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The table below gives an example of the relationships between prices; quantity
demanded and total revenue.
Her elasticity of demand is the absolute value of _________. Julie's elasticity of demand is elastic/ inelastic,
since it is less/more than 1.
Problem 2: If Neil's elasticity of demand for hot dogs is constantly 0.9, and he buys 4 hot dogs when the price is
$1.50 per hot dog, how many will he buy when the price is $1.00 per hot dog?
This time, we are using elasticity to find quantity, instead of the other way around. We will use the same formula,
plug in what we know, and solve from there.
Problem 3: Which of the following goods are likely to have elastic demand, and which are likely to have inelastic
demand?
Home heating oil
Water
Pepsi
Heart medication
Chocolate
Oriental rugs
Problem 4: If supply is unit elastic and demand is inelastic, a shift in which curve would affect quantity more?
Price more?
Problem 5: Katherine advertises to sell cookies for $4 a dozen. She sells 50 dozen, and decides that she can
charge more. She raises the price to $6 a dozen and sells 40 dozen. What is the elasticity of demand? Assuming
that the elasticity of demand is constant, how many would she sell if the price were $10 a box?
To find the elasticity of demand, we need to divide the percent change in quantity by the percent change in
price.
Multiple Choice
1. The quantity of a good demanded rises from 1000 to 1500 units when the
price falls from $1.50 to $1.00 per unit. The price elasticity of demand for
this product is approximately:
A. 1.0
B. .16
C. 2.5
D. 4.0
2. If the elasticity of demand for a commodity is estimated to be 1.5, then a
decrease in price from $2.10 to $1.90 would be expected to increase daily
sales by:
A. 50%
B. 1.5%
C. 5%
D. 15%
3. Demand is said to be inelastic when:
A. the percentage change in quantity demanded is greater than the
percentage change in price of a good
B. in a linear demand curve, quantity demanded is close to zero (given
the price) so that the percentage change in quantity demanded will be
very high
C. the percentage change in price exceeds the percentage change in
quantity demanded of a good
D. a relatively small change in price results in a relatively big change in
quantity demanded
4. Suppose that the Board of Directors of the local symphony proposes that
the admission price to hear the orchestra be raised as a means of raising
additional funds to support music programs. Its members are implicitly
assuming that the price elasticity of demand for a ticket is:
A. less than unity
B. greater than unity
C. unity
D. it really says nothing about price elasticity
5. The determinants of the price elasticity of demand of a particular
commodity include all of the following except:
A. the availability of substitutes for the commodity
B. the time period involved
C. the ease with which resources can be shifted to and from the
production of this commodity to other uses
D. the degree of specificity with which the commodity is defined
6. The fact that the expenditure on food as a percentage of income has
declined as income has increased indicates that food:
A. is an inferior good
B. is a luxury good
C. has an income elasticity of demand less than unity
D. is a normal good with an elastic demand
E. there is not enough information to be able to determine what type of
good food is
7. A tax will be borne completely by suppliers if:
A. the demand curve is perfectly inelastic while the supply curve is
upward sloping
B. the demand curve is downward sloping while the supply curve is
perfectly inelastic
C. the supply curve is perfectly elastic and the demand curve is
negatively slope
D. price elasticities of both supply and demand equal one
E. both the demand and supply curves are perfectly inelastic
8. The quantity of a good demanded rises from 90 units to 110 units when
the price falls from $1.20 to $.80 per unit. The price elasticity of demand for
this product approximates:
A. .5
B. 1.0
C. 2.0
D. 4.0
9. A downhill ski area is experiencing a decline in the number of lift tickets
sold, falling revenues, and inadequate profits. The average price of a lift
ticket is $20 and there are 2,500 tickets sold daily on average. The
estimated price elasticity of demand is 1.5 and the lifts are currently
4. If the price of a good increases by 8% and the quantity demanded decreases by 12%, what is
the price elasticity of demand? Is it elastic, inelastic or unitary elastic?
5. Discount stores sell relatively elastic goods. Ceteris paribus, explain why selling at a relatively
low price is profitable for them?
ANSWERS
Problem : Yesterday, the price of envelopes was $3 a box, and Julie was willing to buy 10 boxes. Today, the
price has gone up to $3.75 a box, and Julie is now willing to buy 8 boxes. Is Julie's demand for envelopes elastic
or inelastic? What is Julie's elasticity of demand?
To find Julie's elasticity of demand, we need to divide the percent change in quantity by the percent change in
price.
% Change in Quantity = (8 - 10)/(10) = -0.20 = -20%
% Change in Price = (3.75 - 3.00)/(3.00) = 0.25 = 25%
Elasticity = |(-20%)/(25%)| = |-0.8| = 0.8
Her elasticity of demand is the absolute value of -0.8, or 0.8. Julie's elasticity of demand is inelastic, since it is
less than 1.
Problem : If Neil's elasticity of demand for hot dogs is constantly 0.9, and he buys 4 hot dogs when the price is
$1.50 per hot dog, how many will he buy when the price is $1.00 per hot dog?
This time, we are using elasticity to find quantity, instead of the other way around. We will use the same formula,
plug in what we know, and solve from there.
Elasticity =
And, in the case of John, %Change in Quantity = (X 4)/4
Therefore :
Elasticity = 0.9 = |((X 4)/4)/(% Change in Price)|
% Change in Price = (1.00 - 1.50)/(1.50) = -33%
0.9 = |(X 4)/4)/(-33%)|
|((X - 4)/4)| = 0.3
0.3 = (X - 4)/4
X = 5.2
Since Neil probably can't buy fractions of hot dogs, it looks like he will buy 5 hot dogs when the price drops to
$1.00 per hot dog.
Problem : Which of the following goods are likely to have elastic demand, and which are likely to have inelastic
demand?
Home heating oil
Pepsi
Chocolate
Water
Heart medication
Oriental rugs
Elastic demand: Pepsi, chocolate, and Oriental rugs
Inelastic demand: Home heating oil, water, and heart medication
Problem : If supply is unit elastic and demand is inelastic, a shift in which curve would affect quantity more?
Price more?
Shifting the demand curve would affect quantity more, and shifting the supply curve would affect price more.
Problem : Katherine advertises to sell cookies for $4 a dozen. She sells 50 dozen, and decides that she can
charge more. She raises the price to $6 a dozen and sells 40 dozen. What is the elasticity of demand? Assuming
that the elasticity of demand is constant, how many would she sell if the price were $10 a box?
To find the elasticity of demand, we need to divide the percent change in quantity by the percent change in
price.
% Change in Quantity = (40 - 50)/(50) = -0.20 = -20%
% Change in Price = (6.00 - 4.00)/(4.00) = 0.50 = 50%
Elasticity = |(-20%)/(50%)| = |-0.4| = 0.4
The elasticity of demand is 0.4 (elastic).
To find the quantity when the price is $10 a box, we use the same formula:
Elasticity = 0.4 = |(% Change in Quantity)/(% Change in Price)|
% Change in Price = (10.00 - 4.00)/(4.00) = 1.5 = 150%
Remember that before taking the absolute value, elasticity was -0.4, so use -0.4 to calculate the changes in
quantity, or you will end up with a big increase in consumption, instead of a decrease!
-0.4 = |(% Change in Quantity)/(150%)|
|(%Change in Quantity)| = -60% = -0.6
-0.6 = (X - 50)/50
X = 20
The new demand at $10 a dozen will be 20 dozen cookies.
The number of close substitutes the more close substitutes there are in the market,
the more elastic is demand because consumers find it easy to switch
The cost of switching between products there may be costs involved in switching. In
this case, demand tends to be inelastic. For example, mobile phone service providers may
insist on a12 month contract.
The degree of necessity or whether the good is a luxury necessities tend to have
an inelastic demand whereas luxuries tend to have a more elastic demand.
The time period allowed following a price change demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search
for cheaper substitutes and switch their spending.
Peak and off-peak demand - demand is price inelastic at peak times and more elastic at
off-peak times this is particularly the case for transport services.
The breadth of definition of a good or service if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef
are likely to be more elastic following a price change.
When demand is inelastic a rise in price leads to a rise in total revenue a 20% rise in
price might cause demand to contract by only 5% (Ped = -0.25)
When demand is elastic a fall in price leads to a rise in total revenue - for example a 10%
fall in price might cause demand to expand by only 25% (Ped = +2.5)
The table below gives an example of the relationships between prices; quantity demanded and
total revenue. As price falls, the total revenue initially increases, in our example the maximum
revenue occurs at a price of 12 per unit when 520 units are sold giving total revenue of 6240.
Price
Quantity
Total Revenue
Marginal Revenue
per unit
Units
20
200
4000
18
280
5040
13
16
360
5760
14
440
6160
12
520
6240
10
600
6000
-3
680
5440
-7
760
4560
-11
Consider the elasticity of demand of a price change from 20 per unit to 18 per unit. The %
change in demand is 40% following a 10% change in price giving an elasticity of demand of -4
(i.e. highly elastic).
In this situation when demand is price elastic, a fall in price leads to higher total consumer
spending / producer revenue
Consider a price change further down the estimated demand curve from 10 per unit to 8 per
unit. The % change in demand = 13.3% following a 20% fall in price giving a co-efficient of
elasticity of 0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a
reduction in total revenue.
consider the effects of indirect taxes on costs and the importance of elasticity of demand in
determining the effects of a tax on price and quantity.
A tax increases the costs of a business causing an inward shift in supply. The vertical distance
between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the
supplier may be able to pass on some or all of this tax to the consumer by raising price. This is
known as shifting the burden of the tax and this depends on the elasticity of demand and
supply.
Consider the two charts above.
In the left hand diagram, the demand curve is drawn as price elastic. The producer must
absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold).
When demand is elastic, the effect of a tax is still to raise the price but we see a bigger
fall in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand.
In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the
range of this demand curve) and therefore the producer is able to pass on most of the tax
to the consumer through a higher price without losing too much in the way of sales. The
price rises from P1 to P2 but a large rise in price leads only to a small contraction in
demand from Q1 to Q2.
The effect of a change in price on the total revenue & expenditure on a product.
The price volatility in a market following changes in supply this is important for
commodity producers who suffer big price and revenue shifts from one time period to
another.
The effect of a change in an indirect tax on price and quantity demanded and also whether
the business is able to pass on some or all of the tax onto the consumer.
Information on the PED can be used by a business as part of a policy of price discrimination.
This is where a supplier decides to charge different prices for the same product to different
segments of the market e.g. peak and off peak rail travel or prices charged by many of our
domestic and international airlines.
Usually a business will charge a higher price to consumers whose demand for the product is
price inelastic
In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward
shift of supply which leads to a large rise in equilibrium price and quantity and only a relatively
small change in the market price.
In the right hand diagram, a similar increase in supply is drawn together with an inelastic demand
curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively
small expansion in the equilibrium quantity.
I. What is elasticity?
- rubber band elasticity
- the concept - what causes a rubber band to be more or less elastic?
- the independent variable (acts upon)
- the dependent variable (is acted upon)
- which is which for rubber band elasticity?
- calculating rubber band elasticity (i.e., the mathematical formula)
- the concept of elasticity generalized
- ALL elasticities are calculated in exactly the same manner. They all have:
- an independent variable.
- a dependent variable.
- the same equation relating these two variables.
- elasticity coefficient =
(% change in dependent variable / % change in independent variable)
- what are we trying to measure? How responsive is demand to changes in the consumer's
income.
- which is the dependent variable and which the independent variable?
- income (Y) = independent (acts upon)
- Qd = dependent (is acted upon)
- calculating an elasticity coefficient - a numerical example
- interpreting the coefficient
- the sign of the coefficient
- the size of the coefficient
ANSWERS
1. Anna should lower her price. Her price elasticity of demand for chocolate is elastic (greater
than one) and therefore, when she lowers her price she will sell a lot more chocolate. The greater
quantity sold will make up for her lower price, increasing her total revenue. In other words, she is
selling at a lower price but making up for it in volume of sales.
2. Peanut butter and milk are complements because a negative cross price elasticity of demand
means that as the price of milk goes up, the demand for peanut butter goes down. This would
indicate that when the price of milk goes up, we buy less milk and we are also buying less peanut
butter (so we must buy these together -- they are complements).
3. -15%/10% = -.15/.10 = -1.5. Remember the elasticity is always read as the absolute value or a
positive number, so it is 1.5 (elastic, or greater than one). The good is an inferior good because
the sign is negative, indicating that an increase in income will bring a decrease in the demand for
the good.
4. -12%/8% = -.12/.08 = -1.5. Again, drop the negative sign, so the elasticity is 1.5. This means it
is elastic (greater than one).
5. It is profitable because with elastic goods, dropping the price lower can bring them a lot more
business. Therefore, at the low prices they can sell a large volume of goods, making up for the
lower prices and bringing in more revenue (P x Q).