity and TR h Determinants of Price Elasticity of Demand i Substitutability 1 Larger the number of substitute goods that are available the greater the PEoD 2 EoD for a product depends on how narrowly the product is defined ii Proportion of Income 1 Other things equal the higher the price of a good relative to consumers incomes the greater the price elasticity of demand iii Luxuries versus Necessities 1 The more that a good is considered to be a luxury rather than a necessity the greater is the PEoD 2 Price increase will not significantly reduce amount of necessity used iv Time 1 Product demand is more elastic the longer the time period under consideration 2 Consumers often need time to adjust to changes in P Chapter 4 Macroeconomics Erika Smitten 3 Time is needed to find and experiment with other products to see if they are acceptable v Product durability another consideration vi Short run demand for gas is more inelastic than long run demand because in the short run people are stuck with gas guzzling trucks but switch to more fuel efficient vehicles in the long run i Applications of Price Elasticity of Demand i Large Crop Yields 1 Demand for most farm products is highly inelastic a Perhaps 20 25 2 3 Increase productivity tends to depress prices and TR incomes of farmers Inelastic demand for farmers means that large crop yields might be undesirable 4 Achieving the goal of higher total farm incomes requires that farm output be restricted for policymakers 1 Govt pays attention to elasticity of demand when it selects goods and services on which to levy excise taxes 2 Higher tax on a product with elastic demand will bring in less tax revenue legislatures tend to seek out products that have inelastic demand when levying excises ii Excise Taxes a Ex liquor gas cigarettes iii Decriminalization of Illegal Drugs 1 Current war on drugs largely unsuccessful and associated costs have increased markedly 2 Allegedly reduce drug trafficking significantly by taking the profit out of it 3 Demand of addicts highly inelastic and amounts consumed at lower prices would increase only modestly 4 Total expenditures for cocaine and heroine would decline and so would street crime supposedly 5 Dabblers market is relatively elastic and the legalization of hard drugs could increase their consumption a More social acceptance of drugs could increase demand 6 Many economist predict that legalization of drugs would reduce street prices