Week 4 - The Price System

Introduction to
Microeconomics
The Price System (2)
“I try not to break the rules but merely to test their

elasticity” — Bill Veeck
Fall 2018, Sining Wang

Thanks for your feedback !
page 2
Discussion
Can you think of some examples in which the Law

of demand seems to be wrong? i.e., when price
increase (decrease), the quantity demanded are
not necessarily decrease (increase).
page 3
Elasticity
Elasticity: A measure of the responsiveness

of quantity demanded or quantity supplied
to a change in one of its determinants.
Determinants that we study:

Price
Income
Price of related goods
page 4
Elasticity
You design websites for local businesses.
You charge $200 per website, and currently sell 12
websites per month.
You want to rise the price to $ 250.
But may won’t sell as many websites if you raise the

price.
page 5
Price Elasticity of Demand
• A measure of how much the quantity demanded
of a good responds to a change in the price of that
good, computed as the percentage change in quantity
demanded divided by the percentage change in
price.
page 6
perfectly inelastic demand
Price
Example:
Junior year tuition for
college students.
P2
(not exactly...)
P rises by 10%
P1
No change in Q
D
Q Quantity
page 7
Inelastic demand
Price
Example:
P2 Gas Price at different
times.
P rises by 10%
P1
Q2 Q1
Quantity
Q falls less than 10%
page 8
Elastic Demand
Price
Example:
Price of fast-foods
P2 (hamburger)
P rises by 10%
P1
Q2 Q1
Quantity
Q falls more than 10%
page 9
perfectly elastic demand
Price
Example:
Price of blue jean
P2
P1
Q1
Quantity
page 10
unit elastic demand
Price
Example:
A mid-level dinning at
a local restaurant.
P2
P rises by 10%
P1
Q2 Q1
Q falls by 10%
page 11
Elasticity in real world
Eggs 0.1
Healthcare 0.2
Rice 0.5
Housing 0.7
Beef 1.6
Restaurant meals 2.3
Mountain Dew 4.4
page 12
What determines price elasticity?
EXAMPLE 1:
The prices of both Breakfast Cereal and Sunscreen rise by 20%.
For which good does Qd drop the most? why?
Cereal has close substitutes (e.g., pancakes, Eggo waffles,

leftover pizza),
Sunscreen has no close substitutes, so a price increase

would not affect demand very much.
Lesson: Price elasticity is higher when close

substitutes are available.
page 13
EXAMPLE 2: “Blue Jeans” v.s. “Clothing”.
The prices of both goods rise by 20%.

For a narrowly defined good such as blue jeans, there are

many substitutes (khakis, shorts, Speedos?).
For broadly defined goods, there a fewer substitutes available.

(Are there any substitutes for clothing? leafs maybe?).
Lesson: Price elasticity is higher for narrowly defined

goods than for broadly defined ones.
page 14
EXAMPLE 3: Medicine v.s. Caribbean Cruises

Medicine is necessity. A rise in its price would cause little or

even no decrease in demand.
Cruise is luxury. If the price rises, some people will forego it.

Lesson: Price elasticity is higher for luxuries than

for necessities.
page 15
EXAMPLE 4: Gasoline in the Short Run v.s.
Gasoline in the Lone Run.

For which one does Qd drop the most? why?
There’s not much people can do in the short run,

other than carpool.
In the long run, people can buy smaller cars or live

closer to work.

Lesson: Price elasticity is higher in the long run
than in the short run.
page 16
Price Elasticity and Total Revenue
• Revenue =PxQ
A price increase has two effects on revenue:

Higher P means more revenue on each unit you sell.
But you sell fewer units (lower Q)
• Which of these two effects is bigger?
• It depends on the price elasticity of demand.
page 17
Price Elasticity and Total Revenue
• If demand is elastic, then:
price elast. of demand > 1,
% change in Q > % change in P.
•The fall in revenue from lower Q is greater

than the increase in revenue from higher P,
so revenue falls.
page 18
What if non-linear demand curve?
The essential ideas are the same!
Price
P2=6
P1=4
Q2=20 Q1=100
Quantity
page 19
True of False: the slope of a linear demand curve and
the price elasticity of demand are the same.
page 20
True of False: the slope of a linear demand curve and
the price elasticity of demand are the same. NO!
page 21
• Price
elasticity of demand measures how much
Qd responds to a change in P.
• Loosely speaking, it measures the price-

sensitivity of buyers’ demand.
page 22
Calculate Elasticity:
Mid-point method (example)
Initial price: $30, new price: $20
Mid-point price = $25
% change in price = (30-20)/25 = 40%
Initial quantity demanded: 0,

new quantity demanded: 20
Mid-point quantity = 10
% change in quantity = (20 -0)/10 = 200%
Price elasticity of demand = 200% / 40% = 5.0
page 23
Income Elasticity of Demand
• A measure of how much the quantity demanded of
a good responds to a change in people’s income,
computed as the percentage change in quantity
demanded divided by the percentage change in
income.
page 24
Cross-Price Elasticity of Demand
• A measure of how much the quantity demanded of
good A responds to a change in the price change
of good B, computed as the percentage change
in quantity demanded of good A, divided by the
percentage change in the price of good B.
page 25
Price Elasticity of Supply
• A measure of how much the quantity supplied of a
good responds to a change in the price of that good,
computed as the percentage change in quantity
supplied divided by the percentage change in price.
page 26
The Economist as Policy Adviser
• Polly: supply and demand jointly determines equilibrium.
• Norm:The government should raise the minimum wage

and help people escape proverty.
page 27
The Economist as Policy Adviser
• Polly: supply and demand jointly determines equilibrium.
• Norm:The government should raise the minimum wage

and help people escape proverty.
Positive Statements are descriptives. They make a claim

about how the world is.
Normative Statement are prescriptive. They make a claim

about how the world ought to be.
page 28

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Introduction to

“I try not to break the rules but merely to test their

Fall 2018, Sining Wang

Can you think of some examples in which the Law

Elasticity: A measure of the responsiveness

Determinants that we study:

You want to rise the price to $ 250.

But may won’t sell as many websites if you raise the

Restaurant meals 2.3

Mountain Dew 4.4

Cereal has close substitutes (e.g., pancakes, Eggo waffles,

Sunscreen has no close substitutes, so a price increase

Lesson: Price elasticity is higher when close

The prices of both goods rise by 20%.

For a narrowly defined good such as blue jeans, there are

For broadly defined goods, there a fewer substitutes available.

Lesson: Price elasticity is higher for narrowly defined

The prices of both goods rise by 20%.

Medicine is necessity. A rise in its price would cause little or

Lesson: Price elasticity is higher for luxuries than

The prices of both goods rise by 20%.

There’s not much people can do in the short run,

In the long run, people can buy smaller cars or live

A price increase has two effects on revenue:

• Which of these two effects is bigger?

• It depends on the price elasticity of demand.

•The fall in revenue from lower Q is greater

• Loosely speaking, it measures the price-

Initial quantity demanded: 0,

Price elasticity of demand = 200% / 40% = 5.0

• Polly: supply and demand jointly determines equilibrium.

• Norm:The government should raise the minimum wage

• Polly: supply and demand jointly determines equilibrium.

• Norm:The government should raise the minimum wage

Positive Statements are descriptives. They make a claim

Normative Statement are prescriptive. They make a claim

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