Elasticity
Chapter
17
Calculating percent change (%change)
n
%change
n
= 100X(new number – old number)
n
(old number)
Calculating percent change (%change)
n
%change = 100X(new number - old number)/(old number)
n
If old price was
$10 and new price was $12, then:
n
%change = 100x(12-10)/10 = 100x(2)/10 = +20
percent
n
If old price was
$20 and new price was $10, then:
n
%change = 100x(10-20)/20 = 100x(-10)/20 = -50
percent
Elasticity of demand
n
Elasticity
measures the intensity of the response buyers have to a price change
Elasticity of demand
n
Elasticity
measures the intensity of the response buyers have to a price change
n
Compares %change
in quantity demanded to %change in price
n
If %change in Q
> %change in P, the response is elastic
n
If %change in Q
< %change in P, the response is inelastic
Definitions
n
Elastic:
n
A big response to
a small price change
n
%change in Q >
%change in P
n
Inelastic:
n
A small response
to a big price change
n
%change in Q <
%change in P
n
Unit Elastic:
n
%change in Q =
%change in P
Elastic Demand
n
%change in Q >
%change in P
n
big response to a
small price change
n
shallow demand
curves are elastic
Inelastic Demand
n
%change in Q <
%change in P
n
small response to
a big price change
n
steep demand
curves are inelastic
Unit Elastic
n
%change in Q =
%change in P
n
same size
response to a price change
n
this type of
demand curve must always be curved, as shown
Extreme Situations
n
Perfectly
inelastic:
n
%change in Q = 0
no matter what the %change in P is
n
Demand curve is
vertical
n
Perfectly
elastic:
n
%change in P = 0
no matter what the %change in Q is
n
Demand curve is
horizontal
Perfectly Inelastic Demand (chart)
Perfectly Elastic Demand (chart)
Elasticity of Demand: Characteristics
n
Number of
substitutes
n
many substitutes?
elastic
n
few or no
substitutes? inelastic
Elasticity of Demand: Characteristics
n
Necessity or
luxury?
n
can do without
(luxury)? – elastic
n
can’t do without
(necessity)? - inelastic
Elasticity of Demand: Characteristics
n
Percent of budget
spent on the good.
n
big ticket item?
– elastic
n
small price tag?
– inelastic
Examples
n
Elastic Demand:
n
Refrigerators
n
Furniture
n
European
vacations
n
Inelastic Demand:
n
Cigarettes
n
Coffee
n
Gasoline
Total Revenue Test (TR=PxQ)
n
For a price
increase:
n
Elastic if TR
decreases (Q falls faster than P rises)
n
Inelastic if TR
increases (Q falls slower than P rises)
Total Revenue Test (TR=PxQ)
n
For a price
decrease:
n
Elastic if TR
increases (Q rises faster than P falls)
n
Inelastic if TR
decreases (Q rises slower than P falls)
Total Revenue Test: Applications
n
If you sell
elastic goods, always make it appear you are having a sale
n
If you sell
inelastic goods, you can increase your price and increase your revenues
Straight-line Demand Curve
A straight-line demand curve: (chart)
high end:
TR
rises as P falls
elastic
low end:
TR
falls as P falls
inelastic
Elasticity and Taxation
n
Tax Incidence:
n
Identifies who
really ends up paying a tax
n
Taxes can be
either direct or indirect.
Elasticity and Taxation
n
Direct Tax:
n
levied on a
person who ends up paying the tax (income tax is an example)
n
Indirect Tax:
n
levied on a
product.
n
The seller
actually sends the money to the government, but passes the tax onto the
customer, if he can, by raising prices.
Pass the tax to the customer?
n
If the good is
elastic, a P increase causes a big Q decrease and TR decrease
n
The seller “eats”
the tax
n
If the good is
inelastic, a P increase causes a small Q decrease and TR increase
n
The seller passes
the tax on to the customer, who really ends up paying the tax
Taxes create inefficiency
n
All taxes are
paid by people:
n
Consumers pay the
tax on inelastic goods
n
Sellers pay the
tax on elastic goods
n
A tax on goods
shifts supply curve left:
n
Less is bought at
a higher price
n
There is a
deadweight loss to society.
n
It reduces both
consumer surplus and producer surplus
Deadweight Loss due to a Tax (chart)
Deadweight Loss due to a Tax (chart)
Deadweight Loss due to a Tax (chart)
Elasticity of supply
n
Measures the
response of suppliers in providing goods to price changes
n
Compares the
%change in quantity supplied to the %change in price
n
The major
determinant is time:
n
Little or no time
to respond: inelastic
n
As time to
respond increases, more and more elastic
Consumer
Choice: Utility
Chapter 18
Utility Relationships
n
Total Utility
(TU):
n
Total
satisfaction you receive from consuming all of the goods
n
Marginal Utility
(MU):
n
Added
satisfaction you receive from consuming one more of the good
n
If MU is > 0,
then TU increases
n
TU maximizes when
MU diminishes to 0
Law of Diminishing Marginal Utility
n
Use more and more
of one good and diminishing marginal utility will set in.
n
The next unit yields
less satisfaction (utility) to you than the previous one
TU and
MU: Data and Graphs (chart)
How do I know when to stop?
n
Recognize that
diminishing MU exists!
n
Do a marginal
analysis:
n
Last step taken:
did MU>MC?
n
Predict: the next unit is worthwhile and do
it!
n
Last step taken:
did MU=MC or MU<MC?
n
Stop; do not
accept the next unit
n
Using marginal
analysis this way lets you know when to stop
Utility Maximization (chart)
The MU/P Ratio
n
MU = value to the
buyer
n
P = price (money
spent)
n
Form a ratio for
each product:
n
Product x:
MUx/Px
n
Product y:
MUy/Py
n
Etc.
The MU/P ratio
n
Buyer’s
benefit-cost analysis:
n
Compare MU to P
n
All options must
have MU>P (so that MU/P>1)
n
Select the best
option, which has the largest MU/P ratio.
n
Do this and get
the most value for money spent each time.
Reaching Consumer Equilibrium
n
Continue to buy
more items if
n
The MU/P of one
item exceeds the MU/P of another item, and
n
You have not yet
run out of money to spend
n
Consumer
equilibrium exists when the MU/P of all remaining items are equal
n
The consumer
becomes “indifferent”
n
TU is maximized
Utility Maximizing Rule
n
If a person could
get more utility per dollar by buying good X, then they should continue to buy
good X until the ratios are equal.
Utility Maximizing Rule
n
Only then will
utility be maximized.
Consumer Equilibrium
n
This occurs when
the consumer is satisfied with the mix of products he has chosen
n
All potential
purchases have the same MU/P ratio
n
Consumer is
indifferent to each of them
n
Consumer
Equilibrium is upset when:
n
the MU of one
item changes (consumer preference changes), or
n
the P of one item
changes
Upsetting consumer equilibrium
n
Start:
n
MUx/Px
= MUy/Py, consumer is indifferent.
n
Let either MUx
increase or Px decrease.
n
Then MUx/Px
> MUy/Py
n
The consumer will
buy more X, less Y
n
Let either MUx
decrease or Px increase.
n
Then MUx/Px
< MUy/Py
n
The consumer will
buy more Y, less X
Advertising
n
Preferences (MU)
can change, sometimes abruptly
n
Advertising’s
goal is to get you to increase your preference (MU) for a good
n
This will prompt
you to buy the good
n
A successful ad
campaign will increase sales revenue greater than the cost the of campaign