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Chapter 5: Elasticity and its application 1. Sensitivity to price changes: demand a.

The concepts of demand and supply are 2 of the most useful in economics b. Different products can have very different price sensitivities c. For many purposes, economists want to be precise about how sensitive or insensitive changes of quantity demanded are to changes in price d. We want to have a way to measure sensitivity e. The price elasticity of demand is the percent change in quantity demanded divided by the percent change in price f. elasticity is one measure of sensitivity of demand to price g. price elasticity of demand= (%change in quantity demanded)/(%change in price) i. [(Q2-Q1)/Q1)]/ [(P2-P1)/P1)] h. whenever the textbook states a numerical value for an elasticity of demand, it always states the magnitude of the ratio given in the text i. percent change in quantity= (change in quantity/ initial quantity) x 100% i. ((Q2-Q1)/Q1)x 100% j. percent change in price i. (change in price/ initial price) x 100% ii. (P2-P1)/P1)x 100% 2. methods for calculating elasticity a. a good rule as any is to relate the price change to neither the higher nor the lower of the two, but to use their average b. midpoint method i. ex. Price= 90 quantity= 240, new price= 110 new quantity=160 ii. we will always take the average price to be the base price for calculating price changes iii. (90+110)/2=100 iv. similarly, we use the average quantity as the base for measuring the change in quantity 1. (240+160)/2=200 v. elasticity demand= (80/200)/(-20/100)= -2 1. ED=2 c. The larger the price elasticity of demand, the more sensitive quantity demanded is to given changes in price d. Smaller values indicate that demand is less sensitive to price changes e. initial value method 3. the determinants of elasticity of Demand a. breakfast cereal vs sunscreen i. breakfast cereal has close substitutes (pancakes, waffles, pop tarts) so buyers can easily switch if the price rises ii. sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises


b. blue jeans vs clothing i. for narrowly defined goods such as blue jeans, there are many substitutes (khakis, corduroys, shorts) 1. price elasticity is higher when close substitutes are available ii. for broadly defined goods, there may be few or no reasonable substitutes available 1. price elasticity is high for narrowly defined goods than broadly defined goods c. basic food vs Caribbean cruises i. basic food is a necessity 1. a rise in its price causes little or no decrease in demand 2. the elasticitys for necessities such as basic food are low ii. a Caribbean cruise is a luxury 1. if the price rises, some people will forego it 2. the elasticities for luxury goods are high iii. in the short run, we assume that the value for some variable cannot be changed iv. in the long run, the values for all variables can be changed v. gasoline in the short run vs gasoline in the long run 1. when the price of gas rises a. theres not much people can do in the short run other than riding the bus or carpooling b. in the long run, people can buy smaller cars or live closer to where they work

1) elasticity continued a) a demand curve is said to be price elastic when the elasticity is greater than 1 b) a demand curve is said to be price inelastic when the elasticity is less than 1 c) a demand curve is said to be unit elastic when the elasticity is equal to 1 2) perfectly elastic demand extreme case a) any %/ 0% undefined 3) a firm gets revenue from selling its output a) let r denote a firms revenue b) let p denote the price of the firms output c) let Q denote the quantity of output sold by the firm d) R=pQ 4) price elasticity and revenues a) if p rises and Q falls, what happens to R? b) revenue= P x Q 5) Income elasticity of demand= (% change in quantity demanded)/ (%change in income) a) As household income increases, consumption shifts from necessities to luxuries

b) While households may spend more on food and other necessities, they will spend even more on expensive and other luxuries c) Accordingly, poor families spend a higher percentage of their income on food and housing than rich families d) The consumption of a good may fall with an increase in income. Such goods are inferior goods e) A measure of how much the quantity demanded of one good responds to a change in the price of another good i) Percent change in quantity demanded of the first good divided by the percent change in price of the second good ii) Called: cross price elasticity of demand 3/15 1. Dissatisfaction a. Dissatisfaction with the results of the law of supply and demand is motivation for government action b. This dissatisfaction arises from the outcome being politically unacceptable c. For example, if rents on apartments are seen as too expensive, then there may be pressure on the government to regulate the market for apartments d. Some government policies that alter a market outcome by interfering with the law of supply and demand i. One type of price control 1. Price ceilinga legal maximum on the price of a good or service a. Rent controllocal government imposes a maximum legal price b. A price ceiling above the equilibrium price is not bindinghas no effect on the market outcome c. A ceiling is binding on a price if it causes a shortage d. In the long run, supply and demand are more price elastic i. So the shortage is larger ii. Landlords lose their incentive to respond to tenants concerns iii. Tenants get lower quality housing e. With a shortage, the goods must be rationed among the buyers f. Some rationing mechanisms: long waiting lists; preference given to tenants without children; discrimination according to sellers biases (eg on the basis of race); apartments who are willing to pay bribes to building superintendents 2. Another type of price control: Price floor: a legal minimum on the price of a good or service

a. If wages are believed to be too low, then there may be pressure on the government to regulate the labor market b. A minimum wage is below the equilibrium wage is not bindingand therefore has no effect on the market outcome c. When a floor is binding on the wage, it causes a surplus (ex unemployment) i. Minimum wage laws do not affect highly skilled workers ii. They do affect teen workers iii. Studies show a 10% increase in the minimum wage raises teen unemployment by 1-3% d. Farmers participating in the federal commodities programs receive a target floor price for their crops. 2. Evaluating price controls a. Prices are the signals that guide the allocation of societys resources. This allocation is altered when policymakers restrict prices. b. Price controls often intend to help the poor, but often hurt more than help c. If the government is going to try to solve social problems, there are good reasons to try another way i. Attempts to get around the law of supply and demand generally do not work 1. Understanding the law of supply and demand is important in making public policy ii. If government wants higher wages for unskilled labor, it can attempt to increase the demand for such labor. iii. If it wants affordable housing, it can subsidize housing 3. Such methods often generate some problems of their own. However, these are usually more effective than disregarding the law of supply and demand 3/27 a) As the demand for cigarettes is inelastic, most of the tax increase is borne by the consumers and only a small fraction is borne by the sellers. b) If the government imposes a tax on a good whose demand is elastic, the result would be very different c) A good like cheddar cheese (for which other cheeses are close substitutes) has a demand that is price elastic i) If a 10 cent tax is imposed on the sellers ii) There will be a higher price for the buyers and a lower quantity sold for the sellers iii) How will the effect be distributed between price and quantity?

(1) A tax would drive consumers to buy other cheeses, causing a sharp drop in quantity with only a small change in price. iv) The producers pay the bigger portion of the 10 cent tax (1) Most of the tax is borne by the sellers and only a small fraction is borne by the consumers 2) Who pays a luxury tax? a) In 1990, congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, ect b) Goal of the tax: raise revenue from those who could most easily afford to paywealthy customers c) But who really pays a luxury tax? i) Demand is price elastic. In the short run, supply is inelastic 3) Government policies and the allocation of resources a) Each of the policies weve considered affects the allocation of societys resources. i) A binding minimum wage causes a surplus of workers, wasting resources CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS The study of how the allocation of resources affects economic well-being is called welfare economics 1) the term allocation of resources is used to refer to a) how much of each good is produced b) which producers produce it c) which consumers consume it 2) The max amount a buyer will pay for a good is called the buyers willingness to pay (WTP) a) Demand schedule P Quantity demanded Over 300 0 250-300 1 175-250 2 125-175 3 0-125 4 b) At Q= 1, 2, 3, 4: the height of the highest point on the demand curve is the WTP of a buyer who would leave the market if the price was any higher i) Called a marginal buyer price goes up slightly, then they are out of the market. c) Staircase shape i) If the numbers of buyers is large as in a competitive market, there would be a large number of very tiny steps (1) It would look more like a smooth curve 3) Consumer surplus (CS) a) The difference between what a consumer would be willing to pay and what he actually has to pay to buy a certain amount of a good

b) Total CS equals the area of the region that is under the demand curve and above the horizontal line that is at the price level c) CS is the area f the region below the demand the demand curve and above the price line i) Area of triangle = (b)(h)