Chapter 4 Elasticity

Answers to review questions

1 Price changes affect quantity demanded for two reasons: they alter the attractiveness of substitute goods and they alter the real value of consumers income, or their purchasing power. These are called the substitution and the income effects of a price change. The second effect grows larger as the share of consumers budgets spent on the good increases. For example, a 10 per cent change in the price of salt, a good on which most consumers spend very little, will have a small effect on the purchasing power of a consumers income. At the other extreme, a similar change in price for a good such as housing, which comprises a large part of most peoples income, will have a large effect on the purchasing power of a consumers income. A consumer will find it worthwhile seeking ways of mitigating the effect of the increase in the price of housing, but not salt. Elasticity of demand at any point on the demand curve is the pricequantity ratio at that point (P/Q) times the reciprocal of the slope of the demand curve (1/slope). The slope, and hence its reciprocal, is constant along a straight-line demand curve, but the price quantity ratio and hence price elasticity of demand declines as we move down the curve. If the demand for a good is inelastic with respect to its price, an increase in price will lead to an increase in total expenditure. This is because a percentage change in price of given magnitude results in a smaller percentage change in quantity. Consequently the product of price and quantity that is, total expenditure increases. Given the universality of the law of demand, the algebraic sign of the elasticity of demand for a good with respect to its own price is always negative. In this case, knowing that the sign is negative conveys no useful information. In contrast, the elasticity of demand for a good with respect to the price of another good can be either positive or negative, so it is important to keep track of the sign. A positive sign tells us that the two goods are substitutes; a negative sign that they are complements. Likewise, the sign of the income elasticity of demand tells us whether a good is normal (positive value) or inferior (negative value). To increase the quantity of output supplied when price rises, firms need to increase the amount of inputs they buy a time-consuming process for certain kinds of inputs. The process can be speeded up, but only if the firm is willing to incur additional costs. A price elasticity of demand of 0.5 means that a 1 per cent increase in the price of butter will lead to a 0.5 per cent fall in consumption. A 10 per cent reduction in butter consumption would, therefore, require a 20 per cent increase in price. If, however, the elasticity of demand for butter were higher (for example, 2), butter consumption would fall by 10 per cent in response to a smaller 10 per cent increase in the price of butter.

Answers to problems
1 For the demand curve shown, the slope is 1; therefore (1/slope) is also 1. The absolute value of the price elasticity of demand at any point on this demand curve is thus the ratio (P/Q) at that point.

Point A B C D E

Elasticity Infinity 3 1 1/3 0

b c d

Price elasticity of demand is calculated as (P/Q) (1/slope). When P = 3, Q = 9 and (1/slope) is 3. So elasticity = (3/9)3 = 1. If the price increases from $3.00 to $4.00, revenue will fall from $27 000 to $24 000. Using the same formula as in part b, elasticity = (2/12)3 = 0.5.

If the price increases from $2.00 to $3.00, revenue will rise from $24 000 to $27 000.

To maximise revenue from the sale of tickets, price should be set at the midpoint of the demand curve, P = $6/visit. As shown in the graph below, demand is elastic above the midpoint of the demand curve and is inelastic below the midpoint of the demand curve.

The price elasticity of a good generally increases with the number of substitutes it has. It is easier to substitute a Ford or Toyota for a Subaru than it is to substitute a bus ride, motorcycle or a skateboard for a car. Thus the market demand curve for cars is likely to be less elastic with respect to price than the market demand curve for Subarus. The more income a person has, the smaller a given expenditure will be as a proportion of her overall budget, and hence the less likely she will be to respond dramatically to a price change. Thus senior executives, the most highly paid of the three groups, should have the least price-elastic demand curves for a professional membership. Students, the least well paid, should have the most price-elastic demand curves. The cross-price elasticity is calculated as the (percentage change in Qsalsa/percentage change in Pcorn chips) = 4/2 = 2. Since this cross elasticity is negative, the two goods are complements.

The expression for supply elasticity is (P/Q)(1/slope). Since the slope of this supply curve over the price range $4 to $6 is P/Q = 2/3, the elasticity of supply at A is (4/9)(3/2)=2/3. Using the same formula, the elasticity at B is (6/12)(3/2)=3/4.

The inputs required to produce each sushi roll cost a total of $1.20, and this marginal cost is constant. The supply curve of sushi rolls is thus a horizontal line at P = $1.20. The price elasticity of a horizontal supply curve is infinity.

The absolute value of the slope of this demand curve is 1/3, so plugging in the P and Q values at point A into the elasticity formula, (P/Q)(1/slope), we have elasticity at A = (4/6)3 = 2. A 1 per cent price increase will thus translate into a 2 per cent decrease in the quantity demanded. Total expenditure, which is (PQ), will thus now be (1.01P)(.98Q), which is approximately equal to .99Q. Therefore total expenditure will decline by about 1 per cent. What government officials failed to take into account was that people dont demand electricity for its own sake, but rather as a means to accomplish other ends, such as producing cooler air for their homes. By requiring people to buy air conditioners that were more efficient, the government effectively reduced the price of buying cooler air. If the demand for cool air is sufficiently elastic with respect to its price, people may buy so much more cool air that they end up using more electricity. This example highlights the fact that government policies may have unintended consequences and that economists must be skilled in recognising the way in which a knowledge of elasticity can be used to predict the magnitude of the effect of changes in market conditions on market outcomes.

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