Chapter 5: Elasticity and Its Application

5-1: The Elasticity of Demand

  • Elasticity: A measure of a good’s quantity supplied/demanded in response to a change in price

The Price Elasticity of Demand and Its Determinants

  • Price elasticity of demand: how much the quantity demanded changes due to a change in price
    • Elastic goods have big changes in demand in response to changes in price, while inelastic goods do not
  • Factors of price elasticity of demand
    • Availability of Close Substitutes: Goods with substitutes are elastic while those without are not
    • Necessities vs. Luxuries: Necessities are inelastic (demand will always remain the same) while luxuries are elastic
    • Definition of the Market: Items in a broad market (food industry) are more inelastic due to the lack of close substitutes, while items in a narrow market (vanilla ice cream) are elastic
    • Time Horizon: Good become more elastic with time; short term changes may be small, but long term ones are bigger

Computing the Price Elasticity of Demand

  • Formula for price elasticity of demand is defined as: Screen Shot 2022-10-09 at 9 27 40 PM
    • A note about the formule; the change in quantity demanded is negative, while the change in price is positive. Economists use the absolute value to make it easier

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

  • If you use the above formula to calculate elasticity, then the elasticity from Point A to Point B may be different than Point B to Point A
  • Midpoint formula is better suited: Screen Shot 2022-10-09 at 9 32 02 PM
    • Doesn’t change based on direction
  • Concept is more important than calculation for this book

The Variety of Demand Curves

  • Demand is elastic when elasticity is greater than one and inelastic if not
    • When the elasticity is equal to one, the demand is at unit elasticity
    • Rule of thumb for demand curves: slope is close to 0 = demand is elastic, slope is close to infinity = demand is inelastic

    Screen Shot 2022-10-09 at 11 55 58 PM

Total Revenue and the Price Elasticity of Demand

  • Total revenue: Price of a good * Quantity of good sold
    • Graphical representation: Screen Shot 2022-10-09 at 11 57 13 PM
  • Total revenue is affected by elasticity
    • An increase in price of an inelastic good increases revenue while an increase in price of an inelastic good decreases revenue
    • A unit elastic good will not experience a change in total revenue if the price changes

Elasticity and Total Revenue along a Linear Demand Curve

  • Despite having a constant slope, a linear demand curve can have varying elasticities due to differences in percent change
    • At high prices with low quantities, the curve is elastic, while at low prices with high quantities, the curve is inelastic
    • Graph and table: Screen Shot 2022-10-10 at 12 03 59 AM
    • Total revenue changes based on elasticities as well

Other Demand Elasticities

  • The income elasticity of demand is the measure of how quantity demanded changes based on changes in income
    • Formula: Screen Shot 2022-10-10 at 12 08 24 AM
    • Normal goods have positive income elasticities while inferior goods have negative ones
    • Engel’s Law stipulates: As a family’s income rises, the percent of its income spent on food declines, indicating an income elasticity less than one. By contrast, luxuries such as jewelry and recreational goods tend to have large income elasticities because consumers feel that they can do without these goods altogether if their incomes are too low.
    • In other words, if an item makes up a small part of your income, the item is more inelastic because you can afford to pay the difference in price
  • The cross-price elasticity of demand is the measure of how the quantity demanded changes based on price changes of another good
    • Formula: Screen Shot 2022-10-10 at 12 10 47 AM
    • Substitute goods have positive cross-price elasticities while complement goods have negative ones

5-2: The Elasticity of Supply

The Price Elasticity of Supply and Its Determinants

  • Price elasticity of supply: how much the quantity supplied changes due to a change in price
    • Elastic goods have big changes in supply in response to changes in price, while inelastic goods do not
  • Elasticity depends on how easy it is for sellers to change the quantity supplied
    • Beachfront land is inelastic (cannot create more) but manufactured goods are elastic
  • Key determinant of price elasticity of supply is time period
    • Supply is more elastic in the long run vs. short run, as firms cannot change the size of factories easily in a short period of time
    • Other changes, such as closing and opening, make products more elastic

Computing the Price Elasticity of Supply

  • Formula for price elasticity of supply is defined as: Screen Shot 2022-10-10 at 12 33 58 AM

The Variety of Supply Curves

  • On a graph, a slope closer to infinity is inelastic while a slope closer to 0 is elastic

Screen Shot 2022-10-10 at 12 35 25 AM

5-3: Three Applications of Supply, Demand, and Elasticity

Can Good News for Farming Be Bad News for Farmers?

  • Scenario: you are a wehat farmer who spends time making your land as productive as possible
  • New strand of wheat is found that increases wheat production by 20%
  • Because wheat (food) is an inelastic good, the total revenue falls when the quantity sold increases
    • Farmers lose money, but they must use the new strand in order to remain competitive with other farmers
  • Affect of advancements in farming can be seen in the vast decrease in workers in the farm industry
  • Negative effect on farmers still has a positive effect on society; food is cheaper, more workers to do other things

Why Did OPEC Fail to Keep the Price of Oil High?

  • Scenario: OPEC raised the price of oil to increase income
    • From 1973 to 1974, oil prices raised 50%, and they continued to rise
  • OPEC was unable to maintain a high price of oil, and it went back down to low prices during the 90s
  • Can be explained by elasticities
    • Oil is inelastic, and short term prices rose because people needed to buy oil
    • In the long term, non-OPEC countries found different ways to produce oil and oil consumption was made more efficient
  • Short term cuts to supply can lead to short term gains but will lose money in the long run

Screen Shot 2022-10-10 at 12 46 04 AM

Does Drug Interdiction Increase or Decrease Drug-Related Crime?

  • Scenario: drug use is a serious problem, and the government tries to reduce the amount of drugs in the country
  • A raise in law enforcement for drugs reduces the quantity supplied for drugs
    • Raises the price of drugs and reduces the quantity demanded for drugs
  • Demand for drugs remains inelastic (drug users will continue to want drugs), so drug users must pay more money for drugs which leads to crimes in order to obtain said money
  • Reducing demand for drugs can be more beneficial, as it will reduce both the price and quantity of drugs
  • Some argue that enforcing drug laws could be more beneficial to stopping drug crimes in the long run than in the short run, as goods become more elastic over time

Screen Shot 2022-10-10 at 12 46 19 AM

Chapter 6: Supply, Demand, and Government Policies

6-1: Controls on Prices

  • Different groups may want the equilibrium price of a good to go up or down based on their interests, and will lobby legislators to change the price
    • Legislators can create a price ceiling (price maximum, favored by buyers) or price floor (price minimum, favored by suppliers) to make it so that the price can’t go beyond a certain range

How Price Ceilings Affect Market Outcomes

  • A price ceiling above the equilibrium price is not binding and has no effect on the price or quantity of ice cream
  • A price ceiling below the equilibrium price is a binding constraint and affects the good
    • Leads to a shortage because there is too much demand but not enough supply
    • Due to the shortage of the good, sellers must ration their supply to buyers
      • Includes imposing long lines or selling to favored groups (family, friends, racial/ethnic groups, etc.)
    • General rule: When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers
    • Binding constraints are undesirable because discrimination by seller bias is both inefficient and unfair

Screen Shot 2022-10-11 at 12 31 10 PM

How Price Floors Affect Market Outcomes

  • Binding price floors create a surplus of supply because the demand is too low for the supply
    • Surplus of supply leads to further biases on the buyers’ side
      • “Rationing” from buyers could include buying from sellers who are friends, family, of a certain race, etc.
  • Example: Increasing the minimum wage increases the supply of labor but decreases the demand for it, leading to more unemployment

Screen Shot 2022-10-11 at 12 31 26 PM

Evaluating Price Controls

  • Economists dislike price controls because free markets tend to be the best way to organize economic activity
    • Prices are the evolution of millions of decisions and settle at optimal values
  • The government can help to improve an economy, but setting price controls might hurt a group that they want to help
    • A suggestion is to pay rent subsidies rather than create price controls

6-2: Taxes

  • Tax incidence: How taxes are distributed throughout a market

How Taxes on Sellers Affect Market Outcomes

  • Suppose a 50 cent tax was levied on sellers for each sale of an ice cream cone
  • Step One
    • Since the tax is levied on sellers, the supply curve is affected
  • Step Two
    • Since the input price is higher, the supply curve shifts to the left (specifically, the curve shifts upward by 50 cents)
  • Step Three
    • The supply curve shifting to the left means that the price of ice cream went up and the supply of ice cream went down, thus reducing the size of the market
  • Implications
    • The tax makes buyers worse off because they have to pay more for ice cream
    • The tax makes sellers worse off because, despite the increase in price, they lose 50 cents every sale
  • Taxes discourage market activity, decreasing the quantity sold of a good
  • Buyers and sellers both share the burden of taxes
  • Graph: Screen Shot 2022-10-11 at 1 01 55 PM

How Taxes on Buyers Affect Market Outcomes

  • Suppose a 50 cent tax was levied on sellers on each purchase of an ice cream cone
  • Step One
    • Since the tax is levied on buyers, the demand curve is affected
  • Step Two
    • Since the price is higher, the demand curve shifts to the left (specifically, the curve shifts downward by 50 cents)
  • Step Three
    • The demand curve shifting to the left means that the price of ice cream went up (after adding the 50 cent tax) and the supply of ice cream went down, thus reducing the size of the market
  • Implications
    • The effect of a tax on buyers and sellers are the same; the sellers sell for $2.80 and the buyers buy for $3.30, thus reducing the market for ice cream
    • 50 cents always goes to the government which is the reason for the similarity
  • Graph: Screen Shot 2022-10-11 at 1 17 08 PM

Elasticity and Tax Incidence

  • Depending on elasticity, the tax incidence can vary greatly
  • Graph: Screen Shot 2022-10-11 at 1 28 00 PM
  • The more inelastic of supply/demand is the one who has the heavier tax burden (“A tax burden falls more heavily on the side of the market that is less elastic”)
    • This is due to the ability/willingness of buyers/sellers to change the quantity demanded/supplied of a good