Elasticity and Its Application PDF

CHAPTER Elasticity and Its Application 5 I magine that some event drives up the price of gasoline in the United States. It could be a war in the Middl...

CHAPTER Elasticity and Its Application 5 I magine that some event drives up the price of gasoline in the United States. It could be a war in the Middle East that disrupts the world supply of oil, a boom- ing Chinese economy that boosts the world demand for oil, or a new tax on gaso- line passed by Congress. How would U.S. consumers respond to the higher price? It is easy to answer this question in a broad fashion: Consumers would buy less. This conclusion follows from the law of demand, which we learned in the previous chapter. But you might want a precise answer. By how much would con- sumption of gasoline fall? This question can be answered using a concept called elasticity, which we develop in this chapter. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 90 PART II How MARkETs woRk Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. When studying how some event or policy affects a market, we can discuss not only the direction of the effects but also their magnitude. Elasticity is useful in many applications, as we see toward the end of this chapter. Before proceeding, however, you might be curious about the answer to the gasoline question. Many studies have examined consumers’ response to changes in gasoline prices, and they typically find that the quantity demanded responds more in the long run than it does in the short run. A 10 percent increase in gaso- line prices reduces gasoline consumption by about 2.5 percent after a year and by about 6 percent after 5 years. About half of the long-run reduction in quantity demanded arises because people drive less, and half arises because they switch to more fuel-efficient cars. Both responses are reflected in the demand curve and its elasticity. 5-1 The Elasticity of Demand When we introduced demand in Chapter 4, we noted that consumers usually buy more of a good when its price is lower, when their incomes are higher, when the prices of its substitutes are higher, or when the prices of its complements are lower. Our discussion of demand was qualitative, not quantitative. That is, we discussed the direction in which quantity demanded moves but not the size of the change. To measure how much consumers respond to changes in these variables, elasticity economists use the concept of elasticity. a measure of the responsiveness of 5-1a The Price Elasticity of Demand and Its Determinants quantity demanded The law of demand states that a fall in the price of a good raises the quantity or quantity supplied demanded. The price elasticity of demand measures how much the quantity to a change in one demanded responds to a change in price. Demand for a good is said to be elastic of its determinants if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes price elasticity of demand in the price. a measure of how much The price elasticity of demand for any good measures how willing consum- the quantity demanded ers are to buy less of the good as its price rises. Because a demand curve reflects of a good responds to a the many economic, social, and psychological forces that shape consumer pref- change in the price of erences, there is no simple, universal rule for what determines a demand curve’s that good, computed as elasticity. Based on experience, however, we can state some rules of thumb about the percentage change what influences the price elasticity of demand. in quantity demanded divided by the percentage Availability of Close Substitutes Goods with close substitutes tend to have change in price more elastic demand because it is easier for consumers to switch from that good to others. For example, butter and margarine are easily substitutable. A small increase in the price of butter, assuming the price of margarine is held fixed, causes the quantity of butter sold to fall by a large amount. By contrast, because eggs are a food without a close substitute, the demand for eggs is less elastic than the demand for butter. A small increase in the price of eggs does not cause a sizable drop in the quantity of eggs sold. Necessities versus Luxuries Necessities tend to have inelastic demands, whereas luxuries have elastic demands. When the price of a doctor’s visit rises, people do not dramatically reduce the number of times they go to the doctor, although they Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 91 might go somewhat less often. By contrast, when the price of sailboats rises, the quantity of sailboats demanded falls substantially. The reason is that most people view doctor visits as a necessity and sailboats as a luxury. Whether a good is a necessity or a luxury depends not on the intrinsic properties of the good but on the preferences of the buyer. For avid sailors with little concern about their health, sailboats might be a necessity with inelastic demand and doctor visits a luxury with elastic demand. Definition of the Market The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods. For example, food, a broad category, has a fairly inelastic demand because there are no good substitutes for food. Ice cream, a narrower category, has a more elastic demand because it is easy to substitute other desserts for ice cream. Vanilla ice cream, a very narrow cat- egory, has a very elastic demand because other flavors of ice cream are almost perfect substitutes for vanilla. Time Horizon Goods tend to have more elastic demand over longer time horizons. When the price of gasoline rises, the quantity of gasoline demanded falls only slightly in the first few months. Over time, however, people buy more fuel-efficient cars, switch to public transportation, and move closer to where they work. Within several years, the quantity of gasoline demanded falls more substantially. 5-1b Computing the Price Elasticity of Demand Now that we have discussed the price elasticity of demand in general terms, let’s be more precise about how it is measured. Economists compute the price elastic- ity of demand as the percentage change in the quantity demanded divided by the percentage change in the price. That is, percentage change in quantity demanded price elasticity of demand 5 percentage change in price For example, suppose that a 10 percent increase in the price of an ice-cream cone causes the amount of ice cream you buy to fall by 20 percent. We calculate your elasticity of demand as 20 percent price elasticity of demand 5 52 10 percent In this example, the elasticity is 2, reflecting that the change in the quantity demanded is proportionately twice as large as the change in the price. Because the quantity demanded of a good is negatively related to its price, the percentage change in quantity will always have the opposite sign as the percent- age change in price. In this example, the percentage change in price is a positive 10 percent (reflecting an increase), and the percentage change in quantity demanded is a negative 20 percent (reflecting a decrease). For this reason, price elasticities of demand are sometimes reported as negative numbers. In this book, we follow the common practice of dropping the minus sign and reporting all price Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 92 PART II How MARkETs woRk elasticities of demand as positive numbers. (Mathematicians call this the absolute value.) With this convention, a larger price elasticity implies a greater responsive- ness of quantity demanded to changes in price. 5-1c The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities If you try calculating the price elasticity of demand between two points on a demand curve, you will quickly notice an annoying problem: The elasticity from point A to point B seems different from the elasticity from point B to point A. For example, consider these numbers: point A: price 5 $4 quantity 5 120 point B: price 5 $6 quantity 5 80 Going from point A to point B, the price rises by 50 percent and the quantity falls by 33 percent, indicating that the price elasticity of demand is 33/50, or 0.66. Going from point B to point A, the price falls by 33 percent and the quan- tity rises by 50 percent, indicating that the price elasticity of demand is 50/33, or 1.5. This difference arises because the percentage changes are calculated from a different base. One way to avoid this problem is to use the midpoint method for calculating elasticities. The standard procedure for computing a percentage change is to divide the change by the initial level. By contrast, the midpoint method computes a percentage change by dividing the change by the midpoint (or average) of the initial and final levels. For instance, $5 is the midpoint between $4 and $6. There- fore, according to the midpoint method, a change from $4 to $6 is considered a 40 percent rise because (6 2 4) / 5 3 100 5 40. Similarly, a change from $6 to $4 is considered a 40 percent fall. Because the midpoint method gives the same answer regardless of the direc- tion of change, it is often used when calculating the price elasticity of demand between two points. In our example, the midpoint between point A and point B is: midpoint: price 5 $5 quantity 5 100 According to the midpoint method, when going from point A to point B, the price rises by 40 percent and the quantity falls by 40 percent. Similarly, when going from point B to point A, the price falls by 40 percent and the quantity rises by 40 percent. In both directions, the price elasticity of demand equals 1. The following formula expresses the midpoint method for calculating the price elasticity of demand between two points, denoted (Q1, P1) and (Q2, P2): (Q2 2 Q1) / [(Q2 1 Q1) / 2] price elasticity of demand 5 (P2 2 P1) / [(P2 1 P1) / 2] The numerator is the percentage change in quantity computed using the mid- point method, and the denominator is the percentage change in price computed using the midpoint method. If you ever need to calculate elasticities, you should use this formula. In this book, however, we rarely perform such calculations. For most of our purposes, what elasticity represents—the responsiveness of quantity demanded to a change in price—is more important than how it is calculated. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 93 5-1d The Variety of Demand Curves Economists classify demand curves according to their elasticity. Demand is con- sidered elastic when the elasticity is greater than 1, which means the quantity moves proportionately more than the price. Demand is considered inelastic when the elasticity is less than 1, which means the quantity moves proportionately less than the price. If the elasticity is exactly 1, the percentage change in quantity equals the percentage change in price, and demand is said to have unit elasticity. Because the price elasticity of demand measures how much quantity demanded responds to changes in the price, it is closely related to the slope of the demand curve. The following rule of thumb is a useful guide: The flatter the demand curve that passes through a given point, the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand. Figure 1 shows five cases. In the extreme case of a zero elasticity, shown in panel (a), demand is perfectly inelastic, and the demand curve is vertical. In this case, regardless of the price, the quantity demanded stays the same. As the elas- ticity rises, the demand curve gets flatter and flatter, as shown in panels (b), (c), and (d). At the opposite extreme, shown in panel (e), demand is perfectly elastic. This occurs as the price elasticity of demand approaches infinity and the demand curve becomes horizontal, reflecting the fact that very small changes in the price lead to huge changes in the quantity demanded. Finally, if you have trouble keeping straight the terms elastic and inelastic, here’s a memory trick for you: Inelastic curves, such as in panel (a) of Figure 1, look like the letter I. This is not a deep insight, but it might help on your next exam. FYI A Few Elasticities from the Real World W e have talked about what elasticity means, what determines it, and how it is calculated. Beyond these general ideas, you might ask for a specific number. How much, precisely, does the price of a particular These kinds of numbers are fun to think about, and they can be useful when compar- good influence the quantity demanded? ing markets. To answer such a question, economists collect data from market out- Nonetheless, one comes and apply statistical techniques to estimate the price elasticity should take these estimates of demand. Here are some price elasticities of demand, obtained from with a grain of salt. One rea- various studies, for a range of goods: son is that the statistical techniques used to obtain them require some Eggs 0.1 assumptions about the world, and these assumptions might not be true Healthcare 0.2 in practice. (The details of these techniques are beyond the scope of this Cigarettes 0.4 book, but you will encounter them if you take a course in econometrics.) Rice 0.5 Another reason is that the price elasticity of demand need not be the Housing 0.7 same at all points on a demand curve, as we will see shortly in the case Beef 1.6 of a linear demand curve. For both reasons, you should not be surprised Peanut Butter 1.7 if different studies report different price elasticities of demand for the Restaurant Meals 2.3 same good. Mountain Dew 4.4 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 94 PART II How MARkETs woRk FIGURE 1 The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 (b) Inelastic Demand: Elasticity Is Less Than 1 Price Price Demand $5 $5 4 4 1. An 1. A 22% Demand increase increase in price... in price... 0 100 Quantity 0 90 100 Quantity 2.... leaves the quantity demanded unchanged. 2.... leads to an 11% decrease in quantity demanded. (c) Unit Elastic Demand: Elasticity Equals 1 Price $5 4 1. A 22% Demand increase in price... 0 80 100 Quantity 2.... leads to a 22% decrease in quantity demanded. (d) Elastic Demand: Elasticity Is Greater Than 1 (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price Price 1. At any price above $4, quantity $5 demanded is zero. 4 Demand $4 Demand 1. A 22% 2. At exactly $4, increase consumers will in price... buy any quantity. 0 50 100 Quantity 0 Quantity 3. At a price below $4, 2.... leads to a 67% decrease in quantity demanded. quantity demanded is infinite. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 95 5-1e Total Revenue and the Price Elasticity of Demand When studying changes in supply or demand in a market, one variable we often want to study is total revenue, the amount paid by buyers and received by sellers total revenue of a good. In any market, total revenue is P 3 Q, the price of the good times the the amount paid by buyers quantity of the good sold. We can show total revenue graphically, as in Figure 2. and received by sellers of The height of the box under the demand curve is P, and the width is Q. The area a good, computed as the of this box, P 3 Q, equals the total revenue in this market. In Figure 2, where price of the good times P 5 $4 and Q 5 100, total revenue is $4 3 100, or $400. the quantity sold How does total revenue change as one moves along the demand curve? The answer depends on the price elasticity of demand. If demand is inelastic, as in panel (a) of Figure 3, then an increase in the price causes an increase in total revenue. Here an increase in price from $4 to $5 causes the quantity demanded to fall from 100 to 90, so total revenue rises from $400 to $450. An increase in price raises P 3 Q because the fall in Q is proportionately smaller than the rise in P. In other words, the extra revenue from selling units at a higher price (represented by area A in the figure) more than offsets the decline in revenue from selling fewer units (represented by area B). We obtain the opposite result if demand is elastic: An increase in the price causes a decrease in total revenue. In panel (b) of Figure 3, for instance, when the price rises from $4 to $5, the quantity demanded falls from 100 to 70, so total rev- enue falls from $400 to $350. Because demand is elastic, the reduction in the quan- tity demanded is so great that it more than offsets the increase in the price. That is, an increase in price reduces P 3 Q because the fall in Q is proportionately greater than the rise in P. In this case, the extra revenue from selling units at a higher price (area A) is smaller than the decline in revenue from selling fewer units (area B). The examples in this figure illustrate some general rules: When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction: If the price increases, total revenue also increases. Price FIGURE 2 Total Revenue The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P 3 Q. Here, at a price of $4, the quantity demanded is 100 and $4 total revenue is $400. P 3 Q 5 $400 P (revenue) Demand 0 100 Quantity Q Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 96 PART II How MARkETs woRk FIGURE 3 The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. How Total Revenue Changes In this case, an increase in the price leads to a decrease in quantity demanded that When Price Changes is proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450. In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportion- ately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350. (a) The Case of Inelastic Demand (b) The Case of Elastic Demand 2.... the extra revenue from selling at a higher price... Price Price 2.... the extra revenue from 1. When the demand 1. When the demand selling at a higher price... curve is inelastic... curve is elastic... $5 $5 A A $4 $4 Demand B Demand B 0 90 100 Quantity 0 70 100 Quantity 3.... is greater than the lost revenue 3.... is less than the lost revenue from selling fewer units. from selling fewer units. When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directions: If the price increases, total revenue decreases. If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes. 5-1f Elasticity and Total Revenue along a Linear Demand Curve Let’s examine how elasticity varies along a linear demand curve, as shown in Figure 4. We know that a straight line has a constant slope. Slope is defined as “rise over run,” which here is the ratio of the change in price (“rise”) to the change in quantity (“run”). This particular demand curve’s slope is constant because each $1 increase in price causes the same 2-unit decrease in the quantity demanded. Even though the slope of a linear demand curve is constant, the elasticity is not. This is true because the slope is the ratio of changes in the two variables, whereas the elasticity is the ratio of percentage changes in the two variables. You can see this by looking at the table in Figure 4, which shows the demand schedule for the Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 97 Price FIGURE 4 Elasticity is $7 larger Elasticity along a Linear Demand Curve than 1. 6 The slope of a linear demand curve is constant, but its elasticity is not. The price elasticity of demand is calculated 5 using the demand schedule in the table and the midpoint Elasticity is 4 method. At points with a low price and high quantity, the smaller demand curve is inelastic. At points with a high price and than 1. 3 low quantity, the demand curve is elastic. 2 1 0 2 4 6 8 10 12 14 Quantity Percentage Percentage Total Revenue Change Change in Price Quantity (Price × Quantity) in Price Quantity Elasticity Description $7 0 $0 15 200 13.0 Elastic 6 2 12 18 67 3.7 Elastic 5 4 20 22 40 1.8 Elastic 4 6 24 29 29 1.0 Unit elastic 3 8 24 40 22 0.6 Inelastic 2 10 20 67 18 0.3 Inelastic 1 12 12 200 15 0.1 Inelastic 0 14 0 linear demand curve in the graph. The table uses the midpoint method to calcu- late the price elasticity of demand. The table illustrates the following: At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. The explanation for this fact comes from the arithmetic of percentage changes. When the price is low and consumers are buying a lot, a $1 price increase and 2-unit reduction in quantity demanded constitute a large percentage increase in the price and a small percentage decrease in quantity demanded, resulting in a small elasticity. When the price is high and consumers are not buying much, the same $1 price increase and 2-unit reduction in quantity demanded constitute a small percentage increase in the price and a large percentage decrease in quantity demanded, resulting in a large elasticity. The table also presents total revenue at each point on the demand curve. These numbers illustrate the relationship between total revenue and elasticity. When the price is $1, for instance, demand is inelastic and a price increase to $2 raises total revenue. When the price is $5, demand is elastic and a price increase to $6 reduces total revenue. Between $3 and $4, demand is exactly unit elastic and total revenue is the same at these two prices. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 98 PART II How MARkETs woRk The linear demand curve illustrates that the price elasticity of demand need not be the same at all points on a demand curve. A constant elasticity is possible, but it is not always the case. 5-1g Other Demand Elasticities In addition to the price elasticity of demand, economists use other elasticities to describe the behavior of buyers in a market. income elasticity The Income Elasticity of Demand The income elasticity of demand measures of demand how the quantity demanded changes as consumer income changes. It is calcu- a measure of how much lated as the percentage change in quantity demanded divided by the percentage the quantity demanded change in income. That is, of a good responds to a change in consumers’ percentage change in quantity demanded income, computed as income elasticity of demand 5 percentage change in income the percentage change in quantity demanded As we discussed in Chapter 4, most goods are normal goods: Higher income raises divided by the percentage the quantity demanded. Because quantity demanded and income move in the change in income same direction, normal goods have positive income elasticities. A few goods, such as bus rides, are inferior goods: Higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, inferior goods have negative income elasticities. Even among normal goods, income elasticities vary substantially in size. Necessities, such as food and clothing, tend to have small income elasticities because consumers choose to buy some of these goods even when their incomes are low. Luxuries, such as caviar and diamonds, tend to have large income elasticities because consumers feel that they can do without these goods altogether if their incomes are too low. cross-price elasticity The Cross-Price Elasticity of Demand The cross-price elasticity of demand mea- of demand sures how the quantity demanded of one good responds to a change in the price a measure of how much of another good. It is calculated as the percentage change in quantity demanded of the quantity demanded good 1 divided by the percentage change in the price of good 2. That is, of one good responds to a change in the price of percentage change in quantity demanded of good 1 another good, computed cross-price elasticity of demand 5 percentage change in the price of good 2 as the percentage change in quantity demanded of Whether the cross-price elasticity is a positive or negative number depends the first good divided by on whether the two goods are substitutes or complements. As we discussed in the percentage change in Chapter 4, substitutes are goods that are typically used in place of one another, price of the second good such as hamburgers and hot dogs. An increase in hot dog prices induces peo- ple to grill hamburgers instead. Because the price of hot dogs and the quantity of hamburgers demanded move in the same direction, the cross-price elasticity is positive. Conversely, complements are goods that are typically used together, such as computers and software. In this case, the cross-price elasticity is nega- tive, indicating that an increase in the price of computers reduces the quantity of software demanded. Define the price elasticity of demand. Explain the relationship between QuickQuiz total revenue and the price elasticity of demand. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 99 5-2 The Elasticity of Supply When we introduced supply in Chapter 4, we noted that producers of a good offer to sell more of it when the price of the good rises. To turn from qualitative to quantita- tive statements about quantity supplied, we once again use the concept of elasticity. 5-2a The Price Elasticity of Supply and Its Determinants The law of supply states that higher prices raise the quantity supplied. The price price elasticity of supply elasticity of supply measures how much the quantity supplied responds to a measure of how much changes in the price. Supply of a good is said to be elastic if the quantity supplied the quantity supplied responds substantially to changes in the price. Supply is said to be inelastic if the of a good responds to a quantity supplied responds only slightly to changes in the price. change in the price of The price elasticity of supply depends on the flexibility of sellers to change the that good, computed as amount of the good they produce. For example, beachfront land has an inelas- the percentage change in tic supply because it is almost impossible to produce more of it. Manufactured quantity supplied divided goods, such as books, cars, and televisions, have elastic supplies because firms by the percentage change that produce them can run their factories longer in response to a higher price. in price In most markets, a key determinant of the price elasticity of supply is the time period being considered. Supply is usually more elastic in the long run than in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good. Thus, in the short run, the quantity sup- plied is not very responsive to the price. Over longer periods of time, firms can build new factories or close old ones. In addition, new firms can enter a market, and old firms can exit. Thus, in the long run, the quantity supplied can respond substantially to price changes. 5-2b Computing the Price Elasticity of Supply Now that we have a general understanding about the price elasticity of supply, let’s be more precise. Economists compute the price elasticity of supply as the percentage change in the quantity supplied divided by the percentage change in the price. That is, percentage change in quantity supplied price elasticity of supply 5 percentage change in price For example, suppose that an increase in the price of milk from $2.85 to $3.15 a gal- lon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons per month. Using the midpoint method, we calculate the percentage change in price as percentage change in price 5 (3.15 2 2.85) / 3.00 3 100 5 10 percent Similarly, we calculate the percentage change in quantity supplied as: Percentage change in quantity supplied 5 (11,000 2 9,000) / 10,000 3 100 5 20 percent. In this case, the price elasticity of supply is 20 percent price elasticity of supply 5 52 10 percent In this example, the elasticity of 2 indicates that the quantity supplied changes proportionately twice as much as the price. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 100 PART II How MARkETs woRk 5-2c The Variety of Supply Curves Because the price elasticity of supply measures the responsiveness of quantity supplied to changes in price, it is reflected in the appearance of the supply curve. Figure 5 (on the facing page) shows five cases. In the extreme case of zero elasticity, as shown in panel (a), supply is perfectly inelastic and the supply curve is verti- cal. In this case, the quantity supplied is the same regardless of the price. As the elasticity rises, the supply curve gets flatter, which shows that the quantity sup- plied responds more to changes in the price. At the opposite extreme, shown in panel (e), supply is perfectly elastic. This occurs as the price elasticity of supply approaches infinity and the supply curve becomes horizontal, meaning that very small changes in the price lead to very large changes in the quantity supplied. In some markets, the elasticity of supply is not constant but varies over the sup- ply curve. Figure 6 (presented below) shows a typical case for an industry in which firms have factories with a limited capacity for production. For low levels of quantity supplied, the elasticity of supply is high, indicating that firms respond substantially to changes in the price. In this region, firms have capacity for production that is not be- ing used, such as plants and equipment that are idle for all or part of the day. Small increases in price make it profitable for firms to begin using this idle capacity. As the quantity supplied rises, firms begin to reach capacity. Once capacity is fully used, fur- ther increases in production require the construction of new plants. To induce firms to incur this extra expense, the price must rise substantially, so supply becomes less elastic. Figure 6 presents a numerical example of this phenomenon. When the price rises from $3 to $4 (a 29 percent increase, according to the midpoint method), the quantity supplied rises from 100 to 200 (a 67 percent increase). Because quan- tity supplied changes proportionately more than the price, the supply curve has an elasticity greater than 1. By contrast, when the price rises from $12 to $15 (a 22 percent increase), the quantity supplied rises from 500 to 525 (a 5 percent increase). In this case, quantity supplied moves proportionately less than the price, so the elasticity is less than 1. Define the price elasticity of supply. Explain why the price elasticity of QuickQuiz supply might be different in the long run than in the short run. FIGURE 6 Price $15 How the Price Elasticity of Supply Can Vary Elasticity is small Because firms often have a maximum capacity for (less than 1). production, the elasticity of supply may be very high 12 at low levels of quantity supplied and very low at high levels of quantity supplied. Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase Elasticity is large in quantity supplied (computed using the midpoint (greater than 1). method) is larger than the 29 percent increase in price, the supply curve is elastic in this range. By 4 contrast, when the price rises from $12 to $15, 3 the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range. 0 100 200 500 525 Quantity Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 101 The price elasticity of supply determines whether the supply curve is steep or flat. FIGURE 5 Note that all percentage changes are calculated using the midpoint method. The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 (b) Inelastic Supply: Elasticity Is Less Than 1 Price Price Supply Supply $5 $5 4 4 1. An 1. A 22% increase increase in price... in price... 0 100 Quantity 0 100 110 Quantity 2.... leaves the quantity supplied unchanged. 2.... leads to a 10% increase in quantity supplied. (c) Unit Elastic Supply: Elasticity Equals 1 Price Supply $5 4 1. A 22% increase in price... 0 100 125 Quantity 2.... leads to a 22% increase in quantity supplied. (d) Elastic Supply: Elasticity Is Greater Than 1 (e) Perfectly Elastic Supply: Elasticity Equals Infinity Price Price Supply 1. At any price above $4, quantity $5 supplied is infinite. 4 $4 Supply 1. A 22% 2. At exactly $4, increase producers will in price... supply any quantity. 0 100 200 Quantity 0 Quantity 3. At a price below $4, 2.... leads to a 67% increase in quantity supplied. quantity supplied is zero. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 102 PART II How MARkETs woRk 5-3 Three Applications of Supply, Demand, and Elasticity Can good news for farming be bad news for farmers? Why did OPEC, the in- ternational oil cartel, fail to keep the price of oil high? Does drug interdiction increase or decrease drug-related crime? At first, these questions might seem to have little in common. Yet all three questions are about markets, and all mar- kets are subject to the forces of supply and demand. Here we apply the versa- tile tools of supply, demand, and elasticity to answer these seemingly complex questions. 5-3a Can Good News for Farming Be Bad News for Farmers? Imagine you’re a Kansas wheat farmer. Because you earn all your income from selling wheat, you devote much effort to making your land as productive as pos- sible. You monitor weather and soil conditions, check your fields for pests and disease, and study the latest advances in farm technology. You know that the more wheat you grow, the more you will have to sell after the harvest, and the higher your income and standard of living will be. One day, Kansas State University announces a major discovery. Researchers in its agronomy department have devised a new hybrid of wheat that raises the amount farmers can produce from each acre of land by 20 percent. How should you react to this news? Does this discovery make you better off or worse off than you were before? Recall from Chapter 4 that we answer such questions in three steps. First, we examine whether the supply or demand curve shifts. Second, we consider the direction in which the curve shifts. Third, we use the supply-and-demand diagram to see how the market equilibrium changes. In this case, the discovery of the new hybrid affects the supply curve. Because the hybrid increases the amount of wheat that can be produced on each acre of land, farmers are now willing to supply more wheat at any given price. In other words, the supply curve shifts to the right. The demand curve remains the same because consumers’ desire to buy wheat products at any given price is not affected by the introduction of a new hybrid. Figure 7 shows an example of such a change. When the supply curve shifts from S 1 to S 2, the quantity of wheat sold increases from 100 to 110 and the price of wheat falls from $3 to $2. Does this discovery make farmers better off? As a first cut to answering this question, consider what happens to the total revenue received by farmers. Farmers’ total revenue is P 3 Q, the price of the wheat times the quantity sold. The discovery affects farmers in two conflicting ways. The hybrid allows farm- ers to produce more wheat (Q rises), but now each bushel of wheat sells for less (P falls). The price elasticity of demand determines whether total revenue rises or falls. In practice, the demand for basic foodstuffs such as wheat is usually inelastic because these items are relatively inexpensive and have few good substitutes. When the demand curve is inelastic, as it is in Figure 7, a decrease in price causes total revenue to fall. You can see this in the figure: The price of wheat falls sub- stantially, whereas the quantity of wheat sold rises only slightly. Total revenue falls from $300 to $220. Thus, the discovery of the new hybrid lowers the total revenue that farmers receive from the sale of their crops. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 103 Price of FIGURE 7 Wheat 1. When demand is inelastic, 2.... leads an increase in supply... An Increase in Supply in the Market for Wheat to a large fall S1 When an advance in farm technology increases the in price... S2 supply of wheat from S1 to S2, the price of wheat $3 falls. Because the demand for wheat is inelastic, the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price 2 from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 3 100) to $220 ($2 3 110). Demand 0 100 110 Quantity of Wheat 3.... and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. If farmers are made worse off by the discovery of this new hybrid, one might wonder why they adopt it. The answer goes to the heart of how competitive markets work. Because each farmer is only a small part of the market for wheat, she takes the price of wheat as given. For any given price of wheat, it is better to use the new hybrid to produce and sell more wheat. Yet when all farmers do this, the supply of wheat increases, the price falls, and farmers are worse off. This example may at first seem hypothetical, but it helps to explain a major change in the U.S. economy over the past century. Two hundred years ago, most Americans lived on farms. Knowledge about farm methods was sufficiently prim- itive that most Americans had to be farmers to produce enough food to feed the nation’s population. But over time, advances in farm technology increased the amount of food that each farmer could produce. This increase in food supply, together with the inelastic demand for food, caused farm revenues to fall, which in turn encouraged people to leave farming. A few numbers show the magnitude of this historic change. As recently as 1950, 10 million people worked on farms in the United States, representing 17 percent of the labor force. Today, fewer than 3 million people work on farms, or 2 percent of the labor force. This change coincided with tremendous advances in farm productivity: Despite the large drop in the number of farmers, U.S. farms now produce about five times as much output as they did in 1950. This analysis of the market for farm products also explains a seeming paradox of public policy: Certain farm programs try to help farmers by inducing them not to plant crops on all of their land. The purpose of these programs is to reduce the supply of farm products and thereby raise prices. With inelastic demand for their products, farmers as a group receive greater total revenue if they supply a smaller crop to the market. No single farmer would choose to leave her land fallow on her own because each takes the market price as given. But if all farmers do so together, they can all be better off. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 104 PART II How MARkETs woRk DOONESBURY © 1972 G. B. TRUDEAU. REPRINTED WITH PERMISSION OF UNIVERSAL PRESS SYNDICATE. ALL RIGHTS RESERVED. When analyzing the effects of farm technology or farm policy, it is important to keep in mind that what is good for farmers is not necessarily good for society as a whole. Improvement in farm technology can be bad for farmers because it makes farmers increasingly unnecessary, but it is surely good for consumers who pay less for food. Similarly, a policy aimed at reducing the supply of farm products may raise the incomes of farmers, but it does so at the expense of consumers. 5-3b Why Did OPEC Fail to Keep the Price of Oil High? Many of the most disruptive events for the world’s economies over the past sev- eral decades have originated in the world market for oil. In the 1970s, members of the Organization of the Petroleum Exporting Countries (OPEC) decided to raise the world price of oil to increase their incomes. These countries accomplished this goal by agreeing to jointly reduce the amount of oil they supplied. As a result, the price of oil (adjusted for overall inflation) rose more than 50 percent from 1973 to 1974. Then, a few years later, OPEC did the same thing again. From 1979 to 1981, the price of oil approximately doubled. Yet OPEC found it difficult to maintain such a high price. From 1982 to 1985, the price of oil steadily declined about 10 percent per year. Dissatisfaction and disarray soon prevailed among the OPEC countries. In 1986, cooperation among OPEC members completely broke down, and the price of oil plunged 45 percent. In 1990, the price of oil (adjusted for overall inflation) was back to where it be- gan in 1970, and it stayed at that low level throughout most of the 1990s. (In the first decade and a half of the 21st century, the price of oil fluctuated substantially once again, but the main driving force was not OPEC supply restrictions. Instead, booms and busts in economies around the world caused demand to fluctuate, while advances in fracking technology caused large increases in supply.) The OPEC episodes of the 1970s and 1980s show how supply and demand can behave differently in the short run and in the long run. In the short run, both the supply and demand for oil are relatively inelastic. Supply is inelastic because the quantity of known oil reserves and the capacity for oil extraction cannot be changed quickly. Demand is inelastic because buying habits do not respond im- mediately to changes in price. Thus, as panel (a) of Figure 8 shows, the short-run Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 105 When the supply of oil falls, the response depends on the time horizon. In the short run, FIGURE 8 supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. In the long run, however, supply and A Reduction in Supply in demand are relatively elastic, as in panel (b). In this case, the same size shift in the the World Market for Oil supply curve (S1 to S2) causes a smaller increase in the price. (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run Price of Oil Price of Oil 1. In the short run, when supply and 1. In the long run, when demand are inelastic, a shift in supply and demand are supply... elastic, a shift in S2 supply... S1 S2 S1 P2 2.... leads 2.... leads P2 to a small to a large increase P1 increase P1 in price. in price. Demand Demand 0 Quantity of Oil 0 Quantity of Oil supply and demand curves are steep. When the supply of oil shifts from S1 to S2, the price increase from P1 to P2 is large. The situation is very different in the long run. Over long periods of time, pro- ducers of oil outside OPEC respond to high prices by increasing oil exploration and by building new extraction capacity. Consumers respond with greater conser- vation, such as by replacing old inefficient cars with newer efficient ones. Thus, as panel (b) of Figure 8 shows, the long-run supply and demand curves are more elastic. In the long run, the shift in the supply curve from S1 to S2 causes a much smaller increase in the price. This analysis shows why OPEC succeeded in maintaining a high price of oil only in the short run. When OPEC countries agreed to reduce their production of oil, they shifted the supply curve to the left. Even though each OPEC member sold less oil, the price rose by so much in the short run that OPEC incomes rose. In the long run, however, supply and demand are more elastic. As a result, the same reduction in supply, measured by the horizontal shift in the supply curve, caused a smaller increase in the price. Thus, OPEC’s coordinated reduction in supply proved less profitable in the long run. The cartel learned that raising prices is eas- ier in the short run than in the long run. 5-3c Does Drug Interdiction Increase or Decrease Drug-Related Crime? A persistent problem facing our society is the use of illegal drugs, such as heroin, cocaine, ecstasy, and methamphetamine. Drug use has several adverse effects. One is that drug dependence can ruin the lives of drug users and their families. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 106 PART II How MARkETs woRk Another is that drug addicts often turn to robbery and other violent crimes to obtain the money needed to support their habit. To discourage the use of illegal drugs, the U.S. government devotes billions of dollars each year to reducing the flow of drugs into the country. Let’s use the tools of supply and demand to exam- ine this policy of drug interdiction. Suppose the government increases the number of federal agents devoted to the war on drugs. What happens in the market for illegal drugs? As usual, we answer this question in three steps. First, we consider whether the supply or demand curve shifts. Second, we consider the direction of the shift. Third, we see how the shift affects the equilibrium price and quantity. Although the purpose of drug interdiction is to reduce drug use, its direct impact is on the sellers of drugs rather than on the buyers. When the government stops some drugs from entering the country and arrests more smugglers, it raises the cost of selling drugs and, therefore, reduces the quantity of drugs supplied at any given price. The demand for drugs—the amount buyers want at any given price—remains the same. As panel (a) of Figure 9 shows, interdiction shifts the supply curve to the left from S1 to S2 without changing the demand curve. The equilibrium price of drugs rises from P1 to P2, and the equilibrium quantity falls from Q1 to Q2. The fall in the equilibrium quantity shows that drug interdiction does reduce drug use. But what about the amount of drug-related crime? To answer this question, consider the total amount that drug users pay for the drugs they buy. Because few FIGURE 9 Drug interdiction reduces the supply of drugs from S1 to S2, as in panel (a). If the demand for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of Policies to Reduce the drug use falls. By contrast, drug education reduces the demand for drugs from D1 to D2, as Use of Illegal Drugs in panel (b). Because both price and quantity fall, the amount paid by drug users falls. (a) Drug Interdiction (b) Drug Education Price of Price of Drugs Drugs 1. Drug education reduces 1. Drug interdiction reduces the supply of drugs... the demand for drugs... S2 Supply S1 P2 P1 P1 P2 2.... which 2.... which raises the reduces the price... price... D1 Demand D2 0 Q2 Q1 Quantity of Drugs 0 Q2 Q1 Quantity of Drugs 3.... and reduces 3.... and reduces the quantity sold. the quantity sold. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 107 drug addicts are likely to break their destructive habits in response to a higher price, it is likely that the demand for drugs is inelastic, as it is drawn in the figure. If demand is inelastic, then an increase in price raises total revenue in the drug market. That is, because drug interdiction raises the price of drugs proportion- ately more than it reduces drug use, it raises the total amount of money that drug users pay for drugs. Addicts who already had to steal to support their habits would have an even greater need for quick cash. Thus, drug interdiction could increase drug-related crime. Because of this adverse effect of drug interdiction, some analysts argue for alternative approaches to the drug problem. Rather than trying to reduce the sup- ply of drugs, policymakers might try to reduce the demand by pursuing a policy of drug education. Successful drug education has the effects shown in panel (b) of Figure 9. The demand curve shifts to the left from D1 to D2. As a result, the equilibrium quantity falls from Q1 to Q2, and the equilibrium price falls from P1 to P2. Total revenue, P 3 Q, also falls. Thus, in contrast to drug interdiction, drug education can reduce both drug use and drug-related crime. Advocates of drug interdiction might argue that the long-run effects of this pol- icy are different from the short-run effects because the elasticity of demand depends on the time horizon. The demand for drugs is probably inelastic over short periods because higher prices do not substantially affect drug use by estab- lished addicts. But demand may be more elastic over longer periods because higher prices would discourage experimentation with drugs among the young and, over time, lead to fewer drug addicts. In this case, drug interdiction would increase drug-related crime in the short run but decrease it in the long run. How might a drought that destroys half of all farm crops be good for farm- QuickQuiz ers? If such a drought is good for farmers, why don’t farmers destroy their own crops in the absence of a drought? 5-4 Conclusion According to an old quip, even a parrot can become an economist simply by learn- ing to say “supply and demand.” These last two chapters should have convinced you that there is much truth to this statement. The tools of supply and demand allow you to analyze many of the most important events and policies that shape the economy. You are now well on your way to becoming an economist (or at least a well-educated parrot). CHAPTER QuickQuiz 1. A life-saving medicine without any close substitutes 2. The price of a good rises from $8 to $12, and the will tend to have quantity demanded falls from 110 to 90 units. a. a small elasticity of demand. Calculated with the midpoint method, the price b. a large elasticity of demand. elasticity of demand is c. a small elasticity of supply. a. 1/5. d. a large elasticity of supply. b. 1/2. c. 2. d. 5. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 108 PART II How MARkETs woRk 3. A linear, downward-sloping demand curve is 5. An increase in the supply of a good will decrease the a. inelastic total revenue producers receive if b. unit elastic. a. the demand curve is inelastic. c. elastic. b. the demand curve is elastic. d. inelastic at some points, and elastic at others. c. the supply curve is inelastic. 4. The ability of firms to enter and exit a market over d. the supply curve is elastic. time means that, in the long run, 6. Over time, technological advance increases consumers’ a. the demand curve is more elastic. incomes and reduces the price of smartphones. Each b. the demand curve is less elastic. of these forces increases the amount consumers spend c. the supply curve is more elastic. on smartphones if the income elasticity of demand d. the supply curve is less elastic. is greater than ________ and if the price elasticity of demand is greater than ________. a. zero, zero b. zero, one c. one, zero d. one, one SUMMARY The price elasticity of demand measures how much the in consumers’ income. The cross-price elasticity of quantity demanded responds to changes in the price. demand measures how much the quantity demanded Demand tends to be more elastic if close substitutes are of one good responds to changes in the price of available, if the good is a luxury rather than a necessity, another good. if the market is narrowly defined, or if buyers have The price elasticity of supply measures how much the substantial time to react to a price change. quantity supplied responds to changes in the price. The price elasticity of demand is calculated as the This elasticity often depends on the time horizon percentage change in quantity demanded divided by under consideration. In most markets, supply is more the percentage change in price. If quantity demanded elastic in the long run than in the short run. moves proportionately less than the price, then the The price elasticity of supply is calculated as the per- elasticity is less than 1 and demand is said to be inelas- centage change in quantity supplied divided by the tic. If quantity demanded moves proportionately more percentage change in price. If quantity supplied moves than the price, then the elasticity is greater than 1 and proportionately less than the price, then the elasticity is demand is said to be elastic. less than 1 and supply is said to be inelastic. If quantity Total revenue, the total amount paid for a good, supplied moves proportionately more than the price, equals the price of the good times the quantity sold. then the elasticity is greater than 1 and supply is said For inelastic demand curves, total revenue moves in to be elastic. the same direction as the price. For elastic demand The tools of supply and demand can be applied in curves, total revenue moves in the opposite direction many different kinds of markets. This chapter uses as the price. them to analyze the market for wheat, the market for The income elasticity of demand measures how oil, and the market for illegal drugs. much the quantity demanded responds to changes KEY CONCEPTS elasticity, p. 90 total revenue, p. 95 cross-price elasticity of demand, p. 98 price elasticity of demand, p. 90 income elasticity of demand, p. 98 price elasticity of supply, p. 99 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 5 ElAsTiCiTy And iTs APPliCATion 109 QUESTIONS FOR REVIEW 1. Define the price elasticity of demand and the income 6. What do we call a good with an income elasticity less elasticity of demand. than zero? 2. List and explain the four determinants of the price 7. How is the price elasticity of supply calculated? elasticity of demand discussed in the chapter. Explain what it measures. 3. If the elasticity is greater than 1, is demand elastic 8. If a fixed quantity of a good is available, and no more or inelastic? If the elasticity equals zero, is demand can be made, what is the price elasticity of supply? perfectly elastic or perfectly inelastic? 9. A storm destroys half the fava bean crop. Is this event 4. On a supply-and-demand diagram, show equilibrium more likely to hurt fava bean farmers if the demand price, equilibrium quantity, and the total revenue for fava beans is very elastic or very inelastic? Explain. received by producers. 5. If demand is elastic, how will an increase in price change total revenue? Explain. PROBLEMS AND APPLICATIONS 1. For each of the following pairs of goods, which b. Why might this elasticity depend on the time good would you expect to have more elastic horizon? demand and why? 4. A price change causes the quantity demanded of a a. required textbooks or mystery novels good to decrease by 30 percent, while the total revenue b. Beethoven recordings or classical music of that good increases by 15 percent. Is the demand recordings in general curve elastic or inelastic? Explain. c. subway rides during the next 6 months or subway rides during the next 5 years 5. Cups of coffee and donuts are complements. Both d. root beer or water have inelastic demand. A hurricane destroys half the coffee bean crop. Use appropriately labeled diagrams 2. Suppose that business travelers and vacationers have to answer the following questions. the following demand for airline tickets from New a. What happens to the price of coffee beans? York to Boston: b. What happens to the price of a cup of coffee? What Quantity Demanded Quantity Demanded happens to total expenditure on cups of coffee? Price (business travelers) (vacationers) c. What happens to the price of donuts? What happens to total expenditure on donuts? $150 2,100 tickets 1,000 tickets 6. The price of coffee rose sharply last month, while the 200 2,000 800 quantity sold remained the same. Five people suggest 250 1,900 600 various explanations: 300 1,800 400 Leonard: Demand increased, but supply was per- a. As the price of tickets rises from $200 to $250, what fectly inelastic. is the price elasticity of demand for (i) business Sheldon: Demand increased, but it was perfectly travelers and (ii) vacationers? (Use the midpoint inelastic. method in your calculations.) Penny: Demand increased, but supply b. Why might vacationers have a different elasticity decreased at the same time. from business travelers? Howard: Supply decreased, but demand was unit 3. Suppose the price elasticity of demand for heating oil elastic. is 0.2 in the short run and 0.7 in the long run. Raj: Supply decreased, but demand was per- a. If the price of heating oil rises from $1.80 to $2.20 fectly inelastic. per gallon, what happens to the quantity of heating Who could possibly be right? Use graphs to explain oil demanded in the short run? In the long run? your answer. (Use the midpoint method in your calculations.) Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 110 PART II How MARkETs woRk 7. Suppose that your demand schedule for pizza is as 9. Two drivers, Walt and Jessie, each drive up to a gas follows: station. Before looking at the price, each places